It is a rite of passage among personal finance bloggers to write a post that decries a Starbucks Latte-a-day in favor of saving the money and putting it towards your retirement. The key point being that this abstemious behavior, when combined with the miracle of compounding over the long-term, provides a surprisingly large sum of money.
When you forgo a $3 a day latte for 25 years, and instead invest that amount in a low cost index fund returning 8% a year, this will yield a final sum of almost $90,000. Pretty impressive huh? That’s certainly enough to prompt me to make my own coffee in the morning.
Now don’t get me wrong here, I am not turning my nose up at this type of blog post – I am not sneering in any way.
Your Starbucks Habit Just Lost You 90K
On the contrary I applaud this illustration. There is a reason this type of post is popular; it illustrates many important and valuable behaviors, such as:
- Unthinking and automatic spending can have a measurable impact over the long term;
- The power of compound interest is large;
- Frugal habits can make a difference;
- Investing your money for the long term can provide significant growth;
- Never think that small actions won’t make a difference to your wealth.
These are all important points worth making. If you can parcel all that up with a neat post about buying a Starbucks-a-day then you are doing a great service to a great many people.
So what’s my beef?
Investment Returns
The above assumes that the money saved will grow at 8% a year.
And let me be clear, I don’t particularly object to fact that the assumption is 8%.
If the assumption had been 7% per year, or 8% or 9% or whatever I would still have reservations.
Equity Returns
What we’ve done in the above example is assume that the Starbucks consumer has invested in a portfolio heavily weighted to equities and then extrapolated past experience to invoke a future assumption of 8% (or whatever).
But you knew that – what’s my point?
We have assumed that equities are guaranteed to return this amount in the future.
Don’t get me wrong here – I am not one of those perma-bears. I have a well-thumbed copy of Jeremy Siegel’s “Stocks for the Long Run”, and I have bought into equities for the long term. My personal portfolio is around 80% stocks – so I’m on-board the equity train baby!
But stocks are not like a higher returning version of bonds. They are simply more risky and they are not guaranteed to outperform bonds or cash over the long term. If equities were certain to do that then equity managers would be offering you a premium to take your money instead of you having to pay a management fee – see my last post on this issue.
If equities were guaranteed to outperform bonds over the long term then you could borrow cash and invest in equities for a riskless profit (this is called ‘arbitrage’). You would simply take out your 30 year mortgage and pay just the mortgage interest payments. Then instead of paying the principal down each month, you would instead invest in stocks. At the end of the 30 year period you would have earned enough to meet your borrowing costs, pay off the house and leave you with a tidy profit as well.
Apart from a flurry of activity in this vein in the 80’s I don’t see a lot of this type of action among investors.
Why? Coz it’s risky. That’s why.
Zvi Bodie the Norman and Adele Barron Professor of Management at Boston University and co-author of the textbook Financial Economicswith Nobel prize-winner Robert Merton, wrote that the higher expected return for stocks is a reward for taking the risk, but it is an expected return. It is not a “free lunch” or “a loyalty bonus” for long term stock holders.
Starbucks and Public Pensions
So you cannot take your Starbucks savings, invest them in equities and be certain of earning 8%.
But… I probably wouldn’t bet against it; so why am I getting my shorts in a twist?
This issue has been a matter of huge controversy in the actuarial profession.
In the early 2000’s pension plans were funded on the basis that future stock returns could be “banked”. Just like our Starbucks saver, pension plans would take advance credit for future stock returns that have not been realized.
There was then a huge argument in the actuarial profession about whether this practice was justified. It was a debate with sharply polarized sides. Think titanic Game Of Thrones battle with the two armies amassed on both sides and a gory showdown with blood-curdling screams combined with medieval weaponry.
Actually it wasn’t really like that; there was a considerable amount of earnest debate and polite, but somewhat strained, discussion of this issue by a load of old guys.
But what emerged was victory for the progressives. No longer would pension plans be able to take advance credit for an equity return that had not yet been earned, they would have to assume a lower return.
Except…
That only applied to corporate pension plans and not public pension plans.
Public Pension Plans
For some reasons that I don’t really know, and I’m sure you could not care about, public pensions preserved a much more lenient regime. Public pensions are allowed to fund on the basis that their assets magically return their expected assumption.
Who do we blame for this?
For the purpose of this article I’m going to assume it’s the politicians. However, I would forgive you for putting the blame squarely at the feet of the actuarial profession.
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Public pension plans are highly under-funded and a Milliman report from 2017 estimated a total deficit of around $1.5 Trillion! This issue discussed above is still a live, and highly contentious issue. In 2016 a task force of actuaries who was investigating this issue was disbanded under mysterious circumstances.
“This paper (is) being censored by the American Academy of Actuaries” and Society of Actuaries, said Edward Bartholomew, who was a member of the former task force, in an interview. “They didn’t want it to get out.”
Firstly can you think of a more actuarial name than “Bartholomew”, but secondly don’t you think this is the actuarial equivalent of a John le Carre novel!
Back To Personal Finance Bloggers
The issue of whether you can bank your Starbucks savings and assume a future equity return is therefore an ongoing debate. It goes to the very heart of the intersection of modern financial economics and actuarial practice. Personal finance bloggers have unwittingly stumbled into a warzone.
By assuming a future equity return, personal finance bloggers are complicit with the sort of financial smoke and mirrors that politicians are pursuing with the current public pension funding catastrophe.
This article has been republished with permission from Actuary on Fire.