Your Money Milestones

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 Your Money Milestones
A Guide to Making the 9 Most Important
Financial Decisions of Your Life

Moshe A. Milevsky, Ph.D.

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Library of Congress Cataloging-in-Publication Data
Milevsky, Moshe Arye, 1967-
Your money milestones : a guide to making the 9 most important financial decisions in your
life / Moshe A. Milevsky.
p. cm.
ISBN-13: 978-0-13-702910-5 (hardback : alk. paper)
ISBN-10: 0-13-702910-1
1. Finance, Personal. 2. Finance, Personal—Decision making. 3. Investments. I. Title.
HG179.M4592 2010
332.024—dc22
2009034907
 “...A broader view of wealth may indeed be taken for
some purposes... and perhaps it may be convenient to
have a term which will include it as part of personal
wealth in a broader use. Pursuing the lines indicated
by Adam Smith (1784) in The Wealth of Nations, we
may define personal wealth so as to include all those
energies, faculties, and habits which directly con-
tribute to making people industrially efficient....”
—Alfred Marshall (1890) Principles of Economics, Chapter II.
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Dedicated to my genuine pensions,
Dahlia, Natalie, Maya, and Zoe.
This page intentionally left blank
 Contents

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xv

About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xvii

Prologue: Financial Deicide . . . . . . . . . . . . . . . . . . . . . .xix

Introduction: Human Capital: Your Greatest Asset . . . . .1

Is That Glass Half-Empty or Half-Full? Valuing
Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Mark Yourself to Market . . . . . . . . . . . . . . . . . . . . . 6
Is This a Cynic’s Value or True Worth? . . . . . . . . . 7
An Appreciation That Grows with Age . . . . . . . . . 8
The Nine Milestones. . . . . . . . . . . . . . . . . . . . . . . . 9
Money Milestones over Your Lifetime. . . . . . . . . 10
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Chapter 1: Is the Long-Term Value of an Education

Worth the Short-Term Cost? . . . . . . . . . . .13
Investing in a Gold Mine...Called Anastasia . . . . 14
Should We Allow Human Capital
Derivatives? . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
Securitizing Human Capital . . . . . . . . . . . . . . . . . 16
Are College Graduates Truly Wealthier? . . . . . . . 18
The Best-Paying Careers?. . . . . . . . . . . . . . . . . . . 19
Minor Initial Differences Magnify over Time . . . 20
How Investing in Human Capital Pays . . . . . . . . 21
Human Capital Investments over Time . . . . . . .23
College Grads Learn to Buy Different Assets . . . 25
Could the Fortunes of College
Graduates Wane? . . . . . . . . . . . . . . . . . . . . . . . . . 27
Does the Ivy League Pay Greater Dividends?. . . 28
Distinct Groups of Students—And
“Fun Capital”. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
x YOUR MONEY MILESTONES

Did Anastasia Accept the Offer? . . . . . . . . . . . . . 32

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Chapter 2: What Is the Point of Saving

Money Forever? . . . . . . . . . . . . . . . . . . . . .35
The 25-to-25 Jackpot: What Would You Do?. . . . 36
Guiding Principle: Smoothing Consumption. . . . 38
How Does Income Smoothing (Long Division)
Work in Practice? . . . . . . . . . . . . . . . . . . . . . . . . . 40
Advice That Goes Against the Grain—but
Smoothes? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41
We Are Not Mr. Spock in Star Trek . . . . . . . . . .43
Do People Who Win the Lottery
Behave Rationally? . . . . . . . . . . . . . . . . . . . . . . . . 44
The Perils of Not Smoothing . . . . . . . . . . . . . . . . 47
The Smoothest Population of All . . . . . . . . . . . . . 49
Where Does All of This Leave Us? . . . . . . . . . . . 50
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Chapter 3: How Much Debt Is Too Much and

How Much Is Too Little? . . . . . . . . . . . . . .53
Americans Have Diverse Debts . . . . . . . . . . . . . . 54
These Eggs Belong in One Basket . . . . . . . . . . . . 55
Optimal Debt Management Strategies
Across Space and Time . . . . . . . . . . . . . . . . . . . . . 56
Liability Silos Compared . . . . . . . . . . . . . . . . . . .57
Bottom Line: Debt Diversification
Destroys Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Should You Borrow from Yourself? . . . . . . . . . . .61
The Borrowing Sweet Spot: Age 53 . . . . . . . . . .63
Oh, and Being Slim Can Help as Well . . . . . . . .65
Debt Literacy as Distinct from General
Financial Literacy . . . . . . . . . . . . . . . . . . . . . . . . . 66
Concluding Thoughts: Is Debt Soothing
or Smoothing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
CONTENTS xi

Chapter 4: Are Kids Investments and Can

Marriages Diversify? . . . . . . . . . . . . . . . . . .69
Children: Explicit Liabilities, Hidden Assets. . . . 70
Inducing More Children. . . . . . . . . . . . . . . . . . . . 71
Children as Pensions—And a General’s
Revenge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Thwarted by Good Intentions. . . . . . . . . . . . . . . . 75
Is Marriage a Safe Investment on the
Balance Sheet? . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Two Plus Two Equals a Very Safe Four . . . . . . . .80
Fiscally Fatal Attractions . . . . . . . . . . . . . . . . . . .81
Birds of a Feather May Not Flock Together . . . .83
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Chapter 5: Government Tax Authorities: Partners,

Adversaries, or Bazaar Merchants? . . . . . .85
How Do Taxpayers Behave if “Big
Brother” Is Watching?. . . . . . . . . . . . . . . . . . . . . . 87
Treat Your Tax Filing Like a Trip to
the Bazaar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Tax Authorities as Lifetime Partners in
Your Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Tax Lessons from Uruguay (a Beautiful
Little Country in South America) . . . . . . . . . . . .90
Another Puzzle: People Prefer Big
Tax Refunds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
The After-Tax Return Matters . . . . . . . . . . . . . . . 94
Reversals of Fortune . . . . . . . . . . . . . . . . . . . . . . . 96
Bottom Line: Get Tax Savvy . . . . . . . . . . . . . . . . . 98
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Chapter 6: Can You Eat Your House or Will It

Ever Pay Dividends? . . . . . . . . . . . . . . . . .101
Floating Debt Obligations and
Sinking Values . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Back to the Holistic Balance Sheet . . . . . . . . . . 103
xii YOUR MONEY MILESTONES

My Strong Bias: Many Homeowners

Should Have Rented . . . . . . . . . . . . . . . . . . . . . . 105
Housing over Time: A Human
Capital Approach . . . . . . . . . . . . . . . . . . . . . . . .107
The Missing Factor: Housing and
Social Capital . . . . . . . . . . . . . . . . . . . . . . . . . . .108
Investing in Social Capital. . . . . . . . . . . . . . . . . . 110
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

Chapter 7: Insurance Salesmen and Warranty

Peddlers: Are They Smooth Enough? . . . .113
Insurance from Babylonia to Today . . . . . . . . . . 115
Insurance Purchases: Another Form of
Smoothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
Life Insurance as a Hedge for Your Human
Capital: When Young . . . . . . . . . . . . . . . . . . . . . 118
Life Annuities as a Hedge for Your Financial
Capital: When Old. . . . . . . . . . . . . . . . . . . . . . . . 120
What and When Do People Actually Insure? . . . 122
Create Your Own Insurance Company:
The “Small Risk Fund” . . . . . . . . . . . . . . . . . . . . 125
Behavioral Economics in Practice . . . . . . . . . . . 126
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Chapter 8: Portfolio Construction: What Asset

Class Do You Belong To? . . . . . . . . . . . . .129
What Went Wrong?. . . . . . . . . . . . . . . . . . . . . . . 131
Are You a Stock or a Bond or Something
in Between? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
How Does Your Allocation Measure Up? . . . . . 136
Avoiding Robert’s Outcome . . . . . . . . . . . . . . . . 139
Human Capital Impacts Financial Capital
Well Before Your First Job . . . . . . . . . . . . . . . . . 140
Can You Take Diversification Smoothing
Too Far?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
History of Ideas: Credit, Where It’s Due . . . . .144
What About the Rest of Us? Back to
Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . .144
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
CONTENTS xiii

Chapter 9: Retirement: When Is It Time to

Shutter the Well and Close the Mine? . . . .147
Why Are Pensions So Important?. . . . . . . . . . . . 149
Pensions Are a Dying Breed . . . . . . . . . . . . . . . . 150
Retirees with Pension Annuity Income
Are Happier. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Florida’s Elderly, Pension Choices, and
My Brush with Bush . . . . . . . . . . . . . . . . . . . . . . 155
Investment Plans Versus Pension Plans—What
Would You Choose? . . . . . . . . . . . . . . . . . . . . . . 156
Do Retirees Smoothly Transition into
Retirement?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Don’t Count on Pennies from Heaven to
Smooth Your Retirement Ride . . . . . . . . . . . . . . 160
Is It Better to Get a Lump Sum?
The Military View . . . . . . . . . . . . . . . . . . . . . . . . 161
Taking Their Lumps . . . . . . . . . . . . . . . . . . . . . .163
Women and Annuities . . . . . . . . . . . . . . . . . . . .165
Final Recommendations: Get a Pension,
from Somewhere . . . . . . . . . . . . . . . . . . . . . . . . . 166
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

Conclusion: Four Principles to Guide All Financial

Decisions and Money Milestones . . . . . . .169
Create a Decision-Making Process for
All Money Milestones . . . . . . . . . . . . . . . . . . . . .171
The Perfect Job for Me! . . . . . . . . . . . . . . . . . . .176

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
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 Acknowledgments

I would like to start by thanking the various people who claim to

have read my previous book: Are You a Stock or a Bond? Create Your
Own Pension Plan for a Secure Financial Future (FT Press 2008) and
then proceeded to complain that although they liked the general idea,
I should have used the opportunity to discuss the many other finan-
cial issues people face over their life cycle, not just pensions and
retirement income planning.
I directly blame them for having to break my promise to my
family—sworn during the frigid Canadian winter of 2008—that I
would hold off writing yet another book for at least a few years.
This book was researched and written during the 2008/2009 aca-
demic year, while I was on sabbatical from York University (in
Toronto) and spent time as a Visiting Fellow at the University of
Technology, Sydney, Australia, and a Visiting Scholar at the Insurance
and Risk Management Department at the Wharton School, Univer-
sity of Pennsylvania, Philadelphia. I am grateful to both of these insti-
tutions for their hospitality and the faculty for insights and fruitful
conversations.
Likewise, I would like to thank Jim Boyd, Julie Anderson, and
everyone at FT Press who helped convert a rough manuscript into a
finished book. I would also like to express my gratitude to Anna
Abaimova, Faisal Habib, Huaxiong Huang, Kevin Lin, Alexandra
Macqueen, and Tom Salisbury, all affiliated with The QWeMA Group
in Toronto for taking time from their regular obligations to help
answer questions, collect information, and design calculators for our
Dynamic Life Cycle project. In particular I would like to recognize
Alexandra Macqueen who helped with actual research and editing of
this manuscript. Along the same lines, I am indebted to my life part-
ner and wife Edna, who offered critical comments on every aspect of
the manuscript (and almost everything else I do).
Finally, I would like to take this opportunity to apologize to my
four daughters who continue to put up with a father who is obviously
not quite normally distributed. I promise this book is it for a while....
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 About the Author

Moshe A. Milevsky, Ph.D. is a tenured finance professor at the

Schulich School of Business at York University (www.yorku.ca) in
Toronto, Canada, and the executive director of the nonprofit IFID
Centre (www.ifid.ca). He is also the president and CEO of The
QWeMA Group (www.qwema.ca), a software company that develops
intellectual property and numerical algorithms for the financial serv-
ices industry. He also writes a monthly column for Research Maga-
zine that is read by financial advisors and planners in North America.
Moshe is a well-known public speaker and has delivered keynote
lectures and seminars in Europe, South America, the Far East, and
the UK. In June 2009, he was a main platform speaker for MDRT’s
annual meeting. He has consulted for global insurance companies
and pension funds including the Florida State Board of Administra-
tion’s (FSBA) retirement plan. He is currently a member of a variety
of corporate advisory councils. To date he has published seven books,
more than 50 peer-reviewed research papers, and more than 100 per-
sonal finance articles on the topic of insurance, investments, pen-
sions, retirement, and annuities.
Moshe received two National Magazine (Canada) awards in 2003
for his popular-press writing and received a Graham and Dodd scroll
award from the CFA Institute for a 2006 research article in the
Financial Analysts Journal. In the summer of 2002, he was elected a
Fellow of the Fields Institute for Research in Mathematical Sciences,
and in September 2008, he was given a lifetime achievement award
from the Retirement Income Industry Association (RIIA). In May
2009, he was named to Investment Advisor magazine’s IA25 list of
most influential people in the financial advisory business.
Moshe’s previous book Are You a Stock or a Bond? Create Your
Own Pension Plan for a Secure Financial Future was published by FT
Press in September 2008 and is available in fine bookstores every-
where.
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 Prologue: Financial Deicide

From early November 2007 to mid-March 2009, I watched in

horror as about half of my family’s financial net worth, made up
mostly of common stocks and mutual funds in our retirement invest-
ment accounts, disappeared into thin air. This wasn’t a trivial sum of
money: It was in the high six digits. It is far more than my wife or I
can possibly earn in any given year. Like many other investors around
the world who experienced similar losses, I managed to achieve this
stunning feat by complying with every known morsel of established
financial planning wisdom. I lost hundreds of thousands of dollars by
doing everything exactly right.
I didn’t own much in the way of speculative penny stocks, nor did
I take a flyer on some exotic junk bond funds, commodity derivatives,
or collateralized debt obligations. Instead, I built an ultra-low-cost,
globally-diversified portfolio that included what were (at the time)
some of the most solid, well-respected, and best-known companies—
like American International Group (aka AIG), Lehman Brothers,
General Motors, Nortel, and so on. I bought and I held.
This, of course, is exactly what the mainstream financial planning
and investment industry had been preaching for years. I know this
because I have taught it to my undergraduate business students for
almost 20 years.
The spectacular destruction of value that I and many others expe-
rienced has caused many investors to question the underlying prem-
ises of almost everything they’ve been taught about investment risk,
asset allocation, wealth management, and financial planning. And,
although markets have recovered since the March 2009 lows, the
financial situation is still precarious. Indeed, the mainstream financial
news media—including the venerable The Wall Street Journal and
the Economist magazine—have joined the backlash against modern
portfolio theory and the perceived wisdom of decades. Numerous
financial commentators are questioning the views that financial mar-
kets are efficient, or that stocks outperform bonds in the long run, or
that asset allocation and portfolio diversification are appropriate
xx YOUR MONEY MILESTONES

strategies for individual investors. Indeed, entire books have recently

been published with the sole purpose of arguing that we’ve all been
wrong for the last quarter century. Financial heroes and their money
gurus are being slaughtered.
Spectators to this “financial deicide” are thus left to wonder:
“Okay. So, what am I supposed to do with my money? If all the
received wisdom is out the window then how do I make financial
decisions?”

Two Opposing Views of the Future

Let’s step back for a minute to get a wider view. Today, there are
two prevailing and very opposing philosophies for thinking about how
to navigate the world of stock prices and interest rates. You can think
of them as the roulette approach on one side, versus the nuclear
approach on the other.
According to the roulette view, estimating your portfolio’s and
investment’s future value is akin to predicting the odds of getting red
versus black, or odd versus even, on the roulette wheel at the casino.
That is, given sufficient data about the previous behavior and possible
outcomes of the market (or the wheel), you can predict the odds of
success or failure—and make money—with reasonable confidence.
In fact, casino managers at Las Vegas and Atlantic City have a long list
of mathematicians and statisticians who are supposed to be bounced
from the tables, on sight. Apparently they are just too good to be
allowed to play.
In contrast, the nuclear approach asks us to consider the odds of
a nuclear accident—similar to Three Mile Island or Chernobyl—
occurring in a given time period. But this problem is quite different
from calculating the odds of red versus black. You could claim that
over the 60 years since the advent of nuclear energy—which is 21,900
days—we’ve had accidents on two of those days; ergo, the odds of dis-
aster must be 2 in 21,900. However, this argument is ridiculous. It is
impossible to predict a nuclear accident using any statistical or histor-
ical model, and no one seriously tries. Instead, unpredictability is a
given in the nuclear environment, and risk is managed in various
ways.
PROLOGUE xxi

Now, back to stock markets: For many years, financial

researchers—myself included—firmly believed that markets were
like roulette wheels (if you’ll forgive the analogy), in which future
odds and probabilities can be derived and stated with confidence.
Now, though, many are starting to wonder if stock markets are
better described like nuclear events (if you’ll forgive that analogy).
Accidents and meltdowns can occur at any time and without much
warning. But if markets are more like nuclear events than roulette
wheels, then historical relationships might not be very relevant for
interpreting and predicting the future at all, and finding a way to nav-
igate this reframed future requires new approaches.
In light of this dilemma, this book is an attempt to go back to
arithmetic basics to provide some guidance on how to make financial
decisions. Moreover, this advice doesn’t require you to assume very
much statistically about the world around us, other than that the
future is unpredictable. Working from the nuclear metaphor of
uncertainty (versus risk), this book offers a guide—based on arith-
metic operations that are no more complicated than addition, sub-
traction, multiplication, and (most important) division—to help you
properly and confidently manage the nine most important financial
decisions you will make in life.

Aiming for the Best Outcome

The tools I give you for making financial decisions are, as I’ve
said, extremely basic. But the approach I suggest is not simply “use
arithmetic to solve personal financial problems.” Instead, in thinking
about ways to move forward, I was inspired by another group of sci-
entists working—and succeeding—in an environment of uncertainty.
And so, there’s one more idea I want to introduce now, as it will shape
discussions in the rest of the book.
As I complete this manuscript in July 2009, we are closing in on
the 40th anniversary of the U.S. astronauts’ first walk on the moon. In
the late 1950s, when the U.S. space industry was racing the Soviets to
dominate the “final frontier,” a group of research engineers devel-
oped and ultimately refined a new branch of science now known as
Dynamic Control Theory (DCT). This theory was created in response
xxii YOUR MONEY MILESTONES

to the formidable challenge facing the engineers, who had to launch a

rocket far into space without managing or even knowing many of the
conditions in the atmosphere and beyond. Boiled down to its intuitive
essence, DCT—which is now taught in engineering and mathematics
departments all over the world—is a framework that helps decision
makers carefully utilize the levers and knobs that are available for
adjustment, while openly recognizing the multiple variables over
which they have no influence (and hence for which no levers or knobs
are available).
In applying DCT, one of the key steps is scoping out all the fac-
tors that can be quantified for a given decision, and then selecting an
objective function that weighs the relative importance of each, to
evaluate how good a proposed solution is. When this broad frame-
work has been established, the engineering team can work from con-
trollable variables and quantified factors to make the best possible
decisions in the face of unknown factors and uncontrollable variables.
DCT is both powerful and useful because it acknowledges the sub-
stantial randomness that you face over long periods of time and pro-
vides a decision-making mechanism that ultimately tries to maximize
the odds of a regretless outcome.
I think the DCT metaphor is apt for personal finance because
one of my core beliefs is that a large part of our financial future is
uncontrollable. Great wealth, good fortune, and economic success
can be influenced by random luck, uncanny timing, and other factors
outside our immediate authority. In fact, you can argue that even for
the brightest and hardest working among us, the bulk of our financial
successes and economic failures is unpredictable. If this is true, when
making financial decisions, all there is to do is aim for the best out-
come across the remaining minority of possible scenarios you can
foresee and control.
Accordingly, the mission of this book (so to speak) is to provide
you with a useful guide to making milestone financial decisions
through your entire life cycle. Where applicable, I include links to
online calculators so that you can work through and quantify issues
for your own life. (All the calculators can be found at www.quema.ca.)
Each chapter in this book builds toward a comprehensive foundation.
Nevertheless, each chapter, which explores a different financial
milestone, can be read and understood independently. Taken as a
PROLOGUE xxiii

whole, this book is designed to explain how to take the lessons of

DCT and insights from human capital thinking and apply them to the
most important financial milestones in our lives—leaving you with
fresh context for understanding and successfully navigating your own
personal financial journey.
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 Introduction:
Human Capital: Your Greatest Asset

Before you go any farther, I’d like to challenge you to complete a

simple exercise. Ready?
Take out a blank sheet of paper, and draw a straight line right
down the center, splitting the sheet into two equal parts. Now write
“My Assets” on the top-left side of the paper and at the top right, “My
Liabilities.” In the language of financial accounting, I am asking you
to create a personal balance sheet that lists the value of everything
you own and everything you owe.
On the right side of your personal balance sheet—which lists all
your debts and liabilities—you should include the amount you owe
on credit cards, consumer loans, mortgages, and anything else you
relate to as a financial obligation. On the left side you should list the
value of all your assets, including money in bank accounts, traded
stocks, savings bonds, pension accounts, equity in a small business,
the value of a car, and any other items of value you own.
Now, after you list all your assets and liabilities, add them up to
get summary numbers. What is the value of everything you own, and
what is the total value of what you owe?
Finally, subtract what you owe from what you own. The resulting
number—whether positive or negative—is your net worth. Getting
you to think about and then calculate this important number is the
starting point for everything that follows in this book. Through this
exercise, I want you to consider what you are truly worth in stark eco-
nomic terms.
Now, you may have already done an exercise like this in the past.
Perhaps you’ve created a personal or household net worth statement,
and at this point, you’re thinking that you aren’t going to learn any-
thing from this chapter (and maybe even the entire book) that you
don’t already know. Except hang on, because I’m about to tell you
that you probably did the exercise incorrectly and omitted the most
important item and the most valuable asset you own.
1
2 YOUR MONEY MILESTONES

How so? Well, let’s take a look at what happens when I ask my
undergraduate business students to undertake exactly the same
exercise.
As you’ve probably figured out by now, my day job involves
teaching undergraduate and graduate business courses at York Uni-
versity in Toronto. My favorite subject to teach is a 12-week under-
graduate course on the topic of wealth management. When I start
this course anew each semester, on the first day of class, before I dis-
cuss the syllabus, the course textbook, or the final exam schedule, I
ask each student to prepare their own personal balance sheet.
Now, their situations are probably different from yours. To start,
they’re typically only about 20 years old. But already, a large portion
of them have substantial debt obligations: Many of them have taken
out student loans in the range of $10,000 to $40,000. In this way, my
students are like college grads in the United States, in which the aver-
age student loan balance was $20,100 in 2007.1 To be sure, these stu-
dents might not need to pay back their loans for many years, and the
loans might not be accruing any interest while they are in school, but
all of them recognize their loans as liabilities with a current value.2 My
students also report having a substantial amount of credit card debt.
On average, they report slightly more than $3,100 as a revolving bal-
ance on their personal balance sheet. These numbers are broadly reflec-
tive of credit card indebtedness for that age category, according to
Sallie Mae, a U.S. student loan company.3 However, unlike their stu-
dent loans, on these liabilities the interest clock is ticking daily—and
rates can approach 20 percent, and even 30 percent, for some bank
and department store cards.
My students also often include consumer loans on their balance
sheets because many of them owe money on cars they have financed or
funds borrowed from roommates, parents, cousins, and the occasional
loan shark. In sum: Most of them have plenty of debts and liabilities.

1. Reed, Student Debt and the Class of 2007.

2. In Canada, average student loan debt for a graduate with a bachelor’s degree is
$22,800 (2007 Canadian dollars). Bayard and Greenlee, “Graduating in Canada.”
3. From How undergraduate students use credit cards: Sallie Mae’s national study
of usage rates and trends 2009.
INTRODUCTION 3

When they get to the left side of their personal balance sheets,
they often admit to having difficulties finding any values to include.
As you might suspect, at the age of 20 many of them don’t have much
in the way of traditional financial assets. They don’t own houses. They
don’t have any stocks or bonds. They don’t own any mutual funds,
Treasury bills, or savings bonds, and they certainly don’t have any
pension accounts. Remember, some of these kids aren’t yet of legal
drinking age!
Some of my students include the little bit of money they have in a
savings account at the local bank or perhaps the value of the bicycle
they use to ride to class. In fact, sometimes a hand will go up, and a
student will ask me if he should include the newly-increased credit
limit on his MasterCard or Visa on the left side as a financial asset.
(Note: The answer is no.)
Now, you can view this exercise—either the one I posed to you at the
start of this chapter, or the one I give my new students each semester—
as a rather private, possibly intrusive, and perhaps even depressing
assignment. But as I am working through the creation of their personal
balance sheets with my students, I make it clear that I do not want them
to hand their sheets in to me at the end of class. I don’t want to make
them uncomfortable. I’m not trying to pry into their personal financial
affairs. My goal, as I’ve said, is just to get them to compute what they
think their net worth is by subtracting the value of the financial assets
they have identified from the value of their financial liabilities—but
they get to keep the resulting number to themselves, just like you do.

Is That Glass Half-Empty or Half-Full?

Valuing Human Capital
When my students are done creating their initial balance sheet, I
ask them two additional questions. You can think about the answers
to these questions, too. The first is: Do you think your personal bal-
ance sheet will look better ten years from now? When I ask this ques-
tion in class, virtually every hand goes up in response. My students
are optimistic about their career prospects and hence their future
personal balance sheet. I then ask, How many of you got a zero or
negative number for your net worth on the balance sheet today? Be
4 YOUR MONEY MILESTONES

honest now. Reluctantly, and slowly, the vast majority of the juniors
and seniors raise their hands.
At this point, if they were a publicly traded company, with this
admission of a zero or negative net worth number, they would imme-
diately be deemed insolvent or even bankrupt. In fact, the smattering
of students—from a group of 60—who do not raise their hands are
usually exchange students (who perhaps didn’t understand the exer-
cise) or are the children of wealthy parents (maybe in Dubai?) who
don’t have any liabilities.
Now here’s the twist: I then announce to my students that based
on their responses it seems to me they did the exercise all wrong, and
they probably answered both questions incorrectly. I tell them that I
know they are relying on their previous studies of business account-
ing, using bookkeeping techniques or Financial Accounting Stan-
dards Board guidelines, to create their personal balance sheets. Much
to their surprise, I suggest they are undoubtedly missing the most
important item and most valuable asset class they own, and they are
forgetting the reason they enrolled in school and have incurred all
their student loan debt.
And now back to you—what my students have undoubtedly left
off their list of assets is the same thing that’s probably missing from
yours—the value of what economists call human capital.
But what is human capital? At the young age of 20, as I’ve said,
my students generally have little in the way of traditional financial
capital. But they do have 40 to 50 years of salary, bonus, and wage
income ahead of them. One powerful way to consider this future
income is to view it as an asset like a gold mine or oil well with 50
more years of reserves.
Think of it this way: If you own a well or mine, you probably can-
not extract more than a small fraction of the reserves in any given
year. (And it might be very costly to do so.) However, this asset has
substantial value today. I’ll say this again to make sure it’s clear: The
most valuable asset class for most people during most of their working
years is their human capital. Not just college kids in their early 20s or
graduate students in their late 20s—this applies to you in your 30s,
40s, and even 50s and 60s.
INTRODUCTION 5

Human capital should be viewed in exactly the same way as a gold

mine or oil well: It has a tangible present value—right now—even if it
takes many more years before you see six-figure cash flows from it.
Accordingly, they should include the estimated current value of
human capital to create what I call a holistic personal balance sheet.
And I’m giving the same instruction to you. Although you might be
slightly older than 20, your human capital is likely the largest asset on
your personal balance sheet throughout most of your life.
Table I.1 shows how a holistic personal balance sheet might look.

TABLE I.1 Holistic Personal Balance Sheet and Net Worth Calculation

My Assets My Liabilities

Explicit Financial Capital - Visible Debt and Liabilities

+ Implicit Financial Capital 4
- Estimated Hidden Liabilities
+ Estimated Human Capital _____________________________________
= Total Capital = Holistic Net Worth

But how do you come up with an estimate of the value of your

human capital?
To help my students arrive at a reasonable number, I give them a
follow-up assignment to visit our campus alumni office or career cen-
ter to collect data on how much people earn after they graduate from
school. This information is also widely available online (on websites
such as collegegrad.com), broken down by college major, geographi-
cal region, and sometimes even by school grades. As their second
assignment, I ask my students to calculate the present value (that is,
the value today) of the next 50 years of their total after-tax compensa-
tion, including wages, salary, and bonus.
Presto! My students come back to their next class a week later
and joyfully declare that their human capital is currently worth mil-
lions of dollars. Indeed, even using conservative assumptions for

4. I define Implicit Financial Capital as the present value of all defined benefit
pensions, Social Security (or Canada Pension Plan) benefits, and other illiquid
entitlements to future cash flows that you can’t sell or trade in the secondary
market but that you have earned by virtue of your past labor market participation
and are guaranteed to receive after retirement for your lifetime. My students,
generally speaking, do not have any implicit financial capital—yet.
6 YOUR MONEY MILESTONES

salary growth rates and discount rates, coming from one of the better
undergraduate business schools in the country, their human capital
values are well into the seven digits.
I’ve included a human capital calculator at www.qwema.ca, so
you can try this exercise, too. What is your human capital worth?
After you estimate and include your human capital, what does your
holistic personal balance sheet look like?

Mark Yourself to Market

At this point, my students and you have learned lesson number one
from this book, which I call mark yourself to market. If you worked
through the calculations to estimate the value of your human capital,
you have also learned to properly identify and sum the current value of
all your future cash flows, and not just the financial assets you have
today. In so doing, you have created a holistic personal balance sheet
that takes into account both your explicit financial capital (the tradi-
tional financial assets you own today) and your human capital.
Let’s take a closer look at valuing human capital. Using data pro-
vided by the Current Population Survey from the U.S. Census, I esti-
mate that at the age of 25—with the potential of 40 to 50 more years
of labor income ahead—the human capital of a college graduate (not
necessarily a business student) can range anywhere between
$540,000 and $1,700,000 on an after-tax basis.5 (These numbers are
rough estimates based on a number of embedded assumptions,6 but
they’re in the right ballpark.) Ten years later, at the age of 35, that
same college graduate has an implied human capital value between
$560,000 and $1,600,000. At the age of 45 the range is $500,000 to

5. In Canada, the median value of human capital at the age of 25 after completing
an undergraduate degree is roughly $1.3 million, assuming a discount rate of 3.5
percent. Data source: payscale.com; QWeMA Group calculations.
6. In generating these estimates, I included only income from earnings; I adjusted
for tax using average 2008 effective tax rates; and I assumed income from
employment to age 75. Lower estimates are based on 40th percentile income
(only 40 percent of people have incomes lower than this) and a discount rate of 6
percent; upper estimates are based on 90th percentile income (90 percent of
people have incomes lower than this) and a discount rate of 3.5 percent.
INTRODUCTION 7

$1,400,000, and—perhaps surprisingly—at 65 the remaining value of

human capital is between $160,000 and $480,000.7 I want to under-
score that these derived values are not formal measures of net worth
and do not, as I’ve said, take into account any traditional financial
capital, such as the value of pensions or Social Security entitlements.
My human capital estimates simply represent the present (that is, dis-
counted) value of the wages and income you can expect to receive
during your remaining working years.
Using this methodology and data from the Bureau of Labor Sta-
tistics, I can provide estimates of human capital based on specific pro-
fessions and for individuals who have more than a college degree. For
example, at the age of 25, an average physician’s human capital is
worth approximately $2.7 million, an average lawyer’s human capital
is worth approximately $2.1 million, and an average civil engineer’s
human capital is worth approximately $1.4 million. An average
plumber’s human capital is worth $960,000, and an average baker’s
human capital (yes, the Bureau of Labor Statistics has a category for
bakers!) is worth $520,000. (You will have the opportunity to delve
into these differences by occupation further in Chapter 1 (“Is the
Long-Term Value of an Education Worth the Short-Term Cost?”),
that looks at the true value of an education.)

Is This a Cynic’s Value or True Worth?

Now, you might think it rather cynical to evaluate training, educa-
tion, and lifelong learning in purely financial terms. In contrast, I
believe the notion of human capital is ultimately a deeply encourag-
ing one. For example, many of my undergraduate and graduate stu-
dents find comfort in the notion that their holistic net worth contains
this substantial hidden asset. I am also not the first or the only univer-
sity professor to emphasize the importance and value of human capi-
tal. The most celebrated economist in the study of human capital is
Nobel laureate Dr. Gary Becker, from the University of Chicago. He

7. See footnote #5 for the Canadian values.

8 YOUR MONEY MILESTONES

popularized thinking about the value of education as an investment in

human capital in his classic Human Capital: A Theoretical and
Empirical Analysis with Special Reference to Education, first pub-
lished in 1964. Moreover, the concept of human capital can be traced
much farther back to the economist Adam Smith (1723–1790) in The
Wealth of Nations and to Alfred Marshall (1842–1924) in Principles of
Economics.
Interestingly, Professor Becker made the following comments in
the introduction to an early edition of his famous work: “It may seem
odd now, but I hesitated a while before deciding to call my book
Human Capital, and even hedged the risk by using a long subtitle. In
the early days, many people were criticizing this term and the under-
lying analysis because they believed it treated people like slaves or
machines.” He went on to say, “My, how the world has changed! The
name and analysis are now readily accepted by most people not only
in the social sciences but even in the media.”

An Appreciation That Grows with Age

Over the years, in addition to introducing my 20-year-old stu-
dents to the holistic personal balance sheet, I have also presented this
concept to older executives, MBA students, and general audiences
made up of people in their 40s and 50s. Most were enthusiastic and
accepting of this way of thinking about the value of human capital,
although some were not. One objection I have heard, especially from
those in traditional business accounting disciplines, is that human
capital shouldn’t be placed in the same category as financial capital—
as (despite my fondness for the analogy) it isn’t an oil well or gold
mine that can be sold today for a known sum. These skeptics object to
human capital—which is uncertain future earnings—being awarded a
place on the personal balance sheet. After all, the critics claim that
human capital can’t be securitized, sold, or traded, so how can it be
treated in the same way as tangible stocks and bonds?
To audiences who argue against the human capital and holistic
personal balance sheet approaches—especially people in their mid-
dle working years—I pose a question in response, to wit: How much
of your financial capital would you be willing to give up, today, to
turn back the clock a few decades and get back your old human capital?
INTRODUCTION 9

How much money would you be willing to pay, right now, to become
20 years younger? Most of it? All of it? Many, if not most of the skep-
tics say they would be willing to pay quite a lot indeed to regain some
years of youth. Well, I reply, if you are willing to sacrifice so much
financial capital at advanced ages to regain lost human capital, then
it must be worth quite a bit at early ages!

The Nine Milestones

What does human capital have to do with financial milestones and
financial decisions? Throughout your lifetime, as you reach what I am
calling different “money milestones,” to make good decisions you must
understand the hidden assets and hidden liabilities on your holistic
personal balance sheet. Going to school, getting married, having chil-
dren, buying a home, buying insurance, filing your income tax each
year, planning for retirement, making decisions about pensions—all of
these milestones affect your holistic personal balance sheet.8 The con-
cept of human capital, as the largest and most valuable asset class for
most people over most of their lifetimes, is probably the biggest single
factor that you must, in my view, appreciate and include in your per-
sonal financial planning across your lifespan. Accordingly, this book
takes human capital thinking and applies it to nine major financial
milestones you can expect to grapple with in your life.
Now, I’ll be the first to admit that the number 9—which appears
both in the title of this book and is the number of chapter topics to
follow—is both debatable and subjective. In fact, my perceptive wife
claims I first plucked this number straight out of thin air and then
labored to identify topics that added up to the said 9. And, although I
won’t admit to such extreme arbitrariness, I’m open to the argument
that there might be only 7 or possibly as many as 12 important finan-
cial milestones over the course of your life. However, quibbling about
whether there are more or less than 9 is not what this book is about.

8. In my previous book, Are You a Stock or a Bond? (also published by Pearson/FT

Press, 2009), I addressed the narrow implications of human capital on invest-
ment portfolio management. In this book, I expand this thinking to all the major
financial decisions in your life.
10 YOUR MONEY MILESTONES

Truthfully, the nine topics I identified are far from homogenous

in decision structure or actually even comparable to each other in
economic magnitude. Some topics, such as marriage—which I exam-
ine in Chapter 4, (“Are Kids Investments and Can Marriages Diver-
sity?”)—have psychological and sociological dimensions that reach far
beyond financial aspects. Furthermore, the typical marriage decision
itself takes place once, twice, or maybe a handful of times over the
course of the human life cycle (okay, two handfuls in the case of Eliz-
abeth Taylor). In contrast, other decisions such as investment and
portfolio management—which are reviewed in Chapter 8 (“Portfolio
Construction: What Asset Class Do You Belong To?”)—are primarily
financial in nature and take place continuously in time. Can all of
these milestones really be lumped together?
The purpose of highlighting these nine milestones is not to dis-
regard or disrespect the nonfinancial elements in our lives and
decisions but rather to illuminate the often-obscured monetary
implications. The unavoidable truth is that children are expensive to
raise and can place a strain on the family’s finances; initially sound
marriages can fail as a result of financial difficulties; and people can
experience long periods of unemployment if they don’t have proper
career training—or if they overinvest in an education that doesn’t
increase the value of their human capital. In short, ignoring the mon-
etary implications of our decisions can lead to financial regret.

Money Milestones over Your Lifetime

Whatever starting point you are coming from—whether you have
already been converted to my way of thinking about human capital, or
you plan to evaluate the concept as you move along—this book is
designed to get you to think more broadly about your holistic balance
sheet. I illustrate how the four basic principles of arithmetic—addi-
tion, subtraction, multiplication, and especially division—can be used
as a guide for approaching all the money milestones in your life.
So far, I have talked about the value of human capital at specific
points in time—such as my hypothetical physician’s, engineer’s, or
baker’s human capital value at the age of 25. However, another criti-
cal thing to understand about human capital is that it is dynamic—its
value changes over time. (And it can also be changed by providing
INTRODUCTION 11

inputs such as higher education, as you shall see in Chapter 1, on

investing in human capital through higher education.) And as you
know from the examples I have provided to date, the value of your
human capital generally decreases with age, as the number of years
you intend to work decreases.
Accordingly, as you age, and your remaining human capital value
declines, you should be converting or transforming your human cap-
ital into traditional financial capital by saving a fraction of your
wages and income. This saving process is critical to meeting your
money milestones effectively, and I address the question of “How
much is enough?” in Chapter 2 (“What Is the Point of Saving Money
Forever?”).
Marriage and children can also have profound impacts on your
holistic balance sheet, both positive and negative. I discuss the deci-
sion to marry and the decision to (and the cost to) have children in
Chapter 4. Typically coincident with decisions about marriage and
children are decisions about home ownership. You look at that issue
in Chapter 6 (“Can You Eat Your House or Will It Ever Pay Divi-
dends?”), along with the related topic of borrowing money in Chapter
3 (“How Much Debt Is Too Much and How Much Is Too Little?”).
The value of human capital must also be protected, especially earlier
in life—which is where life, disability, health, and critical illness
insurance (all of which I discuss in Chapter 7, “Insurance Salesmen
and Warranty Peddlers: Are They Smooth Enough?”) come into play.
As you save a fraction of your earnings, you need to make sure you
pay as little tax as needed—to retain the maximum value—and this is
a theme of Chapter 5 (“Government Tax Authorities: Partners,
Adversaries, or Bazaar Merchants?”).
Finally, as you near the end of your working years and arrive at
what is traditionally referred to as retirement, the value of your
human capital inevitably declines in value. At this stage, the bulk of
the assets on your personal balance sheet should consist of the finan-
cial capital you have acquired. The conversion of your human capital
to financial capital to sustain you in your nonworking years is, of
course, the reason why retirement planning is so important. You
cover this topic in Chapter 8 (on investing financial capital) and
Chapter 9 (on creating income streams in retirement).
12 YOUR MONEY MILESTONES

Summary: The Four Principles of

Arithmetic in Action
• This book will use four basic principles to understand and eval-
uate your financial decisions through all the significant mile-
stones in the human life cycle.
• To apply the four principles effectively, you need to ADD the
true value of your financial capital and human capital together.
That is your net worth.
• After you add your human capital to your holistic personal bal-
ance sheet, make sure to SUBTRACT all your liabilities to
finally arrive at your economic resources.
• DIVIDE your total economic resources evenly and smoothly
over your lifetime. MULTIPLY all the possible universes you
might encounter in the future and act to smooth resources
across all of them.

The four bullet points might not make much sense to you at this
point, but I promise it will all click in a few chapters.
 1
Is the Long-Term Value of an Education
Worth the Short-Term Cost?

One of my rather bright undergraduate students from a few years

ago, who stayed in touch over the years, decided after some years in
the labor force to invest (more) in her human capital by returning to
graduate school. She wanted to get a master’s degree in advanced
mathematical finance. I encouraged her to look broadly and consider
all the top schools around the world. After a grueling application and
admissions process, she was finally accepted to one of the best gradu-
ate schools, which happens to be located in the U.S. Midwest. This
was quite an achievement for her, and I suspect her acceptance letter
has been framed for posterity.
Unfortunately, a few weeks after the good news came in the mail,
she got a follow-up letter from the school with the financial details
and a huge invoice. She was facing a total cost of almost $80,000 for a
graduate education that takes less than two years to complete. (She
probably didn’t want to frame the invoice.) And although she under-
stood that this was a great investment in her human capital, at the
same time, she didn’t have $80,000 sitting in a bank account ready to
be withdrawn. Furthermore, this was a full-time, intense program
that would limit her ability to earn any outside labor income while she
was in school. So, like most prospective students, she began investi-
gating various private loans through banks and organizations such as
Sallie Mae and government-run student loan programs such as the
Federal Direct Loan Program. The paperwork was daunting, the
money wasn’t free, and she started having some doubts. Was $80,000
in additional debt really worth it? After all, she was still paying off
some of her undergraduate student loans.

