Retirement options with $10,000,000

Note:  I’m pretty sure there is an error in the example that I am about to provide, and if so I know my commenters will find it.

Let’s suppose you have $10,000,000 for retirement.  Sounds pretty good, doesn’t it?  How much would that enable one to spend on consumption each year?  Well it depends on your investment choice, but surely one can’t go too far wrong by following the investment advice of a Nobel-winning finance professor:

The Magic Number: 4%

What It Means: This is another spending guideline. It suggests that a retiree spend an inflation-adjusted 4% of his or her total retirement assets each year, keeping the balance invested with a mix of stocks and bonds.

What’s Wrong With It: No less an authority than Nobel laureate William Sharpe, professor of finance, emeritus, at the Stanford Graduate School of Business has written extensively about this “rule” and why it can ultimately be harmful.

The rigidity of the spending plan is among its problems. If a portfolio underperforms, staying the course is a clear path to running out of money. When returns are better than expected, there is an unspent surplus.

Sharpe offers an alternative to the 4% rule. Instead, invest in TIPS (Treasury Inflation-Protected Securities). If those returns prove insufficient, an investor can always dial up portfolio risk and seek better returns.

I can see the advantage of this strategy.  You preserve your nest egg (in real terms), and you live off the interest on the $10,000,000 investment.  So let’s see how it works out.  I will take a fairly simple example, where the money is invested in 10 year TIPS, and the inflation rate is 2%.  10-year TIPS are currently yielding 1.26%, which would provide an annual income of $126,000, indexed to inflation.

But wait, the income is taxable.  So maybe you only have around $90,000 to spend after taxes.  Still that provides a comfortable lifestyle for the average couple.

But wait, I seem to recall reading that the tax on TIPS applies to both the real interest payments and the inflation adjustment.  So let’s assume that there is 2% inflation, which is roughly the recent trend rate of inflation.   Now your “taxable income” will be $326,000, which puts you into a pretty high tax bracket.  Let’s assume your average income tax rate on $326,000 is about 35% (it’d be lower today, but Obama has big plans.).  In that case you’d have a tax liability of $114,900.  Still, it seems like you’d have a lot of money, even after taxes.

But wait, the $200,000 inflation adjustment isn’t really “income,” it is merely a nominal adjustment in the principle invested in your TIPS, which keeps its real value stable.  It’s not like the Treasury sends you a check each year for $326,000; your actual “income” is still just $126,000.  After you pay your $114,900 tax liability, your net after-tax income on the $10,000,000 investment is $11,900/year.  I hope you like dogfood!

Seriously, I know there are all sorts of strategies that can result in higher retirement incomes.  You can take advantage of our finite lifespans by buying an annuity, for instance.  Obviously someone with $10,000,000 would do fine, more than fine.   But I do have a couple serious points to make:

1.  From my perspective, the state employees who have pensions with COLAs have a pretty sweet deal.  If I was 62 I’d rather have $65,000 a year for life, adjusted for inflation, than $1,000,000 in a 401k.  Peace of mind.  BTW, the average 55-64 year old has $69,127 in their 401k.  Time to start saving folks!  (Full disclosure, I have a 403b, which is similar to a 401k.)

2.  Both wealth inequality and income inequality data are extremely misleading, for all sorts of reasons.  This is just one of those reasons.  I doubt there are too many people who invest in the way I suggested.  Many of the TIPS are probably held in tax deferred accounts, for instance.  But there are definitely some wealthy people who report large interest incomes on their tax forms.  And if they invest conservatively their actual real after-tax income might be only a tenth, or even one one-hundredth of the reported income that shows up in Gini coefficient calculations.  I’m not saying this particular problem is enough to seriously distort those statistics.  It probably isn’t.  But there are also many other flaws that make the indices virtually worthless (flaws which I will explore in future posts.)  In fact, statistics showing consumption inequality are the only valid way to measure economic inequality.  Both income and wealth data are flawed in so many ways as to be nearly worthless.

