When the stock market suffers a “crash” of significant proportions, the most common question asked by those with a position in the market is: do I buy, sell or do nothing? I happen to be a chap who tends to do nothing…well, not nothing. Those who follow this blog are aware that I favor mutual funds, particularly index funds. And as a general rule, all earnings from these funds – dividends, bond interest and capital gains – are automatically reinvested. In the three major market corrections I have experienced (and several minor ones), I haven’t veered from this practice. In a manner of speaking, I dollar-cost average as rule of thumb.
Everyone has his or her own personal circumstance when it comes to deciding what to do in the event of a major correction. Some folks simply must sell into a downturn because of extenuating circumstances, in which case, it is what it is. If you happen to be an individual not in that situation, my experience has been to stay put. However, if your question is should I sell or should I buy, ignoring the stay-put scenario, then I would suggest in either case to do it gradually as opposed to going all in. In short, if you decide to sell to avoid major damage, do so on a measured basis as opposed to all at once. Conversely, if the market seems to be offering you some amazing opportunities, buy but again do so in a measured way.
Major corrections tend to surprise us even when alarming trend lines are stirring our suspicions. For this reason, we tend to want to join the herd in reaction to these suspicions. By selling into a dip, one of two things is likely to happen. You’ll lock in losses, perhaps unnecessarily, or you’ll lock in gains, creating a taxable event, again perhaps unnecessarily. And then, after a bottom is found, when do you get back in…if ever. It’s not unusual for people to miss 20… 30… 40% of a recovery before they convince themselves that the market has rediscovered its footing.
When we experience one of these gut-wrenching market declines, I’m reminded of what Warren Buffett, the Omaha sage, wrote in his 2016 annual letter to Berkshire Hathaway stockholders. Mr. Buffett is an astute investor who views bear markets as opportunities… the louder the growl, the bigger the opportunity. He penned the following in 2016: “Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.” Mr. Buffett, a modern-day (but more philanthropic) Scrooge McDuck, has been swimming in a pool of $130 billion, waiting for such an instance. But he’s a patient man, and I suspect he’s dragging out those washtubs as we speak… at the same time fostering great sympathy for the tragic medical impact the coronavirus is having on so many families.
Without question, the coronavirus has caused a medical crisis of immense proportions, and in its wake, is creating an extremely chaotic stock and bond market upheaval. But from a historical perspective, there is little reason to panic. The economic impact of these dreadful events do dissipate over time¹. And such short-term market conditions do create opportunities for savvy investors. I’m not suggesting that folks ignore short-term consequences, but neither should they abandon their PDQ Principles of investing going forward.
All other things being equal, bear markets are real world opportunities… regardless of the causative factors… that many folks too frequently turn into financial negatives. What’s the old saying, “Be patient, this, too, shall pass.” And based on past experience, it often passes rather quickly. Do the common-sense things that matter. Make high-quality, low-cost, well-diversified investments and exercise the necessary patience to let them work for you over the long term. You may not be able to employ Mr. Buffett’s washtub approach but practicing those PDQ Principles might enable you to dig out a tablespoon or two… perhaps even a teaspoon might work for us lessor mortals.
If not by now, you will soon be fully aware of my devotion to the simplicity of index fund investment portfolios. Many of my examples focus on the “early-in-life” saving for retirement by investing in a single index fund to achieve a modicum of financial comfort thirty… 40… 50 years hence. But, of course, there are more ways than one to skin a cat, while maintaining an allegiance to those PDQ Principles I mention so frequently. Let’s consider another increasingly popular approach.
Target-date funds (TDFs) are offered to investors that seek to grow assets over a specified period of time, usually for retirement. Often named for the year in which an individual plans to retire, the fund’s asset allocation becomes a function of the time available to meet the investment objective.
The notion behind TGFs is something that, not surprisingly, has a great deal of appeal to me – their simplicity and diversity. Generally speaking, most of us accept the idea that stocks are riskier than bonds; that as we grow older, it makes sense to reduce market risk by holding more bonds in our investment portfolio than stock; and that rebalancing a portfolio to properly weight the stock/bond ratio makes sense along the way. Therein lies the appeal of TGFs. By design they radically adjust to a less risky (more conservative) investment mix as the so-called “target date” of an investor’s retirement looms.
This simplicity makes TDFs increasingly popular vehicles for 401(k) plans – and attractive to investors prone to putting their investing activities on autopilot. Particularly when the fund’s portfolio is allocated to various index funds. Take the case of a young man hoping to retire in 2065. He would likely choose a more aggressive target-date 2065 fund. An older individual nearing retirement (say in 2025) might choose a more conservative target-date 2025 fund. My fund company of choice, Vanguard, offers a comprehensive series of target-date funds¹, using several index funds as underlying securities for the investment. Let’s compare a couple of their funds to illustrate those target-date characteristics:
Vanguard Target Retirement 2065 Fund (VLXVX)
The Vanguard Target Retirement 2065 Fund (formed 7/12/2017) has a low-cost annual operating expense ratio of 0.15%. The Fund’s portfolio percentage allocation as of January 31, 2020, stood at 54.2% of assets invested in VG: Total Stock Market Index Fund, 35.6% in VG: Total International Stock Index Fund, 7.1% in VG: Total Bond Market II Index Fun, and 3.1% in VG: Total International Bond Index Fund. In short, a more aggressive 90% in equities and a conservative 10% in bonds and cash equivalents because of its long-term horizon.
Vanguard Target Retirement 2025 Fund (VTTVX)
The Vanguard Target Retirement 2025 Fund (10/27/2003) has a low expense ratio of 0.13%. The fund’s portfolio percentage allocation as of January 31, 2019, stood at 36.2% invested in VG: Total Stock Market Index Fund, 23.5% in VG: Total International Stock Index Fund, 28.4% in VG: Total Bond Market II Index Fund, and 11.9% in VG: Total International Bond Index Fund. This is a less volatile, shorter-term mixture of 60% in equities and a more conservative 40% in bonds and cash equivalents.
Beyond the target date¹ – for folks already in retirement – the Vanguard Target Retirement Income Fund (VTINX) gravitates to an even more conservative, less volatile asset allocation (roughly 18% in domestic equities, 12% in international equities, 37% in domestic bonds, 16% in international bonds, and approximately 17% in short-term TIPS (Treasury Inflation Protected Securities). Its annual expense ratio is a very low .12%. Although I used Vanguard funds in my hypothetical example, a wide variety of marketplace target-date options await the investor – funds with various asset allocation strategies to fit differing risk and management preferences.
The Great Recession of 2008-09 reminded many investors that even for folks close to retirement, TDF’s have their own shortcomings. With all of the talk of their conservative mix of highly diversified investments as retirement nears, they still hold a certain percentage of investments in stock, and they do take a one-size-fits-all approach to investing. In short, the funds simply can’t consider each individual investor’s unique portfolio needs. And the automatic approach to investing strategy simply ignores changing market conditions. Therefore, it’s important that investors consider the caveats of their risk profile when considering TDFs, including the cost and performance of a particular company’s TDF portfolio. It’s always essential to compare fees, and it goes without saying that any conscientious investor should continue to pay attention to changing market conditions. No approach to investing should relieve us of that duty.
For inexperienced investors dealing with an array of confusing choices offered by their employer’s 401(k) program, TDFs can be a relatively low risk starting point in the saving and investment cycle. But there are no panaceas out there. As conditions change in one’s financial life, the types of investment suitable to those changed circumstances might also change.
According to Morningstar Direct, in 2008, target-date fund portfolios for folks planning to retire in 2010 took a nose-dive of 36% from the market’s October 9, 2007 peak, on average, during the Great Recession (the broad index fell 55% during that crisis). Compared to the current coronavirus scare, from the February 20, 2020 market high through last Thursday, TDF portfolios of folks who planned to retire in 2020 dropped by about 13%, on average. During the Great Recession, the 36% loss by near-retirees in TDFs represented more than two-thirds of the 53% decline suffered by those planning to retire in 30 years. By comparison, losses by today’s investors close to retirement represent about half of the 24% market decline.
Hopefully, lessons were learned from the bitter Great Recession experience. We’ll soon find out.
I practice this philosophy every day… obsessively, according to my Gen-X daughters. It’s the underpinnings of everything I have to say about saving and investing. Face it, if you don’t save, you have nothing to invest – unless you’re a debt-leveraging dude. And a critical ingredient of saving is watching those pennies…every single one. Recently, while wandering around Lowe’s tool department, I spotted a penny on the floor. Out of sheer habit, I bent over, picked it up, and stuck it in my pocket. Was it worth the effort? No, but the ingrained habit of watching those pennies is what’s important. (Watch the video below.)
Watching your pennies is a very important factor in making quality investment decisions. In fact, it is crucial to optimizing return on investment. Focus for a moment on the simple act of deciding which of three investments to make. Mutual fund companies charge an “annual operating expense ratio” for managing money in their funds (there are no free lunches, but Vanguard’s John Bogle certainly made the Wazoo crowd more honest than it was prior to the mid-1970s).
Let’s assume that you’re investigating a possible $10,000 investment in three funds of relatively equal quality: 1) a Total Stock Market Index fund that charges an expense ratio of 0.04%; 2) a fund that charges 0.25%; and 3) a third that charges 0.90%.
How does your final choice impact the value of your retirement portfolio 40 years hence, given a theoretical market yield of 7% on each, compounded annually? Per the results in the table, with the first fund, you accumulate approximately $147,400 of value, in the second case $135,500, and in the third case $104,300.
The significant variable in our example is the annual operating expense ratio. In short, a fraction of a single percent (i.e., the .86% difference in Case One and Case Three) could ultimately reduce the value of your retirement portfolio by as much as $43,000 after 40 years on a relatively small initial investment of $10,000. SO, WATCH THOSE PENNIES! Make this mistake enough times while waltzing toward retirement and dog food might be in your future. (By the way, the $43,000 difference is comprised of $14,200 in additional fees and $28,800 in opportunity cost associated with paying those additional fees.) That’s the money the late John Bogle spoke of when he said, “You get what you don’t pay for.”
The scenario I paint above is, of course, hypothetical. Future investment rates of return aren’t predictable with any certainty. Investments that yield higher rates are generally subject to higher risk and volatility. Rates of return vary widely over time, especially for long-term investments, including the potential loss of principal. However, paying a higher annual operating expense has little to do with market risk and more to do with watching your pennies. And if you don’t avoid those tiny fee differentials (i.e., watch those pennies), the down-the-road impact on your lifestyle in retirement can be significant.
With dizzying speed, the Coronavirus has moved the market index from its recent all-time high to bear market territory in just 19 sessions! Amazing. In previous downturns, it has taken the index, on average, 136 trading days to enter bear market status from its most recent high (Source: Dow Jones Market Data). The combination of this new virus and the ridiculous Saudi/Russian kerfuffle regarding crude oil production has been particularly unsettling to investors.
This, too, shall pass, folks. Just keep the faith.
