When is a Million Dollars Not a Million Dollars?

It’s the summer and TV is rife with reality shows promising fame and fortune to the victor.  In fact, some of the shows promise the life-changing sum of $1,000,000!  But I realized one night while the credits were rolling that lives weren’t going to change quite as much with the way the producers were going to pay out these winnings. You see, a few of these programs spread the million bucks over a period of forty years.  That’s $25,000 a year – certainly a life-enhancing amount, but probably not life-changing.  I doubt anyone’s going to call out sick for the rest of their life based on that.  However, the small print also states that the winner can elect a lump-sum value of these future annuity payments if they should so choose.  

So how much is that, exactly? Well, right now might be a great time for America’s top talents to take that lump sum since the 30-year treasury yield is quite low by historical measures. 

Assuming an interest rate of 3.71% throughout the 40 years, that would equate to $516,912 -- a nice amount of cash but hardly a million bucks.  But here’s the lesson to be learned:  it takes about half a million dollars to give a retiree $25,000 a year (principal and interest) if they invest it all in 30-year treasuries at today’s rates.  

But what if you invested that money in the S&P 500 and earned the average rate of return since 1973 of 9.8%?  Well, that $500,000 would now pay you about $51,980/year (P&I).  The problem is two-fold – 1) the S&P doesn’t return 9.8% year after year and 2) nobody would be foolish enough to sink all their retirement assets into the stock market if they needed it for immediate retirement income – would they? So let’s look at a more reasonable approach for a retiree.  

The DFA 60/40 Balanced Strategy has averaged 11.6%/year since 1973 which would provide $60,715/year (P&I) starting from that same dollar figure.  Eureka!  Here’s a viable portfolio for a retiree that invested an appropriate amount in world equity markets, paired it with a conservative bond strategy, and produced a return that would be more than satisfying for most retirees.  Of course, past performance never guarantees future returns and you can’t invest directly in an index, but the academic research behind the design of the Strategy supplies the answer as to why this approach performed as it did during this time period. So – what will you do when you get your million bucks? (Sources of returns data: Google Finance & DFA Matrix Book 2011)