13
14 YOUR MONEY MILESTONES

Investing in a Gold Mine...Called

Anastasia
When I found out about the dilemma she was facing—and the
possibility she might abandon her educational plans—I offered Anas-
tasia (not her real name, obviously) a deal, which I will outline here. I
knew she was a bright and hard-working student who would do
extremely well in graduate school and complete the program in the
top of her class. My estimate was that she would then go on to a suc-
cessful career in the financial services industry and likely earn thou-
sands of dollars a year in salary and bonus. In my view, she had the
potential of a high-producing gold mine or oil well, and I personally
wanted the opportunity to invest in her human capital. So, I offered
her $50,000 in cash—to finance the majority of her tuition—in
exchange for a mere 10 percent of her pretax earnings during the first
ten years after she graduated. To my way of thinking, the money I
offered wasn’t a loan or any type of debt. It was an investment. As
long as she was in school, and wasn’t earning any money, she owed
nothing. I invited her to think of this as accepting a slightly higher tax
rate in the future in exchange for a deeply subsidized education today.

Should We Allow Human Capital Derivatives?

As you saw in the Introduction, “Human Capital: Your Greatest
Asset,” investing time and money to develop your human capital pays
off on average. But the dividends and investment returns—especially
given student loan interest payments—might be less than in previous
years, as the cost of investing in human capital (getting a college
degree) continues to increase faster than inflation (as measured by
the consumer price index, or CPI).1 This is especially true for elite
private colleges and universities, in which tuition has risen the most
and the fastest. College graduates in aggregate have more student
loan debt than ever before and are entering the labor force with

1. University tuition fees have risen faster than inflation over the past decade in
both Canada and the United States. For U.S. data, see Baum and Ma, Trends in
College Pricing. Canadian data taken from Statistics Canada, “The Daily: University
Tuition Fees.”
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 15

thousands of dollars in balance sheet liabilities, well before they have

taken out their first mortgages.
According to an article in the Wall Street Journal on September 3,
2009, today, almost two thirds of all college students have borrowed
money to pay for their tuition; their debt load upon graduation is an
average of slightly more than $23,000.
Is there an alternative? I think so.
Here’s what I’m thinking: Perhaps there will come a day in the
not-too-distant future when current and future students can sell a
fraction of their (extraordinarily valuable) human capital when they
are young to finance the costs of investing in education and going to
school. These young students would get a lump sum of cash in
advance or, alternatively, spread out over their years in school. These
sums would not be considered a loan, or “bond-like.” Rather, the
funds would be considered “stock-like”—that is, similar to a company
or a small business issuing shares (via an IPO or seasoned equity
offering) to finance its expansion and investment opportunities. The
money would be repaid by the student, eventually, in the form of pre-
ferred dividends for a predetermined period starting after gradua-
tion. I’m calling this concept Human Capital DerivativeS (HuCaDS),
or, with tongue in cheek, Human Capital Daddy of Sugar.
Here’s how I figured the math. When Anastasia graduated in
approximately 24 months, I anticipated she would be earning at least
six digits—given her previous experience and the typical salary struc-
ture for specialists in her field. And, even if her salary remained con-
stant at $100,000 per year (pretax) for the next ten years, that would
yield me $10,000 for ten years on an initial investment of $50,000. To
analyze this more precisely, I calculated something called the internal
rate of return (or IRR) in my Excel spreadsheet program. A cash out-
flow of 50,000 today followed by zero cash flows for two years (while
she is in school) and then by a positive cash flow of $10,000 from
years 2 through 12 represents an annualized return of 10.25 percent.
That investment return is much better than the rates at my local bank.
In fact, this deal could turn out even better for both of us. Let’s
imagine that Anastasia performs better than expected, and by her
fifth year back in the labor force, she is earning $200,000 per year. So,
for the first five years I would receive $10,000 in dividends and for the
16 YOUR MONEY MILESTONES

remaining five years of our HuCaDS agreement, she would be send-

ing me $20,000 each year to pay back my investment. That works out
to an internal rate of return—for me—of 15.2%. This is better than
you can hope for even in the most irrational of stock market bubbles!
Of course, my HuCaDS arrangement would also leave me
exposed to some downside risk as well. Anastasia might decide to
shelve her completed master’s degree and backpack across Europe or
India for five years after graduation, which might satisfy her lifetime
ambition to travel the world but would generate zero dividends for
me. In that case, her return to the labor force would leave me only
five years of cash flows in the contract term. Alternatively, she might
decide to join the U.S. Peace Corps—or take a minimum-wage job at
McDonalds paying only $25,000. Then the internal rate of return
from my $50,000 investment would be zero, or possibly even nega-
tive. In those cases, I would have been better off putting the $50,000
under my mattress than investing in a HuCaDS with Anastasia. That
is the risk and return trade-off for me: On the upside, I can get
returns in the double digits—and on the downside, I could lose it all.
Now I obviously would invest only a small fraction of my total net
worth in human capital derivative arrangements, but at the same
time, I would also derive some psychic dividends from having helped
finance a student’s education.
I mention this (true) story because I think it could serve as an
alternative for future students to onerous and anonymous student
loan debt, with potentially crushing interest payments. In my teach-
ing career, I see firsthand how current levels of student loan debt
force people into jobs and careers they don’t want or like, simply
because they have to make the loan payments. My HuCaDS proposal
would enable graduates to accept any job they truly want, knowing
that they owe only a floating fraction of their salary as opposed to a
fixed and unyielding obligation, as with a student loan.

Securitizing Human Capital

Now, I am not the first person to think about securitizing human
capital. (Securitization is the process by which a cash-flow-producing
asset is repackaged as a security and sold to investors.) This concept
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 17

can be traced back to the well-known economist Milton Friedman in

an article titled, oddly enough, “The Role of Government in Educa-
tion.”2 This concept has also more recently been advocated by Miguel
Lleras in his book Investing in Human Capital. Friedman, Lleras,
and others have pointed out some of the potential pitfalls in programs
that attempt to securitize human capital. For example, how do you
enforce payment? What happens in the event of a student’s bank-
ruptcy? Can these payments be considered tax-deductible from
income, like corporate debt? Does such an arrangement risk being
labeled usurious (that is, charging exorbitant amounts of interest) if
income payments far exceed the initial equity investment? As with
any ambitious plan, the details have to be ironed out. But I think the
idea itself has merit and should be considered, at least on the individ-
ual level.
In the next few sections you will see how the decisions about
where to go to school, how much time to spend learning, and what to
study can together have a huge impact on the valuation of your human
capital. Here’s what I mean in practical terms: Two 25-year-old gradu-
ate students sharing an apartment might both have little in the way of
financial capital, real liquid assets, or income. Their traditional
accounting balance sheets likely display a negative net worth. Yet,
depending on their chosen courses of study, their holistic balance
sheets can look completely different. One might have a human capital
worth millions of dollars, whereas for the other it might be measured
in hundreds of thousands or even less. Moreover, as you will see from
the discussion of the net worth and financial and asset holdings of col-
lege graduates, not only might their earning power be different, but
the types of assets they are likely to hold in the future can also be quite
different, which has yet other implications I explore in later chapters.
Because I thought you might like to calculate the impact of an invest-
ment in human capital on your personal balance sheet, I have created
a calculator at www.qwema.ca that enables you to project the payoff
from an investment in human capital, based on your age, expected
investment in education, and expected increase in income.

2. In Robert A. Solo, ed., Economics and the Public Interest.

18 YOUR MONEY MILESTONES

In short: Education decisions have deep and persistent impacts

on your financial situation for the rest of your life span, and those
impacts are not necessarily obvious at the outset of your educational
path. The undergraduates I encounter in my personal finance course
have already made the decision to attend college, and they’ve already
(for the most part) chosen their course of study. This chapter is
designed to get my thinking about the impact of education on human
capital into the hands of a bigger audience—so you or your kids, too,
can properly estimate and add the value of investing in human capital
to your personal balance sheet.
Using the metaphor of Dynamic Control Theory (DCT), educa-
tion is one of the variables that impacts your financial well-being and
that is controllable. (You can control how much you get!) In a life filled
with uncertainty, there is robust evidence that educational attainments
pay off over time, and that they can set you up to achieve far greater
wealth than you might otherwise.

Are College Graduates Truly Wealthier?

In the introduction, I mentioned that I ask the undergraduate
students in my personal finance course two questions. The first (opti-
mistic) question is whether they think their personal balance sheet
will look better in ten years’ time than it does now. The second,
seemingly more pessimistic, question asks whether their present net
worth is zero or even negative. The introduction to this book is
largely focused on uncovering the true, but hidden, answer to that
second question. As you now know, invariably, when their human
capital is included, my students are wealthier than they first
thought—as are you.
But if you accept the concept of human capital as the most valuable
asset class on your personal balance sheet for most of your working life,
you also must accept that this is a resource that is depleted over time.
That is: The flip side, or corollary, of the optimistic “You are wealthier
than you think” message is that if you don’t save an appropriate propor-
tion of this wealth—that is, the dividends you reap from your human
capital—then you might find your total personal balance sheet to be in
worse, not better, shape as you age. Remember, with each passing year
you have one less year of proven reserves to draw on (returning to our
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 19

oil-well metaphor). Furthermore, if you take on a disproportionate

amount of student loan—or other—debt relative to the income you can
expect from your chosen career, your holistic balance sheet might actu-
ally shrink over time. Accordingly, decisions about education do not just
influence us at the point they are made but can affect the value of our
human capital for the remainder of our lives. Indeed, education deci-
sions are some of the most important milestones you will face in life.
So, let’s take a closer look at the income, net worth, and personal
debts of college graduates and compare them to high school gradu-
ates, all to get a better sense of how the education decisions you make
impact your human capital. We’ll conclude with some suggestions
about how best to finance college education, the increasingly
expensive investment in human capital.

The Best-Paying Careers?

For many previous generations, and in the eyes of many econo-
mists until about a half-century ago, paying for higher education was
not considered an investment but rather a consumption good such as
an expensive suit, car, or set of golf clubs: It might make you feel bet-
ter about yourself but didn’t necessarily have an investment value.
Today most people would agree that financial returns to education
can be quite substantial. That is, money spent on college education is
generally perceived much more like an investment that will pay divi-
dends well into the future. According to estimates by the Interna-
tional Monetary Fund and the World Bank, the private return to
education—what the individual college student can expect to gain—
is between 20 percent and 30 percent and the social return—or what
society gains from investments in post-secondary education—is from
10 percent to 20 percent.3 The lesson is clear: Investing in human
capital pays dividends. But the question of how much is paid out
depends significantly on your choices about post-secondary educa-
tion. How so?
According to a May 2009 cover story in U.S. News and World
Report, the median national pay for a hairstylist is $33,700 per year.

3. As reported in Lleras, Investing in Human Capital.

20 YOUR MONEY MILESTONES

In contrast, an optometrist earns a median $99,700, which is three

times as much as the hairstylist.4 According to the story, the employ-
ment outlook for both professions is good, and despite the pay gap,
both groups report high job satisfaction. Now, guess which one of
these two professions requires more effort, education, and training?
Yes, the optometrist. You can probably work as a successful hairstylist
with barely a high school diploma (or less) and a short training period.
In contrast, to become an optometrist requires an O.D. degree,
which means, in turn, that you need to spend four years and beyond
in college.
The gap between the expected incomes of a hairstylist and an
optometrist, and between the years of study required for each profes-
sion, provides an important lesson in the economics of the develop-
ment of human capital. Unlike most forms of financial capital, you can’t
actually inherit human capital, win it in the lottery, or stumble across it
in an antique sale. Most people have to work hard and invest time and
effort in nurturing their human capital. In general, the more you are
willing to invest in human capital—in terms of time, money, and
effort—the greater the financial payoff. More important, when you
“mark-to-market” the holistic balance sheet of two 25-year-olds, one
studying to be a hairstylist and the other an optometrist, the human
capital value of the optometrist is more than three times as great as that
of the hairstylist. I estimate that the optometrist’s human capital is
worth approximately $1.8 million whereas the hairstylist’s is worth $0.6
million.5

Minor Initial Differences Magnify over

Time
As you can see, even a small difference in annual wage income
can lead to enormous differences in the holistic balance sheet over
time. This point was emphasized in a study of college majors discussed

4. Using Canadian data from Payscale.com, median salaries are estimated at

$99,300 for an optometrist and $26,000 for a hairstylist in Canada.
5. Using Canadian data from Payscale.com and QWeMA Group calculations, I
estimate a Canadian optometrist’s human capital value at $2.1 million, compared
to $0.5 million for a hairstylist in Canada.
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 21

in a recent issue of Forbes magazine.6 According to data from the

website PayScale.com and published in Forbes, a college graduate
who majored in English and had less than five years of experience
earned a median wage slightly less than $40,000 in 2008. An English
major with 10 years to 20 years of experience earned approximately
$60,000 per year. Thus, roughly speaking, the premium for experi-
ence was $20,000 per year.
In contrast, according to the same survey, a mechanical engineer-
ing college grad with less than five years of experience earned a
median $60,000 in 2008, which is approximately $20,000 more per
year than the English major. Furthermore, the mechanical engineer
with 10 years to 20 years of experience earned a median $90,000 in
wages. The experience premium in this case is $30,000 per year.
Thus, I would argue that the human capital of a mechanical engi-
neer who is just about to graduate is (much) more valuable than the
human capital of an English major for two reasons: First, the engineer’s
initial wage out of college is greater than the English major’s, and sec-
ondly, the premium she will be paid for the experience she builds over
time is higher as well. Thus, the present value of the after-tax wages for
the two graduates over the estimated 40 years of income is greater. For
the English major I estimate it is $1 million and for the mechanical
engineer it is $1.5 million. (Now, wouldn’t it be useful to know this as
you contemplate college majors?) Stay tuned for more insights into
how education decisions affect wealth-building over time.

How Investing in Human Capital Pays

One of the common questions I get from eager young students
who drop by my office is what they should major in or study at
school. Some pose this as an existential, big-picture question:
“What should I do with my life?” Others phrase it as a more tar-
geted question: “I want to work in the investment industry. So, am I
better off taking advanced managerial accounting or advanced
derivative pricing?”

6. Badenhausen, “The Most Lucrative College Majors.”

22 YOUR MONEY MILESTONES

Despite what I’ve already said about varying pay scales by profes-
sion, and keeping in mind I am most definitely not a guidance coun-
selor, my answer is usually as follows: First, figure out what you truly
enjoy doing. A good way to do this is by taking as many different
courses as possible. Then, when you find what you like, find out how
to make money doing that. Although the answer might not satisfy
them, this little piece of advice was given to me by my father many
years ago, and it has worked out well for me personally. Although I’ve
just spent the last few pages talking about the financial impacts of
education decisions, the bottom line, for me, is that human capital
estimates should form only part of your decision about what career to
pursue. (However, I do think they should form at least part of your
deliberations.) Somebody who truly wants to be a hairstylist but who
decides to pursue a career as an optometrist because it pays three
times as much will likely have a higher human capital value than they
otherwise would—but they are also much more likely to be miserable!
I’m sure these remarks will sound odd if you worry about your kids
who just love playing video games...or sleeping all day. Surely figuring
out what you enjoy is not the best strategy for increasing the value of
human capital, is it? Shouldn’t professors be telling students to “aim
high” and go to medical school or become engineers or lawyers?
Oddly enough, additional research—beyond what I’ve already
reported—provides some subtle reasons for the discrepancy between
the net worth of people with and without higher education. That is,
the gap in net worth between people with a college degree and those
with a high school diploma or less is attributable to more than just
educational achievement. How so? Let’s explore this question next.
First, let’s start by examining actual household balance sheet val-
ues as estimated and reported by the U.S. Federal Reserve, as
opposed to the theoretical estimates I have been giving for human
capital (see Table 1.1).
Here are some basic facts. According to 2007 data collected by
the U.S. Federal Reserve in its Survey of Consumer Finances,7 the

7. The SCF is a triennial interview survey of U.S. families sponsored by the Board
of Governors of the Federal Reserve System with cooperation of the U.S.
Department of the Treasury. In the year 2007 survey, 4,422 families were inter-
viewed. See Bucks et al, “Changes in U.S. Family Finances from 2004 to 2007”
for more information.
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 23

TABLE 1.1 Does Education Pay Dividends?: Federal Reserve Board

Survey of Consumer Finances 2007

Education Level Percent of U.S. Average Pretax Average Median

(Head of Population in Household Household Household
Household) Group Income Net Worth Net Worth

No High School 13.5% $31,300 $142,900 $33,000

Diploma
High School 32.9% $51,100 $251,600 $80,300
Diploma
Some College 18.4% $68,100 $365,900 $84,700
College Degree 35.3% $143,800 $1,097,800 $280,800

average net worth of U.S. college graduates is much larger than the
net worth of individuals who don’t have a high school diploma, or who
didn’t attend college. For example, in the year 2007, the average net
worth of a family in which the head of the household has a high-school
diploma only—and did not go on to college—was $251,600, whereas
the average net worth for a college graduate was almost four times
greater at roughly one million dollars. For those without a high school
diploma, the average net worth was a mere $142,900.8 (Note that all
these numbers use the conventional accounting measures of net
worth—namely explicit financial assets minus explicit financial liabili-
ties—and don’t take into account the human capital value I previously
discussed.)

Human Capital Investments over Time

No matter how you report the statistics, one thing is quite clear
from the data: A college education—which is an investment in human
capital—is statistically associated with greater net worth and greater

8. These patterns are seen in Canada as well. Median net worth for households
with less than a high school diploma was $92,433 in 2005; with a high school
diploma was $120,007; and with a university degree was $237,400. From Statis-
tics Canada, The Wealth of Canadians.
24 YOUR MONEY MILESTONES

Detour: Averages Versus Medians

Before you go any further, I want to take a minute to review the
difference between averages and medians. (If this distinction is
already familiar to you, skip ahead.) Note that the numbers you’ve
been reviewing on net worth are simple averages (also known as
the statistical mean). Averages can be distorted by large values (for
example, Bill Gates or Warren Buffet pulling the average earnings
up). Another measure of the middle or expected value of a data set
is the median. The median net worth is more robust than the aver-
age (that is, not as sensitive to outliers such as Buffet or Gates)
because it identifies the point at which 50 percent of the popula-
tion has a net worth above these numbers and 50 percent are
below. Just to be sure this distinction is clear, think of the series of
numbers: 2,10,9,2,4,7,1,1,3,7. If you add them up and divide by 10,
you arrive at a mean or average value of 4.6. On the other hand, if
you rank them from highest to lowest, the mid-point, or median
value, will be between 3 and 4. In general, for the same group of
numbers, the average and the median can be quite different. If, for
example, the numbers I’ve just given represented average and
median earnings of a group of people, the difference would be
quite large.

income. As you can see from Table 1.1, the household headed by a
college graduate had an average income of $143,800 in the year 2007
versus $51,100 for those who completed high school—and just
$31,300 for those without a high school diploma.9 (One of the first
economists to demonstrate this was Columbia University professor
Jacob Mincer in his 1974 book Schooling, Experience and Earnings.)
As you might suspect, these multiples were not just limited to the
year 2007. The gap is consistent across time. Eighteen years earlier, in

9. This finding holds true in Canada, as well: average earnings for those with less
than a high school diploma were $21,230 in 2001; those with a high school
diploma earned $25,477 annually; and those with a university degree earned
$48,648 annually. From 2001 census data as reported in Statistics Canada,
Earnings of Canadians.
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 25

1989, the average net worth of college graduates was $672,400

whereas the equivalent number for high school graduates was
$200,900. Notice that over that 18-year period the average net worth
of college graduates increased by almost 63 percent—from a value of
$672,400 to $1,097,800—whereas the average net worth of high
school graduates increased by only 25 percent. (These amounts are
all given in 2007 dollars, which means they are already inflation-
adjusted. That is, the gap is not a function of inflation.) Indeed, this
appears to provide yet more evidence of the long-term benefit that
accrues from investing in human capital: Your net worth is both
higher and increases faster. However, the reasons are more subtle
than you think.

College Grads Learn to Buy Different

Assets
It seems that U.S. college graduates are wealthier partly because
they own different types of physical assets and financial investments.
And it is these underlying components of net worth—which are quite
oblivious to the education level of their owner—which have increased
in value, which leads to an increase in net worth. For example,
according to the same Survey of Consumer Finances data you previ-
ously saw, in the year 2007 more than 31 percent of college graduates
owned stocks (directly), and 21 percent held investment funds. In
contrast, only 9 percent of those with a high school diploma reported
holding any stocks (directly), and only 6 percent had any investment
funds.
A similar pattern emerges with nonfinancial assets such as real
estate. For example, in the same 2007 survey, 78 percent of college
graduates reported owning a primary residence, whereas only 53 per-
cent of individuals without a high school diploma owned a primary
residence. For high school graduates the ownership rate was 69 per-
cent. Even more noteworthy is the median value of the houses owned
by the various educational groups: The median value of the college
graduate’s primary residence was $280,000. For the high school grad-
uate it was $150,000, and for those without a high school diploma it
was $122,500.
26 YOUR MONEY MILESTONES

What you can see is that the college graduate’s higher net worth is
allocated to a portfolio of assets that are quite different from those in
the other groups who have less education. In aggregate, college grad-
uates have more financial investments, and they own houses that are
more expensive. Now, think about what happened to the value of the
stock market, mutual funds, and housing prices during the period
1989 to 2007; they went up quite strongly. The SP500 increased by
659 percent from January 1989 to January 2007, whereas the value of
housing—as measured by the S&P/Case-Shiller Home Price
(Composite 10) index, which provides data on single-family house
prices in the United States—increased by 187 percent over the same
18 years.
So, perhaps the reason college graduates are wealthier than high
school graduates is because of what they “learned to buy” while in
college, as opposed to their earning power per se. In the words of the
author of a recent study on the same topic, “Assets more likely held
by college graduates appreciate faster than assets held by high school
graduates.”10 This insight is also echoed in a Harvard Business School
working paper in which the authors examine the impact of financial
education on financial market participation and find that cognitive
ability, which is arguably improved by attending college, increases
the odds of holding financial assets such as stocks and bonds.11 Of
course, these same assets can become a double-edged sword because
they are more volatile than other kinds of assets, and this volatility is
not under their individual owner’s control.
What you’ve seen so far is that households headed by individuals
with more education tend to have higher incomes and higher net
worth. The higher net worth comes in part because college graduates
hold different assets than those owned by households with lower levels
of education, and these components of net worth appreciate more
quickly. But you also know that the assets held by households with
higher education levels fluctuate in value more than those held by
other households. Does this mean that college graduates might become
worse off, over time, than other households with less education?

10. Yamashita, “Keeping up with the Joneses in McMansions.”

11. Cole and Shastry, “Smart Money.”
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 27

Could the Fortunes of College Graduates

Wane?
Let’s take a closer look at the Survey of Consumer Finances
(SCF) numbers on household assets. We’ll focus on two groups: the
college graduate household (which represents 35 percent of the U.S.
population) and the high school graduate household (which repre-
sents 33 percent of the U.S. population).
Recall that college graduates are more likely to be homeowners,
and the value of their principal residence is higher as well. The col-
lege graduate owns a home with a median value of $280,000 whereas
the homes owned by high school graduate households have a median
value of $150,000. (All these are 2007 numbers, which is well before
the housing mini-crash of the last few years.) More important, let’s
examine the debt and mortgages college and high school graduates
have on those houses.
According to the SCF data, 62 percent of college graduates
report having a mortgage secured by their primary residence, versus
45 percent of the high school graduate group. In addition, the college
graduate has median debts of $124,000 versus only $40,000 in debt
for the high school graduate group. The college graduate has more
than three times as much debt as the high school graduate, including
mortgages, installment loans, credit card debt, and other unsecured
lines of credit. So, although the college graduate net worth is much
higher than the high school graduate, their (traditional) balance sheet
looks different as well. They have both more assets and more debt.
Moreover, the assets they own are more susceptible to fluctuations in
the market prices of real estate and stock markets.
So, will the college graduates be (that much) better off in the
future? Or might the increased volatility of their financial and real
estate holdings potentially pull their net worth down? Or perhaps the
relatively safe investment in education enables college graduates to
take more investment risk with their traditional financial capital—
because they’re invested more heavily in an asset class (human capital)
that stands to pay dividends over a long period of time, they are set up
to assume more risk with the rest of their (financial) assets. Right now,
28 YOUR MONEY MILESTONES

the questions I’m posing have no firm answers. My intention here is to

illuminate some of the surprising financial impacts of a college educa-
tion—impacts that I think are worth considering when contemplating
education decisions. The rest of this book guides you through protect-
ing your wealth as you move through money milestones, including
how to assess and adjust the amount of financial risk you take on.
The SCF includes some other interesting statistics about the
value of human capital. It turns out that people who are classified as
self-employed, as opposed to working for someone else, report both
greater income and much greater net worth. In 2007 the self-
employed household reported an average net worth of almost
$2,000,000 compared to only $350,000 for those who work for others.
This means that Americans who are their own bosses are six times
wealthier in conventional net worth terms than those who are
employees—and they may be happier, as well, given their increased
work autonomy. It is likely that one of the reasons for this discrepancy
in net worth is that the mean reported household income for the self-
employed is more than double that of those who work for others:
$191,000 versus $83,100.

Does the Ivy League Pay Greater

Dividends?
So, now that you know that higher education pays dividends, you
might wonder whether the particular kind of college education you
get makes a difference to how much you can earn over your lifetime.
Is there a premium for an Ivy League education?
When my eldest daughter was born, more than 15 years ago, the
first word I wanted her to learn—before the conventional mommy or
daddy or bottle—was Harvard. I would buy her cute little shirts with
Harvard logos; sweatshirts with Harvard emblazoned on the front;
Harvard cups, mugs, key chains, and more. Then, when she was no
more than seven or eight years of age I took her with me on a busi-
ness trip to Boston and we visited the campus. (It was freezing and
pouring rain all day. She hated it.) As you can tell, I was just a little
obsessed with the idea that she should go to Harvard.
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 29

As my other children were born—I have four daughters in total—

I taught them the words Yale, Stanford, and Princeton, in that order.
In my mind, they were destined for the Ivy League with all the
rewards and benefits this education brings.
Then I got real.
The cost of one year’s (undergraduate) tuition at Harvard is now
$33,700. At Yale, the number is $35,300. These numbers are not
anomalies: The average cost of tuition at a private university (in the
United States) is approximately $25,000 per year. And these amounts
don’t include another $15,000 or so in annual living expenses and other
fees. In contrast, the average cost of state university tuition is a mere
$6,600 per year. Now compare these costs (five to seven times more
for Ivy League versus state college) to data published by Payscale.com,
which indicate that the median starting salary for an Ivy League col-
lege graduate ranges from $56,200 to $66,500. This not much more—
between about 7 percent and 21 percent more—than the median
starting salary of $52,400 reported for the top state schools. At first
glance, you might wonder if an Ivy League education is worthwhile. If
you pay five to seven times more for tuition at an elite private college,
shouldn’t you earn five to seven times more right out of the gate?
However, research does tend to support the notion that it pays off
(literally), over time, to attend an elite private college. In a report
published by the National Bureau of Economic Research in the
United States, the authors examined this specific question.12 Analyz-
ing the payoff of attending Ivy League and other colleges is not as
easy as you might think. Clearly, some graduates from Harvard and
Yale are unemployed (or volunteering at the Peace Corps), and some
graduates from the lowest-ranked state schools make millions of dol-
lars playing professional basketball or football. Accordingly, studies of
the earnings over time of graduates from Ivy League and state col-
leges focus on averages and medians.
How do these studies measure the quality of schools, and how do
they measure the earnings of students from different schools over
time? First, to gauge the relative quality of different colleges, our

12. Brewer, Eide, and Ehrenberg, “Does it Pay to Attend an Elite Private College?”
30 YOUR MONEY MILESTONES

researchers used library budgets, the SAT scores of entering fresh-

man, and the number of faculty per student. (Generous library budg-
ets, high SAT scores, and lots of faculty per student drove the
rankings up.)
Then, to investigate the earnings over time from graduates of dif-
ferent colleges in the United States, the researchers used results from
the NLS 1972 dataset, which is conducted by the National Center for
Education Statistics. This data contains detailed family and schooling
characteristics for various cohorts of students: 21,000 students who
graduated high school in 1972 and an additional more than 10,000
who graduated in 1980 and 1982. These groups were interviewed 6,
10, and 14 years after they completed high school, so the researchers
extracted quite a bit of information on the relation between college
quality and earnings, among a number of other variables.
Their results were conclusive and robust. The researchers con-
cluded “There is a large premium to attending an elite private institu-
tion and a smaller premium to attending a middle-rated private
institution, relative to a bottom-rated public school.” They also noted
that their analyses suggest the return to elite private colleges
“increased significantly for the 1980s cohort compared to the 1970s
cohort.” As this research was conducted more than ten years ago, it
will be interesting to see if a trend develops, and the 1990s cohort—
people graduating from high school in the 1990s—does even better
than the 1980s cohort does.
Yet, despite all the positive evidence, the authors were careful to
end their study by saying: “We do not attempt to determine the cause
of this change, but it is a potentially important finding in light of the
large tuition increases concentrated at these institutions during the
past two decades.” In other words, although the authors could not
pinpoint the specific reasons for the “large premium” accruing to
graduates of elite private colleges relative to graduates of middle- and
bottom-ranked schools, they suggest the high tuition and significant
tuition increases at elite schools might be offset by later financial
gains to the graduates of these schools. Keep in mind, too, it is not
just the earnings and wages that are higher for (elite) college
graduates—as you have explored, their personal balance sheets look
quite different as well.
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 31

Distinct Groups of Students—And “Fun

Capital”
Either way, it does seem that to afford tuition—whether at expen-
sive private schools or not—students are incurring a substantial and
increasing amount of debt. The average amount of debt held by a typi-
cal undergraduate rose from $16,000 in the early 1990s to $20,100 in
2007 (all reported in constant 2007 dollars). Just recently the Wall
Street Journal reported that it has reached $23,000 in 2009.13 Although
these numbers might seem relatively low to those earning many times
that amount in one year of work, I know from my own years teaching at
a university that some students are taking on much more than this aver-
age amount of debt to make it through with a degree—and the bulk of
students do take out loans to finance their education. According to the
Annual Survey of Colleges, approximately 60 percent of undergradu-
ate students graduate with some student loan debt and this number
might be as high as 70 percent for 2010.14
But what of the 40 percent with no debt? Perhaps some students
have (wealthy) parents and grandparents who saved for their children’s
education and have thus contributed the bulk of the cost. Yet other dili-
gent students manage to find the time to work at one (or two or three)
part-time jobs, the earnings from which enable them to avoid any debt
or loans. I have tremendous respect and great sympathy for these
kids—and they are kids—who have to endure a full semester-load of
coursework in addition to an additional 20 to 30 hours of paid work per
week. These students rarely have time for anything else, and I make a
habit to remind them to keep track of all the debt they do not incur,
compared to their peers with student loans. With no debt, their holistic
net worth is greater, and their holistic balance sheet will likely look
much better in five to ten years. In my view, this lack of debt should be
valued and quantified.

13. See Baum and Payea, Trends in Student Aid.

14. See Baum and Payea, Trends in Student Aid. In Canada 54 percent of students
with a bachelor’s degree graduate with debt. From Bayard and Greenlee,
Graduating in Canada.
32 YOUR MONEY MILESTONES

I would even argue that indebted students, who have decided to

finance their education by borrowing, should really keep track of all
the time they spent having fun while in college, using a journal or
keeping a running total. When these graduates come to me with con-
cerns about all the debt they have incurred and now have to repay, I
remind them of their colleagues who likely spent much less time at
parties and bars, and hence avoided debt. These students should per-
haps create another asset class on the left side of the holistic balance
sheet called “fun capital” to record the sum total of all the hours they
spent clubbing while investing in their human capital.

Did Anastasia Accept the Offer?

By the way, in case you were wondering, Anastasia, the student
who was trying to figure out how to finance her education, turned
down my offer for an equity stake in her future labor income. She
protested that it felt too much like slavery. In fact, she is not alone in
feeling that way. Despite being an advocate for the idea, this is what
none other than Professor Friedman wrote about human capital con-
tracts back in his 1962 classic Capitalism and Freedom: “...they are
economically equivalent to the purchase of a share in an individual’s
earning capacity, and thus partial to slavery.” I guess even he had his
doubts. Oh well. Perhaps I personally shouldn’t have been so greedy.
Maybe next time I’ll ask for 5 percent dividends instead of 10 percent.

Summary: The Four Principles in Action

• Investing in education can clearly ADD to the value of your
human capital, although you might incur debt that you must
SUBTRACT from your holistic balance sheet. The equation
only makes sense if the difference between the additional
human capital value and the debt is positive.
• The premium you can command from higher education will be
MULTIPLIED over your entire working life, so be careful not
1 • IS THE LONG-TERM VALUE OF AN EDUCATION WORTH THE SHORT-TERM COST? 33

to think myopically about the benefits over short versus long

periods of time.
• Remember that the total gains to you can be DIVIDED to
raise your standard of living every year through your entire life
span. More on this in later chapters.
This page intentionally left blank
 2
What Is the Point of Saving Money
Forever?

As you might expect, my business students are required to com-

plete a number of finance-related courses and topics to obtain their
degrees. The most significant among them by far is our corporate
finance course, in which they learn the foundations of managing the
finances of a corporation. In this course, they are taught early on that
the objective of the modern corporation is to maximize shareholder
value. We tell them that all a corporation’s activities—its dividend
policy, compensation practices, and even the amount of money it bor-
rows—should be geared toward creating the most value for individual
shareholders.
This maximize shareholder value (or MSV) mantra is also empha-
sized in many of the other business courses they take. However, it has
recently come under some intellectual pressure as commentators
have questioned whether interests other than those of shareholders,
such as value to the company’s employees, the community in which
the company is located, or even the broader physical environment,
should be considered and perhaps even take precedence. Neverthe-
less, MSV is still very much at the core of what is taught in business
school. And the simplicity of this mantra has the benefit of helping
young and eager students, who have little actual business experience,
solve case studies and analyze complex business situations using the
equivalent of high-school physics equations. To solve the case, just
plug in the MSV formula.
So, when the professor asks the question: Should the billion dol-
lar company buy the million dollar supplier? the 19-year-old junior
answers, yes, claiming this move would maximize shareholder value.

35
36 YOUR MONEY MILESTONES

Alternatively, when the homework queries whether the company

should increase pension benefits to retirees, the ready answer is “no”
from our 20-year-old senior: This option doesn’t provide any addi-
tional value to shareholders.
When these students arrive in my personal finance course, which
in contrast to corporate finance, deals with the individual as opposed
to corporations, I start them off with the following question: What is
the objective of the personal corporation I lightheartedly refer to as
YOU, Inc.? Is there a test equivalent to MSV that can weigh different
proposed courses of action when individual, not corporate, fortunes
are at stake?
The students usually have a number of interesting and rather clever
answers to this question. The most overtly ambitious and vocal ones
tend to argue that the objective of YOU, Inc., is to make as much money
as possible—legally, of course. I don’t necessarily disagree with this
answer but tell them it isn’t much use as a guiding principle for mile-
stone decisions about whether to buy or rent a house, or whether to get
term or whole life insurance, or whether to invest in stocks or in bonds.
Other students answer that perhaps saving 10 percent of salary is
the main operating objective. Another group suggests that retiring from
work as young as possible is the goal to reach. Still others offer that the
objective of YOU, Inc., is to maximize the value of human capital. (At
least somebody was paying attention on the first day of class!) A select
few advocate following spiritual paths or maximizing general feelings of
happiness. For the most part, though, my experience is that the class
doesn’t reach consensus on the matter. At some point, they turn to me
and announce, “Ok, Prof. We give up. What is the main objective that
will guide us in weighing options for YOU, Inc.?” My answer? Long
Division—you know, the standard procedure you all learned in grade
school for dividing large numbers using a series of simple steps. But
how can long division help us in making financial decisions? The rest of
this chapter is devoted to explaining this simple and powerful insight.

The 25-to-25 Jackpot: What Would You Do?

Imagine the following situation: You are 25 years old and your
long-lost and rather eccentric uncle, whom you rarely met and barely
know, has just passed away. When the lawyers vet his will, they discover
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 37

he left you $25 million dollars as an inheritance. Unbeknown to your

family, he was quite wealthy—and it seems he took a liking to you
personally. However, your money has been placed in an ironclad
trust, which you can’t access for the next 25 years. (Let’s assume that
even the best lawyers in town cannot break or dissolve the trust
agreement.) It appears your uncle was concerned about your finan-
cial maturity, and he decided it would be best to wait until you are
(much) older before giving you title to this unprecedented sum of
cash. So, the money is inaccessible for the next quarter century—and
in exactly 25 years, the trustees will hand you a check for $25 million
dollars.
My question to you is: What do you do in the meantime? Let’s say
you have little, if any, financial capital right now. Do you live like a
pauper until the age of 50, waiting for the trust to become unlocked?
Or do you spend recklessly—maybe even close to the entire $25 mil-
lion—counting on your windfall to bail you out in 25 years?
Now, you don’t really need to imagine an eccentric rich uncle and
a surprise inheritance to get your imagination going. Instead, you
could think of a peculiar lottery in which you have just won $25 mil-
lion dollars but must wait 25 years to collect. Or perhaps you’ve
accepted a job in which—with much suspension of disbelief—you
must wait 25 years before you get $25 million in wages and bonus. I
invite you to spend a few minutes thinking about this.
As you might have guessed, I pose this “25-to-25” thought exper-
iment (25 years to 25 million, that is) to my undergraduate finance
students in their personal finance course. What would they do? One
of the first questions I get in response is: “Can you borrow against the
money?” I tell them they can and, to make life easier, I ask them to
assume interest rates for borrowing and lending are close to zero
(which is pretty much what they are today, anyway). After we’ve
established that borrowing against the lump sum is possible, my ques-
tion to my students is, “How much of this $25 million would you bor-
row, exactly, and how would you spread your withdrawals over time?”
The answers called out in response are all over the map. Some
students want to borrow against half the funds today, whereas others
want to borrow against the entire amount. A minority few argue it
would be best to wait and live within current means today and then
38 YOUR MONEY MILESTONES

“live it up” when the money is unlocked at age 50. Others respond
that it’s silly to live an impoverished life for 25 years and only enjoy
wealth in the later part of life.
Discussion then turns to the question of what happens after you
get access to the $25 million in trust. Do you spend it all then? Do
you divide the funds into yearly allotments based on how long you
expect to live and spend it year by year? The exchange is vigorous and
interesting. Occasionally, when I have the time, I have the students
form small groups and ask them to reach agreement about the best
spending plan. I tell them to ignore complications such as premature
death or ill health and assume they all will live to 75 years or 25 years
past the unlocking of the locked trust.

Guiding Principle: Smoothing

Consumption
Finally, after much back and forth, typically a consensus emerges
from the small groups. The students announce they will definitely
borrow against the $25 million. They will try not to borrow too much,
so they do not risk depleting the pot, but at the same time they won’t
borrow too little and deprive themselves early in life. The class gener-
ally proposes the following solution: Borrow $500,000 each year for
the next 25 years. After 25 years, they will have spent exactly $12.5
million, or half the total allotment. This leaves another $12.5 million
to last for the remaining 25 years—with $500,000 available to spend
each year from ages 25 to 75. Simple, right?
Through the thought experiment of the 25-to-25 problem, my
students have now discovered one of the most fundamental—and
yet little-known—concepts in personal finance, that of smoothing
consumption. This principle holds that to maintain the highest pos-
sible standard of living over the course of your life, you should cal-
culate the value of your lifetime resources and smooth your
consumption over your lifetime. That is, borrow when necessary,
typically early in life, and save when necessary, typically later in life,
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 39

so that you create (in the language of economics) a uniform and

smooth consumption stream. I call this concept Long Division
because, like the long division you learned as children, it also helps
us divide large numbers (our total human capital) into equal por-
tions. In this case, you are dividing the large number of your total
lifetime income into the smaller equal portions that represent your
yearly spending.
The idea of practicing Long Division, or smoothing consumption
based on your total capital, over your lifetime, can be traced back to
Nobel Laureate and economics professor Franco Modigliani. He,
together with a number of co-authors in the 1950s and 1960s, was the
first to carefully formulate and test empirically whether people were
actually behaving this way. Now, whether most people rationally sum
their entire lifetime wages and use that figure as a guide for financial
decision-making is one of the most controversial and hotly debated
topics in economics departments at major universities around the
world. The behavioral school of thought, led by scholars such as Pro-
fessor Richard Thaler at the University of Chicago, believes that only
Mr. Spock (from TV’s Star Trek) can consistently make decisions in
this way. For this school of thought, it is clear that few people can
practice what I have described as Long Division, even when all that’s
required is basic addition and subtraction. Other, more classical econ-
omists, argue to salvage the rational life cycle view by explaining away
anomalous individual behavior as quirks and blips, small—not con-
clusive—flaws in the overall rational context of human decision making.
I, personally, don’t want to get into the debate of whether the
majority of people, or the ones that set prices and actually matter, are
rational. This is beyond my pay grade and outside the domain of this
book! What I would like to say is that valuing human capital, Long
Division, and smoothing provide an excellent guide for making the
most important financial decisions in your life.
There is evidence that many people actually do follow this ideal-
istic principle, but many others do not. In this chapter, we’ll look at
how this concept is brought to life by different people.
40 YOUR MONEY MILESTONES

How Does Income Smoothing (Long

Division) Work in Practice?
To understand how this concept might work in practice and how
it affects saving and investing behavior, let’s imagine the following sit-
uation: You are 25, and from the age of 25 to 34 (the next ten years),
you know with perfect certainty that you will earn no more (and no
less) than $25,000 per year. Then, between ages 35 and 54, your peak
earning years, your income will quadruple to $100,000 per year.
Finally, at age 55 you will leave the paid workforce, and from ages 55
to 84, you will receive (a pension of) $25,000 per year. (Let’s ignore
taxes and inflation and interest on money for the moment.)
Hang in there because it’s going to get a bit technical. Table 2.1
shows your income flows over your lifetime (in the life you imagine,
that is).

