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Old 07-21-2014, 12:12 PM   #41
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There's a difference between net worth and cash flow, and the two are often detached as we all know. Most people have both a stash and SS and/or pension. Nowadays, with pension going away and this forum being about ER, many of us have to rely on the stash to tide over till SS kicks in.
I think herein is the answer to the root cause of the confusion and hence our discussion.

Cash flow is what we think of as the general money we have available. Since for many it includes both pension and SS regular periodic payments, the actual withdrawal rate required out of the "net worth" is lower. So the technicalities of what is included as net worth becomes a fuzzy issue since some of the items are not clearly defined as one or the other. Present value of an income stream like pension or SS is not included in strict net worth typically, but it does have a direct effect. Additionally, the hosue you live in may have value, but it does not contribute to an income stream directly. Assuming the house is paid off, it is an cost avoidance in your monthly income. Same for your vehicles or other items with some value that you use, in themselves they have value, but by using them they become a cost avoidance (not counting repairs on house, cars, etc).

I think net present value is one technique to try and put a net worth type value on non-investment assets.

In my perspective, and still being in the working world for now, cash flow is what matters - how much monthly income do I have?
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Old 07-21-2014, 12:20 PM   #42
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I appreciate your comments about public comment periods. I did say "generally" only accepted by accountants.
In the late 80's, in a junior position, I wrote definitions for governments. Public comment periods were an important component of that process.
Actually, there is a movement today to lengthen comment periods, to reduce the quick adoption of concepts that affect us all.
Some of the definitions that I wrote and sheperded thru the processes still stand and some were modified over the years. If enlightened thinking arises, then definitions need to be modified.

This board has taken "FIRE" and used that acronym to denote our particular goals and circumstances.
What would be wrong having our own term that reflects the total worth of individuals?

I am not an accountant, but I once took a graduate level accounting course from a very interesting teacher. He set us up the very first class. He listed the financials from two different corporations with Company A making a million dollars and Company B losing a million dollars. He then asked us which corporation would we rather own? Of course we all took the the one that earned a million, then he proceeded to show us they were the same exact company with both financial results using GAAP.


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Old 07-21-2014, 12:42 PM   #43
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IMO it is important that there be a consistent framework as to what is included in net worth and what is not. Pensions or SS that are not recognized as assets could certainly be disclosed (in a manner similar to the disclosure of contingent liabilities in the link in post #3) even though they are not recognized so users can consider those cash flows in making decisions.
pb4uski... as a practical matter, I agree 100%. But from a conceptual standpoint, let me solicit your input on two specific scenarios:

1. A retiree has $1M in investments, which are included in NW, and which yield $40K per year income. Retiree sells all investments and purchases an SPIA, which also pays $40K per year income, and has no guaranteed period. Let's assume the retiree is a healthy 52 year-old, with an actuarial life expectancy of 33 years. And let's also acknowledge that SPIAs can be easily converted back to cash. Under SOP 82-1, this person's "financial position" just dropped by $1M. Are you in agreement that this accurately portrays the economic reality of the transaction?

2. SOP 82-1 excludes personal assets which have a contingency such as life expectancy. Yet accounting standards for corporate balance sheets allow recognition of certain contingent assets. Deferred tax assets, for example, represent the current value of future deductions, which are contingent upon the existence of future taxable profit. Are you in agreement that accounting standards should accept some contingencies and not others, even when they are equally probable?
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Old 07-21-2014, 12:44 PM   #44
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Net Worth is a calculation, assets minus liabilities. Net Worth is not retirement planning. Retirement planning includes essential and discretionary expenses, income streams such as pensions and Social Security, and any available nest egg or asset to draw from.
You nailed it.

Another way to think of it might be by analogy to a company.

The value of a company is in part a function of its net worth, but is also a function of its projected cash flows discounted at a market discount rate and each analyst might have different estimates of cash flow. Many companies trade at more or less than net worth (book value) because of other things such as return in relation to expected returns, earnings growth, etc. If the company lands a large contract from a financially stable customer it isn't an asset until certain triggering events occur (certain services under the contract are delivered) and monies due to the company under the contract but would be an important consideration in valuing the company because it affects future earnings.