During this endless political season – I’m fine with about six months of campaigning instead of two years – there have been some behind-the-scenes mutterings about how to address America’s extremely low non-retirement household savings. A solution to this dilemma, partial or otherwise, might help stem the ballooning dependence of many of our citizens on so-called government entitlements. Could such a solution be accomplished through the tax code without feathering the nest of those big birds in the upper branches of our national tree? Perhaps. In addition to encouraging non-retirement household savings, such a program might also address the income disparity between those upper branch big birds and the many smaller birds in the middle and lower branches.
According to a 2018 Federal Reserve study, the average American family has less than $11,000 in non-retirement household savings… few readily available financial resources to deal with an emergency. Why? Do they lack the ability... the motivation... the whatever… to create a “rainy day” fund? Yeah, I know, I blogged about rainy day funds back in July 2019, so let’s not cover old ground. But I would like to discuss one idea that is making the rounds among Trump economic advisers should his administration serve a second term.
Who might be the target of these non-retirement household savings accounts? Perhaps those American families who occupy the lower- and middle-income branches earning as much as $200,000 a year. How’s that for attempting to reduce the usual clamor of “tax cuts for the millionayes and billionayes”? So, how is this proposition different from existing retirement plans, you ask? It has some similarities and some distinct differences. The non-retirement household savings account would allow eligible families to sock away up to $10,000 per year pre-tax in a savings fund. A popular suggestion is that the money be invested in low-cost stock index funds, which would minimize risk through diversification. Sound familiar? These features would expand ownership of stock to all participants, allowing millions more folks to share in future stock market gains. These features would not only help reduce the wealth inequality between the big and small birds, they would also enable many more of the smaller birds to enjoy The Amazing Power of Compounding.
This non-retirement household savings account would, of course, be voluntary in nature and employers would be encouraged to match employee contributions. After an accumulation period of five years, funds in the plan could be used for virtually any purpose: to supplement income in the event of job loss; for all emergencies; to buy or improve homes; to start a new business; to send kids to college and/or to private or tech schools; and yes, even for retirement. In short, this type of plan is not meant to be restrictive of use; rather, it’s purpose is to encourage non-retirement household savings.
There would be one very familiar feature. It’s well-known that Uncle Grabby (IRS) gets grumpy when he loses revenue. As with distributions from pre-tax contribution retirement accounts, Grabby would recapture tax revenue delayed by contributions to these household funds when the money is finally withdrawn and spent. In short, and as usual, Grabby would get his pound of flesh by taxing those pre-tax contributions – and the dividends and capital gains they earn – when the money is finally withdrawn. But withdrawal is not a requirement.
These tax-affected non-retirement household savings could well be a major step toward replacing the entitlement culture with incentives to save for broad-based wealth creation – I call ‘em fat and sassy, tax-advantaged rainy day funds. And they would certainly be better than another proposition being circulated by certain “Deep State” forces – a plan to eliminate the existing pre-tax contributions to retirement plans and go “all in” on Roth-type plans. In short, under this troubling proposition, all monies contributed to retirement plans would be after-tax dollars. No pre-tax dollars allowed. I’m a firm believer in Roth plans, but it’s sure nice to have the choice of paying taxes now or paying them later.
Since 1994, 10 major health issues – Zika, SARS, avian flu, etc. – have significantly impacted global markets. In eight of those cases, stocks climbed more than 10% after 12 months once investors properly evaluated the threat. Since 1946, there have been 26 market corrections of at least 13%. On average, it has taken about four months to recover to pre-correction levels¹. Panic if you must, but patience might serve you best. Just remember, big market declines are unsettling. Usually they’re linked to some totally unexpected global event – a time, perhaps, to re-assess your “true” risk tolerance. If you’re very uncomfortable with today’s events, you might want to consider a different asset allocation once the market recovers…and it will. We just don’t know when.
How often do you play the lottery? It’s not uncommon for routine lotto participants to spend $1,000 or so per year chasing this “get-rich-quick” gambit. Buy a ticket and win $100, a $1000, perhaps $1,000,000+ against overwhelming odds. Recall the incredible $1.537 billion drawing won by a single South Carolinian. The odds of winning that prize exceeded 1:302,000,000, roughly the same odds as one citizen in the United States (population 333,000,000+) being selected in a drawing to win the big prize. It happened, but it wasn’t you… or me… or all the other 333,000,000+ Americans. Watch the video below.
How about reducing your odds from 1:302,000,000+ to a more believable 1:1 depending on how patient you are over the next 45 years? Here’s the deal. For those of you in the early stages of a career (say 22 years of age), instead of buying $100/month of lottery tickets, contribute an initial $3,000 (the initial minimum contribution in after-tax dollars) to a Roth IRA and deposit the $100/month (again, after-tax dollars) of “lottery savings” into the Roth for 45 years. Invest every penny of it in Vanguard’s Total Stock Market Index Fund, Admiral shares, compounded quarterly (which has earned a return on investment (ROI) of 7.14% since its 2000 inception – and Voila! you wake up on retirement morning with a $466,000 balance in your Roth account. This is in addition to Social Security, your work-related 401(k) or 403(b), your home, and all the other assets and retirement savings you’ve accumulated during that same period.
Because folks purchase lottery tickets with after-tax dollars, I assumed a $3,000 initial investment (the required minimum) and the $100 monthly contributions would fund a Roth IRA. In retirement, Roth IRA withdrawals are tax-free. The VG Index Fund’s 7.14% ROI is based on the fund’s returns since its 2000 inception. I made no inflation adjustments. By the way, the Total Stock Market Index Fund has earned, on average, 13.82% over the last 10 years, so using 7.14% in my hypothetical example doesn’t seem overly optimistic… but who knows?
Okay, so it doesn’t sound like much compared to $1.537 billion, but think about that $466,000 every time you walk into a convenience store during the next 45 years and throw down a few loose “after-tax” dollars for a lottery ticket. I’ll take the 1:1 chance of ending up with $466,000 upon retirement versus those long odds of being extremely lucky. But remember, to gain these improved odds, you have to be very disciplined… and very patient.
Speaking of the lotto, a quizzical subscriber asked me the following question: If you became a lucky winner and had the choice of taking $50,000 today or $80,000 spread evenly over 30 years, what would you do? And how would you invest the money in either case? In responding to these questions, I assumed that in both cases the money was invested in taxable accounts to avoid muddying the water about who might be eligible to place those winnings in retirement fund vehicles.
As usual, in both cases, my investment choice would be the aforementioned index fund. As to the cash, I would invest the lump sum assuming an annual return of 7.14%, compounded quarterly, which mathematically would grow to $418,000 before taxes and inflation after 30 years. In the second case, I would invest the larger sum evenly over 30 years (assuming the same yield of 7.14%, compounded quarterly), which mathematically would grow to approximately $312,000. Granted, my approach is very simplistic, but it certainly reaffirms the value of “a bird in hand” even when it’s a smaller bird².
A couple of subscribers I’ve chatted with recently seem to think that if they retire with a million bucks in their retirement account, they’ll be in hog heaven. No doubt, it’s a very comforting figure. But should it be? I ran a hypothetical calculation for myself assuming I was 28 years of age. Hey, don’t giggle, I’m only about twice that age (if you’ll permit me to use the term “about twice” quite loosely). I simply want to present an example that at age 28, with a good job, and already having saved $10,000, how much more money would have to be tucked away monthly, invested at 7%, compounded annually, to achieve millionaire status at age 68 (40 years hence).
I grabbed my abacas (Source: Bankrate’s Investing & CD Calculator - Save a Million Dollars Calculator), slapped around a few beads, and Voila! I had my answer. In addition to the $10,000 seed money, I’ll need to invest another $343 per month to reach that million-dollar goal. Seems doable – particularly if I have a generous employer who matches some of my contributions. And there should be nice raises in this mythical future even as my family grows and requires a bigger house, dependable cars and college or trade school educations.
But then I realized that there is more to the calculation than first meets the eye. I forgot to allow for Izzy The Inflation Monster! So, I threw in a 2.5% per year inflation factor to feed that hungry beast who will gobble up as much of my purchasing power as it can during those intervening 40 years.
Using that 2.5% inflation factor, here are the numbers. Beginning with the $10,000 initial investment and adding $343 each month for 40 years, I do end up with roughly $1 million in my retirement account at age 68. Unfortunately, those “gray bearded” million bucks will only purchase $373,300 worth of goods in today’s dollars.
So, I go back to the abacas and bean-count how much more I must save to end up with $1 million in purchasing power at age 68. And boy is that a Zebra of a different stripe! To have $1 million in today’s purchasing power 40 years hence, I will need almost $2.7 million in my retirement account, not just $1 million.
To achieve this new goal, it will require a monthly savings of… gasp… $1,020 instead of the $343 I mentioned earlier. But being a “glass-half-full” chap, I desperately try to see the silver lining of this cloudy dilemma. By saving at the $1,020 clip per month, I’ll have about a million bucks sitting in my retirement account by age 55 – a “fat-cat” millionaire 13 years ahead of the original schedule… for whatever that’s worth.
Still, take heart in the fact that although inflation steals an individual’s purchasing power, it also tends to exert upward pressure on paychecks. In short, the higher $1,000 per month savings requirement might be more achievable than one might imagine. Inflation tends to lift all boats… income as well as expenses.
But don’t forget, this scenario is hypothetical. Future rates of return aren’t predictable with any certainty (they can vary widely over time, especially for long-term investments like I assumed here). Investments that pay higher rates of return invariably come with higher degrees of risks and more volatility. And to really brighten your day, the loss of investment principal is also a possibility. So, immerse yourself in a bowl of Blue Bell® ice cream and hope that the (also mythical) Social Security trust fund (like so much of the other money we send to politicians) doesn’t soon disappear into that fetid, alligator-infested, Washington D. C. swamp – and for goodness sake, start saving!
By the way, there’s stirrings among political investment advisers about tax-free investment accounts for lower and middle-income families – and they’re not retirement accounts. These accounts would accumulate funds that, after five years, could be used to buy or improve homes, start new businesses, send kids to college or private schools, supplement income after job loss, or yes, even for retirement. It’s an interesting idea. We’ll talk more about it in a week or so.
I detect a bit of confusion among certain of my subscribers regarding who pays taxes on capital gains of stock sold during a given year by fund managers. A couple of folks asked why shareholders had to pay taxes on those gains when the “fund” had already paid them. Well, first of all, the fund hasn’t already pay taxes on those distributions. [To view the video below click here.]
Shareholders of the funds – you – end up with the tax bill. And you pay taxes on those distributions whether or not the distributions are reinvested in additional fund shares or received in cash. To clarify, let’s venture behind the scenes to see what actually happens.
Federal law requires fund managers to distribute all dividends, interest and capital gains to shareholders…and report those distributions to you as they occur, typically quarterly and at year-end for dividends and capital gains… and monthlyfor interest.
Although it’s common – and wise – for shareholders to automatically reinvest distributions in additional shares of the mutual fund, that doesn’t eliminate their obligation to pay taxes on such distributions quarterly or by no later than April 15 of the following year. In short, shareholders are responsible for reporting such distributions on their next year’s federal tax return and for paying any tax due, when due.
