How much would you pay annually in order to receive $1,000,000 today? This question is often a good measure of risk tolerance. For the purposes of this article, I am considering this the same as asking how much would you need in return annually if you paid $1,000,000 today. For me, it is around $50,000/year. I had a debate with a friend recently who said that he would demand closer to $75,000 due to long term S&P returns, ignoring points like inflation and risk. This all started from a debate about whether you should take $50,000/year for 20 years or $1,000,000 instantly if you won the lottery. No rational person can make an argument for $50,000/year but the argument moved on to what dollar value would make you change your mind.
Time Value of Money
Would you rather have $1 today or $1 a year from now? Each of you nodded at the $1 today. How about $1 today or $1.02 a year from now? I still expect most of you to have nodded at the $1 today. How about $1 today vs. $3 a year from now? Now everybody should be nodding their head at the $3 a year from now. Whether you actively recognize or act upon it, everybody recognizes the time value of money. Cue obligatory reference to the Stanford marshmallow test which shows appreciation of delayed gratification as an indicator of future success in life. Tying in with many of my earlier posts, this is part of the reason that I am very debt hungry. So long as I am young and employed I want as many dollars today to be able to leverage compound interest for the future.
Market for Risk Tolerances
In the comments below or in a thought experiment, think about the question at the top: specifically, how much would you need per year for you to pay $1,000,000? I think you’ll find there’s a wide variety of choices with the majority coming in around $20k-$75k/year. Whenever an econ nerd such as yours truly sees disparate preferences for risk, I smell an arbitrage opportunity or the ability for a market to exist. For example, if you think you’d take $20k/year and I’d take $75k/year, somebody should pay person A $25k/year for $1,000,000 and then take $70k/year from me. All three of us gets better off (person A by $5k/year, me by $5k/year and the arbitrageur by $45k/year). There should be a business model about this!
Enter annuities and life insurance. Insurance companies business model revolves around differing measures of risk sensitivities. For example, if you have employer-sponsored health insurance, you are often given the option to choose between basic, advanced and a premium option. This is just a dressed up way of measuring a customer’s risk preference and using the differences to provide the best service possible. When somebody says that annuities are a rip-off (in my opinion, they are), they are often referencing that they just have a different risk preference. If I had to pay $1m for a $20k annual annuity, I would say no. There is a pocket of the population that would say yes, however. How do annuity (life insurance) companies manage a guaranteed small outflow of dollars with interspersed large injections of capital from annuities? With life insurance of course! That model guarantees small inflow of dollars interspersed with large outflows of capital at paying out policies. And, similarly, it allows people to self-select based off of their risk preference, choosing whole life, term as well as a variety of other options.
Are most of them ripoffs?
Yes. But, then again, I have a different risk profile.