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SOME PROFESSIONAL investors make a living through arbitrage, exploiting small, short-term differences in the price of stocks, bonds, commodities and currencies. For the average investor, such trades can seem far too complicated. Still, I often look for opportunities for what I call “everyday arbitrage”—situations where I can take advantage of a difference in, say, tax rates or a product’s price.
Here’s an example: In a recent article, I wrote about how 2022’s higher interest rates will significantly reduce the payouts that some retirees will receive from the 2023 lump-sum option on their pension. Today’s high-interest rates also mean that commercially available annuities are generating more income.
This unique environment leads to an “interest-rate arbitrage” opportunity. A friend elected to file for her pension and receive a lump sum in 2022. She could then purchase an immediate lifetime annuity with the money and receive some 25% more than her pension plan’s monthly amount. Had she waited until 2023, her lump-sum payout would have been reduced by about 25%.
I employed a tax arbitrage in 2017, which was a high-tax year for us. In March, I stopped working fulltime. I received a severance package and a vacation-time payout, started consulting work and began my pension. Coincidentally, my wife took a new job that paid her the highest salary of her career.
All this meant 2017 was our highest income year ever, which pushed us into a higher marginal tax bracket. Our income would likely be lower in future years—which led to the tax arbitrage. In December, I opened a solo 401(k) and made a tax-deductible contribution equal to almost my entire consulting income for that year. In a subsequent year, I can withdraw this money as taxable income—but at a lower marginal tax rate. I’m now over age 59½, so there’s no early withdrawal penalty to worry about.
I also like to employ an “everyday arbitrage” strategy for many more mundane financial transactions. For instance, for many years, I commuted from the Philadelphia suburbs to the Princeton, New Jersey, area. Gas costs a lot less in N.J. than in Pennsylvania. I would carefully plan my fuel consumption to refill my tank when I passed through Hamilton, N.J. I also did this when driving from Pennsylvania to our N.J. beach house.
There are certain over-the-counter medications my wife and I take. They cost about 25% less at Costco. There’s no Costco near our home, but there are two stores just off the Garden State Parkway. On our way to visit our sons and their families, we would stop at one to stock up. An added benefit: Costco has gas stations with low prices—low even for N.J.
My wife and I enjoy a good bottle of wine. Pennsylvania had a reputation as one of the least wine-friendly states in the country. Its state stores were known for high prices and limited choice.
When I started traveling for work 30 years ago, my colleagues told me of the best places to shop for wine. I traveled Interstate 95 from Valley Forge, Pa., to the Washington, D.C., suburbs. Engineers are good with numbers, and finding a great Napa Cabernet for under $10 was a noble goal. When we realized that the northern Virginia Costco and Trader Joe’s stores sold wine, we were all in.
Many Pennsylvanians routinely traveled to adjoining states for lower prices and greater selection. Although the situation has improved in the past decade, I know many fellow oenophiles who still make regular trips to Delaware or Maryland to stock up on wine.
I also try to make sure I’m not engaging in false savings. We bought our first beach house in March 2012. That summer, we rented it out for 14 weeks. We drove the 180 miles roundtrip each Saturday morning to clean the unit for the next renters. We took advantage of the trip to take a bike ride on the boardwalk, go out to breakfast and hit the beach for the afternoon.
Our first grandson was born in June 2013. We had planned to continue cleaning the rental ourselves. But for some reason, my wife found it much more enjoyable to go to New York on weekends to visit our grandchild. I found a good cleaner who was willing to fill in.
The cleaner charged $85 to take care of the house. When I calculated the cost of driving 180 miles, plus tolls, plus whatever we spent, I realized that paying a cleaner was a bargain. And that didn’t include the value of our labor—my wife’s labor, of course, being much more valuable than mine—or the opportunity cost of not seeing our grandchild.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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Rick–Great article!
As a fellow engineer, I’ve also found it’s much easier to “play defense” with finances instead of spending the effort needed to maximize gains. My bargain-conscious wife of 35 years and I have been practicing everyday arbitrage in ways similar to your examples, and I am sure it’s a practice we’ll carry into my upcoming (semi-)retirement.
Happy New Year!
But clothes in PA are not taxed. Many people from neighboring states take advantage of that when they can.
I’m not a big clothes shopper, so that didn’t occur to me. Living most of my life near the Delaware border, which has no sales tax. Many folks make the short trip to purchase big ticket items like TVs and appliances.
Rick , can you explain why the immediate annuity will pay out 25% more than the pension lump sum? Thanks.
Rick will know the answer better than I, but I suspect it has to do with the pension dispersement resetting for 2023 to the new higher rates. (and thus a lower lump sum payout) However, the annuities have already been set to the new higher rates, so their payouts are higher moving forward.
In other words, with a higher interest rate, a lump sum is either smaller or a payout over many years is larger. This just happens to be the moment before the 2023 reset/recalculation the pension where you can get both the higher lump sum (from the pension) and the higher payout (from the annuity).
Paula, the annuity will pay out 25% more than the monthly pension benefit, not the lump sum. The simple answer is that the lump sum is calculated using very low interest rates from a year ago, while the annuity is using current rates. The lump sum is the present value of the lifetime series of monthly pension payments. Think of it as the amount of money you would need to invest at a specific interest rate to generate the equivalent lifetime series of monthly payments. For example, say the person’s pension payment was $4,000 a month. This might equate to a lump sum of about $800,000 at last years low interest rates. You can then take that sum of money and purchase a lifetime annuity at today’s interest rates which are significantly higher. The annuity pays about 25% more per month. I hope this helps.
What makes some of us think hard before letting a dollar leave our hands, while others are mindlessly carefree about their spending? Rick, I appreciate your thoughtful thrift.