If a mutual fund is held in a tax-deferred account (i.e., a 401(k), IRA, etc.), the rules regarding distributions are different than as explained above. In tax-deferred cases – those funded with pre-tax contributions – with few exceptions, shareholders will be taxed when the money is withdrawn from such accounts – whether voluntarily or as Required Minimum Distributions (RMDs). However if the account is a Roth IRA or a Roth 401(k), shareholders won’t be taxed on withdrawals since those accounts are funded with after-tax contributions. And there’s a different set of rules, maybe even penalties, covering “early” withdrawals, but that’s another story.
To recap, mutual fund entities do not pay taxes on capital gains, interest and dividends earned by their shareholders. That’s a shareholder’s obligation. So, keep detailed records of all mutual fund distributions – and on your own purchases and sales of fund shares. And report these activities without fail to Uncle Grabby.
Remember, the mutual fund company has already reported the distributions to Uncle Grabby on a 1099-DIV. And Grabby’s watching to make sure you, the shareholder, reports those same distributions on your federal tax return.
Today’s blog takes me down a road less traveled - the discussion of a current event and how it might impact short- and long-term market values and an investor’s response to such an event. Specifically, I want to address the effect of the Coronavirus that reared its ugly head recently in China, and its slow but steady infection of China’s trading partners. (Click here to watch the video below.)
Investors shouldn’t dismiss out of hand the impact of the Coronavirus virus, in particular, on the Chinese behemoth. That nation has quarantined 56 million of its citizens in an attempt to arrest the virus. To date, investors in the United States seem to be of the mind that the American economy is less vulnerable to external shocks than the rest of the world. There’s an element of truth to that. Still, according to the Wall Street Journal’s insightful editorial staff, U. S. companies, Apple, Starbucks and other American stalwarts have temporarily closed stores in China for good reason. And Ford, Apple and Tesla have temporarily halted the production of their commodities in China. Of note, one-sixth of Apple’s sales and close to one-half of chipmaker Qualcomm’s revenues are generated in China. And 80% of active ingredients used by drug-makers to produce finished medicines come from China. Such statistics and a random sampling of corporate activity in reaction to this virus are meaningful red flags. Unless the spread of this virus is arrested soon – and normal business activity resumes – markets across the world, including our own, will feel its impact.
When an economy the size of China’s – the world’s largest oil importer and a major manufacturer – faces a sizable quarantine of citizens, suffers airline service disruptions from many countries and must deal with the closure of international borders and of the aforementioned factories, financial markets there… and here… can’t help but be impacted. China’s loss of 2-3 million barrels per day of oil-related demand alone will be felt worldwide. U. S. crude oil prices have declined over 20% in the last month. Although such price decline could give a boost to motorists at the pump, the Coronavirus crisis is being less than kind to the stocks of major domestic energy companies. Middle East catbird, Saudi Arabia, is advocating a brief curtailment of OPEC production to combat declining demand, a development that would be helpful to U. S. shale producers.
Will this virus have a short- or long-term market impact on the world market? That's the question of the moment. Although various flu viruses impact our country on a much greater scale annually, they are familiar viruses. Not so much the Coronavirus, thus, the greater uncertainty surrounding it. My guess is that, due to this uncertainty – the absence of an effective Coronavirus treatment – the world’s marketplaces will experience increased volatility leaning toward bearish declines. In this country, the Centers for Disease Control and Prevention (CDC) and other federal, state and local health authorities are reacting in an expeditious and professional manner – China, not so much. The impact of the virus on that country is still unfolding… yet to be defined. But it seems to finally have grabbed their government’s belated attention. Past outbreaks such as SARS (severe acute respiratory syndrome) caused stocks to drop initially only to bounce back once the rate of new infections slowed. To date, cases of this new virus in China have doubled the number afflicted by the SARS virus two decades ago – a troubling trend.
Opportunistic investors holding highly-diversified, well-balanced portfolios can weather this significant market uncertainty by judicious buying in a declining market should it occur, but the word of the day is patience… patience to await the opportunities of a soft market and to outlast it if and when it occurs. Despite our country’s own low risk for infection, China’s outbreak will continue to reduce its energy consumption and disrupt the world’s second-largest economy for some time to come.
To wise investors, steady as she goes.
Generally speaking, an early withdrawal from an IRA prior to age 59½ is a big no-no, subject to being included in gross income plus a 10% additional tax penalty. There are exceptions but avoid them if you can.
The main concern folks – especially young folks – have with IRAs is their “forever” feature. “I make contributions to the darn thing, and it’ll be FOREVER before I have access to those dollars,” they grumble. Well, sort of true. IRA rules are designed to discourage you from dipping into the till prematurely as opposed to waiting until the greybeard years (post-59½) for access. After all, IRAs are instruments of retirement. But to assuage some of the apprehension related to this “forever” feature are a few exceptions to the 10% additional tax penalty on early withdrawals.
As youngsters mature and adults grow older, they will come to appreciate the benefits, and on occasion, the early withdrawal exceptions of an IRA – the ability to tap the account for certain very specific purposes. Let’s discuss a few, keeping in mind that the exceptions I mention also have some very specific provisos that must be met to avoid triggering that darn early withdrawal tax penalty. Let’s consider a few exceptions:
1. In the event of job loss, you can make early withdrawals to pay for healthcare insurance premiums.
2. You can pay for medical expenses that exceed 10% of your adjusted gross income.
3. If disabled, to qualify as a tax penalty exception, you must obtain a doctor's verification as proof of your inability to do productive physical or mental activity indefinitely.
4. You can pay qualified higher education expenses for yourself, a spouse, and for offspring, but only if paid to eligible educational institutions.
5. You can early withdraw to buy, build, or rebuild a first home for a parent or grandparent, yourself, a spouse and for offspring, but you must meet the IRS definition of a first-time home buyer. If both you and your spouse qualify as first-time home buyers, then each of you can withdraw $10,000 from each of your respective IRAs without penalty.
6. A qualified reservist distribution is not subject to the penalty tax if certain requirements are met, including a call to active duty for more than 179 days or for an indefinite period as a member of a reserve component.
7. The Substantially Equal Periodic Payment (SEPP) rule allows holders to withdraw retirement account money at any age, penalty-free. There are 3 IRS-approved methods for calculating SEPP withdrawals and you must adhere to such schedules for at least 5 years, or until age 59½ (whichever occurs later), or all amounts withdrawn may become subject to the 10% penalty tax.
8. We’ll discuss inherited IRA withdrawals at another time.
I purposely mention these exceptions because so many folks avoid using IRAs using the excuse that they tie up money “forever” that might be needed to meet more pressing current needs. In doing so, these same people overlook an IRA’s tax-advantaged value of saving money for retirement, long-term exposure to an up trending market, and the benefit of The Amazing Power of Compounding.
Before dismissing IRAs out of hand, remember that there are ways to access IRA accounts for specific purposes, but fair warning, the rules covering Traditional and Roth withdrawals are not all the same. Do your homework and think twice before making a withdrawal.
Let’s review some examples of what The Amazing Power of Compounding can do for savers who follow different contribution patterns. A single $2,000 IRA contribution made at age 15 could grow to almost $59,000 after 50 years, assuming a 7% investment yield, compounded annually. If that same saver contributed the initial $2,000 but added an additional $50 each month for 50 years, the account would grow to about $312,000, earning the same 7% per annum. And if the saver doubled the contribution to $100 each month, the account could reach over $565,000 after 50 years. As youngsters “earn” more money after entering the adult workforce, their annual contributions are likely to be higher, and the resultant IRA balance will grow correspondingly. Amazing, huh?
Aside from pointing out the withdrawal flexibility of IRAs, another purpose of today’s discussion is that since America has devolved into a “do-it-yourself” retirement system (Defined Contribution Plans) as opposed to the old pension system (Defined Benefit Plans)¹, the so-called “wealth gap” between wise early savers and those who choose to wait has morphed into a “wealth chasm”. Contributing to the chasm is the choice of wise savers to avoid the 10% early IRA withdrawal penalty, a penalty our legislators included when passing laws establishing IRAs and other retirement accounts. The withdrawal message is simple: Follow the rules and reap major rewards – violate them and suffer the consequences.
In summary, teaching our younger generations the value of opening Traditional or Roth IRAs – and yeah, Gramps, occasionally providing matching contributions – helps provide them with a head start on saving for retirement. You can also teach them useful lessons about taxes, smart investing, The Amazing Power Of Compounding, and the very important relationship between earning, saving and spending. Discipline, discipline, discipline is the watchword – so important in developing healthy financial habits.
Finally, don’t be intimidated by the “forever” nature of IRAs. There are ways to access funds in both Traditional and Roth IRAs prior to retirement. Still, IRAs should be funds of last resort to raid, but if the pitcher of life throws you an occasional wicked curve, well…
¹See my archived blog “The Tottering Three-Legged Stool” dated 07-26-2019.
Because time is money and money buys time, it’s important that Millennials and Gen-Zers begin saving (and investing) early in life in order to optimize The Amazing Power of Compounding. Have I mentioned that before? Let's flesh out a couple of extraordinary wealth-building tools for our youngsters!
Members of my target generations who are not yet saving have already lost valuable time. Still, as I have pointed out time and again, it’s never too late, but early is best. Almost nothing matters as much in personal finance as deciding NOT to violate the fundamental principle of saving early in life. If you violate this principle, you’ve helped neuter The Amazing Power of Compounding. But enough sermonizing.
Most investors are familiar with Individual Retirement Accounts (IRAs) – and understand that IRAs represent important tools for young investors, who because they are young, can take maximum advantage of time and its supportive co-conspirator, compounding.
Surprisingly, many parents don’t know that youngsters, regardless of age, can contribute to IRAs, but, with rare exception, only if they have earned income. That, of course, is a big “if” especially when paired with a big “maybe” – will a youngster with earned income choose to contribute money to an IRA versus spending it on movies, video games or some early-stage million-dollar habit? More about this later…once we get Grandpa involved.
Both types of IRAs – Roth and Traditional – are suitable for children. Their difference stems from when the individual pays taxes on contributions to the plan. In short, a Traditional IRA is funded with pre-tax dollars, whereas, a Roth IRA is funded with after-tax dollars. Regarding Traditional IRAs, taxes are paid when money is withdrawn from the plan beginning no later than age 72 (at the then-applicable personal tax rate).
In both Traditional and Roth IRAs, money accumulates tax free. But here’s the appealing kicker of a Roth. If and when Roth withdrawals begin decades later, no income tax whatsoever is due. And the Roth is not plagued by Required Minimum Distributions (RMDs) that begin at age 72 for Traditional IRAs – subject, of course, to Uncle Grabby’s IRS rule changes. And he’s capable of that on a whim, re the recent SECURE Act, which curtailed the tax benefits of “stretch” IRAs. Requiring annual payouts from Roth IRAs was not included in this most recent legislation, but what about the next Congressional whim?
Speaking of Uncle Grabby, always be mindful of tax considerations. The contributing child may be required to file a tax return if his or her income exceeds a certain amount. If the child earns less than this amount, he or she will likely be in a 0% tax bracket – and will not benefit from an up-front tax deduction associated with Traditional IRAs. In that case, it makes sense to focus on a Roth, the IRA of choice (in my opinion) for children with limited income.