3.  When you read left-wingers complain that workers pay X% tax rates and billionaires only pay Y%, keep in mind that the statistics they are quoting are completely meaningless.  They are assuming that a 35% tax rate actually means 35%, whereas in the example I just gave the effective tax rate was over 90%.  Again, I am not saying this sort of example is common, but even if our tax system were 100% indexed to inflation, the tax rate comparison between labor taxes and capital income taxes would be meaningless, as capital income is double taxation of labor income, and thus the only efficient and fair tax rate on capital income is zero.

Here’s my optimal tax system:

1.  A progressive consumption tax or a progressive payroll tax.

2.  A set of Pigou taxes (carbon, not cigarettes)

That’s all.



28 Responses to “Retirement options with $10,000,000”

  1. Gravatar of Doc Merlin Doc Merlin
    13. July 2010 at 12:52

    2. A set of Pigou taxes (carbon, not cigarettes)

    Yuck. Pigou taxes quickly become an excuse to tax everything. They also rely on the wisdom (and morality) of legislators to pick things that are properly externalities, instead of just seeking to help their friends. For this reason, I believe that targeted taxes (like Pigou taxes) are a bad idea and that all taxes should be broad base.

  2. Gravatar of foosion foosion
    13. July 2010 at 13:15

    You are right that TIPS inflation adjustment is taxable, so that on an after-tax, after-inflation basis you could lose money. It’s important to remember that this is true of many many things.

    For example, assume inflation is about what is expected. Regular nominal treasuries and TIPS will return about the same amount and be subject to the same tax and after-tax, after-inflation returns. (You might have to sell something to get the cash to pay tax on TIPS inflation adjustment, but that’s not very significant. Hold some in a TIPS fund if liquidity is an issue.)

    Assume wages rise to keep pace with inflation. Same issue.

    Labor income is also subject to many levels of taxation, such as federal, state, sales, FICA.

    Efficiency? This country did very well at times the tax rate on capital was a whole lot higher than it is now, let alone above zero.

    You might want to think some more about your point 3

  3. Gravatar of mlb mlb
    13. July 2010 at 13:16

    Would your consumption tax apply to real estate?

  4. Gravatar of JimP JimP
    13. July 2010 at 14:00

    Ben’s sad face and glum view on life has gone global.

    We need that Roosevelt smile – and that cigarette holder.

    Does anyone know what he used a cigarette holder? (I do).

  5. Gravatar of JimP JimP
    13. July 2010 at 14:01

    What = why

  6. Gravatar of JimP JimP
    13. July 2010 at 14:18

    Roosevelt v Obama

    Need I say more?

  7. Gravatar of Benjamin Cole Benjamin Cole
    13. July 2010 at 14:27

    In 1942 (maybe 1943), Milton Friedman authored a piece for the American Economic Review, in which he proposed progressive consumption taxes to finance the war effort.

    Of course, we have been mobilized nearly ever since, what with the WWII, Korean, Cold War, Vietnam, Persian Gulf I-II, Iraq, Afghanistan wars, and now the War on Terror (the latter also known as the war on your pocketbooks).

    It makes little sense to tax productive behavior–working, or bona-fide investing.

    I agree, let’s go to progressive consumption taxes, sin taxes, pollution taxes, and gasoline taxes.

    And can we tax professional athletes and entertainers, even spitefully and unfairly?

  8. Gravatar of Dilip Dilip
    13. July 2010 at 14:43

    @JimP: Could you please stop hijacking every thread with something inane about Bernanke? Seriously?

  9. Gravatar of Nick Rowe Nick Rowe
    13. July 2010 at 14:59

    There’s consumption, and consumption expenditure. Expenditure on consumer durables is what makes the difference. But I expect that taxing consumption expenditure is still closer to taxing consumption than is taxing income.

    I don’t really understand US 401k thingies. Canadian RSPs let you claim any deposits against taxable income, and withdrawals are included in taxable income. Is that the same? If so, that’s a way of converting an income tax into a consumption expenditure tax, at least during the lifetime, and if there is no limit on contributions.

  10. Gravatar of Jeremy Goodridge Jeremy Goodridge
    13. July 2010 at 15:11

    My favorite tax structure:

    FLAT consumption tax or FLAT personal income tax. And Pigou taxes. And tax credits to help the poor. So, in a sense that’s progressivity BUT ONLY at the bottom. From the middle class up, there should be no progressivity. Note: this should INCLUDE all the various taxes we have now (state/local, Social Security, Medicare, etc, etc). When most people talk about flat taxes they talk about flattening the federal income tax, but then leaving the Social Security tax regressive. That’s a mistake.