Similarly, net worth is only part of the retirement resource equation. There are other cash flows like life contingent pensions and SS that are not recognized as assets because the triggering events have not yet occurred (the beneficiary continuing to live) but are critical to retirement planning because they affect future cash flow. So someone with mid level net worth and a large life pension may be better prepared to retire than someone with higher net worth and no pension.

A natural question might be why isn't a life contingent pension recognized as an asset? IMO, the issue is that the person might receive zero future payments if they die today or many future payments if they live a long life. Would it make sense to value the pension based on expected mortality, record it as an asset, have a lender rely on it in granting credit and then have the borrower die the next day and the loan go bad because the cash flows from the pension are never collected? I think not. That why it is not recognized as an asset and included in net worth. It can be disclosed and the bank can include it or not or in part in making its lending decision.

So to a large degree net worth is what was suggested in an earlier post, that if you were to die today and your assets were liquidated in an orderly manner (not fire sale) and your liabilities were to be paid off, it is what would be left for your beneficiaries.
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Old 07-21-2014, 12:54 PM   #45
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I use the simple, straight-forward definition of assets minus liabilities. The "what would your heirs receive if you died today" definition is almost as simple, although that brings things like estate taxes, life insurance and survivor benefits into the picture, which I exclude.
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Old 07-21-2014, 01:03 PM   #46
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I use the simple, straight-forward definition of assets minus liabilities. The "what would your heirs receive if you died today" definition is almost as simple, although that brings things like estate taxes, life insurance and survivor benefits into the picture, which I exclude.
In my financial plan, this is called "estate value".
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Old 07-21-2014, 02:42 PM   #47
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As far as FIRECalc inputs, they should probably be limited to just stocks and bonds. That's what the calculator is set up to "simulate". Not rental houses or primary residences or present value of pensions or annuities or SS, or even cash for that matter. They do not behave like stocks or bonds. You can add those in as income streams outside the standard portfolio. Net worth and FIRECalc aren't compatible.

My detailed retirement plan optimizes lifetime yearly spending. It includes SS, a pension, cash, taxes, a mortgage, and different spending needs. I have to check different time periods for each spouse to avoid optimizing with an unlikely assumption. Assuming you live to 100, for example, may favor taking SS at 70 fairly strongly unless you have a fairly high rate of return assumption. Assuming two spouses die simultaneously can also be distorting. I'm not sure any of that complexity can be described in a single number of any type.
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Old 07-21-2014, 08:32 PM   #48
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I agree with you regarding the definition of Net worth. The questions then become: Are Social Security and Pensions considered assets? How does one value them?

NPV calculations are relatively simple. The problem is very few people know when they're going to sop collecting. :-)
Good question. I'm not certain of the correct answer, but I don't include pensions and social security in our net worth. I will classify them as income in an income statement (budget) when the time comes.

Net worth is a financial snapshot at a specific time. To my knowledge, there is no way to calculate a pension or social security balance at a point in time.

Businesses include accounts receivable as assets in their balance sheets. But these receivables are finite - a specific dollar amount. And generally not made as a series of payments. We did have a series of payments coming into our business once and it was classified as income on the income statement.
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Old 07-22-2014, 04:43 PM   #49
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pb4uski... as a practical matter, I agree 100%. But from a conceptual standpoint, let me solicit your input on two specific scenarios:

1. A retiree has $1M in investments, which are included in NW, and which yield $40K per year income. Retiree sells all investments and purchases an SPIA, which also pays $40K per year income, and has no guaranteed period. Let's assume the retiree is a healthy 52 year-old, with an actuarial life expectancy of 33 years. And let's also acknowledge that SPIAs can be easily converted back to cash. Under SOP 82-1, this person's "financial position" just dropped by $1M. Are you in agreement that this accurately portrays the economic reality of the transaction?

