Net Worth Considerations

[pb4uski]

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.

 

[meierlde]

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.

 

[Cobra9777]

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.

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.

 

[pb4uski]

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.

 

[Cobra9777]

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.

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.

 

[pb4uski]

.... 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.

 

[ggbutcher]

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).

 

[ER Fireball]

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.

 

[Mulligan]

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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[Cobra9777]

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...

... let's just agree to disagree.

Done.

... 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.