    My problem with progressivity at the top end is that it is limitless potentially (what progressivity rule do we use?). There will always be the argument that we can just take more from the top end. And when you try to return to a flatter structure, the left always says, “this tax cut benefits the rich more than the middle class”. Morally, I have no problem with the middle class voting taxes on themselves to help the poor, but I have big problem with the middle class voting high taxes on a small minority of richer people.


  11. Gravatar of JL JL
    13. July 2010 at 15:16

    Ah, interesting!
    Every person naturally wants to become a rentier, but it seems to me that the most competitive economies will make it as hard as possible to attain that privilege. After all, a country with 50% of the adults being rentiers will produce less than one where 1% of adults are rentiers.

    Making it too hard is, of course, also a bad idea since (a) people will find a way and emigrate if necessary, (b) if it is impossible, some people will be less motivated to produce.

    So IMHO, good policy should facilitate retirement of old unproductive workers, while highly, yet competitively, taxing the retirement of young productive workers.

    I favor a high VAT (25%) and a low flat tax on income (e.g. 25%), which companies can, for the most part, deduct as paid VAT, so that domestic labor is effectively taxed at very low, even zero, rates. And the incentive to avoid VAT for labor intensive services is reduced.

    Additionally, pigou taxes (including cigs), a high land value or real estate tax (with exemptions for special industrial zones) and a tax on FDIC insured deposits (e.g. 1%).
    The land value/real estate tax is necessary to prevent wasteful and unproductive use of limited land resources, and real estate bubbles.
    In areas where land is plenty, the tax would be very low.

  12. Gravatar of Joe Joe
    13. July 2010 at 15:52

    Professor Sumner,

    There is a problem with Sharpe’s reasoning.

    When you die, the government will take 50% of it from you. You might as well spend it all and give it all to charity.



  13. Gravatar of Ugly American Ugly American
    13. July 2010 at 16:46

    The US consumes much more than it produces and has for some time.

    That can’t be sustained.

    To fix the economy we must decrease taxes on production and increase taxes on consumption.

    I’m not talking about fairness. I’m talking about survival.

    First keep the value in the country. Then argue about how to divide it.

    The details? The US trade deficit was $60B a month before the contraction with $40B of that being the direct cost of oil imports. Then we spend another $15B a month to fight the people funded by the guys we buy the oil from.

    The only way to fix the US economy and end the wars is to get off oil imports.

    And no, mandated fuel efficiency does not decrease total fuel consumption in the long run – it increases it. To decrease the consumption of imported oil the price must go up so that alternatives can displace it.

  14. Gravatar of Doc Merlin Doc Merlin
    13. July 2010 at 16:51

    Heavily progressive taxes tend to cause rick flight. Look at LeBron’s and Rush Limbaugh’s respective moves to Florida. This makes them unsustainable.

  15. Gravatar of RobbL RobbL
    13. July 2010 at 17:16

    Can you explain a progressive consumption tax? Are you talking about rebates?

  16. Gravatar of Indy Indy
    13. July 2010 at 17:24

    What about property tax?

    I’m not a huge fan of the ad valorem real property tax, but it is (historically) a very stable way for communities to collect revenues, and one of the other arguments in its favor is that it does tend to ensure that there is an inventive to improve empty lots and put idle land towards its most productive or valuable use. It encourages partition, transfer, and alienability, as opposed to stagnating perpetual large familial estates.

    Jeff Bezos and Ted Turner, aspiring to recreate those kinds of holdings for themselves in the high plains and mountain west, would probably disagree with me. As would all those seeking property tax abatement for otherwise highly valuable lands held in an unused natural state under “conservation easements”. Then again, if they are successful in achieving different, lower rates for conservation property, then the existence of property taxes is a useful way to achieve their preferred policy.