TABLE 2.1 Hypothetical Income Smoothing and Sav-

ings Rates over a 60-Year Lifecycle: Is this Prudent?

Age Salary Spending Implied Saving

Rate
25 to 34 (10 years) $25,000 $50,000 –100%
35 to 54 (20 years) $100,000 $50,000 50%
55 to 84 (30 years) $25,000 $50,000 –100%

If this were you, how, exactly, would you plan your financial life?
Would you live cheaply for the first ten years, spend freely for the
following twenty, and then go back to consuming only $25,000 per
year? You can see the similarities between this situation and our
hypothetical inheritance, earlier in the chapter. You can also see that
the “pauper/prosper/pauper” lifestyle doesn’t make much sense.
Instead, the fundamental principle of Long Division, or income
smoothing, suggests that you live beyond your immediate (income)
means early in life and later in life, and then make it up with large
savings during the middle years.
Here’s how this would work in practice.
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 41

Taking a look at our table, if you add up the 10 years of income at

$25,000, plus the 20 years of income at $100,000, plus the $25,000 in
the final 30 years, you get a total income (undiscounted) of exactly
$3,000,000. Then, if you divide this number by the 60 years ahead of
you (from ages 25 to 85), you get an average income of $50,000 per
year. What if you spent $50,000 every year for the next 60 years, under
the assumption you are earning that amount, on average, over the
course of your life? Well, if you assume your investments and borrow-
ings are both allowed to accrue at an interest rate of exactly zero, your
plan is sustainable.
The assumption of zero interest for both discounting and accumu-
lating is obviously quite unrealistic, but not outrageous. That said, it
really does help understand the process of consumption smoothing.
Using the language of finance, if you discount the $3,000,000 in life-
time income, it will be equal to the discounted value of $3,000,000 in
lifetime spending. In general, though, under positive interest rates, this
will not be the case.

Advice That Goes Against the Grain—but Smoothes?

In the example outlined in our table, although your consumption
(what you spend) is a constant amount, your savings rate varies con-
siderably over your lifetime. In the first ten years of your career, your
saving rate is –100 percent (because you are spending $50K and only
making $25K) whereas in the middle years you are saving 50 percent
of what you earn. Normally, this savings pattern—negative savings in
early life, coupled with high savings in middle age—would be consid-
ered poor financial planning advice, which often focuses on saving a
fixed percentage of your earnings over time, but it actually makes
perfect sense in the context of income smoothing, or Long Division.
If you follow conventional financial planning advice about replac-
ing income in retirement, the individual in my example would be
instructed to attempt to replace $70,000 or $80,000 of annual income
at retirement. But, really, this provides a surplus of income at retire-
ment, at the expense of a much lower standard of living in the years
before retirement. The goal of retirement planning should not be
about maintaining a standard of living or arbitrary income amount
taken at a given point in time. Rather, your frame of reference should
42 YOUR MONEY MILESTONES

Detour: A Quick Guide to Discounting

Let’s take a closer look at the concept of discounting I’ve just intro-
duced. (Skip ahead if this concept is already familiar to you.) This
idea is actually so simple that you will likely understand it intu-
itively even if you don’t know the math behind it. Consider this
example: Say you are offered the option of receiving $10,000 today,
or $10,000 in three years. If you are like most people, the choice is
easy; you would prefer to receive $10,000 today over receiving it in
the future. Why? Because $10,000 today has more value than the
same sum received in the future.
But why is this? On one hand, it might appear that the value of
$10,000 received today is the same as $10,000 received in the future.
After all, the bills have the same face value and add up to the same
amount. However, money received now is more valuable because
when you receive money today, you have the opportunity to earn
interest on it over time. So if you receive $10,000 now, you can invest
those funds and earn interest on them, increasing their future value.
However, if you receive the $10,000 at some future date, you have
no opportunity to invest the funds and earn interest. Instead, the
$10,000 is the total future value of the funds. So the present value, or
the value today, of those funds is less than $10,000. This process is
called discounting. The amount by which a sum received in the
future is discounted to get the value today depends on two factors:
how long you have to wait to receive the funds, and the interest rate
it is assumed you can earn on the funds if you receive them today.
In the example I gave in which you have total lifetime income of
$3,000,000, any economic analysis would require that you “discount”
the value of the income you will earn in future years. The process of
discounting is the same as the one I’ve just outlined. If you need
$50,000 in income in a future year, the value of those funds today is
less than $50,000. Accordingly, if you are earning $25,000 but spend-
ing $50,000, but that $50,000 is borrowed from future earnings, you
actually need to borrow less than $50,000.
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 43

be much wider to include your lifetime earning—the fruits of your

human capital over your life course—compared to your lifetime liabil-
ities and spending.
My point here is that despite all the odd and simplifying
assumptions I have made in my example—no death, no taxes, no
inflation, no uncertainty, and zero interest rates—it is clear that
telling people to save, just for the sake of saving, makes no sense.
Instead, the more rational approach is to save so that you can
smooth consumption over your lifetime, especially when earnings
are low. You should be comparing the lifetime income resources
available to you (that is, your human capital) to your lifetime liabili-
ties and adjust your spending so the two are relatively close to each
other. In fact, economist Lawrence Kotlikoff, chair of the Depart-
ment of Economics at Boston University, has developed a software
program that is designed to assist people in planning to smooth their
consumption over time to implement a sustainable life plan. The
software, ESPlanner (for “Economic Security Planner”)1 provides a
way to model changing financial circumstances along with detailed
Social Security and income tax analysis to make recommendations
on the amount of retirement savings and life insurance needed to
maintain a given standard of living throughout your lifetime. I’ve
also provided a calculator at www.qwema.ca to help you work
through a life-cycle smoothing exercise.

We Are Not Mr. Spock in Star Trek

Now, some of you might be thinking: All of this Long Division
business might work in the world of classical economists, in which
humans are always rational—or in the world of Spock, from TV’s Star
Trek. (“Seems logical to me, Captain.”) What can change in practice?
Well, you might not know with certainty that you will earn
$100,000 per year in your peak 20 years. It might be more and it
might be less. So, you would probably want to compensate for this
risk by spending a bit less than $50,000 early on, and then ramping

1. The software was co-developed with Jagadeesh Gokhale, a senior fellow at the
Cato Institute. See www.esplanner.com for more information.
44 YOUR MONEY MILESTONES

up, slowly, if things turn out well. Likewise, what if, like most peo-
ple, you can’t borrow at the zero percent interest rate I mentioned
earlier? What if you can’t get low-cost credit and must repay what
you’ve borrowed using high-cost credit cards charging 25 percent
per year, or worse? Then, yes, you would want to avoid dis-saving
(or “negative saving”) early in life. You might be concerned about
health care, or extreme longevity, or mortgage debt, and these are
all topics I discuss later.
Alternatively, you might be in an environment of abnormally low
interest rates in which you can borrow at negative real (inflation
adjusted) rates; in which case your discounted human capital value
might be actually higher, and your Long Division process leads to a
greater standard of living today.
Back to our example. To be clear, developing good financial
habits, such as saving a portion of income, while you are young will
probably help you during your entire life. But let’s be careful to dis-
tinguish between financial advice and psychological or behavioral
advice. For now, my key message is that advising the young to save,
save, save, just for the sake of it; or advising the middle age to target a
given income replacement rate at retirement, as if that point in time
matters, is inconsistent with human capital thinking. (Kotlikoff calls
these standard recommendations “rules of dumb” because they don’t
provide a reliable basis for financial planning.) Instead, the concept of
Long Division is the rational response to the conventional messages.
In the next section you see that many people have trouble behav-
ing rationally when it comes time to allocating their lifetime resources.

Do People Who Win the Lottery Behave

Rationally?
Now that you’ve seen the rationale for income smoothing, you
may be wondering: Do people actually do this in practice? Are people
rational with their financial expenditures? Sadly, the answer is often
no. For many people, suddenly gaining access to a large lump sum of
money—by winning the lottery, for example—can actually make
them worse off in the end. This is not just anecdotal evidence or some
sensational story of squandered wealth: An interesting study conducted
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 45

Detour: Interest Rates and Discounting

But why would the discounted value of your human capital be
higher when interest rates are low? I’ll take a minute to explain this
here. (Feel free to skip ahead if you are already familiar with the
concept of discounting. Sometimes it can be tedious to explain
this.) Recall that the present value of a sum of money to be
received at a future date is determined by discounting the future
value using the interest rate the money could earn over the period
between today and when it is actually received.
Let’s use the example of a T-bill you purchase at issue and hold to
maturity. The price you pay for your T-bill is discounted at the time
of purchase. That is, you pay something less than the “face” (or
par) value of the bill.
When you hold the T-bill to maturity, and are repaid the face value,
the difference between what you paid and the amount you are
repaid represents the interest on the T-bill. When interest rates are
high, the amount of interest you will earn on your T-bill is also high;
thus there is a bigger discount at the time of purchase. When inter-
est rates are low, the discount on your T-bill is small because your
bill is not going to earn much interest during the holding period.
In an environment of low interest rates, you might purchase a 13-
week T-bill with a face value of $10,000 for $9,800. Then, at the
end of the 13 weeks, you receive a payment of $10,000, the full
face value. The $200 difference between what you paid and what
you received at maturity represents the interest you earned during
the holding period. In this example, the interest rate was a little
more than 2 percent ($200 / $9,800 = 2.04 percent) for 13 weeks,
or about 8 percent for a year.
In contrast, when interest rates are high, the discount on your T-
bill would be greater. Let’s say you purchased the same 13-week T-
bill, with a face value of $10,000, for $9,350. At maturity, when you
receive your $10,000, fully $650 of that sum represents the interest
on your investment. In this example, the interest rate is just under
7 percent ($650 / $9,350 = 6.95 percent) for 13 weeks, or about 28
percent for a year.
46 YOUR MONEY MILESTONES

In the same way, the value of your human capital is higher in a low
interest rate environment. Because interest rates are not signifi-
cantly discounting the value of your future earnings as they reach
maturity (so to speak) and are cashed out by you from year to year,
each year of your future earnings is worth more today. This way of
thinking might seem a little unusual at first, but it makes sense!

among lottery winners in the State of Florida backs this up with some
sobering evidence. First, some background.
During the period from 1993 to 2002, approximately 35,000 peo-
ple were first-time winners in Florida’s popular Fantasy5 lottery
game. And, although the median sum won was somewhere between
$10,000 and $50,000; about 250 people won between $100,000 and
$150,000—and 153 were lucky enough to get more than $150,000.
So, these are not trivial sums. You would expect them to have a joyous
impact on the winners and a positive effect on their personal
finances. (By the way, these numbers are quite accurate because the
U.S. Internal Revenue Service requires that all winnings above $600
be reported to them directly by the lottery organizers. Indeed, the
information about the names, addresses, county of residence, and
winnings is publicly available.)
Did the winners’ financial lives improve or worsen after their
wins? Some clever researchers at Vanderbilt University set out to
explore, using data on Florida lottery winners, whether the financial
lives of these lucky few improved after their jackpots.2 Granted,
coming to a consensus on how an “improved financial situation” is
defined can be difficult. However, one measure of financial well-
being that is both easy to define and easy to collect information
about is bankruptcy. The authors of the Vanderbilt study obtained
the electronic records for all personal bankruptcies filed in Florida
over a period of more than 20 years: from early 1985 (well before
the first person studied won the lottery) all the way to late 2007,
when the last individual in the lottery database received his or her
winnings.

2. Hankins, Hoekstra, and Skiba, “The Ticket to Easy Street?”

2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 47

At first glance, these two databases—people winning the lottery

and people filing for bankruptcy protection—might seem unrelated
to each other. Although one might expect that a mere $600 wouldn’t
help those in financial distress escape or avoid bankruptcy filing,
what about those who received $50,000 or $100,000 in found money?
You wouldn’t normally expect lottery winners to declare bankruptcy
after their jackpots, would you? In fact, you might expect the
reverse—that they’d be among the least likely to file for bankruptcy
protection.
By now, I suspect you know where I’m going.
To carefully measure the financial impact of “sudden and large
sums of money” on the financial health of the winners, the
researchers split the lottery winners into three groups. Small winners
were defined as those who won less than $10,000. Moderate winners
received between $10,000 and $50,000, and large winners won jack-
pots from $50,000 to $150,000.
First, here is a sobering fact about the bankruptcy filing rate.
Although the bankruptcy rate in Florida held steady overall at about
0.5 percent for the adult population, the rate for lottery winners was
almost double the rate for the adult population. This is an average
across all winners and across time. But as it turns out, this is not the
most alarming finding from the research!

The Perils of Not Smoothing

What the study also found was that among the medium and large
lottery winners, the bankruptcy rate dropped significantly in the first
two years after winning (by 27 percent and 50 percent, respectively).
Indeed, the extra and unexpected money presumably enabled them to
pay down debts, repair their budgets, and bring their financial houses
into order. Unfortunately, just three to five years after winning, the sit-
uation for large winners was actually worse than if they had not won
the lottery. Not only was the large winner just as likely to file for bank-
ruptcy, but also the rate of bankruptcy filing among this group was
quadruple that of the general population. In aggregate, it seems that
receiving large financial windfalls only delays bankruptcy rather than
prevents it.
48 YOUR MONEY MILESTONES

Let me rephrase this just to be clear: Winning a large and unex-

pected sum of money was actually hazardous to the financial health of
the winners! The first two years—with an extra 50 or 150 grand—was,
in a word, grand. But in the next year or so, for a relatively large group
of these lottery winners, things got worse than they were before they
won the lottery. This is not just a statement about probabilities and
frequencies. The bankruptcy database enabled the researchers to
compare the level of assets and liabilities of various filers for bank-
ruptcy at the time of filing. What they found was that the net assets of
those who received $25,000 to $150,000 were only $8,000 higher than
those who won small amounts of less than $1,500. More specifically,
small winners in the group who filed for bankruptcy reported unse-
cured debt of approximately $59,000 when they filed, compared to
unsecured debt of $52,000 for large winners. Where in the world did
all the large winners’ money go?
Now, you might question whether anything can be learned from a
study limited to bankrupt lottery winners. Others might question
whether anything can be learned from a group of less than 2,000 indi-
viduals, which is the overlap between the lottery and bankruptcy
datasets. You could even argue that people who are in financial dis-
tress or on the verge of filing for bankruptcy might increase the fre-
quency and amount they spend on gaming, in hopes of a bailout win.
Indeed, the bankruptcy laws in the State of Florida provide for a
homestead exemption that allows most bankruptcy filers to keep their
houses. Perhaps the lottery winners planned to “game the system” by
purchasing principal residences, which can’t be seized in the event of
bankruptcy, or paying off mortgages—and only then spending to the
point of bankruptcy.
However, the researchers were careful to control for this possibil-
ity (using a variety of statistical tricks that I will not delve into here).3
The results indicate that there was no effort to shelter winnings
strategically. Instead, it seems apparent that at the end of the day a
large and statistically significant number of lottery-winning individu-
als grossly mismanaged their random good fortune. Instead of saving
an extra dollar of found money, they spent it and another one or two

3. If you are inclined, I urge you to read the paper “The Ticket to Easy Street?”
2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 49

dollars along the way. These individuals did not practice Long Divi-
sion by smoothing their consumption, and their irrational approach
actually left them worse off than before.

The Smoothest Population of All

Similar results have been documented with other groups (not lim-
ited to lottery winners) and other circumstances (with, for example,
U.S. federal government rebate checks.) The evidence from these
studies is clear: People generally use unexpected windfalls to reduce
some debt, initially. But, eventually, they go back to the exact same
level of indebtedness. Many just don’t plan or think ahead. This is one
of the reasons that courts in both the United States and Canada, when
awarding damages in the case of negligence and injury judgments,
have moved away from large lump-sum judgments to structured set-
tlements that are paid out over time. In the language of the authors of
the lottery study: “Policymakers ought to use considerable caution in
giving additional resources to heavily indebted individuals with the
hope of increasing their financial well-being.” I will return to this
theme and a discussion of the value of annuities over cash payouts
later in the book (in our look at pensions and retirement planning).
Although thousands of lottery winners in Florida don’t appear to
behave rationally when it comes to their financial affairs, this result is
by no means universal nor is it a fact of life for low income-earners. A
recent study of the ultra-poor population in West Africa, India, and
Bangladesh, published by a group of economists in their recent book
Portfolios of the Poor,4 seems to indicate behavior in distant cultures
and places that is the exact opposite of our lottery winners.
The authors’ in-depth study of 250 families focused on the finan-
cial planning abilities of a rather overlooked segment of the world’s
population, those earning less than $2 USD per day on average. This
group, it turns out, suffers from highly irregular and unpredictable
income flows that are dependent on events outside their immediate
control. During some days and even weeks, these families earned no

4. Collins, Morduch, Rutherford, and Ruthven, Portfolios of the Poor: How the
World’s Poor Live on $2 a Day.
50 YOUR MONEY MILESTONES

income at all, and at other times, they earned more than their average
of $2 in a given day. (In other words, their average earnings were $2
per day, but with huge swings, or in the language of statisticians, a
very large standard deviation.)
And yet, despite these erratic circumstances, the authors found
that few of these families consumed based on their immediate, daily
earnings only. Instead, on days for which income was greater than
average, they set aside (relatively) substantial sums of money and did
not spend it. This fund served as a reserve for days in which they did-
n’t earn anything. By drawing on their reserve, on days when they
earned less than average, they would still consume relatively the same
amount compared to the days when things were better.
Now, although this seems like a commonsense solution preached
by any parent who has admonished his offspring to save for a rainy
day, the level of consistency in implementing this practice among the
world’s poorest families, in such dire circumstances, seems remark-
able. Overall, the authors claim that the consumption profile of the
world’s poorest families over their life cycle was relatively smooth and
based on an average of their meager daily earnings. In other words:
they practice Long Division.
Indeed, according to a review of the book in The Economist, “The
subjects used a combination of loans and savings to ensure their lives
were not, literally, hostage to fortune. Hardly anyone lived utterly
hand to mouth.” The review went on to say, “The research provides
evidence of the sophistication with which poor people think about
their finances.”5 It would seem that their behavior could serve as a
financial inspiration to us all.

Where Does All of This Leave Us?

One can speculate only whether our bankrupt lottery winners—
and possibly all lottery winners—would be better off financially, in
the very long run, if their winnings were specified or perhaps even
mandated in an annuity (periodic income) form, as opposed to a sin-
gle lump sum. And, although I’m sure some would convert their

5. “Smooth Operators,” The Economist.

2 • WHAT IS THE POINT OF SAVING MONEY FOREVER? 51

annuities into (much smaller) lump sums, hence unraveling any pol-
icy benefits, it certainly makes me wonder whether money can actu-
ally be hazardous to your wealth.
At the very least, perhaps it’s a blessing in disguise that our most
valuable asset, human capital, can be monetized only slowly and with
great effort. Indeed, if you could take infinite advances against our
future labor income and sell it all in the marketplace today, you would
much likely be worse off in the long term. In the meantime, perhaps
the most rational approach to maximizing your financial well-being over
your lifetime is not to plan for a lottery win but to adopt the perspec-
tives of the world’s poorest people in planning your spending over time.
In this chapter you have learned what is probably the most funda-
mental axiom within strategic personal financial planning for individ-
uals, and that is the notion of consumption smoothing. That is, every
financial (and insurance) decision that you make in your life should
be motivated by the objective of removing the jagged corners and
rough edges in life. More on this in later chapters.

Summary: The Four Principles in Action

• Long DIVISION provides a fresh, strongly intuitive, and useful
perspective that can potentially better outcomes at each stage
of life: early on, when you are investing in human capital during
your income-earning years, and long into retirement.
• Long Division encourages us to use the simple tools of ADDI-
TION and SUBTRACTION to take a holistic view of our life-
time earnings and liabilities, smoothly steering our day-to-day
spending.
• Much of conventional financial planning rules-of-thumb are
not quite rational; for example, the idea of replacing 70 percent
of your salary at retirement. This rule relies on inappropriate
MULTIPLICATION of income later in life to set retirement
saving goals. Instead, you should put your focus on DIVIDING
your resources over time.
• The evidence also shows that simply ADDING income (in the
form of sudden financial windfalls) does not necessarily improve
our standards of living over time—lottery winners in Florida do a
worse job of managing cash than do the world’s poorest citizens.
This page intentionally left blank
 3
How Much Debt Is Too Much and How
Much Is Too Little?

As you learned in the previous chapter, it makes little economic

sense to target a fixed or unyielding savings rate (while you are work-
ing) or replacement rate (for income in retirement). Instead, the cor-
rect way of thinking about saving rates is as the output of a financial
plan that seeks to smooth consumption or equally distribute the ben-
efits of human capital over the entire life cycle. That is: When you are
young, have few financial resources, and are investing time to develop
and improve your human capital, spending more than you earn is, in
fact, quite rational. Similarly, during your middle and later working
years, when your earnings are likely the highest they will ever be, it
makes sense to save at much higher rates than normally advocated.
All of this I introduced in the last chapter, and I called this process
Long Division. Now, critical to the successful application of the Long
Division process is the ability to borrow money at reasonable rates,
whether it is to buy a house, finance a car, or invest in education.
In this chapter, I take a much closer look at the borrowing
process. I won’t particularly focus on the amount of debt Americans
have on their personal balance sheets, but rather the puzzling phe-
nomena of how Americans diversify their debts and thereby fail to
optimize their overall debt management strategies. Right now, the
ways people use debt inhibit success with Long Division. Let’s delve
into what’s going on and how (and why) you can do better.

53
54 YOUR MONEY MILESTONES

Americans Have Diverse Debts

Recall that according to data from the Survey of Consumer
Finances (SCF) conducted in 2007, close to 77 percent of American
households had some type of debt on their financial balance sheet. In
2007, those who had debts owed a median $69,000 to their creditors.1
This number is estimated to have risen approximately 180 percent
over the last 18 years and is now 50 percent higher than it was at the
beginning of the decade.2 The trend line has been moving upward
regardless of whether debt is examined relative to income or assets.
Since 1989, the real growth of household debt has outpaced the
growth of income by an annualized rate of 5 percent, and it has out-
paced the growth of assets by 3 percent.
Americans also have a wide variety of debt. For example, debts
and liabilities can be held as mortgages, lines of credit, student loans,
and vehicle loans—and credit cards and other installment debts.
Table 3.1 provides a summary of the various debts held by American
families.
Note that 46 percent of Americans have a mortgage on a princi-
pal residence, and 46 percent have credit card debt. The average size
of the principal residence mortgage, for those who actually had a
mortgage, was $152,988. These numbers do not include the informal
debt markets in which money is owed to friends, relatives, commu-
nity charities, and so on.
Only recently, as a result of the financial crisis, has the overall sav-
ings rate increased. Right now it stands at just under 6 percent (in

1. Figures in 2009 dollars.

2. According to the most recent Survey of Financial Security (2005), the median
amount of debt held by Canadian households increased by 37.5 percent since
1999 and equaled to $47,500 (2009 dollars). The median amounts of debt and
the percentages of Canadians that have them are as follows: mortgages ($99.4K,
36.5 percent), lines of credit ($9.6K, 24.9 percent), credit cards ($2.6K, 39.3 per-
cent), student loans ($9.6K, 11.8 percent), vehicle loans ($11.8K, 25.8 percent),
and other types of debt ($6.4K, 14.1 percent). See Statistics Canada, The Wealth
of Canadians.
3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 55

TABLE 3.1 What do American Families Owe, and to Whom do They

Owe It?

Median Average % With This Type of Debt

$ $ %
Main Residence Mortgage 111,618 152,988 46.3
Other Real Estate Mortgage 102,401 182,070 5.5
Line of credit (Unsecured) 3,891 24,679 1.7
Credit card 3,072 7,475 46.1
Student loans 12,288 22,016 15.2
Vehicle loans 11,776 14,951 34.9
Other debt 5,120 15,667 6.8
Sum of Percentages: 156.5
Total Debt in any Form: 68,916 129,026 77

early 2009), which is much higher than the rate of -0.4 percent
reported by the U.S. Department of Commerce for 2005.3

These Eggs Belong in One Basket

Now, this might not be what jumps out at you from scanning that
table, but what I see—and what concerns me about current levels of
debt—is the extent to which Americans are diversifying their debt by
having multiple liabilities at differing interest rates, instead of using
their income and savings to minimize their borrowing costs.
To understand the phenomenon of “debt diversification,” look
again at our table. Notice that the numbers in the last column add up to
156.5 percent, or more than 100 percent. What this tells us is that some
people owe money to at least two different creditors, and perhaps even

3. Source: U.S. Commerce Department News Releases, August 2008 and April
2009. In Canada, the personal savings rate was 1.2 percent in 2005 and 4.7 per-
cent in the first quarter of 2009. Canadian data from Statistics Canada, “Eco-
nomic indicators, by province and territory (monthly and quarterly),” from
CANSIM tables 079-0003 and 080-0014.
56 YOUR MONEY MILESTONES

more. In fact, the greater the sum of percentages is here, the larger the
fraction of the population that has more than one type of liability.
Many students, for example, borrow from banks using a personal
line of credit, have credit cards, and participate in government stu-
dent loan programs. Now, many of these students might not have
much choice and are essentially forced to borrow from various
sources. Nevertheless, the evidence suggests that a large segment of
the borrowing population is able to consolidate and optimize their
debt, yet chooses not to.
I suspect that people might be spreading their debts across vari-
ous creditors—even in the absence of any liquidity constraints (which
are limits on the amount you can borrow)—to fulfill an unconscious
desire to compartmentalize their liabilities (that is, to break the total
amount down into easier-to-swallow chunks). Or perhaps this is a
remnant from our approach to asset management, in which we are
told not to place all our investment eggs in one basket.
Today, with interest rates at historically low levels and many Amer-
icans fretting about the prospect of higher rates going forward, I believe
it is important to deflect consumers’ attention away from speculating on
the direction of interest rates and more toward examining their own
personal financial balance sheets. Optimal debt management strategies
can and should be implemented independently of the direction of
short-term rates.

Optimal Debt Management Strategies

Across Space and Time
The anecdotal evidence I have encountered is consistent with
what the sparse data suggests. Informal discussions with financial
planners and retail bankers indicate that many of you choose to rely
on various sources of debt, often on an ongoing basis, as opposed to
keeping all your debts aggregated in one account. For example: your
neighbor might be running a credit card balance and making monthly
home mortgage payments, while financing a vehicle and drawing
down a line of credit for renovations, all at different interest rates.
This practice—many different debts at many different rates—
illustrates one dimension of a flawed debt management strategy: debt
3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 57

diversification across space silos. Another dimension of poor debt

management can be labeled debt diversification across time. This
refers to the tendency of consumers to hold and deposit income dol-
lars in a low-interest (taxable) bank accounts rather than using the
funds to reduce outstanding debt balances immediately, in which the
interest charge accumulates at higher (“non-tax-deductible”) rates.
Clearly, it is not rational to diversify debts across either space silos or
time (giving rise to what economists call a cash-flow mismatch), espe-
cially when cheaper debt management strategies are readily available.
The benefits of making an aggregate debt repayment to a single cred-
itor can be substantial. This might be obvious to many, yet it is not
widely practiced, perhaps because the magnitude of the cost of not
implementing this strategy is not well understood.

Liability Silos Compared

According to the 2007 Survey of Consumer Finances, the average
U.S. household carries a credit card balance of $7,500 (2009 dollars).
I will use this number in the numerical example to follow. Let’s fur-
ther assume (just for the sake of this example) that a consumer has an
additional $7,500 balance outstanding on a line of credit. If this fam-
ily can only afford to make a constant payment of $200 per month in
each of these accounts, how long will it take to pay down each type of
debt and how much will it cost?
Research shows that the average credit card charges an annual
percentage rate of 15 percent. A typical secured line of credit would
charge 3.25 percent, based on the current (June 2009) prime rate of
interest. However, some people cannot borrow at average rates.
Accordingly, here are prepared scenarios with average rates (for
credit cards) and prime rates (for lines of credit), and suboptimal
(higher) rates for both debt instruments. All the rates, however, are
assumed to remain constant over time.
Table 3.2 illustrates how long it would take to eliminate the bal-
ance on each account (or debt silo) assuming the same initial balances
of $7,500 and identical payments of $200 per month.
58 YOUR MONEY MILESTONES

TABLE 3.2 How Many Months Does it Take to Pay Off a Debt of
$7,500 in $200 Monthly Increments and What is the Total Cost?

Account Months Sum of Cash Flows

Line of credit (3.25%) 40 $ 7,891

Line of credit (5.25%) 41 $ 8,153
Credit card (15%) 51 $ 10,009
Credit card (18%) 55 $ 10,852

The results are as follows: It takes 40 months to pay off the line of
credit under a 3.25 percent rate and 41 months under the 5.25 per-
cent rate. In contrast, it takes 51 months to eliminate the credit card
debt charging 15 percent and a whopping 55 months to pay off the
credit card charging 18 percent. The total amount paid will vary for
each form of debt and interest rate. It ranges from $7,891 for the
lower interest line of credit to $10,852 for the retail credit card—a dif-
ference of $2,961. Accordingly, if this customer can choose to hold
her debt at 3.25 percent versus 18 percent, she will save nearly
$3,000—or 40 percent of the original debt amount—by using the line
of credit.
Now, if you go even further and assume a hypothetical consumer
who has three different types of debt: two credit cards (with rates of
15 percent and 18 percent) and a line of credit (charging 3.25 per-
cent)—all with the exact same hypothetical balance, the benefits
would be even more pronounced. In total, all the payments that must
be made to pay off the three accounts, that is, the line of credit and
the two credit cards at their respective rates, is $28,752. However, if
all three accounts were consolidated into the line of credit (that is, not
diversified), the payments would only total 3 x $7,891 = $23,672,
which represents potential savings of $5,080 over the life of the liabil-
ities. In addition, the total amount of debt would be eliminated faster,
saving 16 months, compared to waiting 55 months until the last pay-
ment on the retail credit card is made. Alternatively, transferring the
credit card balances to the (higher) 5.25 percent line of credit, versus
holding three separate accounts would result in total payments of
$24,460; leading to total savings of $4,292.
3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 59

You might be interested to look at the effects of debt diversifica-

tion in your own life. I’ve created a calculator at www.qwema.ca that
enables you to enter and compare various debt scenarios, calculating
the impact of any debt diversification you are doing now and the
effects any debt consolidation can make for you.
It is important to stress that the point of this analysis is not to
zero-in on credit card companies and high interest rates, but rather to
illustrate the benefits of optimal debt management. The numerical
results would be comparable if you used a car loan, student loan, or
even a personal loan charging similar interest rates.
Another interesting study that sheds light on the avoidable and
unnecessary financing costs incurred by many consumers comes from
an article recently published in the American Economic Review.4 For
this article, the authors tracked every credit card and checking transac-
tion completed by a group of almost 1,000 households over a two-year
period. The authors’ intent was to identify all the costs these house-
holds could (theoretically) have avoided by simply making different,
more intelligent decisions using the credit cards and accounts they
already had. Examples of foregone savings opportunities uncovered in
their research included people who allowed interest to accrue on a
credit card, while extra cash sat idle in a bank account that could have
paid down a portion of the debt. Others included individuals with dif-
ferent credit cards, each with different interest rates, and all carrying a
balance, even though the lowest-rate card had available credit. (Earlier
in the chapter, I called this debt diversification.) Yet other examples
included people paying checking account fees for an account with a
zero balance, and overdraft fees on their bank account when they could
have used a much cheaper source of credit such as a credit card.
The interesting finding from this research study was that these
careless practices were not rare, nor were they of trivial magnitude.
The hypothetical annual savings per household amounted to hundreds
of dollars on average, and in some cases, it was in the thousands of dol-
lars. Once again, the evidence suggests that there are intelligent ways to
manage debt, and there are careless ways. Within the context of Long

4. Stango and Zinman, “What Do Consumers Really Pay on Their Checking and
Credit Card Accounts?”
60 YOUR MONEY MILESTONES

Division, debt per se is not imprudent or irresponsible. There is noth-

ing wrong with smoothing consumption by borrowing money (espe-
cially when you are young) provided you are smart about how you
manage your financial affairs. And evidence from this study shows that
the savings can be measured in thousands of dollars.

Bottom Line: Debt Diversification

Destroys Value
I am careful to shy away from preaching the virtues of debt-free
living or lamenting the increasing debt load over the last decade. My
analyses and the framework of Long Division takes for granted the
necessity, inevitability, and benefit of debt. My agenda is more
straightforward: first, to point out the extent of debt diversification
and second, to quantify the benefits of consolidating debt. This chapter
identifies two distinct dimensions of inappropriate debt-management
strategies. The first dimension is debt diversification across space
(different silos). The second dimension comes from mismanaging
debt levels across time, in which salary income and deposits sit in low
(or zero) interest accounts while the debt clock is ticking at much
higher rates. Both forms of debt diversification destroy value.
I think that the prevalence of debt diversification can be traced to
what behavioral economists label the existence of mental accounts.
According to the work of Nobel Prize-winning economist Daniel
Kahneman and his co-researcher Richard H. Thaler, investors tend to
segregate and manage their investment holdings in distinct “lock-
boxes” or silos.5 They make decisions within each of these investment
lock-boxes without taking into account the interaction between them.
Thus, for example, investors avoid realizing investment losses on a
particular brokerage account because they want to “close it out” at a
profit. Or consumers create and adhere to budgets for various finan-
cial expenditures but structure the boundaries between these individ-
ual activities arbitrarily. Or people set a financial goal to pay off their
mortgage within 10 or 15 years, even if it means incurring other debts
and liabilities at higher rates along the way.

5. See Thaler and Sunstein, Nudge.

3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 61

The same behavioral phenomena are evident with personal debts

and liabilities. Consumers might be keeping their diversified debts in
small mental accounts—perhaps to avoid the “sticker shock” of get-
ting one statement with a very large balance—even though these
debts can easily be consolidated. If the interest rates underlying the
different silos were identical and the payment terms were the same,
this practice would be harmless. However, in a world of differing
interest rates, small payments over prolonged periods can add up to
substantial sums.

Should You Borrow from Yourself?

The problem of inefficient debt management via diversification
doesn’t just manifest itself in the odd mix of liabilities on the right side
of an individual’s personal balance sheet. In fact, the same problem
occurs when individuals have credit card and other consumer loans at
high rates, when they could easily tap into (and sell some of) their
investments to pay off these loans instead. One example is 401(k)
loans.6 At first glance, advising people to borrow from their 401(k)
plan seems inappropriate and inadvisable except for extreme circum-
stances. No self-respecting financial commentator would advocate
this as a first resort. And yet, research suggests that Americans collec-
tively could save billions of dollars yearly if they did exactly that. Let
me explain.
Two economists at the Federal Reserve Board carefully examined
data from the U.S. Survey of Consumer Finance (SCF), a dataset you
previously saw. In particular, they looked at households who had vari-
ous outstanding debts, such as credit cards, lines of credit, and con-
sumer loans but who also had a 401(k) plan that allowed them to
borrow. Borrowing from the 401(k) obligates you to repay the sum of
funds withdrawn over approximately two or three years, but without
any additional interest cost or tax penalties. In other words, you have to
pay back only principal. Thus, in theory, borrowing from your 401(k)
deprives the missing investments (the withdrawn funds) from growing

6. These are similar to group RRSPs in Canada. However, you can’t borrow against
the assets or from group RRSPs. You can withdraw the funds from an individual
RRSP to pay off high-interest debt, but this is a taxable event that complicates
the analysis and relative benefit.
62 YOUR MONEY MILESTONES

at the same rate as the rest of the investments in the plan. However, if
the rate of interest you are paying on your debt exceeds a reasonable
estimate of this return, it actually makes sense to borrow from the
401(k) instead of from other sources. Why? Because your personal bal-
ance sheet will improve by swapping debts within the various silos.
When these economists began their study, they did not expect to
find many people who could actually borrow from their 401(k) plans
but chose instead to carry high-interest debt. And yet, this is exactly
what they did find. People preferred to carry high-interest debt
rather than borrow from their 401(k), even though it would save them
money in the long run.
Here are some summary statistics. In 2004, the most recent data
available to the authors, approximately 46 percent of surveyed house-
holds reported having a 401(k) plan. The ability to borrow from a
401(k) is something that is determined by the plan sponsors and the
company, and approximately 32 percent of households reported the
ability to take loans from their 401(k) plan. However, a mere 5 per-
cent of surveyed households reported having an outstanding 401(k)
plan loan. This is a small fraction of the total household population,
but it has actually doubled over the previous 12 years. Stated differ-
ently, the loan rate among eligible households was 16 percent. The
median outstanding loan balance was $4,000.7
The main insight from their study, which should resonate with
the results of the previous section, is that a much higher percentage
of eligible households had outstanding consumer debts, likely at rela-
tively higher interest rates given the cost of maintaining credit cards
and other such loans.
The authors claim that approximately 40 percent to 60 percent of
eligible households, depending on the assumptions used, would gain
from restructuring household debt and borrowing from 401(k) plans
instead. Ultimately, the authors estimate that U.S. households could
have shifted more than $9 billion in debt, which is $3,400 per house-
hold, to save $3.3 billion collectively, or an average of $200 per house-
hold per year.
One rather ironic positive aspect of the recent credit crisis and
the greater difficulty many consumers are experiencing in obtaining

7. Stango and Zinman

3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 63

consumer debt is they will likely increase the amount they borrow
from their 401(k) plans, simply because they have no other alterna-
tive. On the one hand, this act will clearly diminish and reduce the
long-term value of their retirement savings. And yet, this likely
implies they will not be paying high interest rates. Only time will tell
whether the good (lower rates) offsets the bad (lower retirement
balances).

The Borrowing Sweet Spot: Age 53

Although it seems many people are making expensive financial
mistakes when it comes to borrowing money and the rates they pay, it
appears that age has something important to do with it. In fact,
researchers at Harvard University and the Federal Reserve Bank of
Chicago found that it seems you will be paying the “best rates” on
your debt at precisely the age of 53.8 If you are younger or older, you
can expect to pay more. Odd result? Let me explain.
Going far beyond the Survey of Consumer Finances data, the
authors merged a massive panel dataset from a number of national
and international financial institutions. They looked at a number of
financial choices people make about borrowing from a variety of dif-
ferent countries, not just the United States (and including places like
Argentina). For example, they examined data on rates paid for home
equity loans (these are similar to a mortgage) and home equity lines
of credit and car loans and small business credit cards.
They also conducted a rather clever study on credit card balance
transfers. In this study, the authors examined (anonymously, hope-
fully) the records of about 15,000 people who transferred credit card
balances from (high-interest) cards to “teaser offer” low-interest
cards. Note that the teaser rates apply only to the transferred balance
and not new purchases. Moreover, any payments made on the new
credit card go toward paying down the transferred balance loan (at
low rates) as opposed to the new purchase balance (at standard rates).

8. Agarwal, Driscoll, Gabaix, and Laibson, “The Age of Reason: Financial Deci-
sions over the Lifecycle.”
64 YOUR MONEY MILESTONES

It is clear that the smart thing to do while the teaser rate is in

force is to continue using the old card for new purchases and avoid
using the new card at all, once a balance has been transferred to it.
The authors deduced the number of people—and their ages—who
behaved smartly after transferring a balance. (All this assumes some-
body carrying a balance at all can be described as clever. Presumably
they were smoothing consumption.)
The bottom line is that the authors compared financial behavior
and the presence of smart financial decisions—such as loan balances,
credit scores, general education, and so on. The main research ques-
tion underlying all their analyses was At what age do consumers
exhibit the best and smartest financial planning behavior?
The results of their rather exhaustive study across all these differ-
ent data are remarkably consistent. Thus, for example, they docu-
mented that college graduates are “better” at these decisions and
hence pay less in total costs compared to high school graduates (yet
another reason to invest in human capital). They also found that indi-
viduals with graduate degrees made better decisions than those with
only a college degree. And yet, there was something about age 53.
In their words: “We find that younger adults and older adults bor-
row at higher interest rates and pay more fees than middle-aged
adults, controlling for all observable characteristics including multi-
ple measures of risk.” The researchers documented something they
called a “U-shaped pattern” in the price people pay for financial serv-
ices, and their explanation for this pattern was part behavioral and
part biological. They believe the U-shaped pattern comes from a
trade-off between wisdom, which comes from experience, and age-
related declines in cognitive ability. For the authors, the trade-offs
are as follows: younger borrowers lack life experience; however, older
adults are sometimes subject to decreasing cognitive capacity.
To sum up, in the words of the authors: “Middle-aged adults may
be at a decision making sweet spot. They have substantial amount of
practical experience and have not yet had significant cognitive
decline.”
3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 65

Oh, and Being Slim Can Help as Well

And, if you are surprised to learn that age 53 is the optimal age in
terms of the lowest financing costs, some researchers in Japan have
found an even more shocking result: being skinny pays interest!9
These researchers established a number of rather odd empirical
facts, albeit with data that is limited to the Japanese, which perhaps
should be interpreted with tongue in cheek. They examined data
from the comprehensive Japan Household Survey on Consumer
Preferences and Satisfaction in 2005. This provides a comprehensive
report of both financial (balance sheet, income statement) and—in
contrast to the Survey of Consumer Finances in the U.S.—detailed
health metrics for Japanese households. In particular, they focused
on body mass index (BMI), which is defined as weight in kilograms
divided by height in meters squared. If the BMI value was less than
18.5, the individual was defined as underweight. If the BMI was
between 18.5 and 25, the individual was defined as normal. And any-
thing above 25 was considered pre-obese and then, beyond 30,
obese. (In Japan, BMI categories are calculated slightly differently
than in North America.) This number was then “regressed” (or linked
to) whether the individual had any debt. Accordingly, the average
BMI for debtors was approximately 23.26, whereas the BMI for non-
debtors was 22.7, which was a statistically significant difference.
It seems that debtors are likely to be more obese than nondebtors
are; a fact the researchers attributed to what economists label greater
“time discounting.” In other words, according to the researchers,
overweight people tend to be more impatient and would rather con-
sume more today than tomorrow. Hence, although they might like to
smooth (a lot) of consumption, they tilt the smoothing toward the
present as opposed to the future. A survey administered by the
researchers seems to indicate that people with higher BMI values
tended to discount at greater personal interest rates and in general
exhibited more impatience.
Whether these results are applicable to the United States or
Canada is unclear, but one thing is certain: Your human capital will be

9. Ikeda, Kang, and Ohtake, “Fat Debtors.”

66 YOUR MONEY MILESTONES

worth much more if you keep consumption both smooth and rela-
tively modest, which can have desirable effects on your waistline, too!

