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