I stated previously that while this perpetual value method is a highly effective investing concept, it isn’t the most efficient, that’s because you have to remove some of the investment and then replenish it with fresh capital. I now want to expand on that and show where this model has its weaknesses and how it compares to traditional investing methods, but also show why despite all of that, I find this model to be better.
In traditional long-term investing, the key is time: you don’t have to contribute a whole lot of money if you start early enough and invest in tax-efficient investing vehicles like Roth IRAs. I covered this subject extensively in my post about the time value of money; but a quick refresher is to understand that if you remain disciplined and passive with your investing, you can achieve 10% average growth annually that multiplies over with every additional year. In my TVM post, I gave the example on a person who invested $2,000 per year for 8 years and then stopped investing. They let it grow with an above-average growth rate of 12% and after 38 years, the total investment of $16k turned into $2,288,996. If you paid taxes upfront through Roth IRAs, that means you can cash out that whole $2,272,996 in capital gains without paying taxes on it. That is the power of long-term passive investing.
It’s hard to line these up directly apples-to-apples, since the perpetual value method feeds back into the budget over time which distorts the distinction between contribution and return. But while we can’t line up the investment contributions next to each other directly, we can set the end result as constant and work backwards from there. In the model I’ve presented with static $50k annual wages, and 10% constant growth, the perpetual fund started with $5k in annual investing and would increase by $1k every year. After 30 years the investment fund would have a balance of $1,112,571. Over that time there was a total of $585k that was put into the fund. Meanwhile, to achieve $1.1 Million over 30 years through passive investing, you would have to invest $5,857 per year if provided with the same constant 10% growth rate. Over 30 years, that means you would have to invest a total of $175,72. But this concept is slightly misleading since even though $585k was invested over 30 years through the perpetual fund, you were pulling out parts of that amount over that time and spending it.
Comparing Budget Impacts
To explain this difference, let’s look at how each method affects your daily life. If you made $50k over 30 years, that means you earned a total of $1.5 Million in wages, so while you invested $585k over that time, it doesn’t mean you lived on $915k over those 30 years. When we compare how much our spending budgets were, we actually were able to spend $1,415,122 over those 30 years through the perpetual fund. That means over 30 years, we passed up on a total of less than $85k of the $1.5 Million and yet had over $1 million in investing, meanwhile the traditional investing method meant we had to forgo more than double the amount at $175k over that time to have that same $1.1 Million.
What this is demonstrating is that the perpetual value method is able to generate the same returns over time while coming at a lesser financial burden to the user over that time, even though the nominal value of the investment is higher than the traditional method. On top of that, the perpetual value method provides the funding to the user in a more convenient time as well. In the traditional method, you are still getting your normal paychecks every month or every other week, and you only see the total value of your wages at the end of the year. Meanwhile the perpetual fund provides an increasing percentage of your total wages upfront and allows you to make larger transactions that would have required you to either put more money into short-term savings, or to take a loan out and pay interest on it over time.
The other part about the perpetual fund that gives it an advantage over traditional investing is the option to consume even more in the short-run my link. Going back to year 15, where we start the year with $11k and live on an additional $31k in wages, this meant we had an annual spending budget of $42k. What this scenario is also providing you is actually the ability to live on $61k even though your wages are only $50k. This means that while the model is projected for you to invest $19k in year 15, and have an annual budget of $42k, you could decide to live a little more and live on $55k for that year. This still allows you to invest $6,000 back into the fund over that year, and it would cut into some of your future growth, but you get to enjoy living on more than you earned that year if you so desired. In addition to all that, if we’re still assuming a constant 10% growth, that would mean that the fund would still be bigger in year 16, even though you took out more than what you put back in during that year. Traditional investing wouldn’t be able to do this since $55k is beyond what we are earning in wages and the principle of the traditional method is to not pull from the investment until retirement age. The perpetual fund allows you to observe your financial position as if you were making $61k even though your wages were only $50k, thus every year you have an artificial raise, which then allows you to invest more money than would have been comfortable doing with your $50k income.
Tax Implication Warning
While the perpetual fund does give you an artificial raise, that also does expose another inefficiency in the model. In traditional investing, you can place the investment in IRAs that can either reduce taxable income today, or it can be used to pre-pay taxes so that capital gains in the future are tax-free. Since we are cashing out parts of the investment fund yearly through the perpetual fund, that means the capital gains portion of what you liquidate is subject to the reduced tax rate of Capital Gains Tax, which could increase the tax bill by an additional couple thousand dollars in taxes if not handled carefully. I will explain methods on tax efficiency next, but not all of the investment has to be in taxable investing accounts for the perpetual fund; a portion can still be put through the traditional method that will help bring in some of the tax benefits at a reduced rate.
I won’t get too detailed in this, because it’s taxes and nobody willfully reads about taxes, but I do want to show how some of the perpetual fund can be used IRAs to take advantage of tax deductions.