2. SOP 82-1 excludes personal assets which have a contingency such as life expectancy. Yet accounting standards for corporate balance sheets allow recognition of certain contingent assets. Deferred tax assets, for example, represent the current value of future deductions, which are contingent upon the existence of future taxable profit. Are you in agreement that accounting standards should accept some contingencies and not others, even when they are equally probable?
I think any standard setter would be very reluctant to allow an asset that can go "poof" and disappear immediately like a life contingent annuity or any other life contingent asset. I would much rather defend the bizarre $1m decline in net worth in the example you created than defend recognizing an asset, having a creditor make a decision based on that asset and having the asset evaporate into thin air the next day because the annuitant dies. No prudent lender would make a loan based on such an "asset" without a corresponding life insurance policy on the annuitant so it seems sensible to me that an asset is not recognized.

Preparers can always use disclosure in such situations to let readers know of these life contingent benefits and users can make their own decisions as to how to factor them into investing and lending decisions.
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Old 07-22-2014, 08:22 PM   #50
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I think any standard setter would be very reluctant to allow an asset that can go "poof" and disappear immediately like a life contingent annuity or any other life contingent asset. I would much rather defend the bizarre $1m decline in net worth in the example you created than defend recognizing an asset, having a creditor make a decision based on that asset and having the asset evaporate into thin air the next day because the annuitant dies. No prudent lender would make a loan based on such an "asset" without a corresponding life insurance policy on the annuitant so it seems sensible to me that an asset is not recognized.

Preparers can always use disclosure in such situations to let readers know of these life contingent benefits and users can make their own decisions as to how to factor them into investing and lending decisions.
Appreciate your perspective. Just strikes me as odd that:

1. With the stroke of a CFO's pen, a completely unauditable increase in a corporation's profit forecast (which could easily go "poof" at any time) results in a corresponding increase in deferred tax assets, which in any event, cannot convert to cash for several years.

Yet...

2. A statistically sound, auditable estimate of actuarial life expectancy results in zero asset recognition for an annuity contract that can be converted back to a pile of cash in a matter of days.

Some pretty obvious inconsistency in the 2 standards. But worse, from my point of view, and I believe from the point of view of any rational creditor, #2 is a more reliable asset than #1, in terms of realizability for purposes of repaying debt.

I realize that standard-setters have to make pragmatic trade-offs, and often, consistency and expediency win over conceptual integrity. But I would hate to be the accountant who has to explain the $1M drop in net worth in my example. That's an undefendable position by any common-sense analysis.
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Old 07-22-2014, 08:47 PM   #51
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You're certainly entitled to your opinion.

Let me ask you this. The day after the person spends their entire stash of $1m to buy a life annuity with a nice $4,500 monthly payment for life, they approach you for a 15 year, $200,000 loan. The only cash flow they have is from the life annuity but they can easily make the loan payments of $1.700 a month from the annuity cash flow. The life annuity is their only asset. How much are you willing to lend them? Why?

I would also dispute your characterization of the DTA. If the increase in the profit forecast was beyond reason, it would probably not be accepted by their auditors and the DTA would not be recognized. Been there, done that. Much, much more than the stroke of a CFO's pen.
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Old 07-22-2014, 10:48 PM   #52
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As far as FIRECalc inputs, they should probably be limited to just stocks and bonds. That's what the calculator is set up to "simulate". Not rental houses or primary residences or present value of pensions or annuities or SS, or even cash for that matter. They do not behave like stocks or bonds. You can add those in as income streams outside the standard portfolio. Net worth and FIRECalc aren't compatible.

My detailed retirement plan optimizes lifetime yearly spending. It includes SS, a pension, cash, taxes, a mortgage, and different spending needs. I have to check different time periods for each spouse to avoid optimizing with an unlikely assumption. Assuming you live to 100, for example, may favor taking SS at 70 fairly strongly unless you have a fairly high rate of return assumption. Assuming two spouses die simultaneously can also be distorting. I'm not sure any of that complexity can be described in a single number of any type.
Actually FIRECalc handles this correctly it has the other income expenses tab, that asks first for SS and then for pensions and other income or expenses. It then takes these amounts and subtracts them from the spending entered on the first page, to determine the amount that must be provided by the portfolio. So you would not enter them on the portfolio line on the start page but as income on the pensions and other income side.

