Chapter 8

STEP 4—WEIGH THE NOW AND THE LATER

Throughout this book I have talked about the need to develop your own personal rate of discount and, more generally, how making good decisions requires clarity on how much weight to put on the costs and benefits that arise today versus those that are received or have to be paid in the future. Each of us is different, and each decision has its own unique cost/reward timeline, but in every case we need to do three things before we can assign “values” to things that may or may not happen in the future. We have already talked about one of them, that is, determining the relative likelihood of those future events. The other two are the concern of this chapter.

First, we have to figure out what our time horizon is, that is, how far into the future is it worth thinking about. There are many reasons to limit the endpoint of our consideration of future events. Sometimes, the events are far enough in the future so that by the time they happen, our original decision will be moot. For example, when I considered how many running shoes to buy, I knew that by the time I was eighty-five or ninety, I would almost certainly either not be running or no longer be alive so I didn’t have to think about shoe technology beyond that point. Sometimes, the “expanding funnel of doubt” that makes up the future will be so wide and opaque that it will simply not be possible or worthwhile to imagine—let alone evaluate—the possibilities. Finally, even if it might be relevant and we theoretically could evaluate the probabilities, sometimes we simply don’t care what happens beyond a certain point and therefore should limit the extent of our analysis.

This last point is actually part of the second task we need to engage in when we weigh the future, that of explicitly determining a personal rate of discount. Mathematically, determining the endpoint of the timeline we consider is the same as saying that beyond a certain point, our personal rate of discount is infinite and the Present Value of events that happen that far in the future is zero and therefore irrelevant to our choice. Now let’s see how important and rewarding it can be to carefully consider both one’s own and others’ personal rates of discount.

Finding Your Personal Rate of Discount

“There are two kinds of people in the world. There are the high discounters and the low discounters. The low discounters are always going to be fine. It’s the high discounters that we have to worry about.”

Dean Ippolitto, FSA — Speaking to an EBRI (Employee Benefits Research Institute) working group on what US retirement policy should be.

“The key to a happy life is to always make those decisions that maximize the present value of future pleasure.”

Arthur (Tad) Verney, FSA — to a colleague on a beautiful summer day explaining why it was vitally important to leave work early for an afternoon on the golf course.

Each person has their own personal rate of discount that they use to make (mostly financial) decisions. Whether or not we are aware of it, we are constantly “discounting” the future consequences of our actions. As in most psychological processes, I believe it is helpful to everyone to make those unconscious “value judgments” conscious. Not only do we gain a measure of control over the decisions we make, but by being aware of our own personal rate of discount we can gain insights into problems and can even find “win-win” solutions to problems that would never have otherwise occurred to us.

I used to believe that the fact that most people’s discount rates are extremely high and that there is quite a lot of variation in these rates from individual to individual, largely reflected cognitive errors and a failure to analyze the particular problem accurately. This impression was fortified by watching countless employees of my clients opt to receive their pensions as a lump sum or choose to cash out their 401(k) balances early, paying both penalty and income taxes rather than doing the “rational” thing and allowing the money to accumulate over time, tax free. The effective discount rate implied by these decisions was often well over 10% and in every case far in excess of what any investor could reasonably expect to earn in the marketplace. I no longer believe that people are necessarily making a mistake in their determination but are in fact consciously or unconsciously applying their own value judgments to the present and the future. About twenty years ago, I actually developed a theory to explain this phenomenon and even got it published in an actuarial journal.³⁵ Clever as it was, it didn’t make me famous mostly because it turns out that the actual psychology of time preference is much more complicated than I suggested and is a problem that, unknown to me, behavioral economists had been working on well before I considered it.³⁶

So, recognizing that, as part of our natural makeup, we each have different time preferences, it turns out that there are numerous practical and empirical issues that arise when different people and different organizations utilize different discount rates to evaluate the Present Value of different future scenarios and an enormous amount of benefit that can be gained by understanding this.

Using Your Personal Rate of Discount to Create a Win-Win Scenario

The first actuary I met when I showed up for my first day of work right after college was not my boss Mordecai, but a senior actuarial student named Tad, who was assigned to show me around and give me some rudimentary instruction on some of the tasks that I would be engaged in. With his shaggy long blond hair and laid-back manner, Tad looked like the kind of guy who would be far more comfortable hanging out in a surf shop in Southern California than being dressed in an ill-fitting suit, confined to a cubicle in a large insurance company in Hartford, Connecticut. With both California and east coast roots in his family history, he was an unusual mix of naiveté and street savvy combined with an endearing curiosity about how the world worked and a powerful intuition for math and algorithmic thinking. In fact, he had originally started his career in California but then decided to come east and personally financed a trip to Connecticut to get a job at Connecticut General Life Insurance. He was quite sure he would be hired because he knew that they had openings for eleven actuarial students and he figured that even if his chances of getting any one of the jobs was only one third, the chance that he would be rejected for all eleven was vanishingly small. Fortunately, he got the job despite his basic misunderstanding of how not all probabilities are mutually independent.