As suggested earlier, creating an IRA for an eligible youngster is a wise move. Because of the youth factor, The Amazing Power of Compounding will work its magic over a longer period, and the results will be – well – truly amazing. But remember, the child must keep a Roth until age 59½ for all withdrawals to be tax-free. (Prior to age 59½, Roth contributions, but not investment earnings, can be withdrawn for any reason without tax or penalty under existing Uncle Grabby rules).
In summary, children, regardless of age, can contribute to an IRA if they have earned income. Others (including Gramps) can contribute to the child’s IRA, too, as long as the amount of the child’s earned income is not exceeded. By the way, a minor’s IRA must be set up as a custodial account by a parent or other adult.
Also, there are opportunities to contribute to an IRA without a job! We’ll talk more about that next week.
I recently ran across a very intriguing question posed by a young chap - a Gen Zer - about the risks of investing. And he wasn't just asking about "typical" risks, like investing in a company's stock that goes bust. He, like many members of his generation, are growing up during an era when they are constantly bombarded with frightening scenarios - real and Internet-produced - that have them living slightly on edge. It seems that he had heard we might be on the brink of another "Great Depression." If so, he asked, what happens to all of the money invested in the stock market?
Radio and television personality, Art Linkletter, wrote a bestselling book titled, Kids Say the Darndest Things. The idea for the book was in response to his young son’s comment that he wasn’t going back to school after a disappointing first day in Kindergarten. “Why not?” Art asked. His son, Jack, replied, “Because I can’t read, I can’t write, and they won’t let me talk.”
Youngsters, even older youngsters, often have thought-provoking ways of looking at things… stimulating others to ponder such outlooks. What if another Great Depression comes, wouldn’t all that investing go to waste? Perhaps, but let’s consider the prospect of starting to save and invest while very young. Reminds me of that old adage: The Amazing Power of Compounding. Yeah, I know, you’ve heard me mention it before. But, yes, the younger you start saving and investing, the higher the payoff. For example, if you save and invest $100 per month, earning 7% per annum, compounded annually, here’s the theoretical retirement nest egg you might accumulate by age 65 (before taxes and inflation):
1. Beginning at age 20, you’ll have $357,867 upon reaching age 65.
2. Beginning at age 30, you’ll have $173,177 upon reaching age 65.
3. Beginning at age 40, you’ll have $ 79,290 upon reaching age 65.
Now, if another Great Depression does come, wouldn’t you rather be in the middle of accumulating a nest egg of sizable proportions than not? The longer you wait to save and invest the more financially unprepared you are to experience a depression, a recession, or just the ordinary run-of-the mill economic cycles that constantly bombard the marketplace. And in the event of such setbacks, perhaps you could salvage a portion of your portfolio. Assuming you have a good plan, investing is never a waste of time. (Here's the link to the video below.)
As to the question, “And how does our money just disappear anyway?” Well, in order for it to disappear, you must earn it in the first place. And there are a variety of ways for it to disappear. Million Dollar Habits will get you there about as quick as anything. A poor investment plan or strategy can chew up dollars fairly quickly, too. Just plain bad luck often chews up a chunk. And despite following best investment practices throughout your working career, that ravenous old dude, Izzy the Inflation Monster, and his free-spending sidekick, Uncle Sam, are magicians at making your money disappear.
Previously, I mentioned that if you began saving and investing $100 per month, earning 7% per annum, compounded annually, you would have $357,867 at age 65 before inflation and federal taxes. But what if Uncle Sam taxed you at a marginal rate of 25%, and what if the inflation rate over that 45-year period had averaged 2% per annum? Taxes would transform your ending balance to $212,516 and the distressing combination of taxes and inflation would reduce your spending power to $87,173.
Well, your $357,867 didn’t completely disappear, but once Sam takes his cut and after being subjected to the ravages of Izzy the Inflation Monster, you are left with an anemic purchasing power of $87,173 in retirement. In short, $4 in savings is reduced to $1 in purchasing power.
Perhaps you should start saving and investing at age 10.
Just a thought.
Investing is as complicated as we choose to make it. And investors seem to veer in the direction of complexity in their eternal pursuit of ever higher returns.
As a younger man, I fell victim to that pursuit, too, and it took several years to find my way out of the forest. Like so many young folks who achieve a bit of success, who now have a few extra dollars to invest, and who credit themselves with investment skills not yet learned or that simply don’t exist, it seems to be part of the maturation process. It doesn’t have to be. The hard part of saving and investing is the saving part. But for the moment, let’s talk about the investing part.
There’s a good bit of luck involved in playing the stock market game. Regardless of the amount of time spent researching, it’s very difficult to predict the future variables that affect even a “can’t miss” stock. In my own case, after years of being both right and wrong judging (guessing) market moves, a very cursory study of my success as an investor became self-evident. On balance, to put it kindly, I was barely breaking even. Not being totally muleheaded, I stopped researching individual stocks and started searching for a better investment strategy. One soon caught my eye – a controversial and somewhat revolutionary new product: THE INDEX FUND (click here to play video).
John Bogle, iconic founder of The Vanguard Group in 1974, created the first credible index fund available to the general public. It roared to an most inauspicious beginning. According to Bogle, the fund’s initial public offering (IPO) in August 1976 “may have been the worst underwriting in Wall Street history”. The IPO’s initial target was $250 million. It fell short of that goal by roughly 95%, and for the next decade, struggled for attention. Its results seemed to be attracting more criticism than new investors, but Bogle, being a patient man, believed that the concept could not be long ignored.
Still, a strategy of simply tracking the broad market was almost totally rejected as an investment plan and quickly became known as “Bogle’s folly”. Fidelity’s Edward Johnson scoffed at the thought that most investors would be satisfied with receiving average market returns (I call it "Dare to be Average") on their fund investments. Bogle’s feeling was the exact opposite, that index funds could provide investors, large and small, with the most effective stock market strategy of all time.
In his mind, the strength of the S&P 500 Index investment strategy was to buy a broad stake in American business and hold it forever. And because it was a passive investment requiring little management, it could be held long-term at a very low cost. In short, index fund owners would become that rarity among investors – long-term owners of stock, a valuable counterweight to the prevailing view of most market participants. And that this countervailing market force could be enormously important to small investors as well as to society in general.
In my mind (an oil industry graduate), John Bogle (who died January 16, 2019) was the personal investment industry’s George Mitchell. To those not familiar with George, he was Mitchell Energy’s CEO – a long-time wildcatter whose tenacity reordered the world’s energy dynamic by insisting that crude oil and natural gas entrained in rock could, indeed, be economically recovered. Every time you pull into a gas station, you should thank George for his stubborn streak. And every time you check your Roth IRA balance, thank John Bogle for his own brand of stubbornness.
Bogle, like Mitchell, was a man of vision who thought outside the box. Those studies I mentioned earlier kept revealing an unsettling result to the staid investment industry’s active manager proponents. Low-cost funds kept winning the “yield war”, which began to dispel the collective Wazoos’ notion that investors must pay more to get more…the antithesis of Bogle’s notion “that investors as a group not only don’t get what they pay for, they get precisely what they don’t pay for.” Without question, part of the out-performance of index funds is directly attributable to their lower operating expense ratios. In short, indexing’s low-cost effect means the investor keeps more of what his or her fund earns.
According to Vanguard studies, from 1976 to 2016, indexing saved investors close to $153 billion!
It’s true that 20 percent or so of the managed (active) funds outperform index (passive) funds on an annual basis, but it’s seldom the same 20 percent!
Today, broad market index funds modeled on the original Vanguard fund rule the roost, a general recognition that Dare to be Average has become a more commonly accepted practice among small savers in the investment community. This is why it plays such an outsized and important role in this blog’s strategic model.
I’m not suggesting that you invest exclusively in Index funds. I am suggesting, however, that small investors new to the game use an index fund strategy around which to build a portfolio based on those PDQ Principles – Patience, Diversification and Quality – that I talk so much about. And keep it simple.
The latest dream (occasionally realized) among millennials is to become financially independent and retire early (a movement called FIRE) – a dream about retiring before or by age 40. As I understand it, the plan is to retire from a 9-to-5 regimen, but not to quit working. In short, these folks want to spend the rest of their post-40 lives doing what turns their crank. Of course, this kind of independence from the grindstone requires money. It can be done, but because it does require money, it also requires a huge dose of discipline at a very early age – an ingredient missing in the makeup of many people, including I suspect, quite a few of these potential FIRE devotees.
The easiest path, of course, is for a Millennial or Gen-Zer to carefully select his/her parents. I know! I know! I’m being a bit facetious here, but stick with me. These parents don’t have to be super-wealthy (like, Bill and Melinda Gates wealthy) or even Wall Street or Hollywood rich. However, having financially secure parents who possess an entrepreneurial spirit might help. After all, wouldn’t it be advantageous to have parents who could provide opportunities for kids to generate $6,000 per year (in after-tax income) to fund a Roth IRA – quite the challenge in my rather blithe example since the kid must have the means to generate real “earned” income.
Note to parents: Gifts don’t work. In short, the kid must generate his/her own income, file a federal tax return, and pay tax, if due, on the net earnings.
While we're talking IRAs, here's my synopsis of the SECURE Act recently passed by Congress. As of Jan. 1 of this new year, there are new rules and regs that affect the IRA funds you bequeath kids and grandkids.
What, you exclaim? A baby…a preteen…a teenager earning those kinds of bucks? That’s why I mentioned entrepreneurial parents. It’s not out of the question. If, for example, the family owns a business, they might hire the kid to appear in commercials until said kid can perform other tasks for the company – or for third parties. By the way, an advantage to the family business is that the kid’s income is tax-deductible and more than likely taxed at a kid’s lower rate.
Part of the discipline I mentioned earlier is that the parents work hard at instilling in their kid a “savings mindset” such that the kid will continue setting aside $6,000 (the 2020 IRA limit) of their annual earnings for a Roth contribution. This is important because, as the kid matures, he/she will be able to earn larger amounts of net income, and hopefully, will want to continue to contribute $6,000 of this income stream annually to the Roth IRA.
Now, I know my “parent selection” example is farfetched (after all, it is a fairy tale), but where there’s a will, there’s a way. One thing that works in parents’ favor is a constantly swelling account balance in the child’s Roth IRA. Let’s throw out some fairy tale numbers befitting our fairy tale example, which assumes an annual $6,000 contribution (beginning at birth). Let’s invest it in a Vanguard Total Stock Market Index Fund and further assume a 7% annually compounding rate of interest going forward. All things being equal, this plan will produce $260,500 after 20 years, $1,312,400 after 40 years, and $7,919,400 after 65 years (in each case before inflation). And because this is a Roth IRA, no taxes are due on all distributions from the account (once a kid reaches retirement age). But beware of certain withdrawal penalties that come into play prior to reaching age 59½.
Aside from producing over $1,000,000 by age 40, my example also demonstrates The Amazing Power of Compounding, the “greatest force in the universe”, according to math genius, Albert Einstein. Additionally, it demonstrates the importance of my own PDQ Principles…Patience, Diversification and Quality…and a little bit of parental luck-of-the-draw. Not one in 10 million families will follow this fairy tale example using good and valid excuses, but why agonize over the loss of $7,919,400? It’s only money (and a stress-free retirement).
