Friday, October 31, 2014

What to Teach Children About Money

What to Teach Children About Money:
One Version of Picketty's Patrimonial Middle Class
By Frank W. Sudia, FW Sudia Law Office,

Or, one simple, stupid trick to help your child retire rich, and found a dynasty, even if he or she is not exceptionally talented or motivated.

NOTE: This is a philosophical essay on inter-generational economics, which in its current form ignores the tax implications of the proposed scenario. Please contact me or another qualified tax, financial, or estate planning adviser to work through the tax aspects for your personal situation and tax jurisdiction.

A. Introduction

We often hear that we need to “teach our children about money,” for example in advertising from banks and financial advisers. But what are we supposed to tell them? To regularly put money into passbook savings accounts? Is there some meaningful “birds and the bees” financial insight we can give young people?

The recent bestselling book “Capital in the 21st Century” by the French economist Thomas Picketty provides a serious answer. At one point he says, “It is easier to save if you inherited your apartment and don't have to pay rent.”

B. Picketty's Insights

Picketty's overall thesis is that throughout most of history the rich have owned nearly everything there was to own, while everyone else held virtually nothing. The reason for this, he says, is simple. The rate of return on capital has been around 5% per annum (6% in ancient times, possibly trending down to 4% in the future), whereas economic and demographic growth average around 1% (0.1% pre-1700). The inevitable result is that, after a while, the top decile (10%) owns 90% of everything there is to own, within which the top centile (1%) owns 60% of everything there is to own, and most everyone else is just getting by, as we saw from 1700 through 1914.

Once this system gets established, its power to suck up all available gains is so great that almost no amount of individual effort can make a difference, since inherited wealth has become the dominant force. [Unless you are on a new continent with excess cheap land and rapid population and economic growth, which has mostly run its course.]

We saw a brief exceptional period in the 20th century, when as a result of the destruction wrought by two world wars, depression, inflation, bombardment, expropriation, bankruptcy and so on, the Belle Epoch system that prevailed prior to 1914 was struck with a hammer, and the wealth curves were all compressed. These events, followed by record demographic and productivity growth, made it appear that the old rentier system had vanished.

However, the laws of wealth were not repealed. All the curves are U-shaped, and the old system of wealth has bounced back with the power of compounding, especially since 1980, adding 5% to itself every year minus whatever is consumed. The underlying capital base was transformed, with agricultural land being replaced by real estate, industrial and financial assets, but all else has remained the same.

C. Advice to One's Offspring

Armed with the above insights, THIS is what I would tell a child.

Saving does NOT mean putting money into a bank account that pays zero or negative real interest. Such accounts will be used only as concentration accounts, to collect cash prior to placing it into meaningful investments.

The goal is to own assets that yield on average 5% or more per year, risk adjusted, in income and capital appreciation. Any “nominal” asset (whose value is a stated amount of money) is vulnerable to wipe-out by inflation, unless it is an “inflation protected” bond. Hence our goal is to invest wealth in hard capital assets, including real estate, stocks, limited partnerships, timber land, and so on, whose prices will rise in case of any inflation.

For example, Count Otto von Bismarck's personal (Jewish) banker Gerson von Bleichroeder placed much of his wealth into timber land, the value of which held up well despite financial panics, two world wars, hyper-inflation, the Great Depression, etc.

The “return on capital” is not a bonanza, but rather a modest but steady flow. When it reaches a certain point, you no longer need to work, and further along you can withdraw enough for a nice lifestyle, and yet it will continue to grow, albeit at a lesser pace (than if you withdrew nothing). Thus you become a rentier and your money works for you, not you for it.

D. A Suggested Recipe for Action

“It is easier to save if you inherited your apartment and don't have to pay rent.” -- Picketty

Buy your child an apartment, with the proviso that she must deposit its fair market rent into a savings account every month.

Giving such a valuable asset to outright a young person is not a great idea, so instead place it into (e.g.) a grantor trust, with them as the beneficiary upon your death, or whenever you let it vest. This allows you to yank it back if they become a crack addict, join a religious cult, or (more likely) marry the wrong person. The ex-spouse of your child's failed marriage is something every wealthy family needs to plan around (especially to remove them from family partnerships).

Tell your child, “you can live in this apartment, but I want to see bank and/or broker statements showing that you deposited the rent each month, as if you were renting it from a stranger, or I'll boot you out and find a tenant who will pay the going rate.” They will also cover the property taxes, insurance, condo fees, utilities, and so on.

Your child's savings account should start receiving deposits of $1,000 (post tax) per month, or $12,000 per year, which if re-invested at an average yield of 5% compounded annually, will become (in round figures, see table below) $150,000 after 10 years, and $400,000 after 20 years, yielding an annual return of around $20,000 per year, which already is almost enough to live on, and if continued another 10 years, still at only $1,000 per month, will be yielding close to $40,000 income from capital per year, when she reaches age 50.

This is all in constant dollars since as inflation occurs, all the asset values, incomes, rents, and returns will rise accordingly, leaving the basic result unchanged, as long as she stays out of nominal assets, including cash, CDs, and non-inflation protected bonds.

E. Building Out the Investment Plan

None of this can happen if your child pays rent to someone else, in which case these economic factors are working for their landlord, not your child, nor if she keeps savings in a bank account.