Debt Literacy as Distinct from General

Financial Literacy
One last study worth noting, which continues on the “financial
mistakes” theme, is an article called “Debt Literacy, Financial
Experiences and Overindebtedness” published by the National
Bureau of Economic Research in 2009.10 The authors surveyed lev-
els of financial literacy (from a group of approximately 1,000 U.S.
residents) in the general population. They looked in particular at
what they called vulnerable demographic groups within the general
population, such as the elderly, certain minorities, people with
lower incomes and lower net worth, and women. They asked mem-
bers of these groups various questions to elicit their debt literacy.
The exam-style questions were structured to include multiple possi-
ble answers and dealt with a variety of issues such as the mathemat-
ics of interest rates, credit card mechanics, etc. The results were
then graded by the professors who were the authors of the report, as
well as the respondents themselves, who were asked to assess their
literacy.
Their results are quite sobering and alarming. In their words:
“Individuals with lower levels of debt literacy tend to transact in
high-cost manners, incurring higher fees.... One third of the charges
and fees paid by less-knowledgeable individuals can be attributed to
ignorance.”
Even more striking was that many of the people who scored
poorly on the debt literacy questions actually scored their own knowl-
edge quite highly. In particular, the elderly respondents thought they
know much more about interest rates, debts, and credit cards than
they demonstrably did!

10. Lusardi and Tutano.

3 • HOW MUCH DEBT IS TOO MUCH AND HOW MUCH IS TOO LITTLE? 67

Concluding Thoughts: Is Debt Soothing

or Smoothing?
Most financial commentators differentiate between borrowing
that is used for investment purposes at relatively low interest rates
(aka good debt) and discretionary borrowing used for consumption
and expenditures at relatively high interest rates (aka bad debt.)
According to the consensus view, good debt makes financial sense
and should be encouraged in moderation, whereas bad debt, result-
ing from poor financial hygiene (the set of habits, attitudes, and
behaviors people have toward managing their finances) should be
shunned.
In contrast, I have tried to argue that human capital thinking and
holistic balance sheet management results in a different perspective.
Yes, I agree that using your credit card to buy yet another gadget you
will never use and don’t really need is “bad” financial planning. And
individuals who are ignorant of the basics of credit card interest rates
and compounding periods are paying more than they should and suf-
fer from these financial mistakes.
Yet I believe that much less emphasis should be placed on the
purpose of the debt itself or even the absolute rate you pay, and much
greater emphasis on getting the best possible rate relative to your
individual financial condition and the overall standard of living this
creates over the course of your life. Either way, debt isn’t evil. It’s a
tool.
And so, the main question you ask yourself when contemplating
going into debt shouldn’t be, Can I afford this particular purchase?
Rather, I suggest you ask yourself, Will today’s purchase, which might
be financed by high cost and long-term debt, reduce my future stan-
dard of living by more than the purchase will increase my present
standard of living? If the answer to this second question is yes, or
even maybe, the purchase doesn’t make sense from a Long Division
perspective. On the other hand, if you are relatively secure that your
long-term (sometimes called permanent income) is greater than your
current income, by all means go ahead and borrow, consume, and
enjoy.
68 YOUR MONEY MILESTONES

Summary: The Four Principles in Action

• Critical to the successful application of Long DIVISION over
the life cycle is the ability to borrow money at reasonable rates.
Oddly enough, many people behave quite irrationally when it
comes to borrowing money. It’s not that they borrow too much,
but that they tend to pay different rates on different debts and
practice an inappropriate diversification strategy.
• There are two aspects of flawed debt MULTIPLICATION
strategies: diversification across space silos and diversification
across time. Both forms SUBTRACT value from your total
net worth.
• The best way to think about debt is not to focus on the ADDI-
TION of debt, but to focus on getting the best possible rate rela-
tive to your individual financial condition and the overall smooth
standard of living this creates over the course of your life.
 4
Are Kids Investments and Can Marriages
Diversify?

Of the many questions I ask my undergraduate students during the

semester-long course on personal finances, the question I ask to kick-
start the lecture on family economics provoke the strongest response.
Here they are: Are children financial assets or liabilities? And, did your
parents have you for consumption or investment purposes?
After the yelling subsides and the classroom returns to normal, I
add that I’m sure their parents love them very much (for the most
part)—but note that at the same time, my students must acknowledge
that kids aren’t free, and they can have quite a detrimental impact on
a family’s personal finances. Here are some facts: According to my
much-referenced Survey of Consumer Finances (SCF), in the year
2007 couples without children reported an average net worth of more
than $800K, whereas couples with children had an average net worth
of only $594K, or about 25 percent less.1 This gap is not arbitrary or
unique to the year 2007: The same pattern can be observed in the
1998, 2001, and 2004 waves of the survey. Moreover, if anything, the
gap has been getting larger over time. So, at first glance, it seems that
having kids makes you poorer! Now, whether this proves true in the
long run, or whether it is a function of the age of the parents sur-
veyed, or whether net worth is measured much too narrowly (after
all, the SCF measures only traditional financial capital)—all these

1. The median U.S. net worth was $191K for couples without children and $141K
for couples with children. In Canada, the numbers are similar: in 2005, the
median net worth for couples without children at home was $242,900, which is
$53,900 (or 29 percent) more than couples with children under 18, whose net
worth was $189,000. For Canadian data, see The Wealth of Canadians.

69
70 YOUR MONEY MILESTONES

issues are up for debate. However, it seems clear that decisions about
marriage and family have financial implications. In this chapter, I
devote my attention to the implications of life-cycle thinking, holistic
balance-sheet management, and the rule of Long Division to deci-
sions about childbearing and family formation (that is, getting mar-
ried and having kids, not necessarily in that order).

Children: Explicit Liabilities, Hidden

Assets
Like most of the other topics I address in this book, the decision
to have (or not to have) children is deeply personal and involves much
more than simply dollars and cents. For example, in some cultures,
procreation is viewed as a straightforward religious obligation, wholly
independent of personal wealth and financial means. The Biblical
story of God’s commandment to Adam and Eve in Genesis 1:28: Be
fruitful, and multiply, and replenish the earth can be taken quite lit-
erally, as a requirement to have as many children as physically possi-
ble. In countries and places around the world, children are an
economic necessity because they create another helpful pair of hands
within the household, to assist on the family farm or in the fields. Yet
other people view a large family as evidence of financial success; a
status symbol akin to a large house or expensive car. Still others might
not give the question of having children much thought until it is too
late. Yet, independent of all other, nonfinancial factors, the financial
and economic implications of children cannot and should not be
ignored. Why not? Because having children will dramatically alter
your holistic balance sheet—perhaps in ways that will surprise you.
According to a survey conducted by the U.S. Department of Agri-
culture, the average cost of raising a child from birth until 18 is
$221,190 for a child born in 2008.2 (A more precise estimate depends
on your individual income and wealth level, mainly due to a variety of

2. In Canada, the cost to raise a child from birth to age 18 is estimated at

$183K. See Canadian Council on Social Development’s Stats & Facts: Canadian
Families at http://www.ccsd.ca/factsheets/family/index.htm. Figures adjusted for
inflation.
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 71

tax credits and deductions that are available in the U.S. tax code.) I’ve
included a basic calculator at www.qwema.ca to enable you to esti-
mate the cost today of raising your existing or planned kids to age 18.
This range, of course, does not include the escalating cost of college,
and it assumes the child actually moves out of the house at the age of
18. (How many kids do that nowadays?)
At first glance, it seems kids are terribly expensive. If this is so,
could paying parents to have children increase the supply of kids in a
society? Here is but one interesting case.

Inducing More Children

In the mid-1980s, the provincial government in the Canadian
province of Quebec became alarmed at the rapid decline in its overall
fertility rate (defined as the average number of children born to each
female). Historically Quebeckers, with their strong Catholic identity,
had large families with sometimes as many as 15 children per house-
hold. Without a doubt, they had the largest families and highest fertil-
ity rates in Canada.
Demographically, a society needs a fertility rate of 2.1 children per
female to maintain a stable population; one that neither grows nor
shrinks over time. (The extra 0.1 is needed to account for children that
either die prior to giving birth themselves or decide not to have children.)
By the mid-1980s, this rate had fallen drastically in Quebec to 1.36 chil-
dren per female. What this meant, in general terms, is that if there
were a total of five million Quebeckers in the current generation, of
whom half were male and half female and a birthrate of 1.36 children
per woman, one generation from now the population would shrink to
3.4 million Quebeckers. (The 2.5 million males are assumed to have
zero offspring—this not as obvious as you might think—and the 2.5
million females would give birth to the 1.36 children each. So, 2.5 mil-
lion women x 1.36 children per woman = 3.4 million children born.)
Going forward, if you assume half of those 3.4 million new chil-
dren are male and half female, and those females have 1.36 children
each, then the total number of children born in the second generation
would be 2.3 million; and so on, as the effects of the low fertility rate
worked their way through the population. (I am oversimplifying this
discussion, but I trust you get the general picture.) In contemplating
72 YOUR MONEY MILESTONES

the low fertility rate among their shrinking population, the Govern-
ment of Quebec felt it had to do something, soon, or eventually there
would be no more Quebeckers. The human capital of Quebec was at
stake!
So, and this is where the story becomes relevant to money mile-
stones, in the 1980s the provincial government brought in a program
called The Allowance for Newborn Children or, as it became known,
“bucks for babies.” Under this program, parents were paid approxi-
mately $500 Canadian (CAD) (slightly less than $500 U.S. dollars)
upon the birth of their first child, and $1,000 CAD for their second
child. If they had additional children beyond two, they could get
much more, as much as $8,000 (nontaxable!) for each birth.
Now, do you think these payouts helped induce fertility and
increase the birth rate? Well, you might be surprised that the answer
is not by much. After all, when you compare a few thousand dollars in
government transfers to the potentially hundreds of thousands of dol-
lars in future costs to raise each child, it would be surprising if these
sums had any impact at all. In fact, the Government of Quebec
opened the cash registers even further with ongoing financial induce-
ments for children and even began to provide universal daycare at
greatly subsidized rates. But none of this helped much. Indeed, if the
decision not to have children was purely motivated by financial con-
siderations, you would have expected to see greater change to the fer-
tility and birth rate as the cash piled up in the hands of parents.
Interestingly enough, it was only after the provincial govern-
ment went one step further in 2006 and legislated the most liberal
and generous parental leave in the country—that is, the amount of
paid time parents can take off work to care for their children—that
there started to be some noticeable change in behavior. By 2006, the
fertility rate had increased to 1.62 children per female, and the
number of births has been rising each year since. The 2008 rate
was 1.74, which is the highest rate since 1976. Moreover, although
this change might have been a result of all the cumulative induce-
ments, perhaps the ability of working parents to actually stay
home and enjoy their children had the greatest impact of all. By the
way, as of early 2009, the population of Quebec had risen from 6.6
million in 1985 to nearly 8 million; the supply of human capital is
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 73

increasing!3 And, raising these kids might not be as costly as you

think.
In the next section, you see how children can serve not just as
balance sheet liabilities but also as de facto pensions for their par-
ents. Sound strange? Read on for some surprising insights.

Children as Pensions—And a General’s

Revenge
The modern state-funded pension system, like the U.S. Social
Security program or the Canada Pension Plan, can be traced back to
the German chancellor Otto von Bismarck (1815–1898). Over 125
years ago, back in 1881, he introduced his concept of the first state
pension plan to the German parliament. Under his plan, which was
adopted in 1889, a basic income would be provided to all retirees
when they reached the age of retirement and financed by a tax on
workers. (The initial age of retirement proposed by Bismarck and
adopted by the German state was 70. The age of retirement was
reduced to 65 some 27 years later, in 1916.4)
Although I discuss pension milestones and retirement income
planning in greater detail in the final chapter of this book, at this
point I want to explore some general comments about the relation-
ship between pension plans and family dynamics.
Chancellor Bismarck’s pension prototype, which was refined by
Britain’s Sir William Beveridge in the early 1940s, has become known
by the acronym PAYGO, for Pay As You Go. Under a PAYGO pen-
sion, retired workers are supported by, and indirectly receive their

3. Statistics on the fertility, population, and birth rates in Quebec are taken from
the Institute de la statistique, Quebec; available at www.stat.gouv.gc.ca.
4. There is a persistent myth that Germany adopted age 65 as the standard retire-
ment age because that was Bismarck’s age. In fact, Germany initially set age 70
as the retirement age (and Bismarck himself was 74 at the time), and it was not
until 27 years later (in 1916) that the age was lowered to 65. By that time, Bis-
marck had been dead for 18 years. See the brief history at Social Security Online,
the official website of the U.S. Social Security Administration: http://www.
socialsecurity.gov/history/ottob.html.
74 YOUR MONEY MILESTONES

pensions from, younger workers still in the labor force. Think of

PAYGO pensions as a straight demographic transfer, or like passing
the collection plate at church. In a sense, the young (children) sup-
port the old (parents), and this compulsory transfer mechanism is
enforced and managed by the state.
But for PAYGO pension systems to work efficiently and cheaply,
society needs many more (younger) workers in the labor force than
retired workers receiving payments. That is, at the most basic level, to
pay for workers’ pensions, society needs many children. In fact, this is
precisely the reason that so many states (including the Canadian
province of Quebec, as you previously saw) are preoccupied with
increasing fertility rates.
Unfortunately, the pension systems envisioned by Bismarck and
Beveridge have not withstood the test of time and are now on shaky
ground. In many countries, where fertility rates are quite low, the
ratio of retired workers to children is exploding. Thus, although the
original design envisioned perhaps one or two retired workers per
100 active workers contributing to the PAYGO system, the numbers
have now increased to 12 retired workers per hundred active workers
in the year 2010, globally. And, although some developing countries
(such as India) still have old age dependency ratios of eight retirees
per 100 workers, in other countries the ratio is as much as triple the
world average—or more. For example, in Japan the number is close
to 35 retirees per 100 workers, and in Germany, the birthplace of the
state pension plan, the ratio is close to 30 per 100. In the year 2050,
assuming current fertility ratios continue, Japan will be facing an
astonishing 75 retirees per 100 workers; whereas Germany, Italy, and
Spain will have almost 60 retirees to support for every 100 people in
the labor force. For all these countries, there is a connection between
their high projected future old-age dependency ratios and their low
fertility rates: In Japan, the fertility rate is 1.2 lifetime births per
woman; in Spain, it is 1.3; and in Germany, it is 1.4.5 It is clear that for
countries with PAYGO pensions, small families and few children can

5. Projections of worldwide dependency ratios are taken from The 2009 Ageing
Report by the European Commission.
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 75

lead to problems.6 For those of you who are wondering, the situation
in the United States isn’t as bleak, although it is certainly worrisome.
In 2010, the old-age dependency ratio is close to 20 retirees per 100
workers, and it is expected to hit 35 by the year 2050. These are not
European or Japanese numbers, partially because of the relatively
higher U.S. fertility rate of 2.1. Furthermore, the U.S. Social Security
system isn’t as generous (it doesn’t pay as much) as European or
Japanese state pension plans, which is yet another reason that the
United States has some time before it faces the PAYGO pension crisis
unfolding in many other countries, although the United States will
soon have to contend with this as well.
Interestingly, and more relevant to our discussion, when Chan-
cellor Bismarck’s pension scheme was introduced to the German
Reichstag back in 1881, he emphasized that the motivation for his
reforms was to preserve a sense of human dignity for the elderly and
to prevent them from having to rely on charity. Perhaps the PAYGO
pension system can be understood as the revenge of the elderly (Bis-
marck had just turned 66) and the infirm against the young and agile.
In fact, to quote a recent German study, “Bismarck wanted the pen-
sion system as a substitute for the transfer mechanisms of the tradi-
tional family that had been destroyed by the industrial revolution,
seeing it mainly as a means to avoid the neglect and mistreatment of
old people by their children.” The article continues that, “A PAYGO
system may serve as an enforcement device for ungrateful children.”7

Thwarted by Good Intentions

Although Bismarck had good intentions, the viability of his
funding system has been called into question. When Bismarck
picked the age of 70 as the age of retirement, life expectancy in Ger-
many (at birth) was a mere 39 years. It was rare for people to reach
the age of retirement, and even those who were lucky didn’t live

6. See Beck, “A Slow-Burning Fuse,” especially “Scrimp and Save: Pensions Will
Have to Become Far Less Generous,” and “Suffer the Little Children: Most of
the Rich World is Short of Babies.”
7. Emphasis added. Sinn, “The Pay-as-You Go Pension System as Fertility Insur-
ance and an Enforcement Device.”
76 YOUR MONEY MILESTONES

very long after. Indeed, if the German retirement system had added
as many years to the retirement age as have been added to overall
life expectancy over the last century, the official retirement age
would now stand at 95 years rather than 65!8 But now, as fertility
rates drop and life expectancies continue to rise, and as the tradi-
tional age of retirement has actually decreased since Bismarck’s ini-
tial proposal to 65, the sustainability of this model is increasingly
uncertain. And so, perhaps when you think about the high cost of
raising children, it’s worth noting that your kids might be your (only)
pensions given the current fiscal imbalances and structural deficits
of most government pension plans such as U.S. Social Security. That
is, investing in your kids’ developing human capital might help reduce
your own personal liabilities many years from now, in retirement.
What am I talking about?
Think back to the picture of the holistic personal balance sheet I
presented in the Introduction, “Human Capital: Your Greatest
Asset.” On the left side are capital assets, and on the right side are lia-
bilities. Some of these liabilities are explicit, such as the loans and
debts I discussed in Chapter 3 (“How Much Debt Is Too Much and
How Much Is Too Little?”), but many others are implicit. The birth of
a child creates an immediate, implicit liability on the parents’ holistic
balance sheet in that she or he must be cared for, and this requires
resources. This liability might explain why the net worth of families is
lower, on average. But there is another hidden liability on your holis-
tic balance sheet; one that your kids might actually be able to help
you offset—the cost and debts that can accrue as you age. For exam-
ple, people over the age of 65 spend about four times as much as
those under 65 on health care, and a 1997 study found the average
cost of nursing home care in the U.S. ranges from $36,000 to $80,000
per year.9 I am going to suggest that in most (if not all) families with
an above-average number of children—and yes, these families have

8. Liedtke, “From Bismarck’s Pension Trap to the New Silver Workers of

Tomorrow.”
9. Health care costs for people under and over 65 are taken from Goldman and
McGlynn, “U.S. Health Care.” Estimates of national U.S. nursing home expen-
ditures are drawn from data provided by the National Center for Health Statis-
tics, 2000.
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 77

incurred above-average costs of child raising—parents are shielded

from many of the costs of aging. In other words, your kids can func-
tion like pensions!
I am not just speculating (or hoping, since I do have four daugh-
ters). A number of recent studies by gerontologists and social workers
have identified similar cost savings. Research from data in developing
and developed countries alike suggests that a “statistically significant”
portion of grown-up children (27 percent, in one U.S. study) transfer
personal services and cash to their elderly parents, even in countries
with the “most extensive pension and welfare systems.”10 However, it
seems that although some children and grandchildren are their par-
ent’s pension plan, in some cases the situation is reversed, and the pen-
sion that was intended for the grandparent ends up in the pockets and
bellies of the grandchildren. In fact, if the evidence from South Africa
is instructive, this is true more so for girls than for boys, and for grand-
mothers more than grandfathers. According to researchers, female
grandchildren living with grandmother state pension recipients saw
improved health outcomes as a result of the pension income coming
into the household. Yet oddly enough, when grandchildren lived with
a grandfather, there was no change in the children’s health.11 Perhaps
grandmothers use pension income to smooth consumption across the
lives of their granddaughters as opposed to their own life.
So, here’s the bottom line: The birth of a child is truly a milestone
in your human life cycle, with importance on an order of magnitude
that can’t be quantified using dollars and cents. That said, like the
other significant decisions in your life, there is a financial angle to hav-
ing children that also can’t be ignored. Indeed, the short- and medium-
term costs of children can be enormous. For many people, children
are thus a “luxury good” that must be rationed and budgeted for. And
yet, as I have argued, the long-term implications on your personal bal-
ance sheet associated with having children might be contrary to con-
ventional wisdom. Your teenager might eat you out of house and home

10. The discussion of transfers from grown-up children to elderly parents (or “chil-
dren as pensions”) is taken from Cigno, “How to Avoid a Pension Crisis: A Ques-
tion of Intelligent System Design.”
11. Duflo, “Grandmothers and Granddaughters.”
78 YOUR MONEY MILESTONES

today but will help you smooth consumption tomorrow as he cares for
you in later years, either by supporting you financially or by providing
goods and services that you’d otherwise need to purchase. After your
kids are born, your balance sheet needs to adjust to include both the
implicit immediate liabilities associated with raising a child, but also
the future implicit asset they represent for you. As a parent, you are,
once again, wealthier than you think. And that measure doesn’t include
the cute dividends that having children can pay—that is, grandkids!
Now let’s look at how marriage changes our approaches to finan-
cial risk. I’ll focus on one population subset I find especially allur-
ing—Italian women.

Is Marriage a Safe Investment on the

Balance Sheet?
A number of researchers around the world have documented that
women tend to have more conservative, that is, less risky, investment
portfolios than men, and that single females are less likely to invest in
risky assets such as stocks and equities, compared to females who are
married. The consensus from the research seems to be that women
have a higher degree of financial risk aversion and a lower tendency
to allocate their financial capital (and perhaps even human capital) to
risky endeavors than men do.
One of the most frequently referenced studies related to this phe-
nomenon was conducted by two researchers at the University of Cali-
fornia and published under the provocative title “Boys Will Be
Boys.”12 This study provided ample evidence to argue that men are
more prone to what behavioral economists call overconfidence in
investing (which isn’t good for anybody, actually). According to the
authors, this overconfidence leads men to needlessly trade more fre-
quently than women, while investing their savings in a more haz-
ardous manner. As a group, the researchers found that men were
trading more frequently and investing more riskily because they think
they have specialized skill or knowledge about investing, when in
fact—judging by their results in aggregate—they do not. As a result, in

12. See Barber and Odean.

4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 79

the long run, men’s portfolios (especially those of single men) actually
earn less than female investors who are less prone to overconfidence.
I’m sure that you might resonate with this particular explanation—in
particular the women among you—but I believe there might be a
deeper and perhaps more satisfying explanation for the “single,
female, and safe” portfolio phenomenon. This alternative explanation
comes from a recent study of the marital habits and investment deci-
sions of Italian women, conducted by (Italian) researchers at the Insti-
tute for the Study of Labor (IZA) in Bonn.13 Now, being married to a
strong-minded Italian woman whose large family immigrated to
Canada in the 1950s, let me admit at the outset that first, I have to be
very careful about what I say here, and second, I’m clear that Italian
women don’t take any decisions lightly, especially decisions about
marriage. They think strategically, and children and the family are the
center of their universe. Indeed, as you will see, you can learn much
from the financial acumen of Italian women!
Getting back to our study: researchers at the IZA used data from
the Bank of Italy’s survey of Household Income and Wealth, which is a
detailed dataset similar in scope and purpose to the U.S. Survey of
Consumer Finances, during the period 1989 to 2006. The authors pre-
sented evidence, consistent with the international evidence, that
unmarried Italian women are the least likely to hold risky investment
assets such as corporate stocks and common shares. Married women, in
contrast, don’t exhibit the same reluctance to assume investment risk.
The researchers found that in 1989, the first year for which they
had data, single (Italian) females allocated almost 90 percent of their
investable financial capital to safe assets and only negligible amounts
to risky investments. In contrast, in the same year, married (Italian)
females had closer to 85 percent in safe assets and a much larger frac-
tion in risky investments. Although the reported differences might
not appear substantial, these numbers are statistically significant and
quite robust across more than 71,000 individual observations. More-
over, this variation in risky versus safe asset holdings could not be
explained by age, income, wealth, or education. In other words, even

13. Bertocchi, Brunetti, and Torricelli, “Marriage and Other Risky Assets: A Portfo-
lio Approach.”
80 YOUR MONEY MILESTONES

after separating the data into groups of people with equal education,
equal wealth, equal income, and so on, the researchers observed the
“single, female, and safe” phenomenon. So what happened? Could
marriage have changed Italian women’s risk tolerance or emboldened
them to invest more like men? It seems that marriage enamors
women...to the stock market.
The authors’ explanation for this increased risk tolerance was not
psychological, biological, or behavioral. Rather, they attributed this
behavior to the intuitive concept of the family balance sheet and the
value of human capital. In the authors’ words, “Our hypothesis is that
marriage may work as a sort of safe asset when women make portfolio
decisions.” In my words, women focus on the holistic balance sheet of
the family unit and make investment decisions based on all sources of
human capital. After they are married, their holistic balance sheet
gains another source of stable income that then enables them to take
on greater investment risk, even if their so-called personal risk toler-
ance remains unchanged.

Two Plus Two Equals a Very Safe Four

I will return to the impact of human capital on investment and
portfolio considerations later in Chapter 8 (“Portfolio Construction:
What Asset Class Do You Belong To?”), but for now, it’s worth noting
that just like for these Italian women, the entire family’s human capi-
tal should ideally be taken into account in all household financial and
investment decisions. Moreover, although human capital is the most
valuable asset on the personal balance sheet, it is much safer to have
two people each earning and generating their own wages, compared
to only one individual earning double the wages. In this case, 50 plus
50 is definitely safer than 100, even though it might be equal to only
100. It seems that Italian women intuitively know this and base their
financial decisions accordingly. In short, marriage enables them to
take risks that would have been imprudent otherwise.
Now, this study of Italian women provides more than just another
hypothesis or different explanation for observed gender and marital sta-
tus behavior. The authors actually produce some clever evidence that
backs up their “portfolio of marriage” theory. But first, some more Ital-
ian background, not about marriage, but about its opposite—divorce.
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 81

In Italy, divorce did not become legal until the mid-1970s. As you
might imagine, the Roman Catholic Church tried hard to prevent the
legalization of divorce by lobbying for various referendums when the
legislation was introduced, but by 1974, it was (finally) possible to
divorce in Italy. Initially couples could obtain a divorce only after five
years of legal separation, but the (reported) divorce rate jumped from
virtually zero in the early 1970s to almost 30 percent by the end of the
decade. By 2006, the Italian divorce rate was approaching 50 percent.
The reason this is relevant to our study is that as divorce rates
increase—all over the world, and not just in Italy—you would expect
to see a gradual erosion of the perception of marriage as a safe asset.
In other words, the observed difference between the financial capital
allocations of (currently) married females and (currently) single
females should weaken. And, in fact, that is exactly what our Italian
authors observed over the 18 years of data. They conclude, “The dif-
ferential behavior of single women has evolved over time, and this
evolution, rather than being determined by exogenous [external] vari-
ations in risk attitudes, can be related to the increased incidence of
divorce and the expansion of female labor market participation. Our
results suggest that women’s perception of marriage as a safe asset, as
reflected by their portfolio choices, has been shaped by the transfor-
mation of the structure of the family and society.” In other words,
Italian women are no longer placing as much stock, literally, in mar-
riage as a safe asset but are hedging their risk (of marriage break-
down) by increasingly investing like single women.
From my perspective, these findings fit quite nicely with my posi-
tion that many of the decisions people face over their human life
cycle, such as marriage and the possibility of divorce, are (at least par-
tially) driven by holistic balance sheet and income smoothing consid-
erations. That is, when you make milestone decisions, whether about
kids or marriage (or divorce), you should always keep an eye on the
financial angle.

Fiscally Fatal Attractions

Although Italian women display evidence of careful portfolio con-
siderations when it comes to marriage, it seems that back in the
United States the result is less conclusive. If you focus strictly on
82 YOUR MONEY MILESTONES

financial considerations, you find that some women consistently

marry the wrong guy (and vice versa) according to an interesting
study by researchers at Wharton Business School and Northwestern
University.14 In general, the consensus among researchers (and mar-
riage counselors) is that when selecting marriage partners, both males
and females tend to select people with comparable traits, similar val-
ues—and occasionally even the same name! This finding is consistent
with the old saying that “birds of a feather, flock together” and is
described in academic literature as positive assortment (the act of dis-
tributing things into classes or categories of the same type) as
opposed to complementarity (relations between opposites).
However, when looking strictly at how attitudes toward finances
play into how people choose mates, you don’t find “birds of a feather,
flock together” but exactly the opposite. Apparently, a disproportion-
ate number of (what the researchers call) tightwads tend to marry
(what the researcher call) spendthrifts. And, surprisingly, neither is
very happy as a result.
The Wharton and Northwestern researchers surveyed close to a
thousand people, almost half of whom were married, and asked them
questions about their “emotional reactions” to spending. In particu-
lar, they were asked a variety of questions—with answers on a scale of
one to seven—about whether the prospect of spending money made
them anxious, conflicted, or regretful. Individuals reporting larger
values (close to 7) were considered “tightwads,” who generally spend
less than they would ideally like to spend; whereas individuals with
lower self-declared scores (close to 1) were considered “spend-
thrifts,” who generally spend more than they would ideally like to
spend. Next, these individuals were asked to report and quantify their
spouse’s emotional reactions to the prospect of spending money,
using the same “spendthrift to tightwad” scale. Now, you might not
consider this the best or only measure of emotional attitudes to
spending versus saving, but it is a fair starting point. The survey was
administered to both members of the couple, and it included stan-
dard questions that measure marital well-being by assessing the

14. Scott, Small, and Finkel, “Fatal (Fiscal) Attraction: Spendthrifts and Tightwads
in Marriage.”
4 • ARE KIDS INVESTMENTS AND CAN MARRIAGES DIVERSIFY? 83

extent to which partners are satisfied with the marriage, agree on

important issues, and share interests. Finally, the researchers also
posed questions that measured the extent to which money was a
source of conflict in the marriage.

Birds of a Feather May Not Flock Together

The result from all these surveys and questions was indisputable
and quite interesting. The correlation between tightwad/spendthrift
scores of individuals and their spouses was negative and statistically
significant. In other words, opposites are often attracted (or at least
married) to each other. In the language of the researchers,
complementarity as opposed to positive assortment is observed.
Moreover, this bodes poorly for marriages because the same pairs
scored quite low on the marital well-being scale.
Now, why there might be an “opposites attract” phenomena when
it comes to fiscal prudence and financial attitudes is subject to some
speculation, but the authors of the study suggest a rather peculiar rea-
son: They blame it on a form of self-loathing. Bear with me here for a
moment. In their words, “We find that the extent to which people are
attracted to mates with opposing emotional reactions towards spending
is significantly correlated with the extent to which they are dissatisfied
with their own emotional reactions towards spending.” The researchers
actually replicated these results in a variety of other survey formats and
questionnaires that corrected for some of the possible biases that might
occur when people are asked to self-assess attitudes to money.
Although unmarried people claim in surveys that they would like
and plan to select mates who share their emotional attitude toward
spending and savings, to the extent that they dislike their relationship
with spending, they tend to actually be attracted and actually marry
people with the exact opposite emotional attitude. They might be
attempting to correct for or influence the disliked aspect of the self
with this mate choice—perhaps even to diversify the household’s
approach to spending (as one splurges, the other will show restraint).
However, whatever their motivations were, this strategy did not lead
to greater marital bliss; the research suggests that these differences in
emotional attitudes toward spending and saving are actually associated
with greater financial conflict and diminished well-being in marriage.
84 YOUR MONEY MILESTONES

Either way, the results of the above study serve to remind us that
although it might be optimal to think of the family unit as a diversify-
ing source of human capital, which then allows you to better smooth
consumption and practice (what I call) Long Division in a rational
manner, there are many other psychological factors that can have an
extraneous impact on the monetary milestones in your life. Perhaps
diversification is good when it comes to financial capital, but not when
it comes to emotional attitudes to money. In other words: Don’t count
on your spouse to bail you out of your attitude toward spending—or
understand that if you do, your marriage might suffer as a result.

Summary: The Four Principles in Action

• At first glance, it seems that the act of MULTIPLICATION (by
adding to your family) makes you poorer, by SUBTRACT-
ING assets you now need to care for that child. But, in addition
to all the other wonderful benefits from children, they also
ADD to the holistic personal balance sheet. Accounting for
children on your holistic personal balance sheet involves both
subtraction (when they are young) and surprisingly enough,
addition (when you are old).
• With the decreasing number of active workers available to
support pensions for retired workers, the viability of state-
sponsored pension plans is increasingly in question. One alter-
native source of pension-like income transfers is children.
Perhaps people with large families already have this figured
out—DIVIDING support for parents among many kids.
• Evidence from married Italian women—and anecdotally veri-
fied by many others—suggests that marriage can be viewed as
a financially stabilizing event, enabling women to take on more
investment risk than their single counterparts because two plus
two salaries ADD up to a safer income stream.
• Speaking of marriage, it seems that self-loathing tightwads and
spendthrifts are often married to one another. However, these
relationship matches tend to SUBTRACT from marital happi-
ness over time.

You see. Everything boils down to four basic arithmetic operations!

 5
Government Tax Authorities: Partners,
Adversaries, or Bazaar Merchants?

In late 1994, just around the festive Christmas and New Year’s
time of year, the State of Minnesota carried out what can be
described only as a cruel experiment on its citizens. When I tell this
story to my students, they often shudder and some even groan aloud.
I like to start my lecture (and now this chapter) with the story of this
infamous experiment because it can teach us quite a bit about the
most unpleasant, reoccurring financial milestone in everyone’s life:
April 15, which is the deadline for filing taxes in the United States.1
Here’s what happened in Minnesota. Approximately 47,000 taxpay-
ers who filed their (1993) tax returns properly and on time were cho-
sen at random in April 1994 by the Commissioner of Revenue for an
“experimental treatment” in anticipation of the next tax filing season.
From this large group, one subgroup received a generic letter
reminding them to file their taxes honestly and on time. Another
subgroup was informed they had been selected to access special
assistance in compiling their federal tax returns by calling a free help
line. Finally, about 2,000 people were informed by the commis-
sioner, in writing, that the tax returns they were about to file would
be closely examined by the Department of Revenue. Their names
had been randomly generated, and their selection for this subgroup
had nothing to do with (and was not motivated by) their behavior or
compliance in the previous year. Each one of these 2,000 people was
told in advance that they would be audited no matter what they did,
who they were, and how they completed their tax returns. Under

1. In Canada, the yearly deadline is April 30.

85
86 YOUR MONEY MILESTONES

normal circumstances, only 1 percent of returns are audited by the

tax authorities. But this group was given the “benefit” of being
warned to cross every “t” and dot every “i” in their upcoming tax
return. What a wonderful Christmas card!
So what was this experiment about? The tax authorities wanted to
see how, if at all, this advance notice would alter the behavior and
reported income, deductions, and tax liabilities of this particular
“treatment group” relative to previous years and relative to similar
individuals who did not receive the advance warning letter. The
authorities (claimed that they) didn’t want to torture these 2,000 peo-
ple but simply wanted to use the experimental results in an attempt to
measure the extent of tax evasion in Minnesota.
The subsequent behavior of this rather unlucky group of taxpay-
ers is the focus of the next few pages and the impetus for our discus-
sion of the most unpleasant money milestone of all: income taxes.
How would you alter your behavior if you got such an advance notice,
instead of facing the usual 1 percent chance of an audit? Would you
be more cautious; claim fewer deductions; and make sure to report
every penny? Alternatively, would you behave the same as you did last
year? (Be honest now.) The results of this particular experiment will
surprise you.
Before I report on the results, here are a few more relevant
details about the experiment. The Department of Revenue in Min-
nesota segmented this “lucky” group of 2,000 people into three broad
groups based on their reported 1993 adjusted gross income (AGI).
The first group with a reported AGI of less than $10,000 was labeled
the low-income group. The middle-income group had an AGI
between $10,000 and $100,000, and the high-income group included
anybody with an AGI greater than $100,000. Finally, each person,
regardless of their AGI, was identified as either having a high oppor-
tunity to evade taxes or a low opportunity to evade taxes, based on
whether the bulk of their income came from a sole proprietorship
(that is, small business income) versus employment income from
which taxes are automatically deducted at source. So, to recap, six
subgroups were created in total: three categories of income and two
categories around the opportunity to evade.
5 • GOVERNMENT TAX AUTHORITIES 87

By the way, all this information was publicly disclosed and pub-
lished (a few years after the experiment) by a number of researchers
involved in the project, including economics professors at the
National Bureau of Economic Research (NBER), which is the pri-
mary source for the preceding numbers and the conclusions.2 The
NBER economists analyzed the results of the experiment in conjunc-
tion with the staff from the Minnesota Department of Revenue, and
their published paper offers some novel insights into the magnitude
of tax evasion and the behavior of individuals facing a tax audit.

How Do Taxpayers Behave if “Big

Brother” Is Watching?
On to the results: First, as you might have suspected, the treat-
ment group reported more income and paid more taxes relative to the
control group (taxpayers who were not warned) and relative to the
same group’s taxes for the previous year (adjusted for economic fac-
tors such as inflation). Overall, it seems the warning scared them and
they behaved more honestly, especially those who had a natural
(high) opportunity to evade. But the results were far from uniform,
and in some cases, surprisingly, the exact opposite result occurred.
How so? Well, the low-income and medium-income groups who
received the warning increased the federal taxable income they
declared relative both to previous years and to the random group who
did not get advance warning. This increased reported income effect
was even more pronounced among those who were classified as hav-
ing a higher opportunity to evade taxes. That is, they might have cut
some corners in previous years and were apparently much more care-
ful in a year in which they knew their returns would be scrutinized
carefully.
But, oddly enough, and this is the surprising part of the study, the
high income group actually reported lower federal taxable income,
paid less federal tax, and reported lower Minnesota state liabilities.
This is seemingly quite odd. Why would their results differ from the
other groups?

2. Blumenthal, Christian, and Slemrod, “The Determinants of Income Tax Com-

pliance.”
88 YOUR MONEY MILESTONES

To drill down further: Among the group of taxpayers who owned

small businesses and sole proprietorships and received nonemploy-
ment income, the wealthier (those who had adjusted gross income
greater than $100,000) group reported average federal taxable
income of $143,000 for tax year 1994, compared to $176,000 in the
prior year. Let me repeat: The people in this group were warned in
advance that they would be audited, and they still declared a lower
income than the previous year—almost $20,000 lower compared to
the unwarned “control” groups who reported an average income of
$163,000 and fully $33,000 less than they themselves reported the
previous year. This difference was statistically significant (with a high
level of confidence) and thus was extremely unlikely to be the result
of chance.

Treat Your Tax Filing Like a Trip to the

Bazaar
Would you be more aggressive when filing your tax returns if you
were certain of an audit? This seems like a perverse result. This is not
just a handful of people who behaved this way. And unfortunately, it
was impossible to ask the taxpayers why they behaved more aggres-
sively—they surely wouldn’t admit it—or why their behavior differed
so remarkably from the low- and medium-income earners.
Here is the explanation that has been proposed to explain this
behavior, which actually leads to one of the main messages of this
chapter. In the words of the NBER economists and authors of the
definitive study of the experiment, “We have come up with two possi-
ble explanations.... The first is that the audit notice letter induced tax-
payers to seek out professional tax advisors who, among other things,
uncovered legitimate ways to reduce taxable income that the taxpayer
had previously been unaware of.” They continued to say, “The sec-
ond...relies on the idea that, even upon audit, the ‘true’ tax liability is
not ascertainable. The tax liability ultimately paid depends on, among
other things, a process of negotiation between the taxpayer and the
[tax authorities].”3 In other words, the wealthier folks essentially

3. Pages 20-21. Emphasis added.

5 • GOVERNMENT TAX AUTHORITIES 89

viewed their inevitable date with the tax inspector like experienced
tourists visiting an outdoor Moroccan bazaar. The tourist wants to
buy an exotic carpet or antique vase at the lowest possible price, and
the vendor wants to extract the highest possible selling price. The
tourist starts with a ridiculously low and actually insulting bid for the
item, which is more often than not followed by a ridiculously high
offer from the vendor. This haggling process continues back and
forth over a number of bargaining rounds until some equilibrium
point is reached between the tourist’s initial bid and the vendor’s ini-
tial offer. And so, what is the true price of the carpet or vase? Who
knows? All that is known is what this particular haggling session
ended with as an agreed-upon price. Tomorrow, later this afternoon,
or next week, the same item will be sold for a completely different
price depending on the next tourist’s bargaining stamina and negoti-
ating appetite and ability. This is what the researchers were saying:
The true amount of tax owing is not fixed but is arrived at through the
process of negotiation.
Thus, perhaps in contrast to a classical view of the tax code and
regulations as setting out fixed and unvarying obligations, there actu-
ally isn’t a universal and rigid agreed-upon measure of undisputable
personal tax liability. Maybe our tax liabilities are subjective and
negotiable, especially for those in the very high-income (and self-
employed) groups that have many more opportunities to haggle. Get
the right tax accountant or tax lawyer on your side of the stand and
your visit to the Moroccan bazaar will turn out differently. Of course,
at relatively low levels of income and in one-dimensional situations in
which your only income comes from an employer from which taxes
have already been withheld by the time you get your pay, your free-
dom to negotiate is down to virtually zero. This is why the Min-
nesotans with income less than $100,000 who now faced a certain
audit were so much more careful and declared greater relative
income. But at higher and more complex levels, it becomes a game
between you and the tax authorities. In fact, perhaps even at lower
levels one should adopt a souk-like attitude to taxes.
Hopefully you can (now) see why the results from the experiment
have direct implications to anyone who faces an income tax milestone.
I am obviously not advocating tax evasion or avoidance. I am advocating
extreme tax awareness, tax vigilance, and tax efficiency.
90 YOUR MONEY MILESTONES

Tax Authorities as Lifetime Partners in

Your Business
I like to think about the tax authorities and the government as a
lifetime business partner who shares in a fraction of all your business
gains, and shares or subsidizes your business losses. This relationship
is dynamic and universal. You might not like your partner very much,
and you might feel that you got a raw deal when you signed the part-
nership contract or that your partner is too aggressive at times, but
the bottom line is you have a lifetime partner. If you earn $100, you
must share the appropriate sum with your business partner, but if you
lose $100, the business partner will subsidize a portion of the loss.
And so, just as your partner keeps a close eye on your activities to
make sure you pay your fair share of the agreement, you must ensure
that your partner is not taking too much. Furthermore, each financial
decision you make and money milestone you face should be consid-
ered in terms of how it influences your share of the partnership
income. Taxes are not something you should think about once per
year and treat like the inevitable and indisputable cost of the postage
stamp you use to send in the return. Rather, the reality of taxes
should form an ever-present factor in every financial decision you
make. Ask yourself, always; what are the tax implications of this
money milestone?
Indeed, according to Internal Revenue Service estimates quoted
in the same study, although 60 percent of middle-income taxpayers
understated their true tax liability and only 26 percent reported it cor-
rectly, a full 14 percent of taxpayers overstated their tax liability. In
other words, they paid more than they had to. This can be viewed
only as sheer sloppiness or laziness on the part of taxpayers. The mes-
sage here is that you can legally control your tax liability by much
more than you think. Don’t be passive. Be proactive.