My fairy tale point is this, a kid has the advantage of time over adults. For this simple reason, even less than maximum contributions to a Roth can expand exponentially due to exposure to The Amazing Power of Compounding for a long period of time. And youngsters who receive parental encouragement to save (like I did) are more likely to develop good financial habits – habits that increase their future chances for financial stability.
In a future blog, I will present a more age-specific and detailed version of how to use a Roth IRA to build wealth for kids. A version that fits my blog’s primary premise: Because time is money and money is time, it’s crucial that young people start saving (and investing) early in life to optimize The Amazing Power of Compounding. Little else matters in personal finance until we learn not to violate this fundamental principle.
Fair warning to parents who don’t encourage their kids to save and to develop good financial habits. In 2017, $86 billion of student loan debt was owed by Americans aged 60 and over (Source: TransUnion). Some of this debt resulted from older folks going back to school for retraining in the wake of the recent Great Recession. But much of it resulted from parents taking out loans to help pay for their kids’ college expenses.
It’s now timely to replace my rather far-fetched fairy tale scenario with a big dose of reality. Which means it’s time, in future blogs, to take a harder look at Index funds and those fantastic IRAs mentioned in this and previous blogs.
Happy holidays! I hope you spent the last few days exactly as you wanted to - with family and friends, holidaying or relaxing, or even working if that is what brings you great joy! WynnSights just celebrated six months of life on Christmas Eve so I want to take this opportunity to thank everyone who has set eyes on this blog, whether it be once or several times, because you are what really brings it to life! If you ever have an idea for a blog post, or a question or subject you'd like me to explore, please email me and I will do my best to oblige!
Now...I am sorry to switch the mood from joyful to somber, but I would be remiss if I did not share and comment on breaking news in the IRA world. Here goes...
Last week Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act that made several changes to retirement account rules. And as the old saying goes, Congress giveth and Congress taketh away. Their year-end spending package will limit a very popular feature of traditional and Roth IRAs – the ability of savers to extend the life of their retirement accounts by leaving unspent balances to much younger heirs (e.g., grandchildren).
After December 31, 2019, certain young heirs will no longer be able to take required withdrawals over their lifetimes, greatly limiting the time they can receive tax-free or tax-deferred compounding. Beginning in 2020, many heirs must withdraw inherited IRA assets within 10 years rather than based on their own life expectancy (called “stretching”).
Even top Republicans, many on the House Ways & Means Committee, including Kevin Brady of Texas, supported this heist. Brady’s reasoning (summarized): Tax-favored retirement funds should be used for the owner and spouse’s retirement security, not as wealth succession management tools.
Don’t you love it when Washington politicians tell you how to plan your financial future, and then change their mind on a whim? Most graciously (sarcasm), they exempted surviving spouses from this revision of the rules – rules that will highjack certain affected IRA beneficiaries of an estimated $16 billion… call it a tax increase if you’d like… over the next decade (Source: Joint Committee on Taxation).
Happy New Year! (It's a Congressional election year, by the way!)
You may recall my August 2019 blog titled “Hypothetical Henry” in which we discussed the benefits of establishing a 529 account for the educational benefit of children and grandchildren. In that blog, I also mentioned that a youngster with earned income might consider opening a Roth IRA retirement fund. Then again, the kid might prefer to utilize that earned income in ways other than for IRA contributions (yah think?). Well, Gramps, it’s the Christmas season… a time for giving. What better opportunity to discuss the subject with your “employed” grandkids… to create Roth IRAs by offering to make the annual contribution or to match any contributions the kid(s) make. Who knows? This benevolence just might gain their short-term awareness despite its long-term implications.
Of course, your total contribution can't exceed a given grandkid’s earned income – or the tightfisted IRS’s annual limit, whichever is smaller ($6,000 in 2019 and also in 2020). In any event, Gramps might consider “matching” up to his grandkid’s earned income amount, effectively making the IRA contribution himself (i.e., if the grandchild earns $6,000 at a qualifying summer job, Gramps can offer to let the grandkid spend his or her money on other things while Gramps contributes a portion or all of the $6,000 IRA contribution limit using his own funds). The IRS doesn’t give a hoot who makes the contribution so long as it doesn’t exceed the child’s qualifying earned income for the year. By the way, those matches are additive to Gramps’s annual gift exclusion limits.
WynnSights' objective is to incentivize grandkids to start saving and investing for the long-term while still young. In short, to develop the discipline to “save and invest early and often”. The ultimate reward can be huge. And Gramps, if you’re able, contribute the total allowable amount. If not able, be as generous as possible with your match. For example, if the grandkid has $6,000 in earned income but only wishes to contribute $2,000 to a Roth, Gramps can match the grandkid’s contribution 2:1 and still stay within the child’s earned income limit and those restrictive IRS rules.
Although saving for retirement is likely the last thing on a youngster’s mind, most grandkids will find it intriguing that a small investment today can grow into a rather sizable nest egg later. Without instruction, grandchildren might not immediately understand the concepts behind compounding, but they will likely appreciate the fact that their Roth IRA balance is growing. It never hurts to provide examples of the Amazing Power of Compounding – how even small contributions can mushroom into large numbers over time. One tight-fisted Grandpa I know contributes $2,000 per year to each of his kids and grandkid (for 25 years in the specific case of the oldest). Let’s assume in the oldest child’s case, that the $2,000 per annum has earned 7% per year compounded annually to date and will continue to do so for another 20 years. What will it be worth at the end of 45-year period (assuming Gramps hangs around those last 20 years)? A cool $693,000 before inflation… not a bad series of Christmas gifts from the old dude. By the way, since a Roth IRA is a retirement account, income levels could affect contribution amounts along the way. Teenagers aren’t likely to reach those high-income thresholds early on, but later in life they might.
Aside from watching the money tree grow, Roth IRA earnings over the long-term will never be taxable, Roth assets are protected from creditors with a few narrow state-specific exceptions, there are no RMDs (required minimum distributions) later in life, and those “compounding” benefits associated with early contributions can be substantial at retirement. These pluses, of course, assume that Congress keeps its mitts off existing IRA rules and regulations during future legislative sessions¹.
By the way, when an adult opens an IRA account for a minor, it must be in the child’s name as well as in the name of the adult custodian (parent, grandparent or guardian), which introduces certain disadvantages and risks. At age 18 that child or grandchild would gain full control of the Roth IRA and might decide to…shall we say…dip into it. Should such early withdrawals occur, the cumulative annual contributions can be withdrawn first with no tax or penalty. After that, all subsequent investment gains withdrawn would be taxable to the child or grandchild, and subject to early withdrawal penalties if they don’t meet certain IRS “qualified distribution” standards.
Aside from those previously mentioned pluses, the value of teaching your children and grandchildren the importance of saving, the basics of investing, and the discipline to leave a quality portfolio (think low-cost, highly diversified index funds) undisturbed until retirement cannot be overstated. What better way to contribute to your progeny’s future financial well-being than by creating and donating to their very own Roth IRA – accompanied with the reasons why you’re doing it.
As I’ve mentioned in prior blogs, according to that gifted intellect, Albert Einstein, the greatest invention in human history was… you guessed it… compound interest. Try it on for size!
Because it can be so consequential to your long term financial health, I want to dedicate another blog to demonstrating the impact of paying too much for mutual fund annual operating expenses. What may seem immaterial in the short run can cost you big bucks over the long haul. If you are have trouble playing the video below, you can access it through this link: https://youtu.be/A0AIcy7xeNwhttps://youtu.be/A0AIcy7xeNw
Jack Bogle, the now deceased Vanguard icon, was known for his famous utterances, among them, that Vanguard’s fund owners and others benefit from “getting what they don’t pay for”. To point out the significance of this statement (using Bankrate’s Mutual Fund Fees Calculator), let’s measure the cost of Vanguard’s average expense ratio, currently 0.11%, against the industry’s 0.62% average, and determine its impact on a 30-year, $100,000 front-end investment yielding 6%.
To summarize how Wazoos can fleece you over time, after investing $100,000 for 30 years at 6% and while paying .11% vs .62% in average annual operating expenses, the hypothetical Vanguard investor would end up with over $79,000 more of value in his/her account by saving $37,000 in fees. This savings would allow the Vanguard investor to earn an additional $42,000 by avoiding the opportunity cost associated with those fees. Over the long haul, fractions of a percent do make a difference. Better to have the difference show up in an investor’s account than in a Wazoo’s wallet. Reminds me of the old saying, “Watch the pennies and the dollars will take care of themselves.”
No wonder the late Mr. Bogle is given credit for savings billions of dollars for millions of large and small investors who are now taking advantage of the lower fees he forced on the financial industry.
By the way, another “opportunity cost” we often impose on ourselves is keeping too much cash in non- or low-interest-bearing bank accounts or with those certain brokerage firms paying next to nothing. It’s estimated that $9 trillion lounge in such accounts paying about 0.09% or less (Source: Crane Data). A quick check of my Vanguard Group taxable Federal Money Market Fund revealed a YTD yield of 2.11% as of 12-11-2019. This spread between what banks and money funds pay is in a constant state of flux so keep an eye on it.
The latest “fad” among many of the brokerage firms (Schwab, TD Ameritrade and E-Trade come to mind), is called free trading. It ain’t free, folks. Many of those firms who advertise free trades make up the difference by sweeping customer cash into lower yielding deposit accounts, investing it at a higher rate for their own account and keeping the spread. In fairness, a couple of the big boys don’t participate in this sleight of hand…Fidelity and Vanguard. Their retailer accounts’ idle cash is swept into higher yielding money market accounts, benefiting their investors.
Of note, money market mutual funds (short-term securities whose value fluctuates very little) aren’t backed by the government, while bank savings accounts are federally insured against loss, generally up to $250,000.
Despite a major shift by mutual fund providers in recent decades to low-fee options, a surprising 21% of all U.S. Large Cap funds still have expense ratios above 1.5% (source: Morningstar, Inc.). Notably, many of these same high-fee funds also have elevated levels of risk and a portfolio turnover of double the low-fee options. High portfolio turnover invariably leads to higher tax bills associated with the inevitable increase in short-term capital gains.
According to a survey by the Investment Company Institute, a fund trade group, 22% of households that own mutual funds said the fees and expenses they pay “are not very important” or “not at all important”. In a study commissioned by the US Securities and Exchange Commission (SEC), 25% of investors said they didn’t even know which types of fees they pay (while 20% said they didn’t pay any fees at all – yeah, sure). I shudder when I read tidbits like this. And I’ll show you why using some examples.
Studies indicate that investors – busy… or apathetic – seldom get what they pay for when buying “high-fee” mutual funds. A January 2019 Wall Street Journal article by Derek Horstmeyer, an assistant professor of finance at George Mason University’s Business School, sheds light on the detrimental long-term costs of high annual expense ratios (expense ratios are the annual fees expressed as a percentage of assets under management) that accompany many actively managed mutual funds – expense ratios often associated with “some of the worst performing, most poorly managed funds especially in the U.S. Large and Small Cap Fund categories”.