I assume that is the prime question folks on this forum ask will I have enough income in retirement? The second question is how much might i leave. Net Worth really applies as noted if you want a loan.
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Old 07-23-2014, 09:07 AM   #53
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Let me ask you this. The day after the person spends their entire stash of $1m to buy a life annuity with a nice $4,500 monthly payment for life, they approach you for a 15 year, $200,000 loan. The only cash flow they have is from the life annuity but they can easily make the loan payments of $1.700 a month from the annuity cash flow. The life annuity is their only asset. How much are you willing to lend them? Why?
Well I suppose I could also ask if you'd loan $200K for 15 years to a corporation whose only significant asset is $1M in deferred tax assets...

Aside from obvious 5C requirements to evaluate overal creditworthiness plus maybe a satisfactory doctor's report from a recent physical exam, I would make the loan, provided: (1) the annuity be included as security, such that any default prior to death, the contract must be immediately sold in whatever amounts necessary to satisfy the outstanding debt; and (2) life insurance be carried in amounts adequate to repay the debt in the event of default after death.

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I would also dispute your characterization of the DTA. If the increase in the profit forecast was beyond reason, it would probably not be accepted by their auditors and the DTA would not be recognized. Been there, done that. Much, much more than the stroke of a CFO's pen.
I've witnessed the power struggle between CFO and auditor up-close-and-personal on many controversial topics including deferred tax assets. We can dispute my characterization, what's a reasonable profit forecast, and who wins the power struggle most often and why. But the fact remains, deferred tax assets are contingent upon achieving the assumed profitability, no different than an annuity asset which is contingent upon acheiving a certain life expectancy. One is subjective judgment based on such things as the much-anticipated success of some new product introduction; the other is based on solid statistics about how long people live. Yet the profession allows the former to be recognized as an asset, and the latter not. I just find that odd.

FYI, The only reason I'm involved in this discussion is that I elected the annuity option on a DB pension when I retired last year, as a strategy to balance portfolio income and guaranteed income. The pension value is about 20% of NW. I only compute NW for my own trending purposes, so I can follow whatever rules I want. And, as others have noted, it's not really useful from an overall retirement planning standpoint. I just thought it was odd and inconsistent with other accounting standards that the profession doesn't recognize it, given that my financial position has not changed in any substantive way as a result of the annuity election.
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Old 07-23-2014, 09:37 AM   #54
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I would be very willing to lend $200k based on a $1m DTA than on a life annuity solely. I would do my own due diligence and evaluation of the quality of the DTA as collateral as any lender would. Things would have to go sideways in a big way for a $1m DTA to only end up being worth $200k (assuming the DTA was legit to begin with).

OTOH, a loan based solely on a life annuity can go kaput overnight if the beneficiary has a heart attack and otherwise healthy people have heart attacks all the time. Or cancer. Or a car accident. Or many other causes of death.

The fact that neither of us would be willing to lend solely on the life annuity cash flows without a life insurance policy as a additional collateral tells me that perhaps not recognizing the life annuity as an asset is the right answer even though I know you don't like that.
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Old 07-23-2014, 10:24 AM   #55
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Things would have to go sideways in a big way for a $1m DTA to only end up being worth $200k ... OTOH, a loan based solely on a life annuity can go kaput overnight if the beneficiary has a heart attack and otherwise healthy people have heart attacks all the time.
Healthy corporations also face unexpected recessions, competition, product recalls, regulations. Corporate tax rates can drop requiring huge DTA write-downs. I could go on. You seem to assign radically different probabilities to the possible bad outcomes of a DTA vs a life annuity. That's fine; maybe that's been your experience. I put more weight on the fact that the probability can be very accurately quantified for the life annuity. The achievability of corporate profit forecasts is far less quantifiable. That uncertainty increases risk and thus reduces asset quality. I also put more weight on convertibility to cash and timing, where the life annuity wins again.

