Think in terms of what they can do for you
Think of money as potential: the potential to do things you’d like, to improve your situation and happiness.
Of course, not everything requires money. You might get together with family or friends, for example, and be happy that way without spending money. But if something involves getting something that somebody else has or made, then getting that something involves money. Giving that somebody else the money enables you get the thing.
Money is therefore anything generally acceptable as a medium of exchange. It might be a bank account, or notes issued by a government, or even (in days gone by, when these were difficult to come by) cigarettes in a prisoner-of-war camp. You get the idea. Today there’s some thought of digital currencies being added to the list.
So, money is a store of value. Hence its potential.
What do we use it for?
Typically, goods and services, in the short term. Goods might be things like food and appliances. Services might be things like house cleaning and being served in a restaurant. But we also use money for less frequent purchases, for example buying a car or a home. So ideally we’d like to build up our money potential over time, so that we can not only spend it on our short-term needs, but also have enough for some of our medium-term or long-term wants. (By “needs” of course I mean things that are essential to our lives, and by “wants” I mean things that we’d like to have or to do, but which, at a pinch, we can do without.)
So our main focus is naturally on having enough money for our needs, and then some extra money for many of our wants. And it’s the answer to that question (“Do I have enough?”) that greatly influences our perception of the total amount of money we have. We have a pretty good idea of our proposed spending in the next day, week, month, maybe even year, and maybe even for a few years into the future. Beyond that it’s typically tough to know, though of course we can guess or even make a pretty good estimate. But we know there are uncertainties, as to both our future lifestyle and the future cost of the things we’re thinking about – because of course we can’t be sure about how our lives will change nor about future prices; the only certainty is that there will be changes.
That’s why our yardstick tends to be expressed in short-term measures. If we’re paid weekly or monthly, for example, the yardstick of money that’s available is the amount that gets deposited into the bank account weekly or monthly (after the government and other causes have taken their bits), and the yardstick of needs and wants is the amount we need or want to spend over the same period. It’s cash flows that are automatic measures, in our minds.
When we’re paid, we think in terms of cash flows. If you get a job offer at (let’s pick any number) $30,000 a year, you don’t think of it as $1,200,000 over 40 years, nor does the offer get expressed in those terms. $1,200,000: how much is that? Who knows? It’s not a number we deal with in our everyday lives. And in any case, even though it’s mathematically accurate if you multiply $30,000 by 40 years, there are too many ifs, ands and buts for the $1,200,000 to have any relevance or meaning to your life. Your pay will change, you won’t work for the same employer for 40 years, and what $30,000 a year will buy you will decline over the next 40 years.
I say all of this through some personal experience, since it brings to mind a couple of anecdotes from my life.
I remember my first ever job offer, when I was graduating from university in the UK. It was for what was then the very impressive starting salary of £1,000 a year (then the equivalent of $2,800 a year). This meant a lot to me. My summer part-time work paid me £10 a week (roughly half my starting full-time salary) in the form of a £10 note, and it was enough for me to live on and save some of it too, as I lived at home and paid no rent. In fact I recall that I gave my mother my first £10 payment note, and told her that I now hoped to be self-supporting, and she was joyfully emotional about it. Yes, it was a lot of money. I also recall that, by the time I received my first full-time paycheck, my bank balance was down to 14 shillings (70 pence in today’s money, then worth about $2). These were the everyday numbers I understood.
Since I was a mathematician, I actually fondly imagined how, over the next 43 years, I would be paid a total of £43,000, a mountain of money! I had no idea what it meant, of course, as you can tell from the numbers I was used to dealing with. At the time the average house price in the UK was somewhere around £3,000, I think, so in principle I could buy numerous houses! What I would do with them, of course, I had no idea, nor did my fantasy deal with the living expenses and taxes that I would need to pay over the next 43 years. But hey, £43,000 was an idyllic number, and I didn’t care that I had no concept of its value.
That’s the first anecdote.
The other anecdote took place about 25 years later. My career had taken a couple of unexpected turns and I had become a consultant to very large US pension plans (GM, IBM, AT&T – with mammoth pension funds). A journalist interviewed me about some topic that I can’t remember. What I do remember was that, as we chatted after the interview was completed, she asked me if it made me nervous, making recommendations about billions of dollars.