Although that “increased” annualized yield for investing in a low-fee fund (one charging less than 1.5%) versus a high-fee fund (over 1.5%) is largely an across the board phenomena, it is particularly noticeable in the U.S. Large Cap category. Over a 10-year period through the 3rd quarter of 2018, the high-fee category delivered an average annual return of 10.61%, after expenses, while the low-fee option delivered 12.26%, a positive difference of 1.65% percentage points.
The underperformance of high-fee funds was even more pronounced when considering the category of funds charging a ratio of 2.0% or more. In this case, the 10-year high-fee fund yield fell to 10.01%. The underperformance of high-fee funds impacted other asset classes, too, but to a lesser degree. In the case of U.S. Small Cap stocks, the average 10-year overperformance of low-fee funds was .73% points and for International Equity funds, 1.10%.
To illustrate the potential financial penalties associated with high-cost funds, let’s use a simple hypothetical of a high-fee investment of $10,000 increasing at an annualized rate of 5.35%, compounded annually during a 40-year career. After 40 years, the initial onetime investment of $10,000 would be worth about $84,000. Using the same assumptions but changing the annualized rate to 7.00% (to reflect a reduced fee of 1.65%), the low-cost fund would be worth over $160,000 after 40 years, a dollar improvement of $76,000… almost double the high-cost fund. As noted earlier, that 1.65% improvement in yield (due strictly to reduced fees) during a 40-year career can be really significant.
Vanguard’s founder, John Bogle, often said, “The grim irony of investing is that, as a group, investors not only don't get what they pay for, they get precisely what they don't pay for." In short, every dollar you save by investing in a low-cost, unmanaged index fund is a dollar of return that benefits you, not some fund manager.
To ignore the realities of investing in high-fee versus low-fee mutual funds is a mistake as egregious as not optimizing a 401(k) plan employer match (FREE MONEY) at your workplace. I wouldn’t call such an action foolhardy, but I will be so bold as to call it a bullheaded pursuit of a costly million-dollar habit.
My motive for pointing the Horstmeyer study to a wider audience is purposely transparent. It’s another incentive to build a portfolio of funds around a low-fee, broad market index fund – or perhaps, simply stick with an all-index fund portfolio.
In any case, always try to invest at the lowest possible cost.
By eliminating what I call Million-Dollar Habits, (e.g., failure to exercise spending discipline, smoking or vaping, excessive dining out, etc.), almost all of us will rediscover a few dollars we didn’t know we had – enough dollars, at least, to initiate a meaningful savings program in advance of when most people start saving.
Shoot, I’ve had astute but cash-strapped young couples – particularly those with new babies or those buying odds and ends for apartments or first homes – tell me they easily save $100 a month by shopping at Goodwill. Not interested? Try it, you might like paying 10-15 cents on the dollar for virtually new items (toys, baby clothes, kitchen items, knickknacks, etc.).
The savings ingredient in investing is simple, yet critical. If you don’t start saving early in life, you miss the cornerstone of what makes The Amazing Power of Compounding amazing (for a more detailed explanation of compounding, go to my blog titled Before You Get Rich You've Got to Master the Basics). To demonstrate your potential loss, let’s resurrect my stale old example of saving $100 per month, investing it in a Total Stock Market Index Fund (hopefully in a Roth IRA), earning 7%, compounded quarterly, for 45 years. What does it get you? Close to $380,000 before inflation upon retirement. And that’s in addition to Social Security, your 401(k) and other shrewd investments you make along the way.
By the way, you’ll soon learn that I stress simplicity throughout my blog postings, but let’s be quite clear about simplicity. The simplest things in life are very often hard to do. And saving early and often is one of them. You’ll quickly learn why if you haven’t already experienced it.
In an early posting on my daughter’s blog, I introduced those very clear, very simple, very basic principles that I try to adhere to in my own investment program: the PDQ Principles. These principles hold to yet another important principle – that most successful investors are also reliable savers who adopt an investment strategy that combines patience with a portfolio of diversified, quality assets, and then dare to be average! I will devote a later, more detailed blog on daring to be average, where the term is applied only to investing. And, of course, the PDQ Principles strategy, like all savings strategies, requires discipline.
Humankind tends to complicate things far beyond what is usually necessary. Complex strategies are mostly devised by a group of folks I endearingly call the Ivory Tower Boys (Wazoos) who help the average small investor not one whit! And it’s the “small investor” I want to help, a category that includes me. This green eye-shade, Wall Street crowd devises complicated strategies to convince you that you need them to uncomplicate what they’ve creatively complicated. Granted, complex fortunes (the billionaires among us) require greater sophistication, but most of us don’t have complex fortunes. We save a few bucks a month to invest somewhere that, hopefully, over time will grow into a meaningful retirement fund. And the process does not have to be complicated. In fact, it can be quite simple…the simpler the better.
Don’t be fooled by all the bulls**t. And those green pastures (the internet) are littered with that commodity. Some facts are good to know, but you don’t have to possess a full vocabulary of buzzwords. Join me in this effort. Toss most of this recently digested hay aside, adopt a few basic principles of saving and investing, and over time, you will accumulate a nice nest egg for retirement. And yes, you do have the time. Question is, do you have the discipline? All it involves is spending less (saving) by simply delaying gratification – and avoiding those Million-Dollar Habits.
To sum it up, let me quote the small investor’s dearly departed friend and Vanguard founder, John Bogle who said, “Beating the market is a zero-sum game for investors. Money managers, as a group, must provide the market return, but that return comes only before their exorbitant fees, operating expenses, and portfolio turnover costs are deducted. The zero-sum game before costs becomes a loser’s game after costs.”
In his highly publicized support of index funds for the little guy, Bogle also wisely counselled, “Don’t look for the needle in the haystack. Just buy the haystack.”
I have repeatedly stressed the importance of three basic ingredients of saving for investment: time, money…and discipline.
The more time you spend saving, the greater your potential reward. That comes as no surprise. And the more money you save, the greater your potential reward. But without discipline, the simple act of tucking money into your savings account every single month, you WILL fail to achieve your optimal goal.
That’s not a criticism, that’s just a fact.
We’re addressing two very important concepts here: (1). The Time Value of Money and (2). The Amazing Power of Compounding – concepts that are inextricably linked. Let’s use a simple example. If you save $100 per month for 45 years and hide it faithfully in a can buried in the back yard, you’ll end up with $54,000 at age 65, a tidy sum. However, if you save $100 per month and invest it in a low-risk, tax-advantaged investment account (a Roth IRA) paying 7%, compounded monthly for 45 years, you’ll end up with $384,000 at age 65.
Money held as cash, uninvested, has no worth beyond its moldy face value regardless of its time spent in the can (I could mention that it actually loses purchasing power due to Izzy the Inflation Monster but that’s a blog for another day). The same money invested at 7%, compounded monthly for 45 years clearly indicates The Amazing Power of Compounding over time. That’s why discipline is so important in any saving and investment strategy.
Save early, save often, do it without fail, and do a good job of investing it wisely. And please…please…avoid dipping into the till along the way.
During my previous blog posts, I’ve used terms and phrases that require some definition and clarification. Yes, you’ve heard them before, but I want to focus your attention on their importance in developing and carrying out a personal finance plan. I’ll list them in alphabetical order (ignoring the pronoun “The”).
Most financially successful people get that way not through business innovation but by optimizing compound interest on their savings and investments. An important lesson they learn early is that a saver can contribute less now than more later to enjoy the same ultimate accumulation of wealth. A simple example: If a 22-year-old invests $1,000 on January 1 at 7% per annum, next year the investor will have $1,070. The following year, the investor will theoretically gain the same 7% on the initial $1,000 plus the $70 earned last year, which would increase the investor’s balance to $1,145. In 10 years, the investor’s initial $1,000 would grow to $1,967. Upon retirement, at age 65, that single initial investment of $1,000 will have grown to $18,344. Alternatively, to achieve the same nest egg of $18,344 at age 65, a single initial investment at age 32 would need to be $1,967. The magic came from reinvesting the principal plus earned interest every year.
Next to saving, one of the hardest thing to accomplish as an investor is daring to be average. It’s an index fund’s essence, its overriding fundamental. Think about it, if you invest in a Total Stock Market Index fund, or less broadly, an S&P 500 Index fund, you’ve deliberately chosen to be satisfied with a broad market yield. “Why,” you ask, “would I want to just be average?” Truth be told, you’re not just being average. Study after study of index (passive) fund results show that over time, they outperform managed (active) funds. And those managed funds that outperform index funds represent a moving target from one year to the next. In short, here today, probably gone tomorrow.
Beating the market is hard to do. Accounting for what’s known as “survivorship bias” (the attrition rate of poor performing mutual funds), over a very recent 15-year period, roughly 92% of large-cap funds lagged the yield of a simple S&P 500 index fund. Mid-cap and small-cap funds lagged their benchmark indexes even more: roughly 95% and 93%, respectively. In other words, the odds that you’ll do better in an actively managed domestic fund (versus an index fund) are about 1 in 20. That’s why I dared to be average years ago! Certain “friends” told me that, in my case, being average probably came naturally.
An investment technique that involves buying a fixed dollar amount of shares of stock or units of a mutual fund on a regular schedule (say, the 15th of every month), regardless of the share price on that date. In short, the investor purchases fewer units or shares when prices are high and more units or shares when prices are low. A side benefit is that it just might reduce the inclination of an investor to make purchases in a frothy market or sales in a bearish market.
Behavior patterns that, if not modified or completely corrected, could wind up costing an individual hundreds of thousands if not millions of dollars over a lifetime. The most commonly abused such habit is Impulse Buying (more about impulse buying later).
The one-step formula used to estimate the number of years required to double invested funds at a given annual rate of return (i.e., if an investment promises an 8% annual compounded rate of return, it will take about 9 years to double the invested money (72/8 = 9). The Rule of 72 applies to cases of compound interest, not to cases of simple interest (see below). Alternatively, if you divide the number of years (within which you want to double your money) into 72, the result is the approximate yield you’ll need to earn to achieve your objective (72/9 = 8%).
A calculation of how much an individual can “safely” pull from a retirement portfolios on an annual basis without significant risk of long-term depletion. Fair Warning: you’ll get about as many answers to the “safe” withdrawal rate as the number of people you ask the question.
This simple maxim is attributable to those wise parents and financial planners among us. In any event, because Time is Money, it’s always wise to start saving as soon as possible… not when you’re hired part- or full-time right out of high school or college, but RIGHT NOW!
Used for calculating interest on investments where the accumulated interest is not added back to the principal (i.e., multiply the principal amount by the daily interest rate and by the days that elapse between payments). Yeah, I know, you learned that in grade school.
This simple maxim is often attributed to the wise and witty Benjamin Franklin. He reinforced its meaning by simply stating that if a person skips half a day of work, he forfeits half a day of wages. Let’s apply this maxim to a delinquent saver using The Amazing Power of Compounding above. Had our saver waited until age 40 (instead of age 22) to start saving, to reach the same goal of $18,344 at age 65, he would have to make an initial contribution of $3,380 instead of $1,000. In short, if you don’t start saving until later in life, your required initial contribution will necessarily be larger to reach the same goal at age 65.