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The fact that neither of us would be willing to lend solely on the life annuity cash flows without a life insurance policy as a additional collateral tells me that perhaps not recognizing the life annuity as an asset is the right answer even though I know you don't like that.
That's a fairly narrow reason to justify non-recognition. Lots of customer receivables have special credit terms and conditions. The receivable is still an asset.
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Old 07-24-2014, 04:57 PM   #56
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.... I put more weight on the fact that the probability can be very accurately quantified for the life annuity. ...
One thing that you are missing is that the probabilities can be used reliably with a large population (like the issuer of a SPIA that has thousands of lives in their SPIA portfolio) but are unreliable where there is only one life (like in the case of an life annuity owned by an individual) and a heart attack or accident makes a huge difference in outcomes and the cash flows. There is a term for probabilities like that where there are a number of reasonably probable outcomes and a small probability of a disastrous outcome but I don't recall it.

There is obviously no way to talk any sense into you so let's just agree to disagree.
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Old 07-24-2014, 07:39 PM   #57
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I don't see much of a use for the classic net worth computation in our business here, unless you're looking to determine a basis for self-insuring long-term care or something like that.

It's why I do my retirement planning on a monthly income/expense basis. My main retirement income streams (pensions) are just that, a monthly amount for as long as I keep waking up. They don't have meaning (to me, anyway) as a lump sum. I also have savings, but I use the monthly WR I intend it to support through age 100 (optimistic cuss that I am).
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Old 07-24-2014, 09:54 PM   #58
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This board tends to focus on how big the stash is when determining the probability of financial success in retirement. There are fewer folks with pensions, and even fewer folks with pensions that have COLA. And not many people that have lifetime healthcare provisions.

So how do you compare preparedness for retirement? Is more money invested in the market comparable to a COLA'd pension? What is the factor? Very quickly, we need to know what do we think the market will do, what do we think inflation will do, how strong is the source of the pension, how important is it to leave a balance behind, and many other questions.

When I die, my heirs will be interested in the accounting definition of net worth. While I am busy converting oxygen into CO2, I am interested in the cash flow generated by a pension, SS, farm income, and value of investments. Some of the investments can be drawn do or sold to generate cash. My costs are a function of many things, and affected by where I live and how I spend money. What will healthcare cost? Will my retiree healthcare continue to cover those costs?

Very quickly we have many questions to be wrestled with.

There is no simple answer to all of these questions, that will comfort each individual with their own concerns and priorities.
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Old 07-24-2014, 10:37 PM   #59
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When I die, my heirs will be interested in the accounting definition of net worth. While I am busy converting oxygen into CO2, I am interested in the cash flow generated by a pension, SS, farm income, and value of investments. Some of the investments can be drawn do or sold to generate cash. My costs are a function of many things, and affected by where I live and how I spend money. What will healthcare cost? Will my retiree healthcare continue to cover those costs?

ER, When you mentioned the "heirs", that would be my daughter. She would say... "Nice pension dad, but it's not doing much for me. You need to stay healthy and do a better job of saving some of that each month".


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Old 07-25-2014, 07:20 PM   #60
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One thing that you are missing is that the probabilities can be used reliably with a large population (like the issuer of a SPIA that has thousands of lives in their SPIA portfolio) but are unreliable where there is only one life (like in the case of an life annuity owned by an individual) and a heart attack or accident makes a huge difference in outcomes and the cash flows. There is a term for probabilities like that where there are a number of reasonably probable outcomes and a small probability of a disastrous outcome but I don't recall it.
I could easily cite a parallel to your SPIA example for DTAs. But I know when to stop...

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... let's just agree to disagree.
Done.

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... I'm sure there will be a rukus as to why SS and pensions are not included...
Not sure if this qualifies as a "ruckus" or not. I thought it was a fairly thorough discussion, but no real resolution. Interesting that you knew the argument was coming. If anything, I think what we've learned is:

1. If you prepare an "official" personal statement of net worth for use by a banker, for example, as part of a loan request, then you should exclude life-contingent annuities (pensions, SS, SPIAs, etc) to conform with accounting standard SOP 82-1. They can be disclosed in a footnote or just highlighted in your personal cashflow statement.

2. If you are calculating personal net worth for your own trending or other purposes, you can either include or exclude life-contingent annuities in accordance with your own belief about whether or not they represent an asset.

3. The concept of "net worth" is only a portion of the retirement planning process, which should comprehend the complete financial picture of assets, liabilities, expenses, income streams, taxes, other cashflows, and the specific timing of each. Net worth alone may not be a good indicator of retirement preparedness.
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