  17. Gravatar of scott sumner scott sumner
    13. July 2010 at 17:44

    Doc Merlin, If policymakers are not idealistic, we’ll all end up like Burma/North Korea/Zimbabwe in any case. So it would all be hopeless. That’s why I continue to assume at least some idealism. But I do realize that we aren’t Denmark, so I see your point.

    foosion, Yes, I realize that. I used TIPS because the problem is easier to see.

    There were many loopholes in the “good old days” People didn’t actually pay those rates. For instance, 60% of cap gains were excluded when the top rate was 70%.

    In any case there is no good argument for taxing capital. It’s not equitable and its not efficient.

    MLB, Yes, residential RE, and perhaps land.

    JimP, Thanks for those links. I didn’t know about the foreign inflation spreads, but they are not surprising. Yes, FDR was much more inspirational.

    Benjamin, Yes, and BTW, a payroll tax has an identical long run effect to a consumption tax.

    Nick, Good points. Yes, consumption is hard to measure. But it is worth a try.

    In American our 401k contributions are limited. So I am forced to save a lot in accounts that get clobbered at tax time. I should probably be in Muni’s, which are federally tax free.

    Dilip, JimP is a loyal reader who provides lots of good links. Indeed you and Jim have provided more than almost anyone (along with marcus.)

    Jeremy, Those are good points, but I totally oppose any income tax, even a flat tax. A payroll tax is fine, whether flat or progressive.

    JL, Cigarette taxes are extremely regressive, they are not Pigou taxes, and they are ultra-unfair. You might as well put an extra $10,000 year tax on redheads, or on tanning salons . . . wait, Obama already did that. (It will be interesting to see the fraction of the tanning tax that is paid by white folks.)

    The VAT is fine, but a payroll tax is far superior to an income tax.

    Joe, Good point. I also plan a post soon on why death taxes should be abolished.

    Ugly American. Yes but the key isn’t consumption, it is consumption that hurt the environment. Hence Pigou taxes are needed.

    Doc Merlin, Yes, I plan to discuss that soon in a post.

  18. Gravatar of scott sumner scott sumner
    13. July 2010 at 17:49

    Robbl, The easiest way to do it would be with a progressive payroll tax. A payroll and VAT look different at first glance, but in the long run are identical.

    You could also tax luxury goods like yachts, mansions, luxury hotels, spas, jewelry, etc. But I’d prefer a flat VAT, and a progressive payroll tax.

    Indy, Yes, a property tax is also a pretty efficient tax.

  19. Gravatar of Jeremy Goodridge Jeremy Goodridge
    13. July 2010 at 20:17

    Scott: You say “I totally oppose any income tax, even a flat tax. A payroll tax is fine, whether flat or progressive.”. I look forward to hearing more on this — in particular why a payroll tax is better than an income tax. I guess labor income is ok to tax, but business (capital) income is not? I could be missing something here.


  20. Gravatar of JL JL
    14. July 2010 at 02:04

    When I said income tax, I meant to say payroll tax, i.e. a tax on labour, withheld by the employer and up to a point deductible as paid VAT, so that the net taxation on employment at a livable wage is 0%.
    Dividends are taxed as if they were wages.
    A general income tax is too inefficient and too susceptible to fraud.

    If you consider public health to be a public good, cigarette taxes are Pigou taxes. And face it, most modern democracies do consider public health to be a public good.
    And yes, by that logic, tanning salons should also be taxed. Redheads, not so much.

    Would you agree that, if (1) the IRS had a mandate to introduce and set Pigovian taxes at optimal levels (i.e. minimizing total social costs) and (2) a majority of voters decide that the public health is a public good, then (3) the IRS would be obligated to set Pigovian taxes on cigarettes and tanning salons.

  21. Gravatar of q q
    14. July 2010 at 02:53

    i have a simple question about saving and retirement, something i haven’t seen explained before — maybe you can help me answer it, as it’s relevant to this post.

    in aggregate, how much retirement savings do we need? say we have 300M people, each of whom needs $30k per year after retirement (a low number) so using the 4% rule (pretty low margin of safety) each person needs $750K at the beginning of retirement. people will be at different stages of saving / consuming their savings, so say that the average person has half of that at any given time. now do the arithmetic: $750K X 300M X 0.5 = $112 Trillion. the entire asset base of the US is about $50 trillion (about $40 trillion if you don’t count single family housing). so i’m at a loss to see how private savings can fund retirement en masse – i don’t see how the numbers add up.