But Tad was an extremely quick study who never made the same mistake twice. Soon, the quality of the suits improved, and he was able to use his good looks, quick mind, and aptitude for elegant and efficient algorithms to become both a successful actuary and a devastatingly effective pick-up artist. While I was never able to learn anything useful from him about the latter skill, he and I became close friends who shared innumerable conversations about how to apply the actuarial perspective to living a more effective (if not meaningful) life.

One subject that was a perennial favorite in our discussions was the difference in perspective between the individual and the organization. Many of these conversations surrounded the preponderance of power that the organization had and how the individual’s flexibility and nimbleness could be used as a counterbalancing force. Sometimes, those discussions focused on the potential reaction of the company to a couple of their fast-track actuarial students sneaking out of the office in the middle of the afternoon for a round of golf, but more often they centered around pay negotiations and whether and when to consider other job offers. Ultimately, I decided after a couple of years to leave the insurance company and join a consulting firm, while Tad decided to build his career at Connecticut General. Even so, we stayed good friends and saw each other often.

As the years went by and our careers developed, the conversations Tad and I engaged in became more philosophical and ranged more deeply into the nature of time and money. The basic focus was still on how differently companies and individuals look at each and how “win-win” scenarios could be developed such that each was satisfied with any resulting arrangement. Specifically, we were fascinated not just by the mundane differences in how each entity viewed a specific amount of money but also by the different ways each evaluated the passage of time both in terms of time horizons and discounting future events. As developing actuaries, we were schooled by our respective employers on almost a daily basis in how financial decisions to be made by the Company should be taken and how both the long-term viability of the company’s balance sheet and its future profitability would be affected by the choice at issue. Tad was much more fluent than I when it came to how organizations, particularly large insurance companies, think about time and, as a result, in 1996 Tad and another actuary, Bill Bossi, set off on their own to put these theories to the test and formed Disability Insurance Specialists Inc.³⁷

Bill was the perfect partner for Tad. While Tad did the conceptual/philosophical thinking and cooked up the algorithms and business model that would lead to their success, Bill provided the motivation, the contacts, and the leadership to make it happen. In addition to being a fine “big picture” actuary, he had presence, believability, a natural inclination to delegate effectively, and the ability to identify the most important aspects of any question—a vitally important skill for both an actuary and a CEO. He gave everyone around him the sense that he had things under control, even when they weren’t, and as a result he was able to sell their business plan to the senior management of several large insurance companies, an absolutely necessary first step and a challenging one given the skittish and change-resistant nature of the personalities of such executives.

The opportunity that Tad and Bill chose to pursue lay right in the heart of a line of business that almost every big life insurance company at the time engaged in, but almost all struggled with—the provision of disability benefits. Disability insurance is not only a natural adjunct to life insurance but can also be thought of as an extension of retirement benefits, medical insurance, and even workers’ compensation. It is a form of insurance protection that almost everyone needs and, when not automatically provided by one’s employer, many people seek it out on their own. But while the demand for disability insurance is ubiquitous and the basic expertise of providing it is clearly within a large insurance company’s core competency, it turns out that historically it has not been a source of profits for many insurers. In fact, it is very hard to make money at it. There are several reasons for this—some of them technical—but much of the problem is related to human nature and the difference between the way a company and an individual look at the time, risk, and money involved in the arrangement.

The first and most obvious problem comes in the definition of what qualifies as “disability.” Despite pages and pages of definitions and large bureaucracies (medical, legal, and administrative) that have arisen to determine if and when an individual becomes “disabled,” the determination of such a status remains very slippery indeed.³⁸ The second problem is that the administration of the business (underwriting, tracking, and paying beneficiaries) is costly and can substantially eat into the profit margin of a company issuing the policy. Finally, there are the less obvious but no less serious problems related to the timing of when the payments begin, how long they last, and how much reserve the insurance company needs to set aside to provide for the benefits still to be paid.

While Tad and Bill saw opportunities in addressing the first two problems, it was their belief that they were uniquely equipped to deal with the “time horizon and discount rate arbitrage” aspects of this third problem that led them to take the plunge and start their own business.