Tax Lessons from Uruguay (a Beautiful Little Country in

South America)
Over the last few years, I have spent some time in the city of
Montevideo, Uruguay, where I teach a short course at the local uni-
versity on the topic of financial planning and wealth management.
5 • GOVERNMENT TAX AUTHORITIES 91

Teaching this one-week course has been a revelation for both the stu-
dents and for me. They are fascinated by how people deal with money
milestones in North America, and I am equally fascinated by what
they teach me about how things work in South America.
One of the rather surprising things I learned about financial plan-
ning in Uruguay is that salaries, wages, and income tend to be
reported and discussed on an after-tax as opposed to pre-tax basis.
(This is true in Argentina and Brazil as well.) In other words, if you
happen to be asked (and you are willing to divulge) how much you
earn, the number you give is likely to be in after-tax dollars. This is
not just some odd habit or convention. When you get a job offer and
you are told that your salary is 100,000 pesos, the employer means net
to you, after withholding, after deductions, and after taxes. That’s the
number on the check and deposited into your bank account as your
take-home pay. Now compare this to North America. When I got my
first part-time summer job (back in New York City in the 1980s), I
was shocked to get my first paycheck. The number was nothing near
what had been promised in my employment contract! Then, after a
few minutes, it hit me. Taxes were owed and were being deducted at
source. The salary I had been promised was on a pretax basis. On an
after-tax basis (that is, the dollars I could actually consume), the num-
bers were 30 percent lower. Moreover, in some jurisdictions and at
higher income levels, the gross versus net can hit 50 percent.
When I tell my South American students that you can be prom-
ised and guaranteed $100,000 in salary, but never really get that
(ever) because of taxes, they chuckle at the naiveté of Americans and
Canadians who are fooled by pretax numbers. In fact, they can’t help
but wonder why anybody bothers to quote, reference, or cite on any-
thing but an after-tax basis. I think there is much to learn from these
Uruguayans. It’s time to focus much closer attention on the after-tax
returns, after-tax income, and the general tax efficiency of our
investments and our personal income statement. That is: Keep an
eye on your business partner throughout the entire year, not just in
April.
92 YOUR MONEY MILESTONES

Another Puzzle: People Prefer Big Tax

Refunds
While on the topic of puzzling behavior when it comes to income
taxes, I am always amused to see the large number of hands that go
up when I ask the students in my class: Who here would like to get a
large tax refund after you file your income taxes this year? As you
might expect, most students say yes, and the question even appears
like a “no-brainer” to many. In fact, you too might raise your hand and
want to get a refund. According to the Internal Revenue Service,
approximately 75 percent of tax filers get a refund check from the
government, and the average size of the check is around $2,500. In
Canada, the numbers are somewhat smaller, and the average refund
is approximately $1,400 Canadian dollars.
But when you think about it carefully and rationally, you don’t
really want a refund. You want to file your taxes and either owe little
or perhaps get a small refund. In fact, if you (consistently) get a large
refund, you have not been planning your financial affairs efficiently;
your employer is deducting too much tax at the source, and you
should do something about it. Economists and tax specialists have a
name for this: over-withholding, which is when taxpayers remit more
in tax payments over the course of the tax year than they actually owe
in tax by the end of the tax year. Let me be clear about this: With
over-withholding you are giving an interest-free loan to the govern-
ment during the entire year, and you aren’t compensated nor do you
get any brownie points for this.
However, you aren’t required to do this: You have a choice. For
example, in the U.S., tax filers can take advantage of the advanced
Earned Income Tax Credit (EITC), and in Canada taxpayers can file
forms TD1 and T12131 (requesting that tax credits and deductions
be taken into account on your withholdings throughout the year, as
opposed to waiting for tax filing time).
It is ironic that although people get upset at the size of their pay-
check at the end of the month, few take simple steps to do anything
about it. Even when people are told explicitly about their ability to
reduce withholding taxes, and get more money today, the vast major-
ity simply chose not to. Honestly. I didn’t make this up. When you
5 • GOVERNMENT TAX AUTHORITIES 93

think about it, getting a lump sum and large refund after you file your
tax returns, and getting a smaller-than-required paycheck during the
year, violates the number one axiom of money milestones: Long Divi-
sion. Getting a large payment later instead of many smaller earlier
ones is the exact opposite of consumption smoothing.
According to two economists at the University of Michigan and the
Federal Reserve Board, the puzzling preference for over-withholding
is especially prevalent among individuals with low and moderate
incomes.4 These economists designed and helped administer a ques-
tionnaire that they sent to more than a thousand such households,
partially to understand why they were engaging in this seemingly irra-
tional behavior. The authors of this study (and their staff) interviewed
more than 1,000 households in the Detroit metropolitan area, where
the median income is approximately $49,000 per year. They were
careful to skew their sampling toward lower and middle-income fam-
ilies. Participants were asked whether they received a tax refund (80
percent of those who filed said yes), whether they used a tax preparer
to help them file the returns (66 percent had), and whether they
received an advance against their refund (a refund anticipation loan,
which can be quite costly in terms of interest rates).
However, here is where it is puzzling. Respondents were asked
specifically if they would like to get “a paycheck that is $100 larger
each month than your current one, with a tax refund that is $1,200
smaller.” This question was reversed, and the same group was also
asked if they would rather get “a paycheck that was $100 smaller each
month, with a tax refund that is $1,200 larger at the end of the year.”
No matter how the question was phrased, it seems that over one-third
of the group would rather have more withheld in exchange for a big-
ger refund—that actually has a lower present discounted value. More
than half the participants were happy with the status quo (that is,
their smaller paycheck and larger refund), and less than 20 percent of
the group “woke up” to the financial advantage and stated that yes,
they actually would like less withheld and a smaller refund.
The authors were struck by the lack of rationality in all this and
not just because it violates some theory of how people are supposed

4. Barr and Dokko, Paying to Save.

94 YOUR MONEY MILESTONES

to behave. They found that a large majority of low and middle income
taxpayers would prefer to over-withhold and pay more taxes than
needed so that they could get a refund at tax filling time. In other
words, “many of [these] individuals would like to use the federal with-
holding system in effect to save in a temporarily illiquid manner.”
They note that, in contrast to peoples’ observed behavior, “many [low-
and middle-income people] would benefit from having their refund
distributed evenly throughout the year, particularly in light of the
credit constraints and high cost borrowing opportunities available to
this group.” The authors ultimately conclude by saying “that tax filers
want to over-withhold means they are willing to pay in order to save.”
That is, their study found that people with less money and a clear
identified need for the tax return funds do not take advantage of
opportunities to put that (their!) money in their pocket earlier—and
they actually, in effect, pay the government for the use of their money
before it is refunded to them—both in foregone interest and because
a high proportion of the people surveyed take out refund anticipation
loans and “pay a non-trivial fee to a tax preparer, in order to expedite
the receipt of a tax refund.”
In the end, the researchers determined that this phenomena falls
outside the realm of rational behavior and could be explained only as
suggesting that tax filers “seek a pre-commitment device against the
tendency to over-consume.” That is, the households were ensuring
they didn’t overspend during the year, by allowing their “business
partner” to keep more than the partner’s share of income as a kind of
informal loan until tax time. Effective? Maybe. Irrational? For sure.

The After-Tax Return Matters

Wealthier readers of this book, for whom an early versus later
refund of a mere thousand or so dollars isn’t very exciting, should
note that similar behavior can be observed with much greater sums of
money. And, at those levels, suboptimal behavior can cost tens of
thousands of dollars. One of the best examples of this is related to the
sale, promotion, and advertising of mutual fund investment returns.
First, let me give some refresher background on investments and
taxes. When you buy a stock, bond, or any other investment, you don’t
5 • GOVERNMENT TAX AUTHORITIES 95

have to worry about paying any capital gains (and hence income)
taxes until you sell the investment at a profit. In between the pur-
chase and sale, the only taxes you have to concern yourself with are
possible interest (on bonds) and dividends (on stocks) that you might
receive during the holding period. These are taxable in the year in
which you receive them.
Now let’s think about a typical mutual fund that invests in a com-
bination of (many) stocks and (many) bonds. If the manager of the
mutual fund holds on to those stocks and bonds—and doesn’t buy
and sell them very often—then the only taxes you, as a fund holder,
must worry about are the same dividend payments and interest
income that are passed through to you.
On the other hand, if the fund manager engages in frequent trad-
ing of the investments, and turns over the stocks and bonds on a reg-
ular basis, you might find yourself paying capital gains on profits
made by the manager, even though you bought and held the mutual
fund itself. Therefore, when a mutual fund manager who buys and
sells various stocks and bonds advertises that it earned 10 percent (for
example) in a given year, there are three quite different possibilities
for how this 10 percent was obtained:
• The entire 10 percent might be due to interest or dividends
received, or both, even if the underlying securities themselves
didn’t increase in value.
• Alternatively, the stocks and bonds in the fund might have
increased in value without being sold, and in addition, they
earned some dividends and interest.
• Finally, the return might result from the investments them-
selves being sold for a profit.

All three options and any combination of these options can lead
to the 10 percent. Now, this whole discussion might seem rather aca-
demic. After all, who cares how the 10 percent came about, as long as
it’s 10 percent? But from a tax point of view, how the return was
derived can make an enormous difference. If the bulk of the gains
came from “realized gains” (when a security is sold after having
appreciated in price), you, as the mutual fund shareholder, will be
liable for much more in taxes than if the gains were unrealized. Typi-
cally, mutual fund shareholders will be informed at the end of the tax
96 YOUR MONEY MILESTONES

year (by the company, your broker, or your advisor) exactly how much
is taxable and how much is deferred.
Now, here is where this gets interesting. When you go into a local
bank, credit union, or savings and loan association and are told that
the interest rate on a one-year deposit is 5 percent, this obviously
means that a $100 investment will grow to $105 by the end of the
year. But remember, if these funds are sitting outside of a tax shelter
like an IRA (or RRSP in Canada) or 401(k) plan, the $5 gain will be
taxable. So, really, you don’t get $5 on the $100 investment; you don’t
really get 5 percent. Yet, the bank can advertise 5 percent as the inter-
est rate. The same thing applies to mutual funds. They can advertise
that a fund earned 10 percent last year, but this is only on a pretax
basis. On an after-tax basis this number can be as low as 5 percent
depending on how much of the gains within the fund were realized
versus unrealized.5 Moreover, when investment fund companies
advertise that their funds beat 95 percent of all other funds, or that
Fund A was better than Fund B, all this is only on a pretax basis (and
is actually applicable only to people who don’t pay taxes).

Reversals of Fortune
In fact, a very intriguing (and early) study by two Stanford Uni-
versity economists, published by the National Bureau of Economic
Research in 1993, examined the performance and growth of U.S.
mutual funds during the 1963–1992 period on both a pretax and
after-tax basis.6 They calculated and compared the return that a hypo-
thetical taxable investor would receive in each of these funds. They
then arrived at the rather surprising result that “the differences
between the relative ranking of funds on a before and after-tax basis

5. Recently the Securities and Exchange Commission (SEC) in the United States
has imposed disclosure guidelines on mutual funds for reporting after-tax returns.
The SEC requires mutual funds to disclose after-tax returns for one-, five- and
ten-year periods in prospectuses and fund profiles prepared after February 15,
2002. After-tax returns must be calculated using the highest individual federal
income tax rate. In Canada, this is not the case, and this disclosure is not provided
by the companies.
6. Dickson and Shoven, “Ranking Mutual Funds on an After-Tax Basis.”
5 • GOVERNMENT TAX AUTHORITIES 97

are dramatic, especially for middle and high income investors. For
example, one fund that ranks in the 19th percentile on a pretax basis
ranks in the 61st percentile for an upper income taxable investor.”
This means that a fund that seemingly performed worse than fully 81
percent of its peers when viewed on a pre-tax basis rose to beat out 61
percent of those peers when the after-tax return is considered.
These types of result are not limited to U.S. mutual funds. In fact,
partially inspired by the previously mentioned study, together with
some colleagues, I conducted a similar study in Canada using Cana-
dian mutual funds. The study was published in the Canadian Tax
Journal, and the results were similar to the United States.7 We exam-
ined ten years’ worth of investment returns from 343 equity and bal-
anced mutual funds managed by Canadian companies. Overall, we
found that the ranking of mutual funds on a pretax basis is signifi-
cantly different from their ranking on an after-tax basis. Moreover,
two different funds that had relatively similar performance on a pre-
tax basis had a 46 percent chance their ranking was reversed on an
after-tax basis. We also found that mutual funds that reported top
quartile (top 25 percent) performance on a pretax basis often had mis-
erable (bottom quartile) performance on an after-tax basis. Finally, for
someone in the highest marginal tax bracket, the average mutual fund
lost approximately 135 basis points to taxes on fund distributions.
Over time, the cost of inefficient income tax management can
wipe out any investment gains beyond low-turnover index funds. In
other words, you can hire a brilliant manager to buy and sell stocks
for you, and they might outsmart the overall market by a few percent-
age points each year. But, if that entire extra return, which the profes-
sional investment managers have christened using the Greek symbol
alpha, comes from excessive buying and selling, you might end up
worse off after tax. This point was made succinctly in a lovely article
that was written by two well-known money managers in 1993 and
published in the Journal of Portfolio Management, appropriately
called “Is Your Alpha Big Enough to Cover Its Taxes?”8 In contrast to

7. Mawani, Milevsky, and Panyagometh, “The Impact of Personal Income Taxes on

Returns and Rankings of Canadian Equity Mutual Funds.”
8. Jeffrey and Arnott.
98 YOUR MONEY MILESTONES

the low and medium income taxpayers from Detroit I previously

mentioned, who enjoyed the perverse idea of withholding large
chunks of their paycheck, the wealthy are most likely to own mutual
funds outside of a retirement tax shelter. They are the ones vulnera-
ble to mutual fund ranking reversals and large tax bills from ineffi-
cient tax management. They might be losing far more compared to
the inefficiency of waiting a year to get a few thousand dollars in tax
refunds, and they have the most to gain by paying attention to after-
tax returns.

Bottom Line: Get Tax Savvy

A recent study undertaken by economists at Baylor University,
with results published in the Journal of Wealth Management in 2004,
serves to remind us that income taxes can be large hidden liabilities
on our holistic personal balance sheet.9 Individuals with investments
inside tax shelters such as IRA and 401(k) accounts might think they
do not have to worry about the tax efficiency of their investments,
because all gains are tax deferred and all funds withdrawn from these
accounts are taxable as ordinary income. This is true to a point, but it
doesn’t imply that they can forget about tax implications completely.
The future taxes that will be due on all withdrawals should be prop-
erly placed on the right side of the balance sheet. Your partner—the
I.R.S. in the United States and the Canada Revenue Agency in
Canada—actually owns close to 50 percent of the account. If you will
be placing the value of human capital on the balance sheet and treat-
ing it as an asset (which I hope you do), don’t forget to include the
value of all the taxes you will have to pay one day in the future on
those left-hand tax-sheltered accounts. Any comprehensive asset allo-
cation decisions should consider this liability.
So, for example, imagine you have $100,000 (tax-sheltered)
inside an IRA, invested entirely in government bonds, and
$100,000 (taxable) invested entirely in stocks. You might think that
you have $200,000 in net financial capital of which 50 percent is
stocks and 50 percent is bonds; a perfectly balanced portfolio. Alas,

9. Reichenstein, “Tax-Aware Investing.”

5 • GOVERNMENT TAX AUTHORITIES 99

you would be wrong on two counts. First, if you are in the 40-percent
tax bracket (just to keep things simple), your true (net) financial
capital is only $160,000, because $40,000 of the money in the IRA
belongs to your partner, the tax authority. This is not a hypothetical
liability in the distant future: It belongs to them today. Second, of the
$160,000 that is yours, approximately 62.5 percent is invested in
stocks and 37.5 percent is invested in bonds. You have more equity
than you think, and you might want to lighten up on the risk.
It might take time to get used to this way of thinking, but it is per-
fectly consistent with the overall approach I have taken during the
entire book. To help you out, I’ve created a calculator at www.qwema.ca
that enables you to divide your assets to take into account the amount
you owe your “permanent business partner,” the tax authority. And
I’ve included a calculator that can help you calculate the tax implica-
tions of investing in tax-paid or tax-deferred accounts—IRAs versus
Roth IRAs in the United States and Tax-Free Savings Accounts ver-
sus RRSPs in Canada. And, finally, I’ll talk more about asset alloca-
tion and how human capital affects the mix later in Chapter 8
(“Portfolio Construction: What Asset Class Do You Belong To?”), but
hopefully you get the main idea here.
Bottom line, from now on, please, next time anybody quotes an
investment return, interest rate, salary or wage, ask yourself—and
him or her—what does this imply on an after-tax tax basis? Make
sure your perpetual tax partner doesn’t get more than their fair share
of your hard-earned cash. This money milestone is one that you
should pay attention to on a daily basis.

Summary: The Four Principles in Action

• The best way to think about the tax authorities (that is, the gov-
ernment) is as a permanent business partner with whom you
DIVIDE all your gains and losses. They own part of your
human capital and part of your financial capital. Get used to it
and start thinking strategically!
• In many countries, such as South America, people are much
more aware of post- versus pre-tax cash flows and tend to dis-
cuss financial matters in true consumable dollars. In other
100 YOUR MONEY MILESTONES

words, these cultures are careful to SUBTRACT income taxes

up front as opposed to at year end, when taxes are due and
payable.
• Many Americans and Canadians are apparently willing to
share more of their fair share of income with the tax authori-
ties throughout the year, and then wait to get a large refund
when they file their taxes. This preference is somewhat irra-
tional and certainly violates one of the main ideas within
strategic money milestone management, which is Long
DIVISION.
• After-tax returns can matter even more for people holding
unregistered investment accounts. Two mutual funds (or any
investment) with the same before-tax returns can have differ-
ent after-tax returns depending on how those returns were
derived, and these effects can be MULTIPLIED from year to
year. The phenomena of “ranking reversal” and large tax bills
from inefficient tax management can SUBTRACT years of
investment gains!
 6
Can You Eat Your House or Will It Ever
Pay Dividends?

You recall from our previous discussion (in the Introduction,

“Human Capital: Your Greatest Asset”) that for most people during
most of our lives, human capital is the most valuable asset on our
personal balance sheets. But have you ever thought about what asset
is next in line—what your second-most-valuable asset is? It probably
won’t surprise you to learn that for homeowners, this spot is occu-
pied by their personal residence. According to the Survey of Con-
sumer Finances (SCF), their personal residence represented fully 85
percent of homeowners’ financial net worth in 2007. For the general
population under the age of 35 (not limited to homeowners), homes
represented fully 220 percent of their net worth (and because this
statistic includes all people, not just homeowners, it probably
understates the mortgage debt held by under-35 homeowners). For
people over 65, homes represented between 34 percent and 40 per-
cent of their financial net worth.
These are big numbers, and they’ve been getting bigger over
time.1 Over the last two decades, housing has become a much larger
portion of the personal balance sheet. In 1989, the average balance
sheet (not including human capital) for homeowners had about 70
percent allocated to housing, which is 15 percent less than in the year
2007—that shift from 70 percent to 85 percent represents a significant

1. In Canada, the median mortgage amount for a principal residence jumped from
$79,490 to $93,000 between 1999 and 2005 (in constant 2005 dollars), and the
proportion of the personal balance sheet occupied by the primary residence
increased from 36.3 percent to 38.6 percent over the same period. See Statistics
Canada, The Wealth of Canadians.
101
102 YOUR MONEY MILESTONES

increase in the proportion of assets allocated to housing over the last

20 years. In this chapter, you see the impact of changing allocations to
housing on the personal balance sheets of Americans and the surpris-
ing impact that social capital–—not human or financial capital—can
make on your financial fortunes.

Floating Debt Obligations and Sinking

Values
One of the impacts of the shift of financial capital allocations to
the personal residence has been that our financial fortunes now
increasingly fluctuate in lockstep with the value of housing. As dis-
cussed in Chapter 3 (“How Much Debt Is Too Much and How Much
Is Too Little?”), the 2007 Survey of Consumer Finances reports that
46 percent of U.S. households have a mortgage on their principal res-
idence. The average balance, in 2009 dollars, is about $153,000. But
according to the website Moody’sEconomy.com, by mid-2009 a quar-
ter of homeowners with mortgages were estimated to have mortgage
loans that exceed the value of their house.2 In other words, more
than 10 million American households have negative real estate equity,
or what has become known colloquially as being upside down or
underwater on your mortgage loan.
Table 6.1 shows this in stark terms, as it provides some data on
the change in housing values for some regions over the four years
from December 2004 to December 2008, using data from the
S&P/Case-Shiller Home Price Index.
But notwithstanding the significant size and impact of the real
estate market, and its rise or fall in any given period, it’s important to
understand that a house—whether financed with a large, adjustable
rate mortgage or a small, fixed rate mortgage—contains aspects of
both investment and consumption.
It is difficult to forecast—in mid-2009—if and when these indices
and regions will improve, or what these numbers will look like in

2. As quoted in Streitfeld, “The Pain of Selling a Home for Less Than the Loan.”
6 • CAN YOU EAT YOUR HOUSE OR WILL IT EVER PAY DIVIDENDS? 103

TABLE 6.1 Is Your House an Investment or Consump-

tion?: S&P/Case-Shiller Home Price Indices December
2004 to December 2008

Region % Change

Chicago -7.9%
Las Vegas -36.7%
New York -0.9%
Detroit -34.3%
Seattle 15.6%
Minneapolis -20.9%
Composite-10 index -15.28%

2010/2011, but the fact remains that housing can decline in value, and
for prolonged periods. It is definitely not a risk-free investment.
This distinction is basic, and it will not come as a surprise to any-
one reading this book. And yet, it seems to me that this back-to-basics
element of the housing money milestone has gotten downplayed in
the discussions of housing over the past few years, which have
focused on housing as an investment—whether “good” (when hous-
ing values are rising) or “bad” (when values are falling).

Back to the Holistic Balance Sheet

Let’s go back to basics and think about what happens to your
holistic personal balance sheet when you buy a house. Most people
finance the purchase of a home with debt, that is, a mortgage. In the
good old (prudent) days, new home buyers would put down 20 per-
cent of the value of the house and finance the remaining cost of the
house with a long-term 25- or 30-year fixed rate mortgage. Recently,
people typically make a down payment of 2 percent or 1 percent or
perhaps even zero, and finance the majority of the house with
(volatile) floating rate debt that might take up to a century to pay off
in full. In fact, according to the most recent U.S. Housing Survey, out
of 70.2 million households, 9.4 percent reported purchasing their
home with a zero downpayment; and of those who moved to a differ-
ent home within the past year, 16.9 percent reported not having a
104 YOUR MONEY MILESTONES

down payment. These ratios increased considerably within the previ-

ous 10 years: in 1997, they were 6.1 percent and 5.71 percent,
respectively.3 At first glance, when you buy a house for, say, $500,000,
you are increasing the left side of your personal balance sheet (your
assets) by $500,000 dollars. If you used $50,000 as a downpayment,
which came from your own assets, the increase in assets was only
$450,000.
On the right side of the personal balance sheet, you had to
finance the purchase of this house with debt, so if you made a 10 per-
cent down payment and financed the other $450,000, your liabilities
have increased by $450,000 in total. The important thing to remember
is that the equity on your personal balance sheet has not changed. You
have $450,000 more in assets and $450,000 more in liabilities—and
you’ve converted financial capital into a down payment.
Now let’s examine what your personal balance sheet will look like
in five years, ignoring human capital considerations. If you have been
carefully paying down your mortgage debt, perhaps the remaining
liabilities have been reduced to $400,000. And, even if housing prices
have not increased at all, you have created $50,000 more in equity in
your home, for total equity of $100,000. (This is the original down-
payment of $50,000 plus the $50,000 in total payments over the last
five years.)
So far, so good. But now let’s imagine that housing prices fell by
20 percent over that same five-year period. This isn’t inconceivable—
and is exactly what just happened in many regions of the United
States over the last five years, as shown in Table 6.1. In that case, a 20
percent drop in the value of a $500,000 house leaves you with a bal-
ance sheet asset of $400,000. This is exactly what you owe in debt
(mortgage) on the house, and you have no equity. The $50,000 you
originally invested in the house is gone, and all the payments you have
made in the last five years could essentially be considered rent. You
are no further ahead now, financially, than you were five years ago. All
you did was consume housing.

3. Data taken from the American Housing Survey, conducted by Bureau of the
Census for the Department of Housing and Urban Development.
6 • CAN YOU EAT YOUR HOUSE OR WILL IT EVER PAY DIVIDENDS? 105

Let’s explore that notion of consuming housing a little further.

When you buy a house, you can think of a portion of the money you
spent as creating additional and potential financial capital (an
investment, in the world of financial capital). However, another frac-
tion can be viewed as a prepayment of your future liabilities, namely
your need for shelter. In other words, think of the money you spent
on a house as partially going toward a mutual fund (an investment)
and partly going toward a large supply of milk, eggs, cheese, and
other household staples (things you consume).
The reality is that housing fulfills a need: your need for shelter.
This is an implicit liability on your personal balance sheet. By pur-
chasing a house you are pre-paying that liability in advance. Think of
it like a pre-paid phone card, but for rent and for the rest of your life.
According to this line of thinking, the $450,000 mortgage doesn’t
quite increase your total liabilities by $450,000 because you have
reduced your implicit housing liability. What all this implies is that
housing is part consumption (to defuse your implicit shelter liabili-
ties) and part investment, and you should keep both of these dimen-
sions in mind when you consider the housing money milestone.

My Strong Bias: Many Homeowners

Should Have Rented
So, where does this leave us in terms of practical housing advice?
For one, I think that a large proportion of individuals within the pop-
ulation should not own a house, or they should at least push off the
purchase as long as possible, and instead rent. Anyone that followed
this advice in the U.S. over the last few years, possibly the last few
decades, would be much better off today. This is not just me being
preachy or dispensing with advice that—with hindsight—proves cor-
rect. If you actually go back to one of the first principles I discuss in
this book, namely Long Division and the spreading of resources over
time, you can arrive at the same conclusion, but the reason is not as
simple as you might think. It isn’t because housing is a “bad invest-
ment” or has performed poorly relative to other asset classes. Instead,
it relates to the investment characteristics of your human capital
when you are young and as you age.
106 YOUR MONEY MILESTONES

In a number of recent studies, a variety of mathematical econo-

mists have developed a control theory model to derive the optimal or
rational approach to housing over the life cycle.4 (I discussed Dynamic
Control Theory in the Introduction.) You can think of their research
as exploring how Mr. Spock (from Star Trek), who knows all the odds
and can act completely logically, would behave. According to these
researchers, most “typical” people under the age of 40 shouldn’t own a
house but should rent, instead. But again, this isn’t recommended for
the reasons you might think. Here’s the Spock argument against home
ownership early in life: When you are young the vast majority of your
true wealth is locked up in human capital, which is illiquid, nondiver-
sified, and definitely nontradable. It therefore makes little sense to
invest yet another substantial amount of total wealth in yet another
illiquid and nondiversifiable item like a house.
Sure, if you could buy a house that has a bedroom in New York
City, a bathroom in Los Angeles, and a kitchen in Chicago and perhaps
a garage in Las Vegas, yes, your home would be diversified. Buying a
house as an investment has strong similarities to someone being con-
vinced that stocks are good investment in the “long run,” but they
decide to buy only one stock for their portfolio. I don’t care how reli-
able that one stock is, or how large are the dividends, that stock portfo-
lio is not diversified. The same goes for housing.
In addition, when you are young, your human capital and hence
your total wealth is sensitive to the evolution of your wages and
income over time. These two factors tend to decline in a recession
and bad economic times, just like housing. In other words, there is a
good chance that if your job wages take a hit, so will your real estate.
I will actually touch upon this concept again in Chapter 8 (“Portfolio
Construction: What Asset Class Do You Belong To?”), when I discuss
the interaction between your future wages versus stocks, bonds, and
other investments. For now, it is simply worth pointing out that if
your wages are sensitive to economic conditions; it makes little sense
to exposure a large fraction of your financial capital to the same factors

4. Yao and Zhang, “Optimal Life-Cycle Asset Allocation with Housing as Collateral.”
See also Kraft and Munk, “Optimal Housing, Consumption and Investment
Decisions over the Life Cycle.”
6 • CAN YOU EAT YOUR HOUSE OR WILL IT EVER PAY DIVIDENDS? 107

by allocating a significant portion of your balance sheet assets to a

house. In fact, evidence from the U.S.-based Panel Study of Income
Dynamics5 suggests that controlling for levels of wealth, homeowners
actually own less stock-based investments, compared to renters, pos-
sibly because of this same reason. Stocks are diversified, tradable, and
liquid. Houses are not.

Housing over Time: A Human Capital Approach

In sum, a strong argument can be made—absent all the psychic
factors involved in the decision—that renting is the optimal choice
when you are young.
However, when you are older (say 50 or 60) and you have
unlocked a large portion of your illiquid and nontradable human cap-
ital and converted it into financial capital, you can afford to “freeze”
some financial capital and lock into a home purchase. At that stage,
not only do you have more wealth in total, but also your balance sheet
(and especially your human capital) is likely not as sensitive to the
state of the economy and its disruptive impact on wages. So, Mr.
Spock buys his first house—after 25 years of renting—at the age of
50. (Says Spock, “Nowhere am I so desperately needed as among a
shipload of illogical humans.”)
Now, you might justifiably worry here that if you (or Mr. Spock)
don’t buy a house when you’re young, you might never be able to
afford a house when you’re older. I have heard many real estate
agents say that it’s important to get a foothold into the real estate mar-
ket, or you will never be able to afford a house.
Well, I trust that the experience of the last few years has taken some
of the air out of this argument. If you examine the inflation-adjusted
growth in the price of an average house during the last ten years, as
measured by the S&P/Case-Shiller Home Price Index, it equaled only
3.5 percent. And this doesn’t adjust for the often enormous cost of
maintenance that is never captured in the long-term datasets.

5. The PSID is a longitudinal panel survey of U.S. families that measures eco-
nomic, social, and health factors over the life course and across generations.
Data have been collected from the same families and their descendants since
1968.
108 YOUR MONEY MILESTONES

There’s one more dimension that impacts the housing decision

and that is the increasing mobility of the labor force. This dimension
results in a much higher probability that you might need to relocate
for a job, career, or employment opportunities. This is yet another
factor that increases the incentive to rent for as long as possible.
There is nothing more disruptive to a smooth consumption path (and
the practice of Long Division) as having an illiquid and unsellable
house serve as an anchor to a region in economic distress.
Finally, if by renting a house (or condo or apartment) instead of
buying as soon as possible, you are truly concerned you might miss
out on the market, the authors of one of the articles I cited earlier
suggest that you hedge and protect yourself against this risk by invest-
ing some money in a mutual fund that is linked to real estate prices,
such as a real estate investment trust, or REIT.6 This way, you can
participate in the increased value of housing, without having to mow
a single lawn or unclog even one drain.
If you would like to calculate the impact of rent-versus-buy deci-
sion in your own life, I have created a calculator that can help you
work through some scenarios, so you can see what decision makes the
most sense in your case and what the impacts are with different vari-
ables. Go to www.qwema.ca to do your own analysis.

The Missing Factor: Housing and Social Capital

During most of this chapter (and this book), I have focused my
efforts on teasing out the impact of human capital considerations as
they apply to financial capital decisions, using basic rules of arith-
metic. And yet, although I have emphasized these two forms of capi-
tal, I have so far overlooked a third form of capital, which completes
the trinity: social capital.
Social capital—more so than human capital or financial capital—is
not visible to the naked eye, is not easy to measure, and, unlike every
other form of capital I’ve discussed to date, does not belong on the per-
sonal balance sheet. Social capital is loosely defined as the collection of
networks, cooperation, relationship, norms, mutual aid, faith, and various

6. Yao and Zhang, “Optimal Consumption and Portfolio Choices with Risky Hous-
ing and Borrowing Constraints.”
6 • CAN YOU EAT YOUR HOUSE OR WILL IT EVER PAY DIVIDENDS? 109

other forms of “glue” that hold a community together. But what does
social capital have to do with housing? There is actually a strong link
between home ownership and social capital, which is one of the rea-
sons policy makers in the United States (and, to a lesser extent, in the
rest of the world) have encouraged and promoted homeownership.
Please note that I am not veering from my mandate of discussing
money milestones and personal finance when I mention the role of
social capital. The reality is that social capital also serves a smoothing
function. How so? If you live in a community or society with high
social capital values, you are much less likely to experience disrup-
tions in your standard of living. Think about the neighborhood or
community where you live. If you happen to run out of flour while
baking a cake or need to jump-start your vehicle to get to work one
morning, how many neighbors within short walking distance would
you feel comfortable borrowing the cup of flour or jumper cables
from? All of them? Some of them? None of them? And do you know
the names of all your immediate neighbors?
These might sound like unimportant and even off-topic ques-
tions, but they can have a profound impact on financial matters.
Although it doesn’t belong on the personal balance sheet, social capi-
tal is an asset class you can invest in by creating it. Individuals can do
this on a community-specific basis; for example, you can arrange a
monthly “neighbors’ barbeque” for everyone on the block. Specific
communities (and religions and schools) can produce social capital as
well. Researchers—mostly sociologists—have developed indices of
social capital that they’ve used to indentify regions of the country that
score highly, versus poorly, in this dimension. (Apparently Vermont
and Minnesota score highly but Georgia and Tennessee do not.)
At this point, you may be asking, what does all this have to do with
housing?
Well, according to a recent study by researchers at the Federal
Reserve Bank of Chicago and the Office of the Comptroller of the
Currency; housing, social capital, and financial well-being are all
intertwined.7 According to the authors, greater homeownership rates

7. Agarwal, Chomsisengphet, and Liu, “Consumer Bankruptcy and Default.”

110 YOUR MONEY MILESTONES

increase the social capital of a neighborhood simply because home-

owners (versus renters) face larger transaction costs in selling their
house and moving away. This reduced mobility incentivizes home-
owners to invest in things that increase their property value, which, in
turn, also creates more social capital. So social capital is created as a
result of home ownership, and property values rise in the process as
well. Although you might not think about the investment you are
making when you lend that gallon of milk, the logic of investing in
social capital is clear.

Investing in Social Capital

This relationship between social capital and financial well-being
then manifests itself in a number of interesting ways. For example,
the authors in the previously-noted study obtained detailed records of
more than 170,000 individual credit card histories over a two-year
period to observe individual payment behavior and bankruptcy filing
status for each of these 170,000 individuals. The dataset contained
enough information so that the individual’s age, address, marital sta-
tus, and homeownership status could be linked to their credit card
behavior and in particular could determine whether they filed for
bankruptcy protection during the two-year period.
Now, as you might expect, borrowers living in counties and
regions with high unemployment and poor economic conditions and
those individuals who have lower income and wealth status experi-
enced higher default rates. No surprise there.
However, what is interesting is the following conclusion. I quote
from their study: “An individual who continues to live in his state of
birth is 9 percent less likely to default on his credit card and 13 percent
less likely to file for bankruptcy, while an individual who moves 190
miles from his state of birth is 17 percent more likely to default and 15
percent more likely to declare bankruptcy.” This, of course, is consis-
tent with a social capital story under which the closer you live to your
place of birth, the more likely you are to have vested social capital to
protect. Along the same lines, it seems that married individuals are 24
6 • CAN YOU EAT YOUR HOUSE OR WILL IT EVER PAY DIVIDENDS? 111

percent less likely to default on credit cards and 32 percent less likely to
file for bankruptcy. Finally, homeowners—and keep in mind that home
ownership provides another proxy for social capital—are 17 percent
less likely to default and 25 percent less likely to declare bankruptcy.
In sum, I suspect that people grossly underestimate their home
ownership expenditures. They overestimate the amount by which the
house will appreciate over time. They tend to live where they work
(obviously), which means that their housing capital (which is a subset
of financial capital) is exposed to the same economic risks as their
human capital. And yet, the one thing an investment in housing might
achieve is that it creates its own investment in social capital. Perhaps
this one factor outweighs the many other negatives and makes this
particular money milestone worth pursuing.

Summary: The Four Principles in Action

• Americans (as well as Canadians) have ADDED significantly to
their personal balance sheet allocation to housing over the last
few decades. Housing can ADD to your net worth over time.
However, even a small decrease in the value of housing can also
SUBTRACT value from your personal balance sheet, and the
effects of this subtraction can be MULTIPLIED if your house-
hold is over-allocated to housing.
• A more rational way to approach your need for shelter is to
DIVIDE your spending on a primary residence, if you are a
homeowner, into an allocation for shelter (meeting your con-
sumption needs for shelter) and an allocation for investment.
Another rational approach that has been advocated by a num-
ber of financial economists is to hold off on purchasing a house
until you have converted a significant amount of your human
capital into financial capital.
• If the cost of the house, today, exceeds the value of your human
capital, in all likelihood you shouldn’t be a homeowner, period,
regardless of how low the (current) monthly payments are or
how low the interest rate is. This is likely another one of the
most important concepts within strategic financial planning for
individuals.
112 YOUR MONEY MILESTONES

• The role of housing is also connected to another form of capi-

tal: social capital. The effects of investing in social capital can
MULTIPLY your investment in your home, increasing your
financial well-being—and that of your community—in surpris-
ing and unexpected ways. So, it’s not only about the money
after all!
 7
Insurance Salesmen and Warranty
Peddlers: Are They Smooth Enough?

A few months ago, I went to my local electronics store to get a

new cordless telephone because the one in my office had broken after
a few years of daily use. After scanning the aisles, I chose a basic unit
that cost about $110 and headed to the cash register to pay. Upon hand-
ing the salesperson the phone I wanted, she asked, in a bored mono-
tone, a question she’d probably already posed a hundred times so far
that day: Want to buy an extended warranty on that?
I’m sure you’ve had the same experience, too, every time you’ve
bought something from any electronics store. Her pitch continued:
The warranty would “protect me” for the next two years, and if any-
thing should happen to the phone, I could just return for a new one.
She finished her spiel with the announcement that the cost of the
warranty was a mere $45 plus tax, payable now.
I was flabbergasted, but she wasn’t—she recited the whole thing
without displaying any recognition of the irony that protecting the
phone would cost more than 40 percent of the purchase price. When
I asked her if she recommended warranty extension because she
expected the phone to break in the next two years, her response was
“No, but you should still consider the extended warranty”—because I
could then “get the same phone” if anything happened to the one I
was buying. I then asked whether I could just bring the phone back if
it failed and get a new one without buying the extended warranty, and
she said that obviously “something” had to be wrong with it to get a
free replacement—but that the store’s return desk doesn’t tend to ask
many questions. We sparred back and forth for a couple of rounds
that ended when I politely but firmly declined the insurance coverage.

