We introduced Banana Bread Land (BBL) in our last post, as a fun way to figure out what the heck cryptocurrency was. I’m going to continue with BBL. Sometimes, it’s easier to see something from a third-party perspective than from your own.
As a citizen of Banana Bread Land, you have it great. Fresh air, beautiful scenery, a benevolent ruler, and cheap, tasty baked goods. There is something that troubles you. You want to have a happy, healthy retirement. You want to balance working long enough to have enough assets to pay for retirement and relaxing enough years to enjoy it.
Based on a post from an international citizen named smilingdad, you know $1 in monthly expenses needs about $300 in assets to support you. You figure, if you and your partner had 5,000 muffins a month, you would be living the good life in retirement, free to do what you please, eat all the banana nut bread you wanted. That means, if you had 1.5 million muffins, you could retire.
You got to your local financial planner for advice. Her name is Walnut. She seems friendly and competent. She greets you and says hello Vanilla, how can I help you? You tell Walnut you have 1 million muffins saved up. What are your options to retire? Walnut tells you three options make sense in your situation, and a fourth as a backup.
Option A: Invest in a local bakery. This bakery promises to give you 5,000 muffins a month, until the money runs out.
Option B: Invest in a local baked goods distribution center. This distribution center promises you 5,000 muffins every month, an unlimited paycheck for life.
Option C: Invest in a local baked goods distribution center. This distribution center promises you 5,000 muffins a month, an unlimited paycheck for life. As a bonus, any money the distribution center doesn’t need will be invested, and every two years, they’ll increase the number of muffins you receive, minus any fees to invest.
Option D: You work longer, save and invest more money, and wait until you have 1.5 million muffins. You manage the money yourself.
All the options sound intriguing, except Option D, but you need to see some actual numbers on paper. Walnut breaks it down for you.
If you both choose Option A, here’s how much income you’ll get.
In Years 1 to 5, you’ll get 5,000 muffins a month. Same is true for years 6 to 10, 11 to 15, and 16 to 20. Starting in year 21, you’ll get nothing. I’m being super conservative, and assuming the investments return 0% for 20 years. If your investments in the bakery earn money, you’ll get money for a few more years, depending on how the bakery does.
If you both choose Option B, you’ll get 5,000 muffins a month in years 1 to 5, same for years 6 to 20. The bonus is you’ll get 5,000 muffins a month every year you or Chocolate are alive, beyond year 20, unlimited paychecks for life.
How much extra is the cost between Option A and Option B, you ask? Option B sounds too good to be true. Being a competent financial professional, Walnut checks. She says, I double checked the numbers and there is a fee of 1% a year for Option A, and for Option B, because they have more muffins invested and are better at handling money, there is a 0% fee. You and your partner, Chocolate, exclaim Wow! We love the bakery, but the distribution center sounds much better. How does Option C look? This must be a scam. Walnut assures both of you that Option C is legitimate.
If you both choose Option C, you’ll start with 5,000 muffins a month in income. Based on the historical returns of the bakery distribution center, an extra 10% increase in income every 2 years seems reasonable. At the end of year 5, you are projected to have 6,000 muffins a month in income, at the end of year 10, you are projected to have close to 7,300 muffins a month in income, and if we continue by the end of year 20, you will have close to 11,700 muffins a month in income. Actual returns are unknown, says Walnut.
Walnut continues. The fee is 1.5% of your muffins every year, the distribution center promises your income will never go down ever, even if the investments go down that year. Because of the promise of unlimited paychecks for life, you have to keep your money invested with them for 5 years, and if you withdraw above 10% of your money in any year, there will be fees. If you cancel the contract within 5 years, there are penalties. What do you both think, asks Walnut? Aha, says Chocolate, I knew there was a catch, but Option C does have benefits. Think of how we could visit the grandkids, or buy that trophy stand for your award winning banana bread tin collection, or visit someplace every year outside of BBL on a vacation, exclaims Vanilla.
What about Option D, says Chocolate? We can save about 19,000 muffins each a year, if both of us continue to work. Walnut crunches the numbers. If both of you invest 19,000 muffins a year and earn 5% every year, you will have more than 1.5 million muffins after 7 years. The benefits of managing the money yourself, you can take out as much money you want in a given year. You have a chance of earning higher returns and can invest in almost any investment. The bad news, you have no protection if your investments go down, you don’t have unlimited paychecks for life, and you’ll need to carefully watch your muffin pile to make sure it lasts. It’s called longevity risk. Longevity risk multiples the risk of any other risk as you get older.
In any scenario, you need to account for inflation, says Walnut. The value of your muffins will go down every year, as prices for various items such as food, housing, clothing, health care go up over time. Vanilla and Chocolate agree this is a lot to take in, and need time to discuss which option is best for them.
Which option would you choose? Most people in real life choose Option D, stingily guarding their assets, not enjoying the fruits of their hard work, always worried their investments will go down and they will run out of money. They invest their money in 401k plans or other tax advantaged plans, and withdraw as much as they need every year.
Most people not reading this blog are unaware of options B and C. Option B is your classic immediate annuity. The life insurance company guarantees you a fixed amount of money in exchange for money invested up front. You can choose the time frame they guarantee the income. The longer the guarantee, the less money they provide you every year. The shorter the guarantee, the more money they can provide you, at the expense of not knowing how long the money will be paid.
Option C has become popular in the past few years. It is called a fixed index annuity. Because of the risk of unlimited, growing payouts, the life insurance company will ask you to keep your money with them to invest for a fixed period of time. The longer you allow them to invest, the more they credit your account. If you move your money ahead of time, penalties and fees will apply. They will provide a guarantee that any gains you earn are yours to keep forever. We’ll discuss the Power of Zero in a subsequent post.
The good news is, legislation is adding annuities to Option B. More will be able to take advantage of unlimited paychecks for life in their tax-advantaged retirement plans. We’ll see how the competition changes what is offered. Whatever option you choose, talk it over with someone reputable who deals with other people’s money often.
The numbers shown here are not representative of any real product in real life. The concepts are similar to what I presented.
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