Philadelphia Reflections

The musings of a physician who has served the community for over six decades

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Lifetime Healthcare, Using Health Savings Accounts (3)

Let's return for the moment to the difference between what a total market index earns (11%) and what just about every foundation and endowment earns (8%). That 3% difference is so large it has a major effect on what an HSA can provide. If 3% represented what the financial industry imposed as a middle-man cost, it would be an outrage we should work to change. However, it likely has a more benign explanation with standard available protections. Remember, there are two cycles recognized in the stock market, one of which is the daily or weekly volatility which can be ignored by long-term investors. For a century it has had a standard deviation of about three percent, conventionally referred to as if "risk" can be represented as one standard deviation in amount.

However, that is not the risk most long-term investors fear. Roughly following a 30-year cycle, although don't count on that, it has recently been termed a "black swan" risk, of 30-50% volatility. Such disturbances usually last a couple of years and can be utterly disruptive to foundations and nonprofits who meet payroll to keep their doors open. The market has always recovered in a few months or years, but meanwhile, how can you function?

Available solutions vary but generally come down to a choice between a contingency reserve, and a "balanced" portfolio of stocks and bonds, usually in 60/40 ratio. Since bonds generally return about 5% instead of the blue-chip stock average of 10%, the nominal return on a balanced portfolio is reduced from 10% to 8%; the real return after inflation is further reduced from 8% to 5%. However, in the case of a lifetime HSA, the lifetime at risk of a black swan crash stretches from birth to age 66, much longer than 30 years. We suggest the after-inflation bond content of the portfolio should grow 2% a year from age 43 to 66 when the eventual bond content of the portfolio should roughly equal the required lump-sum payment to Medicare. Once the disbursement is made, the remaining portfolio can return to 100% stocks.

It could still fund a Medicare buy-out without disturbing the rest of the investment program if by bad luck the time for a buy-out coincides with a bear market. If there is no bear market, the cost of this safety measure can be shrugged off as just the price of safety, because it also permits the extra risk of 43 years of a 100% stock portfolio. The overall effect -- 43 years of 100% stocks ignoring the risk in the background of a black swan -- is to increase the portfolio's overall total return from 5% to 6%, as well as mostly guaranteeing the fund will be undisturbed by black swans at just the wrong time. This safety assumes no withdrawals from the fund except this one, so no amount of volatility needs to be considered except volatility at the one moment of liquefying a portion to buy out of Medicare. That's individual black swan risk; the black swan risk for the entire population is otherwise practically certain to afflict someone at some time within a 66-year interval. The tiny proportion of people wealthy enough to weather the storm with outside funds can elect not to do it at any time up to the 43rd birthday. However, they should probably be required to fund their own contingency arrangement, because for a poor person to neglect safety is a risk of unraveling the scheme they should not run. Remember for a moment the scheme promises to cost $xxxx for the avoidance of lifetime costs of $350,000, and thus is entitled to insist on reasonable protective rules if someone wants to share the benefits.

Originally published: Wednesday, March 11, 2015; most-recently modified: Sunday, July 21, 2019