113
114 YOUR MONEY MILESTONES

This is not the only silly insurance anecdote I have accumulated

over the years, and I am sure you have your own stories of warranties
that cost half as much (or more) as the (relatively inexpensive) item
they protect. These stories get even more ludicrous, and frustrating,
if you actually buy the policy and try to exercise your warranty and
make a claim, which is denied or the warranty is invalidated for what-
ever reason.
But my favorite ridiculous insurance story comes from a phone call
I received at home during dinner a few years ago, one night near the
end of December. In Toronto, where I live, there’s a lovely lake, Lake
Ontario, where many people sail their boats in the summer and store
them during the winter at various marinas spread across the harbor.
That evening, the man on the other end of the phone line claimed to be
from the largest property and casualty insurance company in Canada,
and he was offering me a special time-limited deal on boat insurance.
Apparently the cost of this insurance was going to be increasing by
more than one-third at the start of January because the re-insurance
treaty (which serves as the protection for the insurance company) was
about to expire. He told me that if I transferred my policy to the com-
pany he worked for within the next 72 hours, I would save more than
$500 on a typical policy. I presume I was erroneously on some database
because I told the caller that I don’t own a boat and hence had no inter-
est in buying (or transferring) a boat insurance policy. However, that
didn’t slow him down. He responded that I should still seriously con-
sider the offer because the renewal rates would definitely be increasing
in January and that I should act quickly—what did this cold-caller want
me to do, go out and buy a boat just so that I could get a good deal on
the insurance? (Perhaps I’d call it...Have I Got a Deal for You!)
I enjoy telling this boat insurance story to my students because I
think it perfectly illustrates a number of myths and misperceptions
about the whole field of insurance—in particular, about the kinds of
potential losses to insure and the proper role of insurance in our lives.
I also think it neatly demonstrates how insurance is largely sold to
people, rather than purchased by them after careful, and rational,
evaluation of the alternatives. However, insurance decisions are
among the most important money milestones you will encounter in
life. This chapter explores how to understand insurance, including
insights from the world of human capital thinking.
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 115

Insurance from Babylonia to Today

The history of insurance stretches back as far as the second and
third millennia BC, when Chinese and Babylonian traders practiced
early methods of transferring and distributing risk. The ancient
Code of Hammurabi (circa 1790 BC) even included a basic form of
insurance, by stipulating that debtors who encountered personal
catastrophe (such as flooding, disability, or death) could be relieved
of their debts.
The inhabitants of Rhodes invented the concept of the “general
average” as a form of property insurance. (And this is the only legal
maxim that survives of the great body of law of the Island of Rhodes,
known as the Lex Rhodia, circa 800 BC.) Merchants whose goods
were shipped together would pay a proportionally divided premium,
which would be used to reimburse any merchant whose goods were
lost during storms or sinkage.1 The monarchs of ancient Persia were
probably the first to introduce the concept of insuring human life,
circa 550 BC to 330 BC. At the start of each new year, people would
present gifts to the king. The amounts paid were registered by the
monarch and, if the gifts were sufficiently large, their value could be
repaid up to two times over to the giver in times of trouble. Later, the
Greeks and Romans circa 600 AD organized guilds called “benevo-
lent societies” that cared for the families and paid funeral expenses of
members upon death.
By 1654, French mathematicians Blaise Pascal and Pierre de Fer-
mat discovered a way to express probabilities and, thereby, under-
stand levels of risk. Pascal’s work led to the first actuary tables that
were used to calculate insurance rates. These tables formalized the
practice of underwriting.
Then, in 1666, the Great Fire of London destroyed around
14,000 buildings. London was still recovering from the plague that
ravaged it a year earlier, and many survivors were now homeless. As
a response to the chaos and outrage from the Great Fire, groups of
underwriters who until that point had dealt exclusively in marine

1. Interestingly, this is actually the source of our modern word “average”—it

comes from the Arabic awariya (“damaged merchandise”).
116 YOUR MONEY MILESTONES

insurance formed companies to offer fire insurance. By 1693, Pas-

cal’s work was used to create the first mortality table and what we
know today as life insurance soon followed.
Insurance companies flourished in Europe, especially after the
Industrial Revolution. But in America, the situation was different:
The colonists’ lives were rife with risks no insurance company wanted
to share. Ultimately, it took another hundred years for insurance to
become established in America. The sale of life insurance in the U.S.
began in the late 1760s, when the Presbyterian churches in Philadel-
phia and New York created the Corporation for Relief of the Poor
and Distressed Widows and Children of Presbyterian Ministers.
Episcopalian priests organized a similar fund in 1769, heralding the
start of the life insurance industry in the United States. (I’ll touch on
just a wee bit more U.S. insurance history in a moment.)

Insurance Purchases: Another Form of

Smoothing
But first: recall the “25-to-25” thought experiment I posed to my
undergraduate students in Chapter 2 (“What Is the Point of Saving
Money Forever?”). However, this time, imagine that instead of being
sure to receive some large sum in the distant future, the experiment is
framed in terms of losses. Imagine there is a 0.1 percent chance that
at some point in your life you will suffer a loss (or have to pay)
$1,000,000 because of some natural disaster or unforeseen accident.
If this one-in-one-thousand event occurs, you will face a sudden and
dramatic reduction in your standard of living. You might have to take
on extra debt, accept a second job, or perhaps even file for credit and
bankruptcy protection. Moreover, if you’ve diligently been practicing
Long Division, your smoothing apparatus will be destroyed.
Now, what if I offered you an insurance policy that could protect
you against this disruption? In exchange for an annual premium of
$1,000, you could rest assured that if this catastrophe occurred, the
loss would be covered. Would you take this policy? I would. Although
my overall standard of living would be reduced marginally because
of the extra $1,000 I would be paying every year, this reduction is
much less painful to me than the enormous disruption from a sudden
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 117

million-dollar drop in my net worth would be. (This hypothetical insur-

ance example differs materially from the cordless phone “protection
policy” because although the disruption to my standard of living rep-
resented by the payment of the extended warranty for the phone is
even more trivial, the loss I would experience if that particular phone
stopped working is so small it doesn’t even register.)
Thus, at its core, insurance is a smoothing mechanism. However,
unlike Long Division, insurance doesn’t smooth consumption across
time; instead, it’s about smoothing across different alternative uni-
verses, ones in which you or I experience an unfortunate roll of
nature’s dice. In one future alternate universe, you don’t get hit with
the million-dollar catastrophe, and your life turns out just fine. In
another, less probable, future alternative universe, you went bankrupt
at the age of 40 because you were hit by the million-dollar disaster.
(And you didn’t insure against this risk.) So, to smooth consumption
over all the alternative universes you will encounter across your life
cycle, you purchase insurance to protect, or smooth, your lifestyle
across all these potential outcomes.
Now, I don’t believe that most people actually think this way
about insurance. (If they did, no one would offer extended warranties
on inexpensive consumer items, or for that matter on boats I don’t
own.) However, this is my recommended way of viewing the money
milestone purchase of insurance.
But this “insurance to smooth” thesis doesn’t imply that you should
go out and insure every single possible bump or blip in any possible uni-
verse. Small losses, such as the failure of a $110 phone after two years of
use, should not be insured, unless you are living in extreme poverty on
$2 per day like almost half of the world population. (In that case, why
are you buying a phone that costs nearly two months’ wages?) The $110
loss will not cause a material disruption or unraveling of your family’s
smooth life-cycle plans. So, I say forget the extended warranty, do not
insure against this loss, and don’t waste your money on the premiums.
On the other hand, if the event you are insuring against could
cause an enormous disruption to your standard of living, go ahead
and insure. So, ultimately, you have to consider two aspects of every
potential catastrophe. First, what is the probability this event will
take place (very small, average, or very high), and second, if the
118 YOUR MONEY MILESTONES

catastrophe occurs, what is the magnitude of the disruption (very

large, substantial, small, miniscule) to your smooth standard of liv-
ing? My proposition is that you should insure only events that have a
potentially disruptive impact on your lifestyle, and only if they have
a relatively low probability of occurring. I’ll explain more about this
two-dimensional approach in a later section. For now remember the
following rule for insurance coverage: Buy it for events that are both
catastrophic and unlikely.

Life Insurance as a Hedge for Your

Human Capital: When Young
According to the American Council of Life Insurers, the total
amount of life insurance coverage in force today in the United States
is approximately $20 trillion dollars.2 This staggering sum of money
would be paid out only if all the insured individuals died at the same
time. Short of a widespread fatal epidemic or a gigantic meteorite hit-
ting our planet, the insurance industry can safely assume that this
amount will not be paid out all at once. In fact, some of this money
might never be paid out at all if people stop paying their premiums
and their policies lapse.
If all the insured individuals in the United States died at the same
time, that would clearly be a disastrous event for the life insurance
industry. But in your own life circumstances, all it takes is one death—
your own—to register as a catastrophe. Recall that when you are young,
your greatest asset is your untapped (or unmonetized) human capital.
Therefore if you die young and with dependents, you’ve lost—or more
to the point, your family and dependants have lost—that future income.
So the proper way to think about life insurance (and disability
insurance, critical illness insurance, and even unemployment insur-
ance) is as a hedge for your human capital. In the world of finance, a
hedge is an investment to limit loss. If something happens to you, the

2. At the end of 2007, according to the Canadian Life and Health Insurance Asso-
ciation, 20 million Canadians owned a combined amount of more than $3.1 tril-
lion of life insurance.
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 119

insurance company will pay out the death benefit (or face value) of
the policy to your beneficiaries.
I explored the concept of insurance as a human capital hedge in
my earlier book (Are You a Stock or a Bond?). At this point I want to
simply emphasize and remind you that as you age and progress
through the human life cycle, the argument (and the need) for life
insurance to protect human capital is much weaker because the value
of human capital declines with age. When you are retired, for example,
it is hard to justify the payment of large insurance premiums to protect
human capital that has a low value. So, in preparation for retirement,
you should have converted a large portion of your human capital into
financial capital, and you should thus be more concerned about pro-
tecting this financial capital that must now sustain you for the rest of
your natural life than protecting your human capital (or your phone!).
Indeed, likely the only argument for maintaining a large and perma-
nent insurance policy at advanced ages is for estate planning or tax
purposes. Life insurance is about smoothing income for your family
and loved ones across alternative future universes: It is not meant as a
consolation prize for the living or as a reward to your spouse for put-
ting up with an old cranky nuisance (that would be you, in retirement).
If you have insurance at later stages in life, the premiums you’ve been
paying and will continue to pay for many years to come would have
likely been better off deposited in some bank account.
According to historians, the origin of the idea that life insurance is
for protecting the value of human capital, and that you should accord-
ingly use an estimate of total future earning power to determine a
suitable amount of life insurance, is Professor Solomon Huebner. Just
shy of a hundred years ago, Huebner taught the first formal courses
on life insurance at the Wharton School of Business at the University
of Pennsylvania. He also wrote the foundational textbooks on life
insurance and helped create the modern insurance industry associa-
tion.3 Huebner outlined his “human life value” approach to life insur-
ance in a series of lectures beginning in 1919. An academic review of

3. For an interesting history on this impact of Dr. Huebner on the entire insurance
industry, see the article by Creek, “Solomon Huebner and the Development of
Life Insurance Sales Professionalism.”
120 YOUR MONEY MILESTONES

his impact on the life insurance industry notes, “Huebner encouraged

salesmen to calculate a man’s career earning potential as his human
life value, wrapping the matter of setting an indemnity in the solemn
science of economics. He especially urged solicitors to target ‘all per-
sons working on a salary, be they ordinary or expert’ for life value
appeals, for in the professions ‘the life value constitutes practically all
their business worth.’” So, when economists at the University of
Chicago, such as Professor Gary Becker and Professor Theodore
Schultz, were talking (in the 1960s and ’70s) about the importance of
investing in and returns from human capital, they were building on
the foundation created (in the 1920s and beyond) by Professor Hueb-
ner, who preached the importance of protecting the human capital
you already have.

Life Annuities as a Hedge for Your

Financial Capital: When Old
Although I discuss the topic of pension and retirement income
planning in Chapter 9 (“Retirement: When Is It Time to Shutter the
Well and Close the Mine?”), this is a good time to remind you that
insurance isn’t just about protecting the family against bad things
(like death and disability or unemployment); it can also be used to
protect the family against something good, namely that you live too
long! Yes, I know this might sound odd, but nowadays you can actually
purchase an insurance policy that will pay out if you live an unexpect-
edly long time. This is called longevity insurance, and it is actively
marketed under various generic names by a number of insurance
companies in the United States and Canada.
Here’s how this works: Think about your future self at the fine old
age of 80. You are in good health, relatively active, but retired from
regular work many years ago. According to your doctor (who you visit
regularly), there’s no reason why you won’t make it to the age of 95
and even beyond. Today the odds are that a healthy 80-year-old
female has a 50/50 chance of living to age 89 (and age 87 for a healthy
80-year-old man). In fact, there is a 25 percent chance that an 80-
year-old female will make it to the age of 93 (or 91 for a man). More-
over, the better your health, the greater your expected longevity.
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 121

There’s even an 11 percent chance for a female, and an 8 percent

chance for a male, of seeing 100 and triple digits on the birthday
cake.4 In the United States today there are close to 100,000 people
above the age of 100. You might be one of them, either now or later.
Now think about the alternative universe analogy. In 90 out of
100 possible future universes, you do not live to 100 and hence don’t
have to worry about providing for yourself at that advanced age. How-
ever, in 10 out of those 100 possible future universes you do. Will you
have enough money saved? Or will you have to reduce your standard
of living? Again you are faced with a smoothing dilemma. But unlike
our 25-to-25 example, this disruption does not come from a sudden
accident or calamity that costs millions of dollars: Instead it is a slow
and prolonged slide that erodes the purchasing power of your money
over time and thus reduces your ability to maintain a smooth and dig-
nified standard of living. So, as I’ve said, it is possible to purchase
insurance so that if you win this particular jackpot, you get either a
large up-front or small periodic payment to help meet your expenses.
(More on smoothing mechanisms for longevity in Chapter 9.)
However, surprisingly enough, your chances of dying might also
be affected not only by your physical health, but also by the health of
the economy you’re living in. There is some interesting research that
seems to indicate that mortality rates (which tell us the rate at which
people die at any given age, or the probability of you personally dying
during the next year) actually decline in bad economic times.
Counter-intuitively, in times when unemployment is above average
and the markets are in a funk, fewer people die, which means that
people live longer. In contrast, when financial times are good, appar-
ently mortality rates increase. Whether this is because people have
more time to exercise and eat carefully in recessions or whether it is
due to reduced smoking or even reduced traffic accidents is all sub-
ject to speculation in a paper published in the American Economic
Review.5 From my perspective though, this phenomenon is more than

4. Calculations based on the RP-2000 Healthy Annuitant and the 1996 Annuity
2000 mortality tables, from the Society of Actuaries. See www.soa.org for more.
5. Miller, Page, Stevens, and Filipski, “Why Are Recessions Good for Your
Health?”
122 YOUR MONEY MILESTONES

just a public policy curiosity. For those concerned about the holistic
management of risk for the household and the value of all assets on
the personal balance sheet, this evidence brings yet another dimension
to the interaction between human capital, financial capital, and the
role of insurance. If you follow the findings of the research paper, you
can almost think of health itself as a personal asset class that is nega-
tively correlated to the economic environment and the performance
of your stock portfolio. (That is, your health moves in the opposite
direction to the economy.) At the extreme, it seems long periods of
unemployment and reduced income, paradoxically, might imply that
you need to save even more money for retirement. How ironic is that?

What and When Do People Actually

Insure?
Like some of the other decisions I have so far addressed, evidence
shows how people actually make their insurance milestone decisions
differs quite substantially from how they should make those decisions.
For example, the research consensus is that low-income households
generally do not have enough life insurance to protect the family if a
death of the breadwinner occurs. An article published in the Journal of
Financial Intermediation reported that a quarter to one-third of
American wives are inadequately insured, meaning they would suffer
a material loss in their standard of living should their spouses die.6
These families either do not have life insurance or have too little. In
contrast to this underinsurance problem among low-income earners, it
appears that high-income households tend to over-insure the life of
the major breadwinner. In other words, a large number of these peo-
ple might actually be worth more dead than alive! Economists have a
politically correct phrase for this: They call it a mismatch between
insurance holdings and insurance vulnerabilities. What you see is
that while on average people in general might have enough life insur-
ance, this average masks a wide disparity in vulnerabilities across the

6. See Auerbach and Kotlikoff, “The Adequacy of Life Insurance Purchases,” and
Bernheim, Lorni, Gokhale, and Kotlikoff, “The Mismatch Between Life Insur-
ance Holdings and Financial Vulnerabilities.”
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 123

socioeconomic spectrum. (Again, you can see that averages can con-
ceal as much as they reveal.)
Another puzzling phenomenon regarding the purchase of life
insurance was reported by researchers at Florida State University.
While examining comprehensive sales data from national insurance
companies, the researchers noticed odd and unpredictable spikes in
the regional purchase of life insurance. They couldn’t explain these
results by looking at promotional offers, discounts, or any other supply-
driven explanations. But, they noticed that, for example, suddenly and
seemingly without cause, weekly sales of life insurance in the State of
Georgia would triple. Or over the course of a month, five times as
many people would apply for life insurance compared to typical
sales volumes.
After scratching their collective heads about this, and running a
variety of statistical tests on the numbers, the researchers decided to
scan the local papers for clues. Perhaps, they figured, a local celebrity
had died, or there had been a major traffic accident fatality or other
corresponding sudden increases in mortality. But it turns out, oddly
enough, that the answer was not in the obituaries section of the news-
paper but in the front page and the weather sections. The regions
with these inexplicable jumps in life insurance purchases had also
recently experienced spikes in serious hurricanes and tornados. Now,
these natural disasters didn’t necessarily kill or even seriously injure
anyone. Sure, the property damage was extensive, which you’d think
might increase the demand for an interest in property and home
insurance, but surprisingly, it also increased the demand for life insur-
ance. According to the researchers this irrational effect can actually
persist for years after large and well-publicized natural catastrophes.
In their words: “Research indicates that the occurrence of a catastro-
phe may lead to an increase in risk perception, risk mitigation, and
insurance purchasing behavior.”7 I think this example actually gets to
the core of how most people treat life and other insurance transac-
tions. That is: Our decisions tend to be emotional and fear-driven, as
opposed to fully rational. Few consumers treat the insurance mile-
stone as part of the life cycle smoothing exercise I previously

7. Fier and Carson, “Catastrophes and the Demand for Life Insurance.”
124 YOUR MONEY MILESTONES

described; however, Table 7.1 provides some illustrations of how to

work through insurance purchases rationally.

TABLE 7.1 You Are 45 Years Old. What Are Multiple Paths of the
Future?
Event (Possible Probability It Will Magnitude (If It Happens to You)
State of Nature) Happen to You

Live to 95 11.4% Unless you are a multimillionaire,

with oodles of cash to spare, get a
pension.
Die within the next 0.62% If you have a family that depends on
five years your income, get life insurance.
Lose your toe in an Less than 0.012% If you work at a job where you need
industrial accident all ten toes, insure them!
Asteroid Apophis 0.0022% Could wipe out a country the size of
hits the Earth in France or Germany and kill millions
2036 of people. If you’re in the strike zone,
perhaps move?

Earth gets sucked No reliable data We are all dead. Don’t bother worry-
into a black hole available ing about it!
Get struck by 5–20% Can be surprisingly benign, although
lightning death from cardiac arrest is common.
Get life insurance if you need it, not
“lightning-strike insurance.”
Get sick from the 20% Annoying. A few days of missed work.
flu this year Do not insure.
Your $110 phone 100% Trivial. No disruption. No insurance!
breaks

As you can see, some events are extremely likely and not very
costly; whereas others are extremely unlikely and extremely costly.
You want to insure (that is, smooth across alternative universes) only
those events that have a relatively small chance of happening and that
are likely to disrupt your and your family’s standard of living.
I’ve provided you with some irrational and rational ways to think
about insurance milestone decisions. Now you might be wondering
how I personally handle these decisions. How rational am I in practice?
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 125

Here’s my guiding principle; it’s the phrase I used earlier: catastrophic

and unlikely.

Create Your Own Insurance Company:

The “Small Risk Fund”
As you gathered from the earlier part of this chapter I (reli-
giously) avoid paying for insurance on any trivial risks that will not
overly disrupt my smooth lifestyle. I don’t buy extended warranties,
trip cancellation insurance, or extra coverage on car rental policies.
This saves me quite a bit of money. At the same time, I have also
asked my own insurance company to increase my deductibles to the
maximum allowed, which means that I personally am liable for the
first $1,000 (or so) of damage to my car and the first $5,000 (or so) of
damage to my house in the event or a storm, flood, or fire. In addi-
tion, although I spent quite a bit of time carefully studying the issue,
I also decided not to buy critical illness insurance, which is rather
popular in Canada. These gambits save me quite a bit of money on an
annual basis. But none of this is irresponsible or neglectful behavior
on my part because I have self-insured, consistent with the smoothing
process I advocate.
You see, I actually keep careful track of all the premiums and fees
I have not paid. This money represents, after all, a rough estimate of
all the damages and costs an insurance company might have to pay
me, on average. So, instead of spending the money I’ve saved on
something else, or just ignoring the savings, I deposit those funds in a
dedicated account that I call my Personal Insurance Reserve Fund. I
manage this account like an insurance company (is supposed to) man-
ages their reserve: risk-free investments only and no dipping into the
cookie jar (except to cover a loss).
So the account sits (earning a bit of interest) and is tapped into on
the unpredictable occasion that our household experiences an unex-
pected financial battering—something that might have been covered
by insurance, had my wife and I decided to buy it. In that case, we tap
into the Reserve Fund to cover the replacement cost. Now, let me
make this clear: I’m not talking about a rainy day fund or slush
account to cover a new roof or resurfacing the driveway. I’m talking
126 YOUR MONEY MILESTONES

about a true insurance reserve fund. Our family constitution (Okay,

the one I maintain in my head) stipulates that the fund can be tapped
only for expenditures that would have been covered by insurance we
declined, and I am careful to deposit all the (hypothetical) premiums
into this account. Not surprisingly, I have been forced to tap into this
reserve fund over the last few years—for a basement leak and an acci-
dental fender bender that the insurance adjuster gleefully informed
me was less than the deductible—but the Reserve Fund is still show-
ing a large surplus and has never been exhausted by any abnormally
large claims. (It isn’t surprising that I’ve had to dip into the Reserve
Fund because the risks I’ve decided to self-insure are both relatively
common and relatively cheap.) And after all, I still have insurance
coverage for the large catastrophic disruptions to my smooth lifestyle.
I’ve created a calculator that enables you to compare risks you should
share with an insurer and those you might want to self-insure, plus
some estimate of the costs you might save by self-insuring. Go to
www.qwema.ca to check it out.
Now, why do I play this game with myself? Why not just merge
this fund into our family’s general account and manage all the money
together?

Behavioral Economics in Practice

Indeed, my behavior demonstrates a number of quirks that
behavioral economists such as Richard Thaler have identified and
explored. When I ponder my reasons for establishing and maintaining
my Insurance Reserve Fund, what I say to myself is usually some vari-
ant of: I do this because I want to avoid the regret associated with tap-
ping into the family’s general finances if something breaks.
(Behavioral economists would call this mental accounting, the
process by which people group their assets into individual, nonfungi-
ble accounts.) I also want to ensure we don’t spend the saved money
on trivial things (thereby displaying my loss aversion, or the strong
human preference for avoiding losses as opposed to acquiring gains)
and impose discipline in our finances (by using a commitment device,
which locks me into a course of action I wouldn’t ordinarily follow but
that produces a desired result). I’m also anchoring (or relying heavily
on one piece of information when making decisions—identifying
7 • INSURANCE SALESMEN AND WARRANTY PEDDLERS 127

“saved money” from my foregone premiums, as opposed to viewing

this money neutrally). In this way, I guess I’m a walking example of
the realities of behavioral economics; that is, how people actually
behave as opposed to how purely rational creatures (what Thaler calls
“Econs”) would behave.
Now, once again, this might seem like the ultimate behavioral fal-
lacy, creating a mental account to which I attribute losses, but like I’ve
said, my account is more than just psychological (or mental!). If you can’t
self-insure because you can’t keep your sticky fingers off the Insurance
Reserve Fund (instead of using it to cover losses, just like an insurance
company would), go ahead and buy all the insurance and warranty poli-
cies you want. (And I know a boat insurance salesperson you should
really talk to.) It’s probably cheaper than paying for financial therapy
from a behavioral psychologist. However, if you can handle the risk and
the disruptions, which will vary in magnitude for different people of
different means, go ahead and save the (unpaid) premiums like I do.
My personal Reserve Fund today contains thousands of dollars,
which is the sum of all the discounts I received from abnormally high
deductibles on my insurance policies. The difference between cover-
ing the first $500 of damage (the standard deductible on home insur-
ance) and the first $5,000 in damage can be up to half of the usual
premium. The home insurance agent was actually quite reluctant to
allow me to do this and made me sign repeatedly that I understood
that the company would likely not cover the vast majority of the
claims they usually receive. But that was exactly the point: By saving
them from paying me a claim 90 percent of the time and covering
only the catastrophic losses, I was saving them money for two reasons:
one obvious and one subtle. The subtle one is that I, as a homeowner,
was signaling to the insurance company that I would take much bet-
ter care of the property (by having sufficient working smoke detectors
and keeping my doors locked). Knowing that I was thus a lower over-
all financial risk to them, they reduced my premiums even further.
Try this yourself. But remember, make sure to save the difference!
Of course, here is the best part of this exercise. If a loss occurs,
you don’t have to argue with an insurance company, you won’t have to
dicker with the adjuster or the agent about whether your claim is cov-
ered, or worry about whether the policy fine print covers what you
128 YOUR MONEY MILESTONES

actually thought it covered. After all, you are making a claim on your
own reserve fund. You only have yourself to argue with.
In closing: The point of insurance is to smooth your lifestyle over
alternative universes. Insurance isn’t an investment or a form of pro-
tective magic. It is important to understand that the investment
return from buying insurance is always negative. That is, you can’t
make money “on average,” and the insurance company make money
“on average” at the same time. Instead, they charge you—and every-
one else—more than the amount they expect to pay out. Otherwise
the company would go bankrupt, and you wouldn’t get paid either.
So, take advantage of this risk pooling mechanism—but don’t go
there for a leisurely swim.

Summary: The Four Principles in Practice

• There are many decisions and money milestones in life that
have an insurance aspect to them, but they tend to be misun-
derstood. At its core, the purchase of any type of insurance is
best understood as a smoothing mechanism.
• However, unlike Long DIVISION that smoothes over your
total resources over time, insurance smoothes consumption not
over time, but over MULTIPLE possible universes.
• In considering insurance purchases, you need to evaluate both
the probability of loss (that is, SUBTRACTION of assets) and
the magnitude of the disruption to your standard of living if a
loss occurs. A rational approach is to insure only catastrophi-
cally unlikely events.
• The real-life world of insurance is full of mismatches and irra-
tionalities. Insurance decisions tend to be emotional and fear-
driven. An alternate approach to wasting money on minor
warranties and insurance policies is to rationally DIVIDE
financial risks into those you will share with an insurer and
those you will self-insure. Set up your own Insurance Reserve
Fund with the money you save by ADDING and saving the
unpaid premiums.
 8
Portfolio Construction: What Asset Class
Do You Belong To?

Sally Sapher, age 60, is the epitome of financial caution. Despite

the thousands of TV commercials, radio announcements, and news-
paper stories touting the importance of global stock market investing
for financial success, she is steadfast in her avoidance of stock market
risk. Her parents lived through the Great Depression, and her uncle
is said to have lost a large part of the family fortune in the stock mar-
ket crash in the late 1920s. So, when Sally resolved to start saving for
her retirement, she chose the safest product she could think of: U.S.
government Treasury bills. For the past 19 years, at the end of every
month, she has deposited $1,000 in her retirement savings account.
By the start of 2009 her retirement nest egg had crept up, ever so
slowly, to a total of $326,094.
In contrast, Sally’s next-door neighbor and good friend Robert
Rischi is your typical stock junkie. He, like Sally, is 60 years old and he
has also been investing $1,000 per month for retirement for the last
19 years. However, unlike Sally, he surrendered to the siren call of the
mutual fund and investment industry and has been allocating all his
savings to a broad array of U.S. equity funds. In the language of
Financial Planning 101, Robert has been dollar-cost averaging into
the stock market, investing a fixed dollar amount every month. (This
means he buys more units when prices are low and fewer when prices
are high, as the fund unit prices vary, but the amount he invests
monthly does not.)
Robert has been careful to stay away from high-cost mutual funds
and concentrated bets on particular industries. After all, he says to
himself, his retirement nest egg isn’t meant for gambling. Instead, he

129
130 YOUR MONEY MILESTONES

has carefully calculated his investment time horizon (the period of

time he expects to grow his portfolio before needing the money) and
his risk tolerance (his ability to handle declines in the value of his
portfolio) and implemented the strategy he thinks is bound to pay off.
Given what he knows about stock market investing, he thinks his low-
cost, diversified approach is a relatively safe way to ensure his nest
egg will grow much faster than Sally’s.
In the language of economists, Robert has a high degree of investor
confidence (in the stock market). To be sure, he’s endured some sleep-
less nights and restless days over the last few years, and especially over
the last 18 months; but he has been adamant in his belief that over the
long run the extra market volatility and financial stress he has endured,
compared to his neighbor, will pay off with handsome returns. Again in
the language of financial economists, Robert is riding the equity pre-
mium or attempting to take advantage of the difference between a
stock market return and a Treasury yield. (The Treasury yield is also
known as the “risk-free rate.”) In fact, he periodically teases his neigh-
bor Sally about her overly cautious approach to saving for retirement
and has promised to invite her to the paradise retirement home in the
Caribbean he plans to buy with the wealth he is accumulating.
So where is Robert after his 19 years of investing? Well, at the
start of 2009, his portfolio was worth $319,126. Yes, you read that
correctly: For all the risk Sally shunned, the equity premium she
apparently missed, and the ribbing she endured, she is actually
$7,000 ahead of Robert after 19 years.
Now, wait a minute, you might cry: what exactly was Robert hold-
ing all these years? You must be cherry-picking those funds or that
period to get those returns! Well, I assumed Robert was holding typi-
cal funds linked to U.S. equity indices. I also assumed he was paying
expenses of (only) 100 basis points each year. If Robert had been pay-
ing 200 basis points in annual fees (which is more typical), his nest
egg would be worth only $282,340, which is $43,754 less than Sally.
And, if you believe that the start of 2009 isn’t a fair ending point,
consider that it could be much worse. At the start of April 2009,
Robert’s (hypothetical) portfolio was worth $286,185, which is
$43,090 less than Sally (with expenses at 100 basis points—or
$252,878 at 200 basis points, which is $66,248 less than Sally).
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 131

Table 8.1 shows Sally and Robert’s account values at different

points in their investing histories. Take a look for yourself and see
how their account values vary over time. I’ve plotted out their invest-
ing results as if they started in January 1993, 1994, and 1995; and as if
they stopped in October and December 2008 and March 2009. You
can see from the table that Sally’s outcomes surpass Robert’s in each
scenario. Robert has the best outcome if he starts in January 1993 and
ends in October 2008; whereas Sally has the best outcome if she starts
at the same time as Robert (in January 1993) and ends in March 2009.
You can also see that, throughout the chart, Sally’s various account
values are much closer than Robert’s. The range between the top and
bottom values for Sally is $47,679, whereas for Robert it is $81,616.

TABLE 8.1 Sally and Robert’s Investing Results

Robert
Ending Account Value: Sally

End Date

October 2008 December 2008 March 2009

January 226,444 214,013 192,893

1993 253,405 255,451 258,591
Start Date

January 196,943 186,385 168,371

1994 231,794 233,837 236,965

January 168,618 159,859 144,828

1995 210,912 212,951 216,067

What Went Wrong?

Writing this in mid-2009, it’s impossible to predict how Sally and
Robert’s situation will look in 2010 or 2011. It could get better for
Robert, and worse for Sally. But, as it stood in mid-2009, after almost
15 years of waiting, risk still hasn’t paid off for Robert.
Now, even though Sally and Robert aren’t real people, Robert’s
story is, unfortunately, not necessarily uncommon. Perhaps you
132 YOUR MONEY MILESTONES

know a Robert or two. For Robert, and others like him, it seems as
though the “stocks for the long run,” buy-and-hold approach has not
worked out. Indeed, the stocks for the long run mantra is increas-
ingly in question: At the end of June 2009, U.S. stocks have under-
performed long-term Treasury bonds for the past 5, 10, 15, 20, and
25 years. In addition, new research on the earliest period of stock
returns has suggested there are methodological flaws in how returns
have been calculated that should cause investors to seriously ques-
tion whether what we’ve been told about stock market returns over
the long period holds any water today.1 Now, I am quite sure that
most prudent financial advisors would never advise Robert to allo-
cate 100 percent of his retirement account to equities, whether U.S.
or international. Perhaps his portfolio would be tempered with some
asset allocation to bonds and other asset classes. The possible alloca-
tions are endless—and indeed, some alternate Roberts might be
ahead of Sally. At the same time, many others who have been buying
and selling (as opposed to simply buying and holding) for the last 20
years have ended with much worse account values than all the previ-
ously mentioned scenarios. A March 2009 study finds that although
the SP500 produced an annualized return of 8.35 percent over the
20-year period ending on December 31, 2008, the average equity
investor who jumps in and out of the market had a return of just 1.87
percent during the same period, or less than inflation.2 Like Robert,
the average investor failed to beat even the risk-free return available
from T-bills. And consider that beating Sally’s results isn’t setting the
bar very high, given the little skill that implementing her strategy
requires.
So what are the alternatives to ending up in Robert’s shoes?
Surely Sally’s strategy isn’t the only appropriate investment approach
to save for retirement; might Robert’s strategy ultimately outperform
Sally’s? Absolutely. However, the reality is you don’t know whether it
will, it will take time to find out, and you don’t even know how long it
might take. Right now, what I do know is that over the 19-year time
horizon I examined, which is as long as many people’s entire invest-
ment savings time span, Robert’s strategy did not end up producing a

1. See Zweig, “Does Stock Market Data Really Go Back 200 Years?”
2. DALBAR, Inc., QAIB 2009.
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 133

premium over Sally’s very basic, risk-free approach. And it isn’t very
useful (to Robert) to suggest that Robert, who wants to retire now,
adjust his timeframe to some uncertain period so that his stocks for
the long run, buy-and-hold approach has a chance of producing
results that surpass Sally’s.
So what are investors to do? In the next section, I take a look at
some alternative ways to approach investing for retirement, including
some new ways to think about your approaches to risk and your labor
market income, and—to revisit the Introduction: “Human Capital:
Your Greatest Asset”—how to include your human capital when you
allocate your overall retirement savings portfolio. These new ways of
thinking take us beyond the standard retirement planning concepts of
investment time horizons, risk aversion, and investor confidence.

Are You a Stock or a Bond or Something

in Between?
I actually wrote an entire book devoted to this topic, so I don’t
want to repeat myself here or belabor points I’ve already made.
Instead, the purpose of this section is to provide you with an explana-
tion of my thinking about the conditions under which individuals
should—and should not—expose their financial capital to stock mar-
ket risk. I’ll also provide you with a method to allocate your invest-
ment portfolio in a way that considers your human capital.
At the outset, I’m going to ask you to think differently about your
labor and wage income (that is, the money you make at your job) than
you probably do now. Our starting point is to think about your labor
and wage income like an investment with its own investment charac-
teristics. In particular, you’re going to examine two dimensions of the
investment characteristics of your labor and wage income: namely,
their flexibility and their sensitivity to general economic conditions.
The first dimension that you’re going to look at is fairly intuitive:
your labor income flexibility. Here’s how you can assess this: Consider
how much flexibility you have to work overtime in your current job.
Can you work for a few extra hours per week or month, if need be,
and get paid more? If yes, although your job responsibilities might be
limited to 35 hours of work per week, you might also have the ability
134 YOUR MONEY MILESTONES

to expand your supply of labor income—that is, by working longer

hours—and thus to convert more of your human capital into financial
capital. In this case, your labor market income is flexible. Other
dimensions of labor market flexibility include taking an extra job and
delaying your expected retirement age.
The flexibility of labor market income varies across occupations
and work settings. A nine-to-five employee who works at a large com-
pany or as a public servant, for example, might not have any ability to
get paid more for working more hours. If you are a schoolteacher, you
are paid a fixed salary no matter how many extra hours you put in
grading student assignments, following up with parents, or chaperon-
ing school dances. But other workers, like hourly laborers, dentists,
and lawyers typically have much more flexibility to work more and
thus earn more. The business model for most lawyers in the United
States and Canada is the billable hours model, in which law firms bill
by the hour (usually in six-minute increments!), and each lawyer care-
fully tracks and usually attempts to maximize her total billable hours.
Similarly, plumbers and construction workers can work far more than
“regular” working hours if the jobs are available and the price is right.
The flexibility dimension is an important variable to assessing the
investment characteristics of your labor and wage income. If you
work in a flexible environment, you have the ability to earn extra
greater dividends—whether they are large or small—from your
human capital. Conversely, if you work in an environment with little
or no flexibility (which we will call a rigid environment), there is
effectively a cap on the returns you can earn from your human capital.
A second, equally important dimension of the investment charac-
teristics of your labor market income, albeit one that is slightly harder
to measure (as it becomes evident only over time), is the relationship
between economic conditions and your compensation. What this
dimension measures is the sensitivity of your career, job, and income
to the economic cycle in general and the financial market in particu-
lar. Some jobs and careers (and hence some sources of labor market
income) are highly correlated to economic cycles, whereas others are
not. A public servant (or tenured professor), to give two examples,
will receive relatively the same compensation in different economic
conditions—that is, whether the SP500 index is up or down, or
whether global stock markets are in a bull or bear mode. But there
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 135

are many other careers whose wage profiles are relatively sensitive to
these kinds of changes. Income from careers that are not correlated
to economic cycles can be thought of as bond-like, whereas income
from careers that are correlated can be thought of as stock-like.
Now, at the outset of this section, I said I was going to explain my
thinking about the conditions under which individuals should and
should not expose their financial capital to stock market risk. What I
am going to suggest is that the amount of risk you take with your finan-
cial capital should be determined holistically, by including both human
and financial capital in the equation, and by assessing and including
the investment characteristics of your income from human capital.
Ok, that’s a mouthful. Let’s unpack this a bit. The two dimensions
I asked you to think about earlier are whether your labor market
income is flexible (versus rigid), and whether it is correlated with
financial market cycles (whether it is stock-like or bond-like). When
these two dimensions come together, you can refer to them as FeBo
(flexible, bond-like) and RiSo (rigid, stock-like).
All else being equal, having a FeBo-like job—think of a barber
who can set his own hours, work on weekends if he wants, and earn
income that is relatively immune to a recession—means you can
afford to invest a substantial portion of your financial capital in more
risky ventures like the stock market. This is because if things don’t
work out for your financial portfolio, you know that your human cap-
ital will not be affected. More important, you can “undo” the damage
done to your wealth by a falling stock market by working some extra
hours (weekends, late nights) to repair your portfolio. Sure, this isn’t
your preferred strategy, but it’s a backup plan.
In contrast to the barber, think of the investment banker’s admin-
istrative staff at a large investment house. I consider this to be RiSo
human capital. They probably don’t have the flexibility to work over-
time, and yet if something happens to their company or the stock
markets, they are less likely to be employed, less likely to earn a
bonus, and less likely to derive dividends from their human capital.
They might earn more than the barber, but the RiSo-like characteris-
tics of the job implies that their retirement savings and investments
should be allocated more toward safer bonds.
Individuals with rigid (nonflexible) income that is sensitive to the
stock market should have little if any equity exposure in their financial
136 YOUR MONEY MILESTONES

capital, regardless of how young and risk-tolerant they are. Why?

Again, because they are already exposed to significant risk through
the investment characteristics of their labor market income. But those
with stable (bond-like) wages that are actually quite flexible, that is,
those who can work overtime or weekends, can afford to take risk and
should be encouraged—although obviously not required—to do so.
Based on your personal situation, how much of your financial
capital should be exposed to stock market risk? To get the answer, I
propose a four-step process:
• First, start by creating your total financial balance sheet, listing
the value of your existing human capital and the estimated value
of your human capital. (If you need a refresher or want help cal-
culating the value of your human capital, flip back to the Intro-
duction. You’ll also find an online calculator at www.qwema.ca.)
• Second, DIVIDE your human capital value into a portion that is
flexible and bond-like (FeBo); versus rigid and stock-like (RiSo).
These are the two extremes of “very safe” and “very risky”
human capital. Keep in mind that this will be a rough estimate!
• Next, decide how much overall risk you are comfortable with on
your total personal balance sheet and what proportion of risk-
free assets you want on your total balance sheet. How many
multiple future outcomes are you willing to tolerate? This might
lead to, for example, 60 percent in total risky assets and 40 per-
cent in total risk-free assets. Now you have to SUBTRACT the
allocations you already have within your human capital.
• Finally, figure out how to allocate the financial capital you have
to invest so that the total ratio, across your financial and human
capital amounts, is the desired risky/risk-free ratio previously
mentioned.

How Does Your Allocation Measure Up?

Here are some examples that will hopefully make this clearer.
In the first example, you have Giovanni. He is a young salesperson,
in his mid-20s, with an estimated $500,000 in human capital. He has
also managed to save $100,000 in financial capital. Giovanni works in
an industry that is strongly correlated to broader market cycles: He is a
salesperson for a pipeline equipment company. Part of his compensation
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 137

is salary ($45,000), and part is commission (which can add up to

another $45,000 in a good year). His salary is guaranteed (that is, bond-
like) while his commissions fluctuate with his sales success, which is
connected to the broader economy and the demand for pipeline equip-
ment. He has determined that 50 percent of his future expected
income is risk-free (bond-like) and 50 percent is risky (stock-like).
Giovanni has also determined his overall risk tolerance. He is
comfortable with an overall allocation of 60 percent to risky assets,
and 40 percent to risk-free assets. Now the question is: how should he
invest his $100,000 of liquid capital to achieve the desired 60/40 split
across his holistic portfolio?
Our next example is Bridget. She is a schoolteacher who has just
retired. She has an estimated $200,000 in remaining human capital.
She thinks that fully 75 percent of the future income from her human
capital is bond-like because she will receive a guaranteed pension of
about $36,000 per year, and this income is not correlated with the
broader economy. (Bridget is now drawing on the implicit human
capital she built up as a pensioned worker during her years of
employment.) Bridget has allocated 25 percent of her future labor
market income to the stock-like category because she provides some
after-school tutoring on a part-time basis, and she finds that the
amount parents are willing to spend on tutoring varies with the eco-
nomic cycle. Bridget also has $200,000 in financial capital to invest.
Her overall risk tolerance is the same as Giovanni’s—because her
pension is guaranteed, she feels she can take some risk in her overall
portfolio allocation. How should Bridget invest her $200,000 of liquid
capital to achieve her desired 60/40 split across her holistic portfolio?
Table 8.2 shows the human and financial capital balances for Gio-
vanni and Bridget, their desired overall portfolio allocation, and the
financial capital allocation that correctly allocates their financial capi-
tal to attain the desired holistic portfolio allocation.
When you look at our table, you can see that the allocation for
your financial capital is not the same as your overall portfolio alloca-
tion. In fact, when you include your human capital, the allocation of
your financial capital might be quite different from your overall target
ratio. But this isn’t the incorrect allocation; rather, it is correct based
on your holistic assets, human capital included.
138 YOUR MONEY MILESTONES

TABLE 8.2 Human and Financial Capital: Invested Together

Giovanni Bridget
Human
Risky Safe Risky Safe
Capital

$250 $250 $50 $150

Total Human
$500 $200
Capital

+ +
Financial
$100 $200
Capital
= =
Total
$600 $400
Capital

Desired
Holistic
60% 40% 60% 40%
Risky/Safe
Mix

Implied
Holistic $360 $240 $240 $160
Portfolio

Financial
Capital $110 ($10) $190 $10
Allocation
110% -10% 95% 5%
Note: All dollar values are in thousands

Bridget’s case provides a good example—because so much of her

expected income from her human capital is bond-like, her financial cap-
ital allocation can be weighted very heavily toward risky assets. Our table
shows a financial capital allocation for Bridget of 95 percent risky/5 per-
cent risk-free assets. You will notice in the table that Giovanni must
invest $110K into the risky (stocks) category in order to maintain a holis-
tic $360K (which is 60% of $600K) in the risky asset. However, he only
has $100K at his disposal to invest. So, to achieve his desired allocation
he must borrow (or leverage) the other $10K. This results in a financial
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 139

asset allocation of 110% risky assets and -10% safe assets. In other
words, he borrows 10% of the risky portfolio value and invests that as
well. In sum, his holistic allocation will be 60% risky and 40% safe.
There are many possible permutations, but hopefully you get the point.