No, I said, because I had no idea what billions of dollars meant. For that matter, a million dollars was beyond my everyday comprehension. The numbers I did know very well, however, were the numbers from 1 to 100. I encountered them every day, I knew a lot about them, and they felt like friends to me. So I expressed all my recommendations and analyses in percentages, since they involved the numbers up to 100, and I didn’t feel nervous at all about that. And if the clients wanted to multiply those percentages by a billion, sure, go right ahead.
Both those examples demonstrate that massive lump sums are difficult to comprehend. We understand things in everyday terms, because we’re intuitively familiar with those orders of magnitudes. Anything else needs to be translated into those familiar terms before we really understand it. We don’t understand what large amounts can do for us. We don’t comprehend their potential.
And yet, moving the context to pension accumulations for our retirement, for many years the prevailing type of pension is called “defined contribution,” in which we save and invest regular amounts of money in a personal investment account – and typically the only thing we know about it is how much money has accumulated there. After some years those accumulated amounts feel very large. To most workers, their pension accumulation is the largest lump sum they own, or it’s second only to the (unmortgaged) value of their home, if they own their home.
And of course it’s typically an incomprehensible number, because we can’t relate it to daily or weekly or monthly or yearly spending.
To appreciate how much we have in those accounts (and having that sort of accumulation is a big deal), we really need to do two things. One is pretty obvious. The other is more subtle, but just as important.
The obvious thing is to convert the lump sum into everyday terms. How big a weekly-monthly-yearly paycheck will it replace? It’s true we don’t know how long we’ll live, so we don’t know how long we need to stretch it out for, but let’s take an average survival period and use that as a starting estimate. That way we can convert the lump sum into its equivalent as a replacement paycheck, and we can start to see whether it’ll cover our needs and perhaps also some of our wants. Sure, there are lots of ifs, ands and buts attached, but it’s a ballpark estimate, and that’s a lot better than just knowing the size of the lump sum.
The more subtle one is to recognize that a paycheck in the future won’t buy as much as the same size paycheck today. Prices will inevitably rise, over time. That’s called inflation. In the same way that £1,000 when I was 22 would have supported me very comfortably for a year but today would require £20,000 for the same consumption because of British inflation, so too its then dollar equivalent of $2,800 would require over $25,000 in US dollars for the same consumption because of US inflation. We tend not to notice inflation very much unless it becomes a large number in a single year, but we are absolutely never aware of the colossal impact it has on purchasing power over several years. And, as I’ve mentioned often, we invariably underestimate how many years we’ll spend in retirement.
So that’s the more subtle conversion: not just from a lump sum to today’s dollars, but then from today’s dollars to today’s purchasing power. In other words, don’t tell me I can expect very roughly $25,000 a year from my lump sum, because I know that $25,000 will buy me less and less as time passes. Instead, give me an estimate how many of today’s dollars I can sustain in purchasing power over the next (let’s say) 20 years.
If, for example, inflation averages 2% a year over the next 20 years (in a future blog post I’ll show how to get a starting estimate of this number, with all the ifs, ands and buts attached), the same lump sum that will generate $25,000 a year of declining purchasing power might generate roughly $20,400 a year of sustainable purchasing power. And really, it’s that $20,400 number that’s relevant. It’s the amount of consumption we can sustain, over time, with the lump sum.
There’s no easy way to get to that $20,400 number. If purchasing power were a different currency, we could express it as 20,400 purchasing power units (PPUs, if such a currency existed). And then the task of expressing the incomprehensible lump sum into a really useful number would be complete. But everything is expressed in dollars, and that’s life. We’ll have to appeal, not only for the lump sum to be converted into annual (or monthly or whatever) amounts, but also for those amounts to be converted into PPUs rather than only into dollars.
We’re making progress. The first appeal – conversion of lump sums into annual equivalents – is being accepted more and more widely. The second appeal – conversion of dollars into PPUs – is only just starting to be recognized as extremely useful. (It’s one of the driving forces of the Let’s Geal Real group, about which I’ll say more one day.)
Convert large lump sums into sustainable purchasing power, in order to really understand how much potential they give you.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.