We give our eleven-year-old son an allowance so that he can learn the value of money, mainly by coming up against the cold, hard, adult fact that money is limited, and that he cannot buy every toy he wants or sees. So far, he’s pretty much grasped the basics of affordability. Ten dollars cannot buy more than ten-dollars-worth of playthings or anything else fun. In fact, because of sales tax (another cruel, soul-crushing, adult reality), ten dollars can really only buy about nine-dollars-worth of fun stuff. He was surprised (as was I, frankly) to discover that even intangible things—in this case a new pack of Fortnite game “skins”—generate sales tax. After using $10 of a $15 gift card to purchase these new costumes for his avatar, he wondered why he could not make another in-game purchase of $5, until we discovered that the skins actually cost $10.39 after tax. Go figure. The fact that he frequently appeals to the “Bank of Mom and Dad” for an unsecured line of credit—virtually always denied—means he understands affordability even as he tries to stretch the definition. It is harder to help him understand opportunity cost, which is a central concept of pretty much every type of financial planning, including the subset of personal retirement planning, insurance planning, and also special needs planning.
Over the weekend, my son was determined to spend the $20 he had managed to save up on a bazillion round Nerf gun bullets. He wanted to purchase them online because this type is harder to find than the regular elongated types. From his insistence, this purchase felt very urgent to him, even though the “Nerf-war” birthday party, during which he planned to employ the bullets, is still five weeks away from the date of this blog. I felt that was way too much money to waste on toy ammunition, 50% of which was likely to end up choking either our lawn mower or our vacuum cleaner. But I tried to put a different spin on it by reminding him that if he spent all his money on Nerf bullets, the opportunity cost would preclude him from spending on anything else. He was not happy but, in the end, since he (thankfully!) doesn’t have a credit card yet, he agreed to delay his purchase as per my suggestion. Sure enough, two days later, it became critical for him to purchase a large quantity of craft glue, shaving cream and “magic solution” which could, when activated by a bit of laundry detergent, produce “slime” on an industrial scale. I pointed out that he was only able to buy the raw materials for the massive quantities of slime because he forwent the purchase of a massive quantity of the foam bullets. Opportunity cost overcome.
Social Security analysis has become something of an art form within financial planning. This is because Social Security will allow a person to either start drawing reduced-retirement benefits before what is termed his/her “full retirement age” (FRA) or delay collecting those benefits until after FRA and get an enhanced benefit. So, for example, if my full-retirement-age (67) benefit is $2,700/month, I could take a benefit of $1,890/month at age 62. Conversely, I could wait until 70 and collect $3,401/month. Hmmmm. On the one hand, $3,401/month is definitely more attractive than $1,890/month. On the other hand, there is the opportunity cost to consider. What if I delay claiming my retirement benefit until age 70 and then hit a massive pothole while riding my electric scooter, conk my head hard and then never make it out of surgery—all in the month after my 70th birthday, hypothetically speaking. The opportunity cost of waiting would be the 96 months since age 62 that I did NOT collect my $1,890 and use this money to cover living costs, thus reducing the amount I would need to take from my IRA.
On the third hand, in the “collect-at-62-die-at-70” scenario, my spouse would only receive $1,890 as a widower’s benefit (assuming his own retirement benefit is not more than that). In the “collect-at-70-die-the-month-later” scenario, my spouse would receive the $3,401. If he lives until age 95, that could be a lot better deal. It becomes even more complicated if, on the fourth hand—sorting out Social Security requires a lot of hands—your situation includes a minor child or an adult child with a disability, who will also receive auxiliary benefits, but not until you start drawing yours. Then, you have to add the opportunity cost of starting their benefits later.
Funding a special needs trust also involves examining the opportunity cost of each potential investment vehicle. I’m a firm believer that over a longtime horizon, loosely defined as 10 years or more, equity investments are going to get you the furthest, particularly if you choose low-cost index mutual funds or exchange traded funds. This is particularly true if the timing of your goal is somewhat flexible, and you will be around to make the adjustment. For example, you can always delay retirement a bit so as not to start in the middle of a market downturn. Or, you can live more frugally for a few years before starting to travel on holidays. Funding a special needs trust, however, is different. The goal cannot be postponed. When the latter of you and the child’s other parent dies, that special needs trust must be funded. Neither would you want your child’s standard of living to be reduced if you die with less assets to pass on than you expected to have. So you might consider a second-to-die life insurance policy to fund at least a portion of the trust. The opportunity cost of using life insurance is the almost certainly higher returns and lower expenses you would have if you had been putting all the funds directly into the market. But the opportunity cost of relying solely on the market is the drop in value your investments would experience, and your insurance policy would avoid, if the market declines significantly.
Other investments require a good look at opportunity cost as well. If I have a sum of money, should I buy an investment property? Gold? Collectibles? More index funds and ETFs? In some parts of the country, the real estate market looks highly attractive. Property values are moving up strongly. And there is a limit to how much a good building in a good location could decline in value, even if the market goes south. The opportunity cost may lie elsewhere, though. What if the costs of carrying the property and maintaining it go up faster than the rent? What about the cost of vacancy when you are between tenants? What about the commissions, taxes and fees on selling the property when you want to realize the capital-gains part of your investment return? And what happens if you only need or want some of that gain but have to sell the entire property to get any of it? It is almost impossible to sell a fraction of a building. I say “almost” because a company called Roofstock is building a business model doing exactly that.
Gold also has its opportunity cost, despite being a “pure” form of currency. Yes, the price of gold can go down. Certainly, it can fail to go up as much as you might expect as well. And as for collectibles, though you may kill two birds with the proverbial single stone by enjoying your collection even while watching it appreciate, there is always the possibility that this “prized” collection will not appreciate and/or that you will not find a willing buyer when you want to exit and sell. Unless you are collecting something like original Picasso or a Stradivarius, in which case, please sign up to do financial planning with me immediately. My opportunity cost of failing to connect would high, if you can afford to collect these items. Your opportunity cost would for failing to connect with me would be high too, even if that Picasso or Stradivarius instrument is beyond your budget. This is because the best way to minimize your opportunity costs and thus maximize the return on your assets is to work together with an objective fiduciary professional, who will help you run the numbers rather than run with your emotions and the bits and pieces of information you read on the Internet.