Avoiding Robert’s Outcome

Was Robert—the individual I started the chapter with, who allo-
cated all his investment nest egg to stocks—wrong? Well, it really
depends on what he does for a living. If he is a stock broker or trader,
his aggressive equity allocation was inconsistent with his human capi-
tal. If he were a barber, perhaps he did the right thing. He probably
will have to work some extra time to make up the stock market losses,
but his human capital hedged his risky financial capital allocation.
Once again, you can’t judge the success of the outcome based on their
age or risk tolerance alone. The same thing goes for Sally. Did she do
the right thing? Well, in hindsight it looks like she did. But, once again,
her very safe financial capital allocation would make more sense if her
job is more risky and tied (implicitly) to stock market fortunes.
One logical outcome of this type of thinking is that, particularly
for an investor whose human capital is “safe” and considerably
weighted to producing flexible, bond-like income, the allocation of
financial capital (alone) to bonds should increase over time as the
total balance sheet assets are composed progressively more of finan-
cial capital (not human capital).
That is, if you have stable, bond-like labor market income, as you
convert your human capital to financial capital, you will want to
ensure your overall allocation keeps the correct proportion of risk-
free assets. This will keep your total holistic portfolio allocation in bal-
ance. In fact, if you do not do this, but maintain the conventional
approach to considering your financial capital in isolation from your
total personal balance sheet, you run the risk—literally—of being
exposed to too much financial risk. You don’t want to end up like
Robert: faced with a depleted human capital balance and what is, in
retrospect, a too-aggressive allocation of your financial capital.
Indeed, the approach I’ve outlined provides a strong underlying
rationale for the standard recommendation for investors to move
increasingly to fixed income allocations as they age: It isn’t because
140 YOUR MONEY MILESTONES

their “risk aversion” has decreased, but that their existing assets have
moved from the human capital side of the ledger to the financial cap-
ital side, and the correct risky/risk-free allocation should be main-
tained for the entire personal balance sheet.
If, on the other hand, your labor market income is rigid and
stock-like (RiSo), in the early years of your savings you will also want
to allocate a higher proportion of your financial capital to safe risk-
free assets such as bonds. As you age, and your total balance sheet is
(ideally) composed increasingly of financial capital, the proportion of
risk you can take with your financial capital will increase while your
holistic risky/risk-free ratio will remain constant.
In other words, age or time alone doesn’t necessarily determine
how much of your nest egg (investment, financial capital) should be
allocated to risky stocks versus safe bonds. It really depends on the
overall composition of your balance sheet.
It must be noted that there are many other variables in retire-
ment income planning this model doesn’t include. We haven’t consid-
ered tax (see Chapter 5, “Government Tax Authorities: Partners,
Adversaries, or Bazaar Merchants?”), pensions (Chapter 9, “Retire-
ment: When Is It Time to Shutter the Well and Close the Mine?”),
how to convert financial capital to income streams in retirement, and
a whole host of important issues. However, what this chapter intends
to provide is a new and hopefully useful way to approach the alloca-
tion of your personal financial resources—one which explicitly takes
your human capital into account.
Do you now wonder what the proper allocation of your financial
assets is, given your holistic personal balance sheet? I have included a
calculator that can enable you to work this out for yourself, at www.
qwema.ca. You can model different proportions and scenarios to see
the varying ideal allocations of your financial capital.

Human Capital Impacts Financial Capital

Well Before Your First Job
What you’ve seen so far is that your total portfolio includes both
your human capital and your financial capital. I’ve recommended that
you allocate your financial capital in a way that takes into account the
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 141

investment characteristics of your human capital. But when is the

right time to start thinking about the investment characteristics of
your labor market income?
Evidence suggests you should start addressing the interaction
between your chosen career (which will affect the value of your
human capital and produce your labor market income) and the struc-
ture of your portfolio (your financial capital) well before you get your
first paying job. A business school professor who studied the career
and earnings paths of MBA students graduating during bull (good)
and bear (bad) markets wrote a particularly interesting article that
illustrates this quite clearly. The study was published in the Journal of
Finance in late 2008 (which was not a particularly good time to be in
the stock market!) and was based on data from a survey of about 2,500
Stanford University MBA students who graduated over the 20-year
period from 1976 to 1995.3 A few results from the study were fairly
obvious. For example, if the stock market performed relatively well
during the typical two-year period over which students study for an
MBA degree, a much greater proportion of graduating students went
to work on Wall Street as investment bankers. This is not surprising
because it is much more likely that investment banks recruit more
MBA grads in good times than bad times. According to the study, in a
year in which the SP500 index increased by 20 percent over the long-
term average, the probability of entering the investment banking busi-
ness increased by two percentage points.
Of course, those students who didn’t get jobs working for invest-
ment banks were not unemployed. They went to work in other, per-
haps lower-paying fields, such as consulting or in high tech. And they
could always switch jobs later in their career, if they really wanted to
work as investment bankers.
However, the rather novel finding from the study is that the ini-
tial labor market conditions had a disproportionate impact on future
career paths and labor earnings. In other words, the presence of a
bull or bear market over the 24 months of the MBA program not
only had an impact on their first job, or early wages, but it also had
an impact on a student’s career as much as 20 years later, through

3. Oyer, “The Making of an Investment Banker.”

142 YOUR MONEY MILESTONES

multiple bear and bull markets. That is, it seems as though the con-
ditions that prevailed during MBA students’ courses of study (and
which affected their chances of working on Wall Street) actually
impacted their career paths not just immediately out of school but
two decades later! If you went to work on Wall Street right after
graduating, your likelihood of working there later on was actually 50
percent higher.
Although it might not be surprising that careers and job paths are
rather “sticky,” it is interesting to quantify the magnitude of this
effect. The study found that 15 years after graduation, investment
bankers from Stanford’s MBA program could expect to earn $1.2 mil-
lion per year, whereas management consultants earned half of that, at
approximately $645,000 per year. Whether any of these (historical
average) numbers will persist going forward remains to be seen. But
one thing is certain, the state of the economy and the market can have
an enormous impact on your lifetime earnings—not just when you
enter the labor market but throughout your career. The final sen-
tence in the article makes this point—and is the reason I have men-
tioned this study. The author writes, and I quote, “The results also
suggest that risk-averse MBA students, especially those interested in
Wall Street careers, may want to take actions to insure themselves
against the random wealth effects imposed by stock returns while
they study. These students should short the stock market upon enter-
ing school so that their portfolios hedge their expected labor income.”
In finance, short selling—also known as shorting—is the practice
of selling assets, usually securities, borrowed from a third party with
the intention of buying identical assets back at a later date to return to
the lender. A short seller hopes to profit from a decline in the value of
the assets, when he will pay less to repurchase the assets than he
received on selling them. So in this case, MBA students could use
short-selling strategies so that if markets decline while they are in
school, thus decreasing their expected salaries upon graduation, they
can nevertheless generate personal profits. In essence, this strategy
allows the student to profit in both bull and bear markets—in a bull
market, from their MBA degree, and in a bear market, from the short
selling strategy. In sum: Your current financial capital allocation
should be based on the risk classification of your human capital, even
before you get your first job!
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 143

Can You Take Diversification Smoothing

Too Far?
Although I have repeatedly advocated applying the basic laws of
arithmetic when it comes to financial planning, and specifically the
concept of Long Division smoothing when dealing with spending and
investing decisions, there is evidence some people have taken this
concept a bit too far when allocating their financial capital to stocks.
In other words, they smooth and divide when they really shouldn’t.
Here is an interesting case in point.
Professor Richard Thaler, from the University of Chicago, along
with one of his colleagues, obtained a large dataset of 401(k) plans in
the United States.4 They observed both the number and type of invest-
ment funds available for those plans, and how people allocated their
savings to different funds, for a large number of employers and plans.
They were interested in measuring which mutual funds and menu
choices were more popular and whether certain funds received
greater allocations than others. This is like asking the manager of a
large restaurant which items on the buffet are more popular (pie) and
which are of lesser interest (salad).
Oddly enough, the researchers found that all items on the menu
(of mutual funds) were equally popular. They all had allocations that
were relatively even, regardless of the number of options available. In
other words, if Company A had three equity-based mutual funds and
two bond-based mutual funds, the typical participant in the plan
would split their asset allocation so that 60 percent was in equity
funds, and 40 percent was in bond funds, and the money would be
evenly distributed and with equal amounts across the five funds. On
the other hand, if Company B’s 401(k) plan had only a single equity
fund and four bond funds, they found most people in that plan would
allocate 20 percent of their savings to equity funds and 80 percent to
bonds. This is like Company A restaurant offering three different sal-
ads and two different types of pie at a buffet, so your meal is made up
of three bowls of salad and two pieces of pie. However, at Company

4. Benartzi and Thaler, “Naïve Diversification Strategies in Defined Contribution

Savings Plans.”
144 YOUR MONEY MILESTONES

B’s restaurant, your meal is now one bowl of salad and four slices of
pie—as though the menu determined the outcomes!5 Clearly, this is
a form of long division and smoothing, but it does not make much
sense. After all, just because the owner of the restaurant decided to
offer six different kinds of pie at the dessert buffet, doesn’t mean you
should have one slice of each for lunch.

History of Ideas: Credit, Where It’s Due

This idea, that you should determine how to invest your financial
capital by including your human capital can, as many other ideas I
have discussed in this book, be traced back to well-known financial
economists. In particular, a 1992 article I read as a graduate student
greatly influenced my thinking in this matter.6 Using the techniques
and idea of Dynamic Control Theory (which I touched on in the
Introduction), the authors and well-known scholars—Professors
Bodie, Merton, and Samuelson—derived the optimal amount of
stocks and bonds that investors should hold over the course of their
life cycle, taking into account the investment characteristics of their
labor income. It might come as no surprise that the authors, who are
all professors with tenure and job security, concluded that, early in
life, investors with relatively stable income could afford to take on
much more stock market risk.

What About the Rest of Us? Back to Human Capital

So how much risk should you take? What proportion of your
assets should be in risk-free securities, and what proportion should be
invested in stock markets in search of the equity premium? I’ve
argued in this chapter that your equity allocation should depend
much less on your so-called time horizon, your hard-to-measure risk
aversion, or your at-times fickle confidence in the stock market, and
much more on the composition and structure of your personal bal-
ance sheet. That is: If your job is reasonably secure, your pension is
protected, and your income is predictable, go ahead and take some

5. This effect was dubbed the 1/n heuristic, which describes the finding that the
greater the number of choices available (n), the finer people sliced their invest-
ment allocations.
6. Bodie, Merton, and Samuelson. “Labor Supply Flexibility and Portfolio Choice
in a Life-Cycle Model.”
8 • PORTFOLIO CONSTRUCTION: WHAT ASSET CLASS DO YOU BELONG TO? 145

stock market risk with the nonessential funds. Thus, I personally am

still very heavily allocated to equities because I have a secure job with
a defined benefit pension. At the same time, it should be clear from
the example of Sally and Robert that there’s nothing wrong with
being risk-averse, particularly if your time horizon is finite (and
whose isn’t?)—it might even be the winning strategy.
Here’s the bottom line: The long run can be very long indeed.
The financial planning theories you have used to quantify the “proba-
bility of regret” or the shortfall risk from equity investing must be
revised after the new statistical evidence uncovered during the past
year. To paraphrase one of the greatest economists of our time, Pro-
fessor and Nobel Laureate Paul Samuelson, the long-run case for
equities should not be oversold.7

Summary: The Four Principles in Practice

• Asset allocation investment decisions should take into account
the value and the risk characteristics of your human capital and
financial capital, jointly. The proper way to do this is to ADD
the value of your human capital to your financial capital to
arrive at total capital otherwise known as economic net worth.
Then, based on your comfort level and risk tolerance, decide
how much of your total economic net worth you want in safe
investments and how much you want in risky investments, for
example 60 percent risky and 40 percent safe. That is the total
asset allocation.
• Then, SUBTRACT from this amount the part of your human
capital that you estimate is relatively safe and the amount that

7. Perhaps the shortest version of Paul Samuelson’s rebuttal of the “stocks for the
long run” argument is summarized in this 1997 quote: “Canny risk averters
should always keep in mind, in a rational, non-paranoid way, the pains they will
feel in...probability-calculated bad-outcome scenarios. (Ask yourself: Will step-
ping down toward a poverty level, when that rarely but inevitably does happen,
outweigh for me the pleasures that occur in those likely outcomes when my
equity nest egg does increase?) When we each do that, those of who truly are
more risk averse will rationally hedge our bets by limiting our exposure to
volatile equities.” As quoted in Bodie, “Letter to the Editor: Are Stocks the Best
Investment for the Long Run?”
146 YOUR MONEY MILESTONES

you estimate is relatively risky. Then DIVIDE or allocate the

remaining financial capital so that the proper allocation is
maintained for your total capital
• This approach is very different from the traditional approach
that completely ignores human capital and allocates and parti-
tions only financial capital. If you erroneously adopt the tradi-
tional approach, you may well end up with MULTIPLE
exposures to investments you already have embedded by virtue
of your job. This is yet another one of the most important
strategic concepts in financial planning for individuals.
 9
Retirement: When Is It Time to Shutter
the Well and Close the Mine?

A few years ago, one of my older colleagues at work decided to

retire at the age of 65 after a distinguished teaching career. He had
been anxiously anticipating this for many years and had even bought a
“countdown clock” for his desk as the official date loomed on the
horizon. And so, with much fanfare we, his friends and associates,
arranged a large retirement party in his honor a few weeks before his
scheduled last day at work. As you might expect, he gave a brief but
emotional speech detailing his mixed feelings about leaving the place
where he had spent more than 25 years of his working life and talked
about his plans to move to a warmer climate, take up sailing, and do
all the wonderful things he didn’t have time for while he was working.
Yes, this anecdote sounds a little hackneyed, but with an estimated
1.8 million of baby boomers turning 65 every year starting in 2011,1 I
suspect these kinds of retirement parties and speeches are common
in workplaces across North America.
As the final day approached, our retiree even helped us interview
and hire his replacement, who promptly moved into his office and
took over his teaching obligations. And so, on that last day at the end
of June, when we all enviously shook his hand as he made his way to
the university parking lot one last time, we wondered if and when he
would ever come back to visit.
It was therefore quite a big surprise when a mere six months later
he appeared in our faculty lounge with a smile that wasn’t quite as

1. North Dakota State Economic Brief, vol. 17 (no. 10), October 2008.

147
148 YOUR MONEY MILESTONES

wide as it had been just half a year earlier. Apparently, he wanted to

teach again! He said he’d had enough of what he called “the longest
vacation in my life.” He missed the work and wanted the stimulation
of teaching (at least part-time). Moreover, the rumors were, I am
told, that his investment portfolio had not turned out quite as well as
he had expected, he had underestimated the cost of retirement, and
hence he missed his former, pre-retirement salary.
Unfortunately, although he had contributed to university life for
more than a quarter of a century, there was little we could do in
return for him. Our employer’s rules (at the time) were clear: After
you retired and started receiving your pension, you couldn’t turn back
the clock. Retirement was thus an irreversible money milestone. We
had already given away his office, reallocated his teaching, and found
a replacement for his committee work. Sure, we could try to locate a
part-time or temporary substitute-teacher position for him on an ad
hoc basis, but the old job was gone. Obviously, he had “exercised his
option” to retire prematurely. Whether for financial or psychological
reasons, he pulled the trigger too soon.
This story demonstrates one of the reasons why I, personally,
intensely dislike the word “retirement.” In my view, the binary con-
cept of retirement as we understand it now—as a fixed point before
which you are working at 100 percent and after which you are not
working at all—is increasingly unworkable. It’s also meaningless to
the millions of people who, unlike my colleague, find themselves out
of the work force by chance rather than by choice. I prefer to think of
this money milestone not as a switch to be flipped, but as the point in
your financial life cycle when your human capital has expired, and all
you have left on your personal balance sheet is financial capital.
This viewpoint provides us with a new place to stand. That is, if
you think of the transition not as “retirement” but as the point at which
you begin to draw on financial capital, not human capital, to sustain
yourself in life, the true challenge of this milestone becomes apparent.
Although early in life the focus of financial planning is nurturing,
investing in, and protecting your human capital, when the vast major-
ity of your wealth is in financial capital format, it is critical to start pro-
tecting that as well. Up to that point, you’ve been monetizing your
human capital to provide an income stream. After that point, you need
to create an income stream without relying on your human capital.
9 • RETIREMENT 149

Over the next few pages, I provide some concrete suggestions

about how to allocate or invest that critical financial capital—as you
approach and anticipate this money milestone—to create a dignified
standard of living for the remainder of your life. In particular, I dis-
cuss the role of pensions, annuities, and other products that help
manage and meet your personal liabilities.

Why Are Pensions So Important?

At its financial core, a classical Defined Benefit pension plan is
the ultimate smoothing machine. It’s institutionalized Long Division
on a formulaic autopilot. How so? Most typical Defined Benefit pen-
sion formulas work something like this: After many years of work (at
the same company), you are entitled to stay home, relax—and still be
paid. Now, as you might expect, the “relaxation paycheck” is not as
generous as the “work paycheck.” It is usually calculated by multiply-
ing the number of years you worked at the company by your final
salary around the date you decide to stay home, and then by two per-
cent. So, for example, if you provide labor services to the company for
30 years and you earn $100,000 per year toward the end of your
career, the company would then pay you an annual pension of 30
times $100,000 times 2 percent, which is $60,000 per year for the rest
of your life! And, if you worked at the company for 35 years, this for-
mula provides that you’d get $70,000 for life. This income would be
guaranteed to never decline but might actually increase if the pension
plan was generous enough to offer a cost-of-living adjustment to off-
set inflation. The basic rule for pensions is this: The greater your
salary when you stop working and the greater the number of years of
service you provided, the greater your pension.
What a great deal (for those who have a Defined Benefit pension).
You might live for another 20 or 30 years, perhaps all the way to the
age of 100, and still be paid regularly. And, if you have a partner or
spouse, many plans will continue the payment to them if you person-
ally are no longer around. (This is known as a survivorship benefit.)
Perhaps this is why they call these the “golden years.”
Now think about this arrangement within the context of our pre-
vious discussions on smoothing consumption and practicing Long
Division over your life cycle. Imagine that you work for a company
150 YOUR MONEY MILESTONES

with a Defined Benefit plan over your entire employable life of 45

years (from the ages of 20 to 65) and then stop working. With 45
years of service multiplied by 2 percent, you would get about 90
percent of your preretirement salary. Considering that you can
probably save on a variety of work-related expenses such as trans-
portation and clothing when you aren’t working, the amount of
money you have available to spend might equal, or even surpass,
what it was when you received a paycheck, not a pension. The result
is that you could have saved absolutely nothing during 45 years
(independent of your pension contributions) and still have the
smoothest of consumption profiles. There would be no jagged drops
or discontinuities (as the economists call it) in your standard of liv-
ing. You would be the poster child for Long Division! More impor-
tant, because it provides you with a lifetime of income—no matter
how long you live—it also insures you against longevity risk, which I
alluded to in Chapter 7 (“Insurance Salesmen and Warranty Ped-
dlers: Are They Smooth Enough?”). And, if other investments (like
money in the stock market, or the value of your house) decline in
value, the pension annuity still pays. So a Defined Benefit pension
smoothes, insures, diversifies, and hedges you all at once. Sign me
up!
Now, unexpected inflation, progressive tax brackets, and other
annoying real-world frictions can throw a wrench into simple rules of
arithmetic and the smoothing provided by a Defined Benefit pension
plan, but you get the idea. Basically, a Defined Benefit plan attempts
to put into practice what I consider the fundamental axiom of life-
cycle wealth management—that is, smoothing or Long Division.

Pensions Are a Dying Breed

However, the reality is that today many employers are cutting
back on their Defined Benefit pensions and replacing them with
Defined Contribution arrangements. These, in my opinion, aren’t
really pensions at all. Instead, Defined Contribution pensions are
(tax-sheltered) investment accounts where the employee (that’s you)
contributes money each month, with some amount of matching con-
tribution from your employer—and then you decide how to invest or
allocate these funds. There are no guarantees provided or benefits
9 • RETIREMENT 151

promised when you eventually decide to leave the employer,

whether at retirement or before. These are called “defined contribu-
tion” plans precisely because the only thing defined is the amount of
your own contribution. Typical examples of Defined Contribution
savings plans include a 401(k) or 403(b) plan in the United States, or
a group RRSP plan in Canada. In theory, Defined Contribution
plans were designed to accumulate a sum of money that would gen-
erate an income stream equivalent to Defined Benefit pensions. But
in light of the horrendous performance of the stock market during
2008 and 2009, and some of the evidence I discussed in Chapter 8
(“Portfolio Construction: What Asset Class Do You Belong To?”),
one has to wonder if these Defined Contribution saving accounts
will provide sufficient resources for retirees.
Here’s what the landscape looks like in mid-2009: If you work in
the private sector in the United States, which means that you work for
a company and are not a government employee, there is only a 20
percent chance that you are covered by a Defined Benefit plan. Most
likely, you are a member of Defined Contribution savings plan at
best, a group that includes some 43 percent of private industry work-
ers. In contrast, if you are part of the public sector, either state or fed-
eral (think fire fighter, police officer, teacher, judge, and senator),
there is a 79 percent chance you are part of Defined Benefit pension
plan.2 Notice the contrast here: Most private sector workers have no
pension; most public sector workers do.
In Canada, the numbers are similar: Private sector pension plan
participation is at 23 percent, and in the public sector, 80 percent of
workers participate in Defined Benefit pensions.3 However, because
the relative and per capita size of the public sector is much larger in
Canada than in the United States, the proportion of total workers
with Defined Benefit pensions is higher in Canada.4 What this means

2. Statistics in this paragraph are from the Bureau of Labor Statistics’ National
Compensation Survey: Employee Benefits in Private Industry, available at http:/
/www.bls.gov/NCS/.
3. Pierlot, “A Pension in Every Pot.”
4. Public sector employment stands at about 6.3 percent of the total U.S. labor
force versus 19.7 percent in Canada. U.S. data from Bureau of Labor Statistics,
Canadian data from Statistics Canada.
152 YOUR MONEY MILESTONES

is that in Canada, the shift from Defined Benefit to Defined Contri-

bution pensions is also taking place, but at a much slower rate.5 The
pension coverage numbers have not always looked as lopsided as they
do now, and many years ago most large private sector companies actu-
ally offered all their employees a Defined Benefit plan. But in the last
few decades, and especially the last few years, the trend has reversed.
For example, although in the year 2009 the percent of private sector
workers who are part of a Defined Benefit plan is 20 percent; in 1974,
the percent was almost double at 44 percent.6 In fact, the number of
corporate Defined Benefit pension plans in the U.S. has plummeted
by nearly 75 percent since 1985.7 Pension plans are dying.
Why has this happened? I could fill a whole book on this topic
(actually, I have, and do not want to repeat myself here),8 but in short,
the pension industry has experienced something of a “perfect storm,”
and they have weathered it with rather faulty navigational equipment.
Pension plan assets have been invested in stocks and other risky instru-
ments that didn’t quite earn the returns the sponsors and managers
estimated. Also, the liabilities of these plans continued to increase as
people increasingly selected early retirement and late deaths (that is,
people are living longer), which increased the burden on the plan.
Likewise, pension regulation has been faulty in that it allowed some
company and most public sector pension plans to hide or at least
obscure the true value of their liabilities. But, another important fac-
tor—and one that cannot be blamed on poor management—is that
many employees over the last few decades, especially the younger
ones, saw little value in a benefit that tied them to one company. Many
younger workers argued that they wanted mobility and portability, and
the chance they would stay at the same company for 30 years was
remote. So, they asked employers to switch to savings-type arrange-
ments, especially during the equity bull run of the 1990s when an
annual return of 20 percent from the stock market was expected by all.

5. Tamagno, Occupational Pension Plans in Canada.

6. Employee Benefit Research Institute, “The Decline of Private-Sector Defined
Benefit Promises.”
7. Pension Benefit Guaranty Corporation, Pension Insurance Data Book 2007.
8. See particularly the introduction to Are You a Stock or a Bond? called “Pensions
are Dying; Long live Pensions.”
9 • RETIREMENT 153

All these different demographic and labor market trends have left
future retirees (including the many baby boomers on the verge of
retirement today) with a shrinking pot of money and no guarantees.
In the language of the holistic balance sheet, as pensions have moved
from Defined Benefit to Defined Contribution and even disap-
peared, retirement income liabilities have shifted from the corporate
to the personal balance sheet. In this new reality, you might have a
more marketable and portable human capital than before, you might
have a large sum of financial capital (the Defined Contribution plan)
you are managing, but you now also have to face the liabilities.
This trend of declining pension coverage, to me, is truly a shame,
given the strong link between true (Defined Benefit) pensions and
life cycle smoothing. What you are left with is the increasing personal
importance of the “retirement” milestone for today’s workforce. That
is, providing for your income needs over your lifetime after you have
left the paid labor force is increasingly up to you.

Retirees with Pension Annuity Income

Are Happier
My pro-pension message is more than just about achieving the
economist’s goal of smoothing consumption or insuring against
longevity risk. One of the consequences of defined contribution and
other nonguaranteed forms of retirement income is that the
employee (then retiree) needs to make all the investment and alloca-
tion decisions on their own, as opposed to receiving guaranteed sums
with no investor discretion. Although the capacity to make your own
investment decisions—with the inherent capacity to “beat” the
implicit return contained on a Defined Benefit pension option—
might seem tempting when you are a young employee, you need to
keep in mind that you will be responsible for making those invest-
ment decisions for the remainder of your life. And as you age, your
capacity to and interest in allocating assets and rebalancing retire-
ment accounts might diminish, although your need for effective and
appropriate investment management will not.
Behavioral financial research suggests that individuals in retirement
who are receiving the bulk of their income from stable, guaranteed,
154 YOUR MONEY MILESTONES

lifetime sources are actually much happier. In addition, as retirees

age into their 90s and beyond—when nearly 40 percent of the popu-
lation is affected by Alzheimer’s and other forms of dementia—it
becomes critical that people’s income be placed on autopilot.9 One
interesting study has attempted to draw connections between the life
satisfaction of retirees and the degree of annuitization of their sources
of income in retirement.10 The study used data from interviews of
households with people ages 51 and older, gathered over a long time
period from 1992 to 2000. The total number of people interviewed
was approximately 40,800; and many of them have been interviewed
every second year since 1992. The participants were asked a detailed
series of questions about their expectations and their experience of
life in retirement. Then, the researchers matched up the degree of
satisfaction expressed by study participants with the extent to which
participants were receiving annuitized income (from Social Security
and private Defined Benefit pensions). This study finds that “the
more people can count on lifelong guaranteed pensions, the more
satisfied they are with their retirement.” In addition, satisfaction
among people with lifelong guaranteed pensions lasts longer than
among people without Defined Benefit pensions—in contrast to
retirees without Defined Benefit pensions, who tend to experience
decreasing rates of satisfaction as they move further into retirement.
This was true across all income levels.
The study theorizes that perhaps people without a Defined Ben-
efit pension become increasingly anxious about outliving their savings
as they age.
Another study found, interestingly and somewhat shockingly, that
your chances of happiness in retirement are highest if you have a
Defined Benefit pension, second highest if you have no pension, and
lowest of all if you have only a Defined Contribution pension. The
authors speculate that this surprising result might show the effect of

9. Plassman et al, “Prevalence of Dementia in the United States.”

10. Panis, “Annuities and Retirement Satisfaction.”
9 • RETIREMENT 155

the relatively high personal risk run by those with Defined Contribu-
tion plans.11

Florida’s Elderly, Pension Choices, and

My Brush with Bush
But what do people actually choose, when presented with a
choice between a Defined Benefit pension and something else? Do
they choose the ultimate smoothing mechanism? The answer to this
question lies in one of the oldest states in the United States (in terms
of population), Florida.
During a 12-month period ending in mid-2003, each one of the
approximately 625,000 government employees who were members of
the Florida pension fund were presented with a unique decision.
Each existing and new employee had the option to switch from a tra-
ditional pension plan to a self-managed investment plan. In other
words, they could either keep their existing pension plan or take the
lump-sum value of their retirement pension—which for some was a
number in the hundreds of thousands of dollars—and invest the pro-
ceeds themselves in a wide range of carefully-vetted mutual funds
consisting of conventional stock and bond choices.
In contrast to many employees facing similar dilemmas in the pri-
vate sector, some of whom I discuss later, this was an honest choice
and not a forced conversion. They didn’t have to switch. They could
maintain the status quo and remain in their current traditional
Defined Benefit pension plan up to and into retirement and beyond.
Nevertheless, switching to the investment plan had both plusses and
minuses. If your investments did well, you might end up with a much
larger sum of money. Alternatively, if your investment choices
flopped, you might end up with less. Clearly, the decision was not an
easy one to make, and either way it had long-term, significant finan-
cial implications. This is why the state was careful in determining
which products they allowed into the investment plan and what annu-
ities employees were allowed to select upon retirement. In fact,
among the many other precautions taken by the state, they also

11. Bender, The Well-Being of Retirees.

156 YOUR MONEY MILESTONES

launched an extensive advertisement and education campaign to

explain these options to people in detail. They even hired the Nobel-
prize-winning economist William Sharpe from Stanford University to
star in a commercial targeted at state employees.

Investment Plans Versus Pension Plans—

What Would You Choose?
One of the important things about the experiment in Florida is
that the new Defined Contribution plan (technically an optional
401[a] plan) was referenced and labeled in all educational and pro-
motional material as an “investment plan,” whereas the existing plan
was called a “pension plan.” This was more than just a “word game” or
attempt at semantics: There is an important difference between a
true pension plan versus a 401(a), 401(k), 403(b), or any other plan.
An investment plan is not a pension plan; it is a tax-sheltered invest-
ment account. The account will (hopefully) grow over time, the
investment returns will (hopefully) beat inflation, and the nest egg
will ideally provide a nice cushion for your retirement. However, at
some point you need to turn this into an actual income stream that
provides you with a respectable income for the rest of your life. In a
pension plan, the income stream is provided automatically (allowing
you to practice Long Division automatically). In an investment plan—
or any similarly labeled account—the responsibility is up to you.
I actually had a rather limited role in all this tumult to help the state
administrators decide what type of investment should be allowed in the
Defined Contribution plan, and specifically to help select individual
annuity choices at retirement for the Defined Contribution plan. Now,
these individual annuities are likely one of the most controversial and
confusing financial instruments in the financial market place today—
and I discuss this more in the conclusion to this chapter—but for now
let me just mention that my job was to help explain which, if any, annu-
ities made sense for the plan.
So, here is the fundamental question—and it is one that is at the
crux of this chapter. Put yourself in a Florida state employee’s shoes.
Would you take $200,000 now (for example) in lieu of a pension and
invest it yourself, together with all the contributions you would
9 • RETIREMENT 157

receive over the next 10 to 20 years until your retirement? Or would

you say “no thanks” to the offer and just wait until retirement and
take a Defined Benefit pension based on your 35 years of service, one
which would entitle you to a guaranteed $40,000 per year (for exam-
ple) for the rest of your life? Indeed, some employees had to make
this decision with numbers far greater than $200,000. For people
with many years of service, higher salaries, or both, the numbers
reached into the millions of dollars.
I’m sure many people actually face a similar decision at retirement.
What would you do? Do you think you could manage and invest the
funds yourself and thus grow the money to an amount that would gen-
erate a greater lifetime income compared to a pension? What if you live
much longer than you expected? What if the market declines just when
you are about to retire? What if inflation is higher than expected? It’s a
tough choice, no question! And yet, if demographics and corporate
trends are any indication, many millions of Americans will be making
this exact choice over the next five to ten years: They have a number (an
amount in an account) and must decide how to convert it into a pension
(income for life).
Now, you might think that the state was trying to bribe or even
worse, outfox their employees. But I can tell you that this was defi-
nitely not the case. For those who planned to stay employed by the
state of Florida, staying in the pension plan was the best choice.
However, for those who were uncertain the length of time they would
remain, or for those who truly believed they could do a better job
managing the money themselves, the investment plan made perfect
and fair sense. In fact, the state bent over backward to make this a
fair choice by giving everybody the option to convert into the invest-
ment plan and then “switch back” into the pension plan at some point
before retirement. This was no cheap gift. According to some
research I conducted and published with a co-author in the Journal
of Risk and Insurance in 2004, this option was quite valuable.12 We
estimated most Floridians would take the investment plan and then
exercise the option to return to a pension, later, prior to retirement.

12. Milevsky and Promislow, “Florida: Pension Election from Defined Benefit to
Defined Contribution and Back.”
158 YOUR MONEY MILESTONES

And so, to conclude the story, when the dust settled on this massive
pension experiment, a mere 4 percent of the people who got the offer
decided to convert or transfer from the pension plan to the investment
plan. Yes, you read that correctly; only four in a hundred people
decided to take the responsibility of accumulating funds and providing
an income stream in retirement upon themselves. The majority of
Floridians were effectively saying, I do not want a number, I want a
pension.
Now, Florida wasn’t an isolated case of one lone southern state
trying to do away with its Defined Benefit pension plan by stealth.
Many other states have considered or are in the process of consider-
ing the same move, and have followed the results of Florida’s process
quite closely. Moreover, the U.S. government, which is responsible
for Social Security, the largest Defined Benefit plan on the planet,
might even go the same route one day. As unlikely as it seems given
the recent performance of the stock market, many commentators
(many more Republicans than Democrats, not surprisingly) have
advocated that the U.S. should follow the model set out in Florida
and allow people to opt out of the Defined Benefit aspect of Social
Security. In fact, although the proposal was heavily criticized and
then abandoned, one of President G.W. Bush’s campaign platforms
in the 2000 election was to offer Americans individual accounts as an
optional alternative to Social Security, similar to Florida’s plan. Isn’t
it interesting that during the same time, the president’s younger
brother was overseeing the Florida experiment? Boy, I would have
loved to be a fly on the wall at their Thanksgiving dinner.

Do Retirees Smoothly Transition into

Retirement?
One of the best places in which to observe whether real people
prefer smoother consumption over their life cycle, and to see
whether they practice what I have called Long Division, occurs at
retirement. The few years around the point at which people stop
working provide an ideal point at which to measure whether people
are smoothing. This is especially the case for individuals who do not
have a substantial pension and suddenly (with no more human capi-
tal) have to live off their accumulated savings and financial capital. If
9 • RETIREMENT 159

people are rational and forward-looking when planning their financial

affairs, one would not expect to see large drops or gaps in living stan-
dards, but a smooth ride. However, if people are not practicing Long
Division, they will wake up at retirement and realize they have to
tighten their belt.
Unfortunately, though, at first glance the empirical evidence
doesn’t seem supportive of the rational life cycle smoothing hypothesis.
Instead, what is often observed is declining spending in retirement.
Economists actually have a name for this: They call it the retirement-
consumption puzzle, and it has been documented in a variety of coun-
tries around the world and over extensive periods of time.13 Here’s the
puzzle: People spend much less and seem to live on greatly reduced
consumption rates in retirement than they did before retiring. Now,
sure, there is obviously a reduction in work-related costs (dry-cleaning
your suits, commuting to work), but the evidence suggests reductions
of as much as 30 percent compared to pre-retirees who are still working
and earning wages from their human capital. Why is the drop so great?
Some researchers at the University of Chicago and the Federal
Reserve Bank have provided a solution for this 30 percent drop puz-
zle, and they could support their explanation using a rather clever
dataset of food diaries, as they note in their research published in the
Journal of Political Economy.14 According to them, it is important to
differentiate between consumption and expenditures. At first glance,
the two might seem to be synonyms for each other, but in fact, con-
sumption is a much broader category. The distinction is more than
just semantics. It gets at the heart of one of the main axiomatic sug-
gestions in this book—to practice Long Division.
Here’s the explanation. When you spend $50 to buy some ingre-
dients to bake a special cake, your observable expenditures are
$50. However, if you spend two hours driving around town looking
for these ingredients and then spend another three hours baking
the cake itself, your total spending is more than $50. Don’t forget the
five hours! In fact, if you price your time at $10 per hour, your true

13. Hurd and Rohwedder, “The Retirement-Consumption Puzzle.”

14. Hurst and Aguilar, “Consumption vs. Expenditure.”
160 YOUR MONEY MILESTONES

consumption was $50 in cold hard cash and another $50 in the
imputed cost of time. Thus, you really spent $100 baking the cake.
What the study found was that although retirees might appear to
be spending less than one would expect in the first few years of retire-
ment, they are, in fact, substituting their personal time and spending
that time instead! Economists call this “home production.” If you
focus exclusively on the dollars and cents flowing out of their bank
account, you will miss the possibly larger flow of (the dollar value of)
time—you won’t solve the puzzle.
Now, this is more than just a frivolous accounting exercise: It
actually helps refine our understanding of life-cycle planning. This
research can serve a warning sign to those who blithely think they will
need “much less” when they retire. Maybe you’ve seen the evidence
of retirees with (lower) spending getting by on less. Or you might
have personal evidence from a relative who does not spend very
much in retirement. Yet, it would be dangerous to extrapolate this
anecdotal evidence to your own retirement. In all likelihood your
great-aunt is spending more time cooking her own food, shopping for
a better deal on milk and eggs, or standing in line for a half hour to
get the early bird dinner special at Denny’s in Boca. This doesn’t
imply you will be doing the same during your own retirement. You
have to be willing to substitute large amounts of your own time to
reduce your expenditures, or cash outflows. But your total consump-
tion (properly defined to include your time) might only be marginally,
if at all, lower.

Don’t Count on Pennies from Heaven to

Smooth Your Retirement Ride
Now, you might be thinking that none of this applies to you, as
you personally expect to receive an inheritance to help fund your
expenses in retirement. For years, media stories have reported on the
coming “biggest wealth transfer in history,” as the parents of boomer
children leave legacies after death. In fact, a 2006 study showed that
some 1.5 million Canadians were counting on an inheritance to fund
their retirement, and in a recent survey, fully one-third of Canadian
boomers said they expected to receive an inheritance with an average
value of $150,600. In addition, 64 percent of those surveyed in 2006
9 • RETIREMENT 161

said they had carried debt into retirement, presumably expecting to

reduce or eliminate it with an inheritance.
However, as the first wave of boomers inherits funds, reality is
falling far below expectations. The average inheritance received by
Canadians in 2006 was $56,000; fully $100,000 below the average
expected amount. And in the United States, as well, the numbers
don’t look much different: Recent reports have found that for
boomers who had already received an inheritance by 2004, the aver-
age value was just $64,000; and that of those Americans who had
received inheritances, only 6.9 percent got more than $100,000.15 The
message is clear: Don’t expect lump-sum bailouts to smooth your
retirement ride.