  22. Gravatar of scott sumner scott sumner
    14. July 2010 at 06:35

    jeremy, Yes, I will do a post. All taxes on capital represent double taxation of the same income twice. They discourage saving and encourage consumption, whereas we should be doing the opposite, or at the very least have a neutral stance.

    It is also unfair, as thrifty people with the same income get taxed at a higher rates then big spenders with the same income.

    Even some liberal economists oppose all taxes on capital.

    JL, Studies have found that there are no significant externalities associated with smoking. So the optimal cigarette tax is very small, much smaller than current cigarette taxes. Pigou taxes are supposed to address externalities—I have no idea what you mean by “Public health.” Would cigarette taxes make people healthier? Sure, but that’s not an externality argument.
    Cigarette taxes are also incredibly regressive.

    I doubt there are important externalities from tanning salons–I certainly haven’t seen such evidence.

    q, We need to encourage much more saving, and if we do so then the total amount of assets will rise. I favor something closer to the Singapore approach, which is forced saving.

    BTW, If we don’t have enough wealth, then it isn’t just private pensions that will fall short, public pensions also must be funded from taxes levied on the private sector.

  23. Gravatar of jean jean
    14. July 2010 at 06:54

    What about inheritance tax?
    Although it may reduce saving incentive, it may also lower an important source of inequality.

  24. Gravatar of JL JL
    14. July 2010 at 07:10

    “Would cigarette taxes make people healthier? Sure, but that’s not an externality argument.”

    It is if you consider public health a public (or common) good, by which I mean that the collective society benefits from better collective health.
    I.e. if you smoke, everybody, including me, is worse off.
    As opposed to a world wear individual health is exclusively a private concern.

    Fundamentally this is a moral question (individualism vs. collectivism, personal liberty vs. the welfare state), so I do propose settling it democratically. Many arguments can be made for each side.

    But if the moral question has been settled in favor of the collective view, cigarette taxes become a Pigovian tax by definition.

  25. Gravatar of JL JL
    14. July 2010 at 07:27

    “I favor something closer to the Singapore approach, which is forced saving.”

    I have always thought that, if we had forced, or highly encouraged, saving, with tax deferment and restrictions on how the money could be spent (but no restrictions on how it could be invested).
    And if a government would have high consumption/Pigou/land tax revenues, yet spend very frugally.
    Then the tax surpluses could be given to (productive) citizens as cheap loans, or as dividends in those savings accounts, in order to cover the large costs:
    health care, education, home financing, retirement, and disability/unemployment/welfare benefits.

    However, I am unsure weather such an approach would be better than a laissez-faire approach.
    If people were rational, such a system would be unnecessary. It would not be worth the overhead. Lower taxes would be better.

    Yet, looking at Singapore vs. western countries, it seems that people are not that rational and that forcing them to save produces better overall results.

  26. Gravatar of jean jean
    14. July 2010 at 07:27

    For cigarettes, you forget to mention second-hand smoke. But admittedly, the externality is probably neglectible compared the current level of tobacco taxes.

  27. Gravatar of Ted Ted
    14. July 2010 at 07:57

    Scott– Why no LVT?

  28. Gravatar of ssumner ssumner
    15. July 2010 at 09:27

    jean, Inheritance taxes to not reduce inequality in a sensible way. I will do a post soon. The problem of inequality is differences in consumption, not differences in wealth. We need progressive consumption taxes to reduce inequality of consumption.

    JL, I still don’t understand your public health argument. If I smoke it doesn’t make you significantly unhealthier. And it doesn’t increase your taxes significantly. So why should you care?

    JL, “If people were rational” they might save nothing, and use moral blackmail to get the state to take care of them in their old age. So forced saving means lower taxes.

    I was with you until you started talking about cheap government loans to people. Why would we want the government to do that?

    Jean, I was thinking of second hand smoke. But the health risk is negligable, as you say.

    Ted, Yes, a land tax probably makes a lot of sense. I really haven’t studied the issue, but it sounds efficient.

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