As Tad and Bill thought about disability benefits, they realized that what is most important to someone who files a disability claim is that they get paid fast. For the family of the employee filing the claim, the amount of benefit, or even how long the payments lasts, is not nearly as important as the fact that the benefits start as soon as possible. This is because not only (as we have discussed before) does an individual use a high rate of discount valuing those near-term payments far more than those in the future but also because the individual is not thinking about the “time horizon.” Instead, individuals are most focused on the fact that they will be paid for as long as they are disabled and don’t think too much about when the payments might end, either through death or recovery.

On the other hand, from the perspective of the company making those payments, the date the benefits begin is not nearly as important as the date they end. Insurance companies need to recognize as an expense (and hold as a reserve) the total Present Value of the claims that are expected to be paid, and that Present Value determination is based—by law—on a discount rate much lower than any rate that an individual would use. Thus, not only is the existence of those future payments vitally important to the company, but the value that the company places on them is much higher than that assigned by the individual. It was this difference between how individuals and their organizations valued that future stream of payments that Disability Insurance Specialists took advantage of. Tad and Bill set up a claims administration operation that was focused on the one hand on processing incoming claims as fast as possible and on the other hand included an extraordinary vigilance in monitoring very closely the health status of the individuals who were getting paid so that those who recovered or died would be identified immediately, and their claim payments would stop as soon as possible. With these as their highest priorities, Disability Insurance Specialists was able to provide service that led to both more satisfied customers and higher profits for the insurance companies who decided in greater and greater numbers to outsource their claims administration to Tad and Bill.

In addition to other more mundane factors that led to the company’s success (among other things, Tad and Bill were both great people managers who knew how to provide their employees with the right mix of present and future compensation, financial and otherwise, to keep their workforce stable and highly productive), there is one other reason why Bill and Tad are now playing a lot of golf. Specifically, in developing their business strategy, they were aware of and relied heavily on the fact that their own personal discount rates and time horizons differed substantially from that of the companies whose claims administration function they took over.

In particular, Bill and Tad knew what their time horizon was and had thought clearly as to what the value (to them) of profits and losses would be in all of the future years between the beginning and the end of their venture. Thus, with their flexible and nimble staffing model and no need to explain things to outside shareholders, they were able to accommodate the ups and downs of disability claim volumes that followed the economic cycle better than an insurance company for whom the time lag associated with hiring and “de-hiring” large numbers of people was very expensive. Even more importantly, by being aware of their timeline from the outset, Tad and Bill were able to design their business model around a time horizon that worked for their personal financial objectives. They did not ignore the endpoint of their business or, as most insurance companies do, consider themselves as “immortal.”

As a result of all of the factors above, Bill and Tad have been able to cash in by transferring profits and equity back to some of the insurance companies that helped put them in business to begin with and by doing so have converted their success into a stream of steady and certain income that will last them the rest of their lives. Even this last deal took advantage of the difference between the discount rate used by the insurance companies to value future costs and that used by Tad and Bill to value the income they received. In short, they used a deeper and broader understanding of Present Value to create a “win-win” situation and assure their own financial security.

Tad and Bill have been attentive to their own personal rates of discount for over thirty years, and it has served them well. But you don’t have to be an actuary to determine your own discount rate. Everyone has the capability to do it, and it’s not that hard. All you have to do is let go of the notion that there is a “right” answer. Not only can your discount rate differ from your neighbor’s, but it might also differ depending on the question, and it will almost certainly differ when you consider different time periods in the future. If the question is about receiving/paying money now versus some point in the future, it might be driven by how much interest you can earn on the money between now and that point in the future, but it will likely include many other factors as well.

So how do you begin? Well, after you have gone through steps 1–3 and you have some future scenarios that have values (monetary or not) payable at various points in the future, just start asking yourself questions about those “payment points.” If, for example, you are thirty-five years old and trying to decide between leasing a new car for $400 per month and increasing your 401(k) contributions by the same amount, you should ask yourself how much more important is that $400 of “new car value” compared to the income that the $400 will provide from your 401(k) plan thirty years from now. You don’t need to know how much income you will be getting—you just need to have a sense of the trade-offs. Would $1000 of income thirty years from now be worth giving up the $400 for? How about $2000? What about compared to the $400 lease payment you will be making two years from now? The specific answers you get are not nearly as important as becoming conscious of how you personally weigh value that you get now versus value that you get later. Don’t worry if you get lots of different values depending on the choices and the points in the future that emerge.

Just like with step 3, the specific values you get from answering the above questions are not nearly important as the relative weights you are putting on the “now,” the “later,” and the “much later.” As we will see in the next chapter where we address the final step of Present Value thinking, “doing the numbers” is a lot less complicated than it might seem.