IRAs can’t be withdrawn before the age of 59.5 without incurring a 10% penalty (with some exceptions). Thus we can’t invest all our money into IRAs because of two reasons:
- We need to be able to withdraw funds prior to turning 60.
- We’ll be investing more than the $5,500 limit that you can put into an IRA (That is the max for IRAs in general, so the combined total between the two must be under $5,500. Thus you can have something like $3,000 in a Traditional IRA, and $2,500 in a Roth IRA for a combined total of $5,500 but just don’t go over $5,500 in combined total).
But just because we withdraw funds doesn’t mean we can’t use IRAs at all, it just means that what we withdraw needs to come from a taxable investing account. If we split our investing so that a portion is going to IRAs and the rest goes into taxable accounts, we can still benefit from tax benefits while still having the flexibility to withdraw funds; we just need to make sure we’re only withdrawing from the taxable account and that there’s enough in the account to cover the amount we’re trying to liquidate.
For simplicity, let’s use a $100 investment as an example.
If we decided to invest $100 that grows 10% and we will liquidate 5% annually, what we can do is put $60 into a taxable account and $40 into an IRA. At the end of the year, the taxable account grew by $6 with a total of now $66, while the IRA grew by $4 with a total of $44. This means we still have a total investment of $110 with the two accounts combined, just like if we assumed the $100 was invested into a single account. When we decide to cash out funds at the beginning of year 2, we’re still calculating the 5% from the total value, including how much we have in the IRA, thus we’ll liquidate $5.50. Even though our calculated 5% includes the IRA, that $5.50 will come only from the taxable account. This means that we now begin the year with a taxable investing account balance of $60.50 and an IRA balance of $44. If we invest another $100 in that second year, we continue to split the investment between the two accounts so that the taxable account now has balance of $120.50 and the IRA is now $84. They both grow by 10% so at the end of the year we have a taxable account balance of $132.55 & an IRA balance of $92.40. At the beginning of year 3 we again pull 5% of the combined total investment portfolio of $224.95. The $11.25 liquidation again comes only from the taxable account, which leaves the balance at now $121.30.
Through this method, we are able to either offset some the capital gains we incur by investing in Traditional IRAs, or we can set ourselves up for the future with tax-free capital gains for our withdrawals we make in the years after we turn 60 years old. All this can still happen without completely depleting the taxable investing account.
There isn’t a set formula of what percentage should be used for each account, and there is still the cap of $5,500 currently on IRAs, but as long as there’s enough being contributed to the taxable account to cover the withdrawal rate, you’re in a good position. Also choosing between Traditional IRA & Roth IRAs are flexible as well. Choosing between the two options boil down to what tax benefit do you want: reduced taxes today or in the future? There is no right answer since both are beneficial, but one tip is to use Roth when you have a relatively low tax bill and Traditional IRA for when you have a relatively higher tax bill. The model I’ve been using has been assuming a static income rate, but the tax bill still increases annually because we’re cashing out more each year which incurs a higher capital gains tax. With that and the general assumptions that we’ll be making more money and paying more taxes in the future, it may be preferable to focus on Roth contributions first and once the tax bill becomes cumbersome do you start incorporating Traditional IRA contributions.
Influences on the Perpetual Value concept
This perpetual value concept may be unique, it isn’t completely original. For all the differences expressed between long-term passive investing and this new concept, they are more similar than they differ from each other. I look at this perpetual value method as a modified version of that long-term passive method that greases the gears to run more efficiently. It still is aiming for long-term growth by primarily focusing on diversified equities through ETFs that are passively managed and have steady long-term growth.
Perpetual value also borrows concepts from annuities, in that the cash out mimics how annuities pay out funds throughout the year that help provide supplement income to the user. But annuities are dependent on you having a large amount of capital which you hand over to a firm to guarantee you a set amount of supplemental income against the instability of short-term market fluctuations. The perpetual fund deviates from this since it doesn’t wait for you to have a large balance to start getting pay outs, and also your investments stay in-house to capitalize on long-term growth.
So far the model has assumed constant growth and has ignored market fluctuations, but that is mostly due to simplifying the theory. In reality, 10% can’t be assumed in a given year, but that also isn’t a huge deterrent either because we aren’t concerned about pulling from principal. Even though that is one of the fundamental rules in nest-egg management is to never pull from principal, that is because a nest-egg doesn’t have inflow of capital. Even if the market drops by 20%, we can still pull 5% of the account balance. While it may be lower than we anticipated, we can still do that since we’re still increasing our investment contributions and with dollar-cost-averaging, we’ll be buying more equities at a short-term low that will help fuel more growth down the road once the market recovers.
I’m sorry these are really technical concepts that aren’t very reader-friendly; but that’s sadly finance. What I want to leave you with is understanding that measuring investing success isn’t simply increasing your capital gains, but rather how to maximize the long-term growth with the least impact on your short-term wellbeing. This theory borrows from many developed concepts active in today’s market, but this mixture provides a unique set of outcomes that benefit today and tomorrow, instead of having to choose one over the other.