This brilliant analogy comes from Prof. Michael Finke
You’ll remember (and don’t worry, I’ll remind you, because I know you really won’t remember) that last time I explained that buying a guaranteed lifetime income from a life insurance company is probably a very attractive alternative to keeping a lump sum of money and drawing down from it as long as you live. Why? Because you’ll probably withdraw a safely low amount each year, just in case you live a long time, and you obviously don’t want to run out of money – whereas the insurance company guarantees your annual amount, no matter how long you live.
How can the insurance company make that guarantee, when you obviously can’t, and they too have no idea how long you’ll live? They do it by pooling your capital with the capital of many others, and then even if some in that pool live much longer than average, the bigger the pool, the more likely it will be that the projected average age at death really will work out as planned – or pretty close to it, so add in a margin of safety (for the insurance company) and there isn’t a pay-out problem.
That’s it, in essence.
Let’s face it: most people would respond, “OK, if you say so, but honestly it’s still not clear to me.”
And that’s where Michael Finke comes in. Or, to give him his full title, Dr Michael Finke, Professor of Wealth Management and Frank M. Engel Distinguished Chair in Economic Security at the American College of Financial Services. I heard his cake analogy in a podcast interview hosted by Dr David Blanchett, who is himself an Adjunct Professor of Wealth Management at the same college, as well as a Managing Director and Head of Retirement Research for PGIM DC Solutions. (By the way, while we’re into big names, I was once at a conference where the three panelists at one session were Blanchett, Finke and Dr Wade Pfau (whom I’ve written about more than once), and I remember thinking then, as I still do: gosh, it doesn’t get any better than this.)
Anyway, back to Michael’s explanation: the birthday cake analogy. I’ve changed his wording a little bit, because in his podcast he spoke spontaneously and off the cuff rather than with a considered phraseology; but the idea is identical with what he said. (I actually played the podcast a few seconds at a time and wrote down exactly what he said, to make sure I get it right. And I’ve added a couple of features that he didn’t deal with, to complete the explanation.)
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The first thing Michael observed is how the certainty that the income will last a lifetime influences spending. If, for example, a lump sum of $500,000 buys a lifetime income of $3,000 a month, and you compare the spending of someone who keeps the lump sum and draws down on it monthly with someone who instead owns the right to the lifetime income, you’ll find that the person with the lifetime income spends more. This has been observed and reported consistently in practice; and the reason is simple. It’s that, if you don’t know how long your money will last, you naturally draw on it cautiously rather than risk running out of it.
And that leads to the birthday cake analogy.
Your spouse calls and says that somewhere between 5 and 40 kids are going to show up for a birthday party. On average 20 tend to show up. There’s a birthday cake on the counter. Cut each kid a slice of cake as they walk through the door, but make sure you don’t run out of cake.
The first kid walks through the door. Do you cut the cake into 20 slices? No, because you don’t want to run out of cake. Maybe you cut it into 30 pieces, or 35, depending on how risk-averse you are. So the first kid gets this smaller piece of cake, they’re a little bit disappointed, but you’re not going to run out of cake – probably.
But then maybe the 30th kid comes through the door, and now you’re starting to get really worried, because you’ve only got 5 pieces left. So you cut even smaller slices, there’s a lot of anxiety … you get the picture.
What if, instead, you could work with a nearby bakery that’s willing to make a deal? The deal is that, since on average 20 kids are going to show up, the bakery will let you cut the cake into 20 slices; and if more than 20 show up, the bakery will deliver a second cake which you can again cut into 20 slices. When it’s over, you return the unused cake to the bakery, so that they can assemble all the returned bits into nice new cakes. You’ll be charged a little bit more for each cake in this deal, but each 20-piece slice is bigger than what you’d cut by yourself; so each kid gets a bigger slice, and you never have to worry about running out of cake.
What have you done? You start with a risk – not knowing how many kids will show up for the birthday party – and you’ve transferred it to an institution, in this case the bakery, by paying a little bit more. How can the bakery afford to take this risk? It can do it because it’s pretty sure that, over several such parties, the number of kids will average out to 20; so it can let you give those larger slices to more than 20 kids (if that’s what you need to do), because if there are fewer than 20, the bakery will get back the unused portion of your cake, enabling it to supply the parties where more than 20 turn up.
It’s the same thing in retirement. You don’t know how long you’re going to live. The average may be 20 years, but for you it could be 25 years, or 40, or whatever. You could spread your money, if you’re very risk-averse, to last until age 95 or even 100; and even then there’s a chance you might outlive your savings.
What you can do instead is to partner with an insurance company, which will (for a small extra margin) give you a guaranteed lifetime income calculated as if you’re going to live to the average expectancy from your current age. So you don’t have to worry about running out of money, you can spend more and worry less.
Michael adds that this is why people spend more when they have a guaranteed lifetime income. The longevity risk that makes people nervous about spending is no longer a financial consideration that acts as a barrier to spending down your savings.
The birthday cake analogy is easy to understand, isn’t it? It’s brilliant, Michael – thanks.
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Takeaway
You can have lots more kids coming to a birthday party than the average expectation, and you can still give them each a large slice of cake, because even if more than expected show up, there’ll be other parties where fewer than expected show up. And while that’s a risk you can’t take, it’s easy for a bakery, because it’s involved with so many parties that it can rely on the average working out.
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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.