This simple concept recognizes that cash in hand is worth more than the same amount of cash received a year from now. Why? Because cash in hand can be invested to earn income during that year (not sure how that applies to birds).
The U. S. Treasury Department’s Internal Revenue Service and its impulse buying sidekick, the U. S. Congress.
Another maxim often incorrectly attributed to Benjamin Franklin (and frequently used by my father), but first coined by William Lowndes, a long-ago Secretary to the Treasury of Great Britain who used pence and pounds. Impulse buyers might keep this old maxim in mind while shopping.
Those intellectual, highbrow, disdainful investment advisors who attempt to convince us that investing should not be simple; that they alone can introduce order to the market’s chaos with their complex investment theories.
This simple rule of thumb states that whatever your age is should dictate the percentage of your portfolio that should be in fixed income (bonds). The rest would be in equities (stocks). For example, a person aged 65 would have 65% of his/her retirement portfolio allocated to fixed income (bonds). I’m not completely sold on this formula because it exposes investors to the ravages of Izzy the Inflation Monster. There will be an upcoming blog on the long-term impact of inflation on saving for retirement. You’ll be surprised how damaging it can be.
The average family only saves a little more than a $100,000 or so by the decade leading up to their retirement.
When you associate that number with the fact that 50% of all individual Americans age 65 and older have annual incomes in the range of $24,000 – far less than what most need to meet living and healthcare expenses – it’s reason to wonder how they plan to financially navigate the 10-20 years many will spend in retirement.
In last week's blog - "Excuses for Not Saving in Your 50s" - I mentioned various options that delinquent non-savers might pursue to bridge the gap between a “no worries” and a “high stress” retirement resulting from a lifetime of deficient personal financial management. Today, I want to remind my readers, particularly the young ones, that there’s a better way. One that, in conjunction with an increasingly unstable Social Security program, should provide a more secure retirement (85% of Americans 65 and older draw Social Security that ultimately will require some political attention to ensure its long term availability).
The key to a secure retirement is not rocket science. You need a plan. And it’s never too late to develop a plan but right now is best. I’m talking in your 20s; certainly no later than your 30s. And build that plan around a simple set of principles – the PDQ Principles come to mind…Patience, Diversification and Quality. But first you must save. Once you develop the habit of saving on a routine and consistent basis, then you apply these principles.
As I’ve stated ad nauseum, keep it simple. Build your portfolio around a low-cost index fund (S&P 500, Total Stock Market, etc.). Such a fund automatically provides you with diversification and quality, and a steady and routine savings habit necessarily embodies patience. And remember, you need to employ all three principles together. Now, let’s provide a simple example that demonstrates both The Amazing Power of Compounding and the importance of Daring to be Average (an index fund, in essence, yields the market rate of return…no more, no less) .
Let’s assume that you’re a 25-year-old high school or college graduate that earns $50,000 per year; that you save 10% of your after tax salary – about $400/month; that you create a Roth IRA and invest in a Total Stock Market Index Fund; and that the fund earns 7% per year, compounded quarterly for 40 years. Using a Bankrate calculator, upon retirement at age 65, your Roth would be worth $1 million before inflation. To demonstrate the amazing power of compounding, using the foregoing numbers, had you deposited the money in a bank account earning a fraction of 1 percent, you would have ended up with less than $200,000.
Everything discussed in this blog is “old hat”. We’ve been down this road before. My point is simply this. Based on statistics year-in, year-out, folks keep arriving at retirement’s doorstep financially ill-prepared for 10-20 years of retirement living. There’s a better way.
My example is strictly hypothetical, but it’s a gentle reminder that, while young, with a bit of prior planning and by developing a few good habits (no, not those million-dollar spending habits), an individual can enter a “stress-reduced” retirement phase of life simply because of good financial planning.
Try it. You might like it.
I’ve spent three recent blogs discussing the various excuses made by the 20-, 30-, and 40-something age groups for not sufficiently saving for retirement. I now introduce the reasons that 50-somethings don't save and what it means for them if they only have $100,000 or so socked away right before their 6th decade of life - with retirement right around the corner. I'll pause here while you watch the video that features those excuses...
As mentioned, for the most part, the average family had socked away little more than a $100,000 or so by the decade leading up to their retirement. And how inadequate that sum of money would likely be – in combination with Social Security – to navigate perhaps the 15-30 years many folks will spend in retirement. So what do these delinquent non-savers do to bridge the gap between a “no worries” retirement and one filled with the stress and strain emanating from poor financial management during those earlier years?
The first thing that pops into my head is to suggest that these “late savers” keep working beyond the normal retirement years. Some folks do this anyhow because they enjoy what they do and have no desire to hang up their spurs. But so often, these are the very people who do not need to continue working. In any event, to keep working is a choice many people will have to make. That’s assuming it remains a viable option. Studies show that over half of retirees actually quit working earlier than expected because of ill health, layoffs, or the development of unexpected responsibilities such as taking care of elderly family members. The list of reasons forcing early retirement are many and seldom anticipated. As insurance against the unexpected, a backup plan to the “work option” is always wise.
It’s not uncommon for those with inadequate savings to enter the retirement years saddled with a mortgage on their home. A home in which they raised their family, but an empty nest that is now too large for an aging couple or a surviving spouse. And even if a mortgage no longer exists, upkeep and property taxes continue to take an outsized bite from those Social Security checks and what little income (or some small portion of the principle) their savings produces. Still, downsizing can often reduce the carry on a home both in maintenance costs, utilities and property taxes – unless the aging seniors suffer the misfortune of living in an area where a newer, smaller home can cost as much as a larger, older home. In short, downsizing is not foolproof, but it’s an option particularly when one considers that age and/or infirmities ultimately become factors in caring for a home. And remember, those savings resulting from downsizing, like yields on investments, compound over time.
While speaking of mortgages, folks approaching retirement with inadequate savings should pay particular attention to debt (and living expenses in general). Any family, young or old, carrying too much debt is less likely to save enough for retirement. And once a family reaches that “decade before retirement” threshold with inadequate savings, it becomes extremely important to concentrate on debt reduction, particularly credit card debt. An effective way to do this is to get out those scissors. Cut up the cards. Or at the very least, pay off the balance(s) each month. In short, fine-tune that monthly budget (assuming you have one). Be ruthless in cutting back on needless purchases. For starters, quit dining out so much. Cut back on movies or those monthly subscriptions to all of that fine TV entertainment. How about slimming down the travel budget or eliminating those low-probability lottery tickets? And do you need the very latest in electronic gadgetry? In short, take another hard look at your Million Dollar Habits… the very habits that might have contributed to your unfortunate financial predicament in the first place.
A common surprise is that, despite the government charts, many retirees underestimate their longevity – their time spent in retirement. And along with that underestimation comes a plethora of other surprises… often ordinary but very inconvenient costs. Just because you’re older doesn’t mean the AC won’t go out, a termite invasion won’t occur, the washer and/or dryer won’t quit, or the house won’t need a fresh coat of paint. Nor does it mean that an elderly parent or an adult child won’t need financial help. Or that a bright young grandchild won’t need some assistance in meeting tuition payments. Even for those who did a good job saving for retirement with IRAs and such, reaching age 70½ can have some unexpected negative consequences. I’m talking about those Required Minimum Distributions (RMDs) that must be withdrawn whether or not needed to buy groceries. Although RMDs are always nice sources of retirement income, they shove a surprising number of retirees into higher tax brackets (yeah, I know, you thought your tax rate would go down with age). And because of those myriad stealthy Obamacare taxes, RMDs too often translate into increased Medicare Part B premiums, which are tied to annual income... another serious bite out of those Social Security checks.
In summary, the point of trying to catch up after entering the fifth decade of your life can be a painful process, but it’s time to stop kidding yourself about your true financial situation. Lay your cards on the table as you consider the available options. They may or may not be realizable options. You may not be able to work due to health issues or the lack of available opportunities. You may not be able to gain much ground by downsizing. Maybe you’ve already slashed your debt and expenses to the bone. Point is, you need to do something and a good place to start is to develop (at last) a plan… a budget you actually follow… a practical approach to the last third of your life.
And remember, It’s Never Too Late, But Right Now Is Best.
It seems reasonable to assume that most 40-somethings are individuals in their prime. Folks with 15-20 years of work and life’s experiences. Folks who’ve paid their dues and have incomes that reflect this experience and know-how. And hopefully, the college graduates among them have finally paid off those hefty student loans, freeing up disposable income for other purposes – including saving and investing, perhaps?
Oh, no! Here comes a new set of excuses. The mortgage payment is bigger because they bought a larger home in their late 30s or early 40s. And why? Well, an extra kid popped up and/or friends were buying larger homes. Must keep up with the Joneses…the Johnsons…the Jacksons. Also, those darn older kids need their own transportation – and the oldest one is heading off to college with the middle youngster already a junior in high school. And some of those Million Dollar Habits still lurk in the weeds.
Predictably, our 40-something seldom savers are far behind schedule in the median savings category with an estimated balance of barely $60,000 – not even approaching the old rule-of-thumb bromide of needing to save at least three times one’s salary by age 40. Fidelity recommends that individuals have savings of three times their annual salary by age 40. So, if your salary is $55,000, you should have a balance of $165,000 already banked; at age 45, four times their annual salary; and six times that level by age 50. Read more in The Average Retirement Savings by Age | Investopedia. Whether a family is behind schedule or not (being a bit of a pessimist, I’m guessing they’re behind), it’s time to start maxing out those 401(k) or 403(b) contributions. And while they’re at it, open one of those Roth IRAs and max that sucker out, too. To reach Fidelity’s benchmarks, consider putting salary increases toward retirement savings. And after paying off student loans, commit those payments to the retirement nest egg as well.
Did I hear you say, “Yeah, sure.” Well, just remember, you’re way behind schedule and the catch-up years are disappearing fast. In 2019, the maximum contribution to an IRA is $6,000. So, just do it! Get in a hurry. And quit smoking and impulse buying. You’re certainly not getting any younger and time is of the essence. Yes, you have good and valid reasons not to save – bigger mortgages, kids in or heading for college, and car payments stretching out beyond seven years, etc. But you also have good and valid reasons to save… and fewer years to do so.
Using the same assumptions as in previous blogs (saver invests $440 per month at 6.45% compounded annually) except for the new start date of age 40, here are the numbers: the median savings of the 40-something group is $60,000 versus the early saver’s group of $212,500; at age 50, using the new numbers, the savings of the 40-something group is $185,600 versus the early saver’s group of $470,500; and at age 65, the savings of the 40-something group is $605,700 versus the early saver’s group of $1,333,200.