Is It Better to Get a Lump Sum? The

Military View
Despite the considerable psychological evidence that most
retirees say they are “happier” when they receive an income from a
lifetime annuity (that is, a Defined Benefit pension) compared to
those generating their own cash flow from a portfolio of investments
(that is, a Defined Contribution pension), there are important excep-
tions to this rule, especially when people are younger. Some prefer to
take their nest egg as a lump sum at retirement and create their own
personal pension plan. There are many legitimate reasons for this.
For example, one fear that people have—which biases them toward
taking a lump sum—is that they might have an (medical) emergency
that require large sums of money, quickly. Selecting an annuity would
make it hard to react to such emergencies. Another legitimate con-
cern is the fear of default or bankruptcy on the part of the entity pay-
ing the pension annuity. There are thousands of airline pilots (who
worked for United Airlines) and engineers (who worked for Nortel)
and steel workers (employed by Bethlehem Steel) who deeply regret
not having taken their lump-sum pension entitlements as soon and as
early as possible. One would expect that these are the exceptions to
the rule and perhaps extreme cases. But are they? To this end, there

15. All figures from BMO Retirement Institute, “Passing It On.”

162 YOUR MONEY MILESTONES

is actually an interesting study that quantified exactly how much more

“a bird in the hand” is worth more than “two in the bush.”
In January of 1992, the U.S Department of Defense (DoD)
began a drawdown program among mid-career military personnel, in
an attempt to scale down the size of U.S. defense forces. You can
think of this as an early retirement of sorts, which was partially driven
by the collapse of the Soviet Union and the reduced need for a large
military force. The original 1991 Defense Authorization Act directed
the DoD to reduce the military by approximately 400,000 by the year
1995, which represented a 25 percent reduction.
Over the same period, approximately 65,000 of those military per-
sonnel, who had between 5 and 20 years of service, were offered an
interesting financial choice, which is directly related to our discussion of
pensions and annuities. According to a study published in the American
Economic Review in 2001, each one of these 65,000 individuals was
asked to choose between receiving a separation benefit in the form of a
lump-sum payment or instead taking their entitlement as an annual
annuity.16 In terms of their rank, the group included 11,000 officers and
55,000 enlisted personnel. Guess what the majority decided to do?
Now, the authors in the American Economic Review study make
clear that the choice was fair and unbiased, similar to the choices
offered to participants in the state of Florida’s experiment previously
described. First, on average, the present value of the promised annuity
payments was actually much higher—using market interest rates at the
time of approximately 8 percent—compared to the lump-sum payment.
In other words, if you took the lump sum and invested this amount at
the going long-term government rate of 8 percent, you would NOT be
able to generate the annuity payments yourself.
Here is a typical (or idealized) situation to help understand the
trade-off. The separating service member was given the choice
between $50,000 upfront (today) and a periodic annuity of $800 per
month for the next 20 years. If you add up the 20 years times 12 pay-
ments per year you get 240 x $800, or $192,000 in total. Now, obviously,
this $192,000 was to be received over a very long period, so it is
incorrect to simply add up the 240 payments. These must be
discounted and converted into present value terms. (You may recall

16. Warner and Pleeter, “The Personal Discount Rate.”

9 • RETIREMENT 163

the concept of discounting from Chapter 2, “What Is the Point of Sav-

ing Money Forever?”)
At the time this offer was given (around 1992), long-term (risk-
free) interest rates were approximately 7 percent per year. So, under a
7 percent rate the discounted value was $100,000. This was still dou-
ble the $50,000 cash offer. Even under a 15 percent discount rate the
present value was $60,000. It was only under a 19 percent rate that the
discounted value of the $800 per month would equal $50,000. In other
words, the individual would have to invest the $50,000 lump sum (if
they picked this instead of the annuity) to earn a guaranteed 19 per-
cent per year to generate the same $800 per month for life amount.
This disparity was why the economists within the DoD estimated
most people would take the (relatively generous) annuity instead of
the (relatively meager) lump sum. After all, the only way the lump sum
would generate an ongoing cash flow on the order of magnitude of the
annuity payment, was if they could guarantee an investment return of
19 percent per year.

Taking Their Lumps

And yet, as you could tell from the way in which I have been setting
up the story so far, the vast majority of military personal did not take
the periodic annuity. They took the lump sum. In particular, among the
enlisted personnel with less than 10 years of service, more than 90 per-
cent took the lump sum. Among those with less than 10 years of serv-
ice, over half took the lump sum. Now, you can’t argue that “these folks
just needed the money” because in theory they could have borrowed
against an annuity payment (or perhaps even sold it) if they so chose.
As you would also expect, there was a big difference between person-
nel in the Army, Navy, and Air Force, which are the three branches of
the U.S. military. The Air Force officers were the most likely to select
the periodic annuity (55 percent of them chose the annuity), whereas a
fully 95 percent of enlisted army (nonofficers) selected the lump sum.
All of this is rather puzzling, especially when you remember that
most retired people like pension annuities. Why wouldn’t the same
apply to payments earlier in life (at the age of 40 or 50)? After all, the
deck was heavily stacked toward picking the periodic annuity. In fact,
this demand for immediacy is observed with lottery winners who are
164 YOUR MONEY MILESTONES

given a choice between a lump sum and periodic annuity.17 And there
are a number of companies who offer to convert your annuity into
cash (...at a discount rate of 21 percent).
Ironically, the authors of the study concluded that because so
many people selected the lump sum, despite the fact the annuity was
worth almost twice as much, these (suboptimal?) choices actually
saved the U.S. taxpayers $1.7 billion in severance costs.
Now, some might wonder if this choice was driven by tax consid-
erations, medical concerns, and other such factors. However, the
researchers determined that the choices did not affect the benefits
(or after-tax payments) received by these individuals. It is also hard to
argue that the U.S. government would renege or default on the annu-
ity promise to the U.S. military—after all, they’re the ones with the
guns! Nor can you pin this decision on a lack of sophistication or lack
of education—these are Air Force pilots and officers, after all. These
folks can figure out how to land an F16 on a ship in the middle of the
ocean. I’m sure they can work out the present value of an annuity and
compare it with a lump sum.
So, perhaps the takeaway is what behavioral economists called
anchoring.18 If somebody suddenly and out of the blue offers you a
sum of money, or an offer to take it as a periodic annuity, chances are
people want the money now and do not take the annuity. (Although I
would argue you should take the annuity when the equivalent rate is
19 percent!) They have anchored on the lump sum available today, as
opposed to a stream of income, in smaller amounts, that will flow at
some point later, even if the stream of income adds up to a larger
amount than the lump sum, over time. In contrast, when people work
for an employer for 10, 20, or 30 years under the expectation that they
will get a pension one day, and they are given the option of converting
this into a defined contribution plan (à la Florida), they would rather
have the safety and security of the lifetime pension. That is, they have

17. See, for example, comments from Dr. Joel Slemrod (Professor of Economics at
the University of Michigan) as quoted in Fox, “The Curious Capitalist: How the
Payoff Decisions of Lottery Winners Have Shifted the Income Distribution.”
18. Thaler and Sunstein, Nudge: Improving Decisions about Health, Wealth and
Happiness.
9 • RETIREMENT 165

anchored on the pension, not on a lump sum. This is especially true

when you consider the vast sums of money lost within 401(k) and IRA
plans, in the stock market, over the most recent decade.

Women and Annuities

While on the topic of pension annuities, it seems that although
there is a general reluctance to take a lump sum of money and con-
vert it into a life annuity, women are actually more amenable to annu-
ities than men. It is unclear whether this is due to the higher
(apparent) risk aversion of women, or whether it appeals to a differ-
ent aspect of the female psyche, but according to another study pub-
lished in the American Economic Review, when experiment subjects
were asked to choose between pension lump sums versus annuities,
women choose the annuity option more often.19 Now, granted, this
evidence comes from questionnaires and hypotheticals, as opposed to
real, live, choices made by retirees, but the results should still res-
onate with readers.
The fact that wealthier (female) individuals live longer compared
to individuals with lower net worth (and especially males) is well
established in the economics and actuarial research literature. For
example, according to the study, a 70-year-old male who happens to
be in the lowest 20th percentile of the population in terms of wealth
(that is, 80 percent of the population are wealthier) can expect to live
six more years to the age of 76. In contrast, a 70 year-old female who
is at the 80th percentile of the population in terms of wealth (that is,
only 20 percent are wealthier) can expect to live 16 more years to the
age of 86. The extra 10 years of required income and spending for the
wealthier female compared to the poorer male should have an enor-
mous impact on observed financial behavior both before and after
retirement. All else being equal, if you think in terms of Long Divi-
sion and smoothing of consumption over the life cycle, you would
expect to see wealthier individuals—which implies a longer life
expectancy in retirement—saving proportionally more and spending
proportionally less compared to averages and conventional wisdom.

19. Agnew, Anderson, Gerlach, and Szykman. “Who Chooses Annuities?”

166 YOUR MONEY MILESTONES

This finding was actually observed and documented by the

researchers when they examined numbers from a dataset called the
Dynamics of the Oldest Old (AHEAD).20 It is more than just some
empirical verification of an economic theory; it has practical implica-
tions as well. That is, the small but noticeable group of people who
seem to be over-saving in their working years (“Why is mom such a
tightwad?”) or under-spending in their retirement years (“Why is
grandma so stingy?”) might actually be practicing a more sophisti-
cated form of Long Division over a much longer life.

Final Recommendations: Get a Pension,

from Somewhere
After reading the last few pages you might be wondering: geez,
what can I do if my employer doesn’t offer a defined benefit pension?
Am I out of luck, doomed to an unhappy, less-wealthy retirement?
Well, you might try to speak to your local human resources
department, or even your boss, to see if they can do something about
it. Unfortunately, though, this is not likely to be a fruitful conversa-
tion. More practically, I would suggest you look into buying your own
defined benefit retirement pension on the open market. This is not as
esoteric or difficult as it might sound. Insurance companies have
been selling stand-alone pensions for centuries, often under generic
names like “guaranteed living income benefits” or “single premium
income annuities.” Now, this is not the place to delve into the minutia
of these instruments, which I discussed in my previous book, Are You
a Stock or a Bond? Instead, I recommend you seek some professional
advice to create a personal pension plan. However, to get you started,
I’ve created a calculator at www.qwema.ca. that enables you to esti-
mate the price for a single premium income annuity, which you could
use to create your own pension plan in retirement.

20. Assets and Health Dynamics of the Oldest-Old (AHEAD) is a national survey of
community-based Americans born in 1923 or earlier. It is sponsored by the
National Institute on Aging. The focus of the AHEAD survey is to understand
the impacts and interrelationships of changes and transitions for older Ameri-
cans in three major domains: health, finances, and family.
9 • RETIREMENT 167

Finally, where does all of this leave you? Ideally, make sure some of
your household retirement income comes from a pension that pays life-
time income for the rest of your life—even if you have to create your
own “pension plan” using purchased annuities. This insures you against
longevity (something I discussed in Chapter 7) and will likely make you
a happier retiree. In addition, most important, if somebody wants to
offer you the choice between a relatively low lump sum and a relatively
higher periodic annuity, or the choice between a Defined Benefit pen-
sion and a Defined Contribution investment account, remember what
happened in sunny Florida. Those folks know retirement.

Summary: The Four Principles in Practice

• “Retirement” is best understood not as a sudden switch but as
the point in your financial life cycle when your human capital
has been largely SUBTRACTED and removed, and what you
have left on your personal balance sheet is the financial capital
you have ADDED over time. Retirement is when the human
capital expires.
• Defined benefit pensions are the “ultimate smoothing mecha-
nism” and can be thought of as an institutionalized version of
Long DIVISION. Pensions smooth, insure, diversify, and
hedge all at once. There is also evidence that pensions make
retired people happier!
• Given the evidence in favor of annuitization (which is just
another type of pension), the recommendation is that if you are
given a choice, MULTIPLY your chances of success by allocat-
ing some of your nest egg to the Defined Benefit pension
(while working) or the income annuity (while retired). You
might need to create your own annuitized income in retire-
ment to ensure you have a smooth life cycle ride.
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 Conclusion:
Four Principles to Guide All Financial
Decisions and Money Milestones

During the last few years I have been extremely fortunate to

meet thousands of ordinary Americans (and Canadians) at book sign-
ings and public lectures all over North America. During the recep-
tions and cocktails that are inexorably associated with these events, I
have had the opportunity to hear from many individuals about their
financial successes, their woes, and travails. I have been asked for
personal and detailed financial advice (which I am extremely reluc-
tant to offer), and I have also received my fair share of criticism for
things I have said and written in previous books and various media
articles. These impromptu discussions with ordinary investors from
Vancouver to Miami and from San Diego to Halifax have enabled me
to learn a tremendous amount about common financial attitudes and
decisions outside of the academic ivory tower.
And, when the opportunity has allowed itself, I have also man-
aged to conduct some informal research that makes all the shrimp
cocktails1 worthwhile. In fact, by now I have asked this question thou-
sands of times, and perhaps you have responded to this as well. I ask:
What was the worst financial decision you made in your life?

When asked this question, some people reply immediately, and

others take a few minutes and wait to hear what others had to say. Yet,

1. Ok. Technically I don’t eat shrimp. But I’m sure you get the point.

169
170 YOUR MONEY MILESTONES

for the most part, every single person can recall—and quite vividly—
some bad financial decision they made in the past. During the fright-
ening period around fall 2008, when banks and insurance companies
were on the verge of failing all around us, answers to this question were
self-evident: everybody regretted the stocks and mutual funds they
held. Then as the real estate crisis played itself out, people regretted
the house they purchased. I also heard from people who regretted the
business deal they partnered on; they regretted the job they accepted;
they regretted the tenant they rented their apartment to; they regret-
ted the car that turned out to be a lemon; and so on. The replies were
fast and furious and easy for people to recollect.
To misquote the great Frank Sinatra, in today’s economy, we’ve
all had quite a few regrets. Hey, who doesn’t have a lousy mutual fund
they should have sold months ago, or an expensive house they shouldn’t
have bought, or a great investment they missed out on. Nearly every-
one has some personal or anecdotal story of financial regret, usually
employing the general syntax: “If only I had...back when...we would
be rich today....” Often these stories are nostalgically transmitted
from parents to children and across generations, which can influence
financial attitudes towards risk taking and decision making for
decades. Everyone has some financial decision they regret.
But then, with these same audiences and groups I follow up with
a subsequent question:
What was the best financial decision you made in your life?

Oddly enough, the replies to this question are fewer and farther
between. The best decision is not immediately obvious or easy to rec-
ollect. Yes, I occasionally hear of the apocryphal penny stock that has
“done very well” or the special mutual fund that “worked out nicely,”
but there is much less conviction and feeling compared to the deci-
sions they regret. Sure, a handful of people talk nostalgically about
the decision to get married or even the decision to get divorced. One
or two mention their grandkids (not the kids, oddly). I even had one
person tell me that the best decision was buying a lottery ticket a few
years ago, which ended-up winning the jackpot! Yet, one thing is
quite clear. The memories aren’t as vivid, the stories aren’t as clear,
and the examples are few. Does this imply that most of their decisions
CONCLUSION 171

have been failures? I doubt it. I believe they are not thinking broadly
enough about what constitutes a regretless financial decision.
Indeed, rarely do people include human capital considerations as
part of their financial decisions, despite the fact they have a much
greater impact on their personal balance sheet. I never heard people
say to me in response to my question: going to college, or not major-
ing in art, or not taking a particular job after college, or insuring the
house that never burned down was the best decision I made.
In fact, these same individuals with so many financial regrets
rarely recollect the fuzzy decisions they made years ago with little
fanfare, which paved the way for their relative prosperity and thriving
daily life. Who commits to memory the job offer they didn’t take from
the company they don’t remember, which then happened to declare
bankruptcy a few years later? Or what about the mutual fund they
briefly considered purchasing, but then forgot about, that was even-
tually frozen or liquidated for pennies on the dollar? Think about it.
You might remember the rare near-miss, but what about the much
more frequent far-miss? Alas, it seems that human beings are hard-
wired to unearth some regret from nearly all outcomes.
Making the best decision at each money milestone in your life is
just as important as NOT making the wrong one, but is obviously less
memorable. As I have argued in this book, it is very important to
properly identify all the money milestones in our life and approach
them in a more strategic manner. Do this by recognizing the interac-
tion between all disparate factors that impact the assets and liabilities
on you personal balance sheet.

Create a Decision-Making Process for All

Money Milestones
When I have an opportunity, I ask a third and final follow-up
question with these audiences: What was the process you went
through to make the best financial decision? Alas, here is where I get
few, if any, replies. Often there is dead silence. Few people went
through a process to help make the decision. I find this to be the most
surprising response of all. People remember the outcome and not the
process.
172 YOUR MONEY MILESTONES

According to the Webster dictionary the word decision is synony-

mous with “the act of reaching a conclusion.” Notice the emphasis on
the word reaching and conclusion. Yet, few people I spoke to could
pinpoint or remember these “acts” of reaching conclusions. They all
remember the lousy and regrettable outcomes, and some remember
the beneficial ones, but few, if any, remember the process itself.
Moreover, it seems that many people I talk to are confusing the
decision itself—which might have been flawless—and the outcome
that was terrible. (That is, they remember the failure, not the success.)
The behavioral economics literature indicates that people don’t
seem to make financial decisions; instead—and excuse the colloquial
expression—they kind of just fall into them. After the fact, yes, they
talk about it being a success or failure. They blame somebody for talk-
ing them into the decision, or not thinking about it enough before the
decision. But by not having a decision process in place, they were set-
ting themselves up for regret.
The last few years of financial volatility, economic turmoil, and
even scholarly research have caused many diligent practitioners and
prudent individuals to throw up their arms in despair and pretty
much give up on commonsense financial planning. Stock markets
have proven to be much less efficient and rational than previously
believed. Well-diversified portfolios dropped by more than 50 per-
cent over less than 12 months, and large financial institutions with
decades of profitable history collapsed seemingly overnight. Add to
these catastrophes the increasing scholarly research that demon-
strates how people’s brains aren’t wired to properly and rationally bal-
ance risk and return, and you can’t help but succumb to those who
simply want to live for the moment. And yet, with all this negative evi-
dence, you still have to make financial decisions. How do you deal
with the money milestones in your life? What’s the main insight?
According to a famous Jewish story that has been transmitted
from parents to children over the generations, approximately two
thousand years ago a Talmudic scholar by the name of Hillel was
asked by a religious skeptic to summarize the entire body of Jewish
knowledge and tradition, “while standing on one foot.” This is roughly
CONCLUSION 173

equivalent to asking for a summary of the Encyclopedia Britannica

while riding down an elevator. Hillel responded with what is now a
classic Judeo-Christian proverb, “What is hateful to you, do not do
unto your neighbor.” The rest, he said, was just commentary.
I obviously can’t summarize the main idea in this book while
standing on one foot (despite the many media requests2 to do so) nor
can I recap 60,000 words in one charmingly witty sentence. However,
I would like to conclude by suggesting four unifying and guiding prin-
ciples to help navigate all of life’s money milestones.

PRINCIPLE 1: ADDITION—Identify the true value of

all your financial and human capital resources. Your
human capital is your most valuable asset for most of your
working life. It represents the discounted value of your future
wages. This asset tends to be undervalued and underappreci-
ated, especially early in life. As you progress through the
human life cycle, you convert (hidden) human capital into (vis-
ible) financial capital by saving and investing. Both forms of
capital belong on the holistic personal balance sheet and deter-
mine your net worth—you must add your human capital to
your financial capital to truly understand your financial posi-
tion in life.
PRINCPLE 2: SUBTRACTION—Recognize and budget
for all the hidden liabilities in your future. A truly
healthy and realistic holistic balance sheet will account for the
hidden liabilities on your personal balance sheet. Many of the
money milestones you might pass through in life can add to the
hidden liabilities side of your personal balance sheet—notably
marriage and children, although both might strengthen and
add to your assets over time. Your capacity to generate income
from your human capital also can create hidden liabilities, in
that its loss creates a gap that you need to fill. A clear-eyed view
at your life circumstances through the lens of human capital
can help you identify, hedge, and bridge all the liabilities you
encounter in life. Don’t add assets without subtracting any cor-
responding liabilities.

2. It should be worth noting that Hillel’s contemporary and nemesis Shamai

responded to the same request by telling the skeptic to effectively go jump in the
lake. I have great sympathy and admiration for Shamai’s approach.
174 YOUR MONEY MILESTONES

PRINCIPLE 3: DIVISION—Plan to spend your total

resources evenly and smoothly over time. When you rec-
ognize and account for the value of all the assets on your per-
sonal balance sheet, devise a long-term consumption (or
spending) plan that spreads your total (human and financial)
resources over your entire life cycle. It makes little sense to
starve yourself for decades so that you can enjoy life in middle
age, or when you are old and frail. Likewise, if you “live it up”
today without any consideration for tomorrow, you might
regret this as well. Think long term and avoid foreseeable dis-
ruptions by budgeting for all predictable liabilities.
PRINCIPLE 4: MULTIPLICATION—Prepare for many
alternative and unexpected universes. Recognize that
there are many different future paths of your evolving human
life cycle. At each instant in time there are an infinite number
of money paths and states of nature over which your future can
develop. You owe it to yourself to consider all of them, today.
Make sure that you make decisions that help smooth your con-
sumption over all possible paths and not just the expected or
hoped-for path. So, insure against all catastrophic and unfore-
seeable disruptions. Be a smooth operator over time and space.

Notice that I deliberately didn’t include those tiresome financial

sound bites such as “buy low and sell high” or “live within your finan-
cial means” or “buy term insurance and invest the difference” or “buy
stocks for the long run” or “keep an emergency reserve of three
month’s salary” or “education pays” or other such nuggets that have
actually become titles of entire tomes in personal finance. Despite
their popularity, these sound bites don’t actually help unify all the
money milestones—and they all stem from some underlying princi-
ple or viewpoint, but they don’t express it.
CONCLUSION 175

Therefore, our random tour of Italian women, Florida’s lottery

winners, Minnesotan taxpayers, African grandmothers, and over-
weight Japanese borrowers—and the many other characters I intro-
duced you to in this book—should remind you that although some
consumers are quite clever about managing their financial affairs,
many others are not. But one thing is certain: Money milestones are
universal.
I think that my four guiding principles should help connect the
dots for many dispersed financial decisions in your life. For example,
investing in what appears to be costly education actually maximizes the
value of your human capital (Chapter 1); whereas borrowing money or
living beyond your immediate means and income isn’t necessarily inap-
propriate (Chapters 2 and 3) provided it smoothes the ups and downs.
Children might cause an immediate reduction in disposable income
and noticeable reduction in your financial capital but might also defuse
some long-term retirement liabilities (Chapter 4), in addition to the
many other nonfinancial pleasures they can bring. Remember, also,
that a fraction of your human capital dividends belongs to your lifetime
partner, the tax authority; which is why you must be vigilant to ensure
your partner doesn’t claim more than a fair share (Chapter 5). Buying a
house might seem like the most disruptive of all financial transactions,
but in fact it hedges future liabilities (Chapter 6), even though it is not
prudent for all. In the same vein, life, property, and other insurance
policies help smooth your consumption across alternative universes
(Chapter 7), whereas retirement planning (Chapter 9) and investment
allocation (Chapter 8) are about practicing long division over time so
that you are protected against the surprising risk of a long life.
To quote the parting words of Mr. Spock from the mythical planet
of Vulcan—who is likely the only entity who is rational enough to per-
fectly smooth consumption across time and space—may you live long
and prosper.
176 YOUR MONEY MILESTONES

THE PERFECT JOB FOR ME!

Everyone has the choice of what to be,
I shall pick the one which will be a pleasure to me.
Maybe a fun job and one which makes money,
Or perhaps my boss should be a little bit funny.
The job of a sanitation engineer might be right,
But smelling the awful scent of garbage would not be a delight.
Rotten food, diapers, or an old broken toy,
Picking them up would not be a joy.
Then the profession of a teacher came to my mind,
But all those students screaming and not being so kind,
Calling out answers and yelling out at me,
I think I’ll change my mind of what I should be.
Maybe an interior designer would be fun,
Picking out carpets for everyone,
Yellow wall orange wall pink wall too,
I think that’s what I’ll decide to do.
Occupations galore so many jobs for you and me,
Let’s not regret our jobs and pick a fantastic one to be.

—Natalie Abigail Milevsky, Age 10

Spring 2009, Toronto
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 INDEX
NUMBERS (ARMs), 102
adjusted gross income
1/n heuristic, 144
(AGI), 86
2007 Survey of Consumer
after-tax returns, 94-96
Finances, 57
allocation of stocks and bonds,
401(k) plans, 143. See also
136-138
retirement
Allowance for Newborn
borrowing from, 61-63
Children, The, 72
A alpha, 97
American Council of Life
“A Pension in Every Pot,” 151 Insurers, 118
accounts American Economic Review,
debt, 53 162, 165
affect on value, 60-66 American International Group
“Debt Literacy, Financial (AIG), xix
Experiences and anchoring, 126
Overindebtedness,” 66 Annual Survey of Colleges, 31
diversity of, 54-56 annuities, 120, 122
education, 31-32 payouts, selecting over lump
home ownership, 101-109 sums, 161-166
management, 56-60 pensions, 153-154
silos, 57 women and, 165-166
smoothing, 67 “Annuities and Retirement
mental, 60 Satisfaction,” 154
taxes on retirement, 98-99 Are You a Stock or a Bond?, 9
adjustable rate mortgages Argentina, 91

185
186 INDEX

assets, 1, 69 Becker, Gary, 7, 120

children as, 70 behavior of taxpayers, 87-89
home ownership, 101-102 behavioral economics, 126-128
affect of buying houses, benefits of financial
103-105 planning, 50
comparing to renting, benevolent societies, 115
105-109 Beveridge, Sir William, 73
values, 102-103 birth rates, 72. See also
portfolios, 129-131 children
allocation, 136-138 Bismarck, Otto von, 73
avoiding losses, 139-140 BMI values, 65
building, 133-136 bonds, 3
long term investments, portfolios
131-133 allocation, 136-138
Assets and Health avoiding losses, 139-140
Dynamics of the Oldest Old building, 133-136
(AHEAD), 166 taxes, 94-96
authorities, taxes, 90-91 borrowing from retirement
automobile loans, 54 plans, 61-63. See also debt
averages, 24 Boston University, 43
avoiding portfolio losses, Brazil, 91
139-140 bucks for babies, 72
awariya (“damaged Buffet, Warren, 24
merchandise”), 115 Bureau of Labor Statistics, 7
Bush, George W., 158
B business relationships with tax
balance sheets, affect on authorities, 90-91
buying houses, 103-105 buying houses, affect of,
balances 103-105
paying down debt, 57-60
transfers, 63
C
Bangladesh, 49 Canada, 49
Bank of Italy, 79 tax refunds, 92
bankruptcy, 110 Canada Revenue Agency, 98
lottery winners and, 48 Canadian Council on Social
Baylor University, 98 Development, 70
INDEX 187

Canadian Life and Health consumption, 102

Insurance Association, 118 across time, smoothing, 117
Canadian Pension Plan, 73 home ownership as, 104
Canadian Tax Journal, 97 retirement-consumption
capital puzzle, 159
human, 3-5 “Consumption vs.
home ownership, 107 Expenditure,” 159
impact on financial costs, education, 13-14
capital, 140-142 consumer finance decisions,
social, 108 25-26
investments in, 110-111 debt, 31-32
Capitalism and Freedom, 32 financial rewards of, 18-19
careers, 108 high-paying careers, 19-20
high-paying, 19-20 human capital derivatives,
cash-flow mismatch, 57 14-16
catastrophes, insurance, 117. investing in human capital,
See also insurance 21-24
Chicago, Illinois, 106 ivy league, 28-30
children, 69 securitizing human capital,
as assets and liabilities, 70 16-18
fertility rates, 71-73 Survey of Consumer
as pensions, 73-77 Finances (SCF), 27-28
Code of Hammurabi, 115 wage considerations, 20-21
college degrees, 23. See also CPI (consumer price
education index), 14
Commissioner of Revenue, 85 credit cards
complementarity, 82 bankruptcy filings
composition of balance against, 110
sheets, 144 debt, 2. See also debt
“Consumer Bankruptcy and Current Population Survey, 6
Default,” 109
consumer price index D
(CPI), 14 DCT (Dynamic Control
Theory), xxi, 18, 106, 144
de Fermat, Pierre, 115
188 INDEX

debt, 53. See also liabilities investments, 13-14

affect on value, 60-66 human capital
“Debt Literacy, Financial derivatives, 14-16
Experiences and securitizing human
Overindebtedness,” 66 capital, 16-18
diversity of, 54-56 deductions, taxes, 17
education, 31-32 Defense Authorization Act
home ownership, 101-102 (1991), 162
affect of buying houses, Defined Benefit pension
103-105 plans, 149-150
comparing to renting, Defined Contribution plans,
105-109 150, 156
values, 102-103 degree of annuitization, 154
management, 56-60 degrees, college, 23
silos, 57 Denny’s, 160
smoothing, 67 Department of Economics at
“Debt Literacy, Financial Boston University, 43
Experiences and Department of Revenue, 85
Overindebtedness,” 66 derivatives, 14-16
decision-making processes, “determinants of income tax
171-175 compliance, The,” 85
education Detroit, Michigan, 93
consumer finance disappearance of pensions,
decisions, 25-26 150-153
debt, 31-32 discounting, 42
financial rewards of, interest rates, 45-46
18-19 disruption, magnitude of, 118
high-paying careers, diversification, 69
19-20 debt, 54
investing in human smoothing, 143-145
capital, 21-24 divorce rates, 81
ivy league, 28-30 “Does it Pay to Attend an Elite
Survey of Consumer Private College?,” 29
Finances (SCF), 27-28 dollar-cost averaging, 129
wage considerations, drawdown programs, 162
20-21 Dynamic Control Theory
insurance, 122-125 (DCT), xxi, 18, 106, 144
INDEX 189

E equity, 102. See also home

ownership
early bird dinner specials, 160
ESPlanner (Economic
Earned Income Tax Credit
Security Planner), 43
(EITC), 92
evasion, tax, 87-89
earnings, 43
expectancy, life, 76-77
Earnings of Canadians, 24
expenditures, 159
Economics and the Public
extended warranties, 117
Interest, 17
Economist, The, 50 F
education
family balance sheets, 80. See
consumer finance decisions,
also marriage
25-26
“Fat Debtors,” 65
costs, 13-14
“Fatal (Fiscal) Attraction:
human capital
Spendthrifts and Tightwads
derivatives, 14-16
in Marriage.,” 82
securitizing human
Federal Direct Loan
capital, 16-18
Program, 13
debt, 31-32
Federal Reserve Bank, 159
financial rewards of, 18-19
of Chicago, 63, 109
high-paying careers, 19-20
Federal Reserve Board, 93
human capital investments,
Survey of Consumer
21-24
Finances 2007, 23
ivy league, 28-30
fertility rates, 71-73
Survey of Consumer
financial capital, impact of
Finances (SCF), 27-28
human capital on, 140-142
wage considerations, 20-21
financial decisions, 170-171
emotion
financial planning, 50. See also
aspect of financial
planning
windfalls, 44, 47
financial rewards of education,
attitudes toward
18-19
investments, 83
fixed rate mortgages, 102
Employee Benefit Research
floating debt obligations,
Institute, 152
102-103
employment opportunities, 108
Florida, 46, 48
pensions, 155-156
190 INDEX

“Florida: Pension Election comparing to renting,

from Defined Benefit to 105-109
Defined Contribution and values, 102-103
Back,” 157 homestead exemptions, 48
Forbes magazine, 21 Household Income and
funeral expenses, 115 Wealth survey, 79
housing. See also home
G ownership
Gates, Bill, 24 mortgages, 101-103
general average, invention value of, 26
of, 115 Huebner, Solomon, 120
General Motors, xix human capital, 3-5
Georgia, 109 consumer finance decisions,
Germany, retirement programs 25-26
in, 73 derivatives, education costs,
governments 14-16
fertility rates and, 71-73 fertility rates, 71-73
tax authorities, 90-91 home ownership, 107
Great Depression, 129 impact on financial capital,
Great Fire of London 140-142
(1666), 115 investments in, 21-24
guilds, 115 securitizing, 16-18
Survey of Consumer
H Finances (SCF), 27-28
haggling, 89 Human Capital: A Theoretical
Harvard University, 28, 63 and Empirical Analysis with
health, affect on interest rates, Special Reference to
65-66 Education, 8
hedging, 119
I
high school diplomas, 23
high-paying careers, 19-20 “Impact of Personal Income
history of insurance, 115-116 Taxes on Returns and
holistic personal balance Rankings of Canadian Equity
sheets, 5 Mutual Funds, The,” 97
home ownership, 101-102 Implicit Financial Capital, 5
buying houses, affect on
balance sheets, 103-105
INDEX 191

importance of pensions, investments

149-150 education
income consumer finance
debt smoothing, 67 decisions, 25-26
smoothing, 40-50 costs, 13-14
taxes, 98-99. See also taxes debt, 31-32
India, 49 financial rewards of,
inflation, education costs 18-19
and, 14 high-paying careers,
inheritances, affect on 19-20
retirement, 160-161 human capital
installment debts, 54 derivatives, 14-16
Institute for the Study of investing in human
Labor (IZA), 79 capital, 21-24
insurance, 113-114 ivy league, 28-30
annuities, 120-122 securitizing human
behavioral economics, capital, 16-18
126-128 Survey of Consumer
decisions, 122-125 Finances (SCF), 27-28
history of, 115-116 wage considerations,
life, 118-120 20-21
self-insurance, 125-126 emotional attitudes
smoothing, 116-118 toward, 83
interest rates home ownership, 101-102
debt, 59. See also debt affect of buying houses,
discounting, 45-46 103, 105
optimal, 63-64 comparing to renting,
internal rate of return 105-109
(IRR), 15 values, 102-103
Internal Revenue Service outcome of long term,
(IRS), 90-91 131-133
after-tax refunds, 94-96 plans, selecting, 156-158
tax refunds, 92-94 portfolios, 133. See also
International Monetary portfolios
Fund, 19 social capital, 110-111
Investing in Human taxes, 94-96
Capital, 17
192 INDEX

IRA (Individual Retirement levels of debt, 53

Account), 99 affect on value, 60-66
IRR (internal rate of “Debt Literacy, Financial
return), 15 Experiences and
“Is Your Alpha Big Enough to Overindebtedness,” 66
Cover Its Taxes?,” 97 diversity of, 54-56
Island of Rhodes, 115 management, 56-60
ivy league educations, 28-30 Lex Rhodia, 115
liabilities, 1, 43, 54, 69.
J–K See also debt
Japan, 65 children as, 70
jobs, 108 mortgages, 105. See also
Journal of Finance, 141 mortgages
Journal of Financial life annuities, 120-122
Intermediation, 122 life expectancy, affect on
Journal of Political pensions, 76-77
Economy, 159 life insurance, 118, 120
Journal of Portfolio lifetime earnings, 43
Management, 97 lifetime liabilities, 43
Journal of Risk and Lleras, Miguel, 17
Insurance, 157 loans, student, 14. See also
Journal of Wealth education
Management, 98 Long Division, 39-44, 60, 84,
93, 105
Kahneman, Daniel, 60
insurance, 116
Kotlikoff, Lawrence, 43
pensions, 149, 156
L smoothing, 143
longevity insurance, 120
labor force, 108 Los Angeles, California, 106
Las Vegas, Nevada, 106 losses
Latin America, 91 aversion, 126
laws, bankruptcy, 48 insurance, 127. See also
Lehman Brothers, xix insurance
portfolios, avoiding, 139-140
INDEX 193

lotteries, winning, 44, 47 Modigliani, Franco, 39

lump sum retirements, money
selecting, 161-166 decision-making processes,
171-175
M emotional attitudes
magnitude of the toward, 83
disruption, 118 milestones, 10-11
“making of an investment saving, 35-36
banker, The,” 141 income smoothing,
management, debt, 56-60 40-41, 44
affect on value, 60-66 perils of not smoothing,
“Debt Literacy, Financial 47-50
Experiences and planning, 36-38
Overindebtedness,” 66 smoothing consumption,
mark yourself to market, 6-7 38-39
marriage, 78-84 windfalls, 44, 47
“Marriage and Other Risky Montevideo, Uruguay, 90
Assets: A Portfolio Moody’sEconomy.com, 102
Approach,” 79 Moroccan bazaars, 89
Marshall, Alfred, 8 mortgages, 101-102.
MasterCard, 3 See also debt
maturity, T-bills, 45 values, 102-103
maximize shareholder value “Most Lucrative College
(or MSV), 35 Majors, The,” 21
medians, 24 mutual funds, 3
mental accounts, 60, 126 taxes, 94-96
middle-age adults, optimal
interest rates, 64
N
milestones, 9-11 National Bureau of Economic
money, decision-making Research (NBER), 29, 87, 96
processes, 171-175 National Center for Education
military pensions, 163-165 Statistics, 30
Mincer, Jacob, 24 National Institute on
Minnesota, 85, 109 Aging, 166
194 INDEX

negative real estate equity, 102 PAYGO (Pay As You Go)

negotiation, process of, 88 pension systems, 73-75
net worth, 1 paying down debt balances,
based on education, 23 57-60
New York City, 91, 106 “Paying to Save,” 93
no high school diplomas, 23 PayScale.com, 21
Nortel, xix pension accounts, 3
nuclear approach, xx Pension Benefit Guaranty
Nudge, Improving Decisions Corporation, 152
about Health, Wealth and Pension Insurance Data
Happiness, 164 Book 2007, 152
pensions, 147-148
O annuities, 120-122, 153-154
Occupational Pension Plans in children as, 73-77
Canada, 152 disappearance of, 150-153
Office of the Comptroller of Florida, 155-156
the Currency, 109 importance of, 149-150
“Optimal Consumption and inheritance and, 160-161
Portfolio Choices with Risky obtaining, 166
Housing and Borrowing payouts, selecting, 161-166
Constraints,” 108 plans, selecting, 156-158
optimal interest rates, 63-64 taxes, 98-99
outcomes, long term transitions, 158-160
investments, 131-133 “Pensions are Dying, Long live
over-withholding taxes, 92 Pensions,” 152
overconfidence in perils of not smoothing, 47-50
investing, 78 Persi, 115
“Personal Discount Rate,
P The,” 162
“Pain of Selling a Home planning
for Less than the Loan, benefits of, 50
The,” 102 education
Panel Study of Income consumer finance
Dynamics (PSID), 107 decisions, 25-26
Pascal, Blaise, 115 costs, 13-14
“Passing it on,” 161 debt, 31-32
INDEX 195

financial rewards of, Q–R

18-19
QWeMA Group, 20
high-paying careers,
calculations, 7
19-20
human capital “Ranking Mutual Funds on an
derivatives, 14-16 After-Tax Basis,” 96
investing in human real estate market, 102. See
capital, 21-24 also home ownership
ivy league, 28-30 recessions, home ownership
securitizing human during, 106
capital, 16-18 refunds
Survey of Consumer after-tax, 94-96
Finances (SCF), 27-28 anticipation loans, 93
wage considerations, taxes, 92-94
20-21 REITs, 108
income smoothing, 40-41 Relationships with tax
retirement, borrowing from, authorities, 90-91
61-63 renting, comparing to home
saving money, 36, 38 ownership, 105-109
policies, insurance, 116. See reporting taxes, 87-89
also insurance retirement, 147-148
portfolios, 129, 131 accounts, taxes on, 98-99
allocation, 136-138 annuities, 120-122, 153-154
avoiding losses, 139-140 borrowing from, 61-63
building, 133-136 children as pensions, 73-77
long term investments, disappearance of pensions,
131-133 150-153
Portfolios of the Poor, 49 Florida, 155-156
positive assortment, 82 importance of, 149-150
pretax basis, investments, 97 inheritance and, 160-161
“Prevalence of Dementia in payouts, selecting, 161-166
the United States,” 154 plans
Princeton, 29 obtaining, 166
Principles of Economics, 8 selecting, 156-158
probability of regret, 145 saving for, 41
process of negotiation, 88 transitions, 158-160
property insurance, 123
196 INDEX

“Retirement-Consumption self-insurance, 125-126

Puzzle, The,” 159 self-managed investment
Rhodes, 115 plans, 155
risk, 142 Sharpe, William, 156
risk-free investments, homes shelters, tax, 98-99
as, 103 short sellers, 142
“Role of Government in silos, debt, 57, 60
Education, The,” 17 Slemrod, Joel, 164
Roth IRAs, 99 Smith, Adam, 8
roulette view, xx smoothing
consumption, 38-39
S long division, 40-44
S&P/Case-Shiller Home Price perils of not, 47-50
Indices, 26, 102 debt, 67
Sallie Mae, 2, 13 diversification, 143-145
Samuelso, Paul, 145 insurance, 116-118
saving money, 35-36 social capital, 108-111
income smoothing, 40-41, 44 Social Security, 73
perils of not smoothing, 47-50 Solo, Robert A., 17
planning, 36-38 some college, 23
smoothing consumption, Soviet Union, 162
38-39 Stanford, 29
windfalls, 44, 47 Stanford University, 96, 156
savings bonds, 3 Star Trek, 43
SCF (Survey of Consumer Statistics Canada, 151
Finances), 27-28 Statistics’ National
Schooling, Experience and Compensation Survey, 151
Earnings, 24 sticker shock, 61
Schultz, Theodore, 120 stocks
Securities and Exchange investments. See investments
Commission (SEC), 96 portfolios
securitizing human capital, allocation, 136-138
16-18 avoiding losses, 139-140
selecting building, 133-136
pension payouts, 161-166 taxes, 94-96
pension plans, 156-158 structure of balance
stocks and bonds, 133-136 sheets, 144
INDEX 197

student loans, 54. See also U

education
U.S. Census, 6
Survey of Consumer Finances
U.S. data from Bureau of
(SCF), 25-28, 54, 69, 101
Labor Statistics, 151
T U.S. Department of
Commerce, 55
T-bills, 45
U.S Department of Defense
“Tax-Aware Investing,” 98
(DoD), 162
tax-deferred IRA accounts, 99
U.S. Federal Reserve, 22
taxes, 85-86
U.S. News and World
after-tax refunds, 94-96
Report, 19
authorities, 90-91
U.S. Survey of Consumer
deductions, 17
Finances, 79
pensions, 150. See also
underwater, 102
pensions
unemployment insurance, 122
refunds, 92-94
United States, 49
reporting, 87-89
universities, 23. See also
retirement accounts, 98-99
education
shelters, 98-99
University of Chicago, 7, 159
Tennessee, 109
University of Michigan, 93
Thaler, Richard H., 60,
University of Pennsylvania, 119
126, 143
upside down, 102
“Ticket to Easy Street,
Uruguay, 90
The?,” 46
time value of human capital V
investments, 23-25
values
total capital, 39
BMI values, 65
transfers, balances, 63
debt, affect on, 60-66
transitions into retirement,
discounting, 46
158-160
of homes, 102-103
Treasury bills, 3
Vanderbilt University, 46
trends, debt, 54
vehicle loans, 54
tuition fees, 14
Vermont, 109
Visa, 3
198 INDEX

W–Z
wages, education
considerations, 20-21
Wall Street Journal, 15
warranties, 113-114, 117
Wealth of Nations, The, 8
well-being, financial, 109
Well-Being of Retirees,
The, 155
West Africa, 49
Wharton School of
Business, 119
“Who Chooses Annuities?,” 165
“Why Are Recessions Good for
Your Health?,” 121
windfalls, 44, 47
winning lotteries, 44, 47
withholding taxes, 92
women and annuities, 165-166
World Bank, 19
www.qwema.ca, 43
Yale University, 29
York University, 2
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