Once she concentrates $10,000 or more into a holding account, the next step is to place it into diverse “real” investments, namely index funds, real estate investment trusts (REIT), hedge funds (HF), private equity (PE) funds, venture capital (VC) funds, etc. The goal is to accumulate large enough chunks to meet the high minimum investment requirements of the more serious investment vehicles.

Some REITs allow investments as low as $4,000, and some PE, VC and hedge funds admit partners with as little as $10,000, but the best investments are open only to those with high incomes and/or large amounts to invest – a fact that further concentrates wealth at the top, since only those who are already rich can get into those better yielding deals in the first place.

By the time she is in her 40s, hopefully her income from employment has also gone up, and she has "gotten with the program" and is continuing to contribute 30% of her income, as she would if she were still renting. At this point she now has the resources to get into the better private placements, for which $50-100K chunks are needed.

As the years go by, until you vest her dwelling unit, you can periodically sell the unit in the trust and replace it with another one, possibly bigger, better located, or closer to her next job. 

Throughout this scenario your child is not just "learning" the value of money but living it, since the "rent" that she deposits each month (net of taxes and repairs) represents the return on the "residential capital" you provided for her use, which is first concentrated in a bank account, and then placed into index funds or preferably private partnerships that directly own productive assets, where it continues to earn a risk adjusted 5% per annum, compounded annually, forever.

This is what I suggest you teach your child about money. Many more scenarios can be devised, but this one merely consists of accumulating your child's lifetime rent (or mortgage) payments directly into capital, which she can live on and bequeath to her heirs, in accord with Piketty's scenario of the "patrimonial middle class."

F. Implications of the Plan

Many financial or legal pros will immediately notice the advantages of this plan, however let's "call out" some of the more obvious ones here:

1. At no time is your child given any money, or placed in a situation where they don't need to work. Rather they are required to work a normal career, while becoming comfortably wealthy on the side.

2. It relies on conservative assumptions about your child's lifetime earnings. Walking dogs or working as manager at a MacDonald's could yield enough to pay rent at these levels. If they earned more, and saved more of it, over a longer working life, these numbers could be much higher.

3. Your child should have solid buy-in and strong motivation to get with this "savings program," because her financial results will be striking and immediate, with a clear long term trajectory.

4. We assume a basic level of financial maturity including the ability to evaluate and negotiate investments, however with support from knowledgeable kin and/or financial advisers, this is realistic. She may also acquire financial acumen by joining an investment club or taking finance classes, etc.

5. Direct ownership of rental real estate is another investment option, however this assumes your child has the business skills to select and manage tenants and work with contractors. This is real work and not everyone is cut out for it. For many, shares of REITs or oil and gas master trusts would be better.

6. If contributions are continued until age 60+ the income should provide a comfortable retirement even if she lives to age 120 (now possible) or if anything bad happens to Social Security. Otherwise Social Security will supplement her ongoing return on capital.

7. As our system of wealth becomes more concentrated, and less merit based, now is a good time to secure ongoing middle class status for your descendants.

G. Example Calculation (Crude)

The following table presents a simplified example based on the text above. Each year begins with a Base amount, which Earns 5% and has NewDep added to it, yielding a total Result which then becomes the Base for the next year. THIS is a “savings plan!”

Year Base Earns New Dep Result
1 0 0 12,000 12,000
2 12,000 600 12,000 24,600
3 24,600 1,230 12,000 37,830
4 37,830 1,892 12,000 51,722
5 51,722 2,586 12,000 66,308
6 66,308 3,315 12,000 81,623
7 81,623 4,081 12,000 97,704
8 97,704 4,885 12,000 114,589
9 114,589 5,729 12,000 132,319
10 132,319 6,616 12,000 150,935
11 150,935 7,547 12,000 170,481
12 170,481 8,524 12,000 191,006
13 191,006 9,550 12,000 212,556
14 212,556 10,628 12,000 235,184
15 235,184 11,759 12,000 258,943
16 258,943 12,947 12,000 283,890
17 283,890 14,194 12,000 310,084
18 310,084 15,504 12,000 337,589
19 337,589 16,879 12,000 366,468
20 366,468 18,323 12,000 396,791
21 396,791 19,840 12,000 428,631
22 428,631 21,432 12,000 462,063
23 462,063 23,103 12,000 497,166
24 497,166 24,858 12,000 534,024
25 534,024 26,701 12,000 572,725
26 572,725 28,636 12,000 613,361
27 613,361 30,668 12,000 656,030
28 656,030 32,801 12,000 700,831
29 700,831 35,042 12,000 747,873
30 747,873 37,394 12,000 797,266
31 797,266 39,863 12,000 849,129
32 849,129 42,456 12,000 903,586
33 903,586 45,179 12,000 960,765
34 960,765 48,038 12,000 1,020,804
35 1,020,804 51,040 12,000 1,083,844
36 1,083,844 54,192 12,000 1,150,036
37 1,150,036 57,502 12,000 1,219,538
38 1,219,538 60,977 12,000 1,292,515
39 1,292,515 64,626 12,000 1,369,140
40 1,369,140 68,457 12,000 1,449,597

Note: This table ignores taxes, expenses, and your child's lifetime earnings trajectory.

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DISCLAIMER: This is not legal, tax or accounting advice, and does not create an attorney-client relationship, which can only be created by a written engagement letter. This information cannot be used to promote any investment or avoid any tax penalty. Please revalidate all these ideas with your legal, tax, accounting, estate, and/or investment advisers in view of your personal financial situation and tax jurisdiction.