The value of starting to save early in a career and the associated value of compounding bigger numbers for longer periods of time really does make a startling difference in how financially comfortable you are in retirement. In this hypothetical case, over $727,000 worth of difference. Holy Molyl! If only…
By the time young people reach their 30s, they are more experienced and valuable to an employer who, most likely, will reward these more productive employees with salary increases. Or, if they are young entrepreneurs, they will reward themselves by being more adept at managing a business and increasing its profitability. Yet, most of these 30-somethings – if college graduates – will still have an outstanding student loan, a spouse, and a starter home (mortgage) purchased to make room for a couple of kids - more excuses to not save money. After all, mortgage payments, credit cards and other debt must be paid. And those pesky kids are now involved in all kinds of activities. And the car is coming of age, requiring frequent repair. These are all good reasons to spend money – and to not save anything – or at most, not save very much.
By all accounts, it would be nice to save about three times one’s salary by age 40. But those stubborn government statistics indicate that most families have saved in the neighborhood of only $40,000 by this stage in life¹. Should we infer from this statistic that the family income is only $13,000? Of course not, but it most definitely is an indication that the 30-something family is “way behind the curve” in what it should be saving.
Remember the savings and investment strategy introduced in the 20-something blog (Oct. 4)? Let’s assume that another small percentage of families decide to become savers by ridding themselves of that insidious Million-Dollar Habit, smoking. Let's use the same assumptions as were used in last week’s blog, except that this group begins to routinely save at age 30 versus tucking away only a sporadic $20,000 like that 30-something group.
To recap those assumptions, beginning at age 30, the saver invests $440 of after-tax money every month in a Roth IRA, compounded monthly at 6.45%. Remember, at age 30, his/her savings account holds only $20,000; by age 40, it is worth $110,900 versus the early saver’s $212,482; by age 50, $280,761 versus the early saver’s $470,532, and by age 65, it is worth $848,600 versus the early saver’s $1,333,235 (for that 20-something kid who started saving at age 20).
Oh, the value of starting to save early in life and the benefits derived from compounding larger numbers earlier in the game! In short, by saving only occasionally during the first decade of a career, those excuses cost our sporadic saver over $484,635 in retirement savings (even though our sporadic saver began to steadily save after age 30).
Wait until you see what sporadic saving will cost those procrastinators in their 40s. That sad story is next (week).
¹Transamerica data shows 30-somethings have a median $45,000 saved. But to be headed for a comfortable retirement, ideally, the family should have about the equivalent of their annual salary saved as a nest egg at age 30, twice their salary at age 35 and three times their salary by age 40.
In their 20s, just after high school or college, most unskilled or inexperienced workers don't knock down much dough. Many were raised by parents who made the same excuses for not saving that their kids are now making. Parents who, like their kids, went to college on borrowed money, had a good time, lingered on campus a couple of extra semesters longer than necessary, worked some - but not too much - during summer and semester breaks, and finally graduated burdened with a rather hefty student loan debt.
Hey, I’m not being critical here – just stating the facts – well, maybe I'm being a little critical. And I’m not speaking just of student loan debt. There’s also credit card debt, car notes, mortgage debt, and personal debt of one sort or another that must be dealt with. As an aside and speaking of debt reduction, eliminate the costliest debt first – usually credit card debt carrying interest rates of up to an astounding 20%. But best of all, avoid debt whenever possible.
Unfortunately, because credit is plentiful, it’s easy to load up on debt in today’s world. For this and other reasons, most 20-somethings save very little by age 30. Many don’t save one thin dime. A common reason is that many 20-somethings believe that learning about personal finance is too difficult – with scant validity – largely a myth we hope to dispel with this blog. Give credit to a spidery financial industry (the Wazoos) working hard to spin the web that dealing with personal finances is SOOO COMPLEX. Well, it doesn’t have to be. Not if we keep a suspicious eye on the Wazoos. They’re experts at using fine print and acronyms to convince us. They develop elaborate schemes – not to enlighten us, but to convince us to let them manage our money (primarily to enrich themselves).
One of the big gaps in today’s learning process is that our educational systems no longer teach the rudiments of personal finance to youngsters. However, all is not lost. Twenty-somethings are still blessed with time, God willing. Lots of it. But when the time factor is mentioned, up bubbles the oft-used excuse, “I just don’t have any time to spend on budgeting or messing with my personal finances.” Hogwash! Most younger people do lead busy lives – mostly watching television² on average 19-25% of their waking hours, not to mention time spent shopping or pursuing hobbies. Okay, so we have 40 years-plus to make up for lost time but remember… time is fleeting. And the decade you can least afford to lose is the one right out of school.
Many folks work for employers that offer a “matching contribution” (FREE MONEY) in their 401(k), 403(b) and other savings plans. And these same folks can even set up their own IRAs – Traditional or Roth. We’ll define the various savings plans in greater detail as we go along. Question is, will new hires take advantage of any of them now instead of later? The statistics say not likely, at least not nearly to the extent they should. One good move by employers in recent years is to automatically enroll new hires in defined contribution savings plans. Experience shows that once enrolled, few drop out… a good thing. And that participation rates nearly double to 93% under automatic enrollment compared with 47% under voluntary enrollment.
This brings up that most troublesome of habits – deferring financial opportunities until tomorrow, always tomorrow. Remember that “It’s Never Too Late, but Early is Better”. It seems so obvious that the longer we wait to save… to invest… to pay down debt...the more we miss those fleeting opportunities for investment gains. And the most egregious missed opportunity of all is to NOT participate in an available 401(k) or 403(b) - to fail to take full advantage of the EMPLOYER’S MATCH – that free money mentioned above. Just remember, time slips away, and suddenly you’re – gasp – 30!!!
So, c’mon, don’t worry about personal finances later. Worry about them right now and do something about it. Remember, these bad habits – putting off saving, investing and paying down debt until later – affect us the most right now. The longer we wait, the more we miss out on potential investment gains and the glories of compounding.
To place all this palaver in context, let’s create a simple example of an investment strategy ignored by most of the 20-something crowd. In our example, we’ll assume that the average 20-something – college educated or not – starts making enough “earned income” (remember that term) at age 20 to save a few bucks if he/she chooses to do so. Further, let’s assume this potential saver gives up smoking two packs a day of cigarettes (the most egregious of the many Million-Dollar Habits). Twenty cancer sticks cost about $7.26/pack (average price of a pack of those “cowboy killing” Marlboro Reds). Our ex-smoker now has $14.52/day, including Sundays, or roughly $440/month to invest. Based on some unusually sound advice from a friend, the new saver decides to invest this windfall in a Vanguard Total Stock Market Index Fund that, since inception, has yielded roughly 6.45% per annum (no guarantees, the past is not prologue). Our new saver now routinely deposits the $440 into a Roth IRA and invests it in the Index fund. After investing $440 of after-tax money each month in a Roth, compounded annually at 6.45%, by age 30, his IRA is worth $74,365; by age 40, $212,482; by age 50, 470,532; and by age 65, $1,333,235! Yes, you noticed. I’m being terribly optimistic, but I’m trying to make a point.
Compare these numbers to those mentioned in a Government Accountability Office (GAO) study, which noted that median retirement savings for most Americans, in the decade after retirement (age 65-75), totals about $150,000, a far cry from the $1.3 million figure mentioned above. That pathetic figure belongs to those former 20-somethings who decided to keep smoking or who simply chose not to start saving during their 20s. The $150,000 could have been $1.3 million-plus. Coulda! Woulda! Shoulda! Who knows, maybe in their 30s, this smoke-saturated group finally joins the savers, but even so, this Johnny-come-lately attitude has already proved to be a costly mistake in terms of future investment earnings.
Almost 45 million Americans have student loan debt. We owe over $1.56 trillion ($521 billion more than the total U.S. credit card debt).
The average loan debt for the Class of 2018 graduates is $29,800¹ (69% of that class took out student loans). The average monthly student loan payment is $393. The student loan delinquency rate is 11.5% (90+ days delinquent or in default).
Source: U.S. Federal Reserve
The point of all this blather is that we must first become savers in order to make money as investors. And by the way, index fund investing is not gambling. More correctly defined, it is “calculated risk-taking” by investors who employ dollar-cost-averaging in a highly diversified portfolio and dare to be average.
In short, young investors need to develop a good investment strategy and stick with it over the long term – a strategy that offsets our gambling proclivities; that avoids our tendency to roll the dice on a single “sure winner”; that defies our desire to play the Powerball lottery (with those wonderful odds of multiple millions to one), and so on. And just remember that a stock market chart looks like a sawtooth in the short-term – up and down, up and down – but smooths out over the long haul in a decidedly upward direction.
In next week’s blog, we’ll discuss the consequences of the 20-something’s “lost decade” error in judgment.
¹These student debt statistics will negatively impact the ability of several generations of savers to do just that… SAVE!
² The average millennial watches television 26 hours a week (3.7 hours a day) and older Americans (35-44) watch it 36 hours a week (5.14 hours a week).
SCARY FACT: The median retirement savings for most Americans in the decade preceding retirement (age 55-64) wallows in the neighborhood of $100,000, according to the Government Accountability Office (GAO). Despite all of those zeroes, it’s a frighteningly inadequate number, if accurate – a dollar figure that will exhaust quickly in retirement. Particularly if you live a couple or so decades after retiring… as many people do.
The same GAO study revealed that during the 10 years after retirement (age 65-74), the amount on hand was around $150,000. In short, even accounting for inflation-adjusting Social Security checks, most Americans enter the Golden Years with woefully meager nest eggs. Holy Moly! Captain Marvel, how do all of these Baby Boomers and Generation-X folks plan to survive 15-25 years of those relentless day-to-day expenses in addition to mounting healthcare costs?
These startling GAO numbers are supported by some median net worth numbers cited in a Business Insider article by Jim Wang. Of course, retirement savings and median net worth numbers differ in that retirement savings is a component of net worth. Point is, the Business Insider article’s numbers support the accuracy of the GAO numbers (i.e., in the 55-64 age group, Wang’s median net worth figure is $144,000 compared to GAO’s retirement savings number of $100,000. In the 65-69 age group, Wang’s median net worth is $194,000 and GAO’s retirement savings number is $150,000). I cite these statistics to focus your attention on how so very few folks properly prepare for retirement in today’s America.
It seems to be a bit late in the game for the older generations to take much corrective action, but what about those in the under age 35 category – the Millennials? No good news here. They hold less than $7,000 of median net worth… wow! And I suspect very little of that $7,000 is truly investable savings. More probably, it’s equity in a home. And what’s my point, you ask? Well, let’s revive one of my favorite old dictums: It’s Never Too Late but Early is Best!
Using my usual financial data to make the point, what would happen to these same age categories, had they, at age 20, established a Roth IRA, saved a paltry $100/month, and invested in an Index fund earning 7% compounded quarterly? How would their net worth have been impacted over time?
It appears that in America’s near future, Social Security, a good but terribly underfunded program (refer to A Tottering Stool blog July 26, 2019 in the Archives section), will provide most of the income for half of the people over 65. You’ve probably heard the rumors about little old ladies (and little old men) eating cat food to avoid occasional bouts of hunger. The foregoing statistics tell you why that possibility just might exit. By the way, until her untimely recent demise, my cat enjoyed her food, so, maybe it won’t be so bad.
Despite my witticisms, the foregoing facts are alarming. But they can be avoided. How, you might ask? Simple. Start saving early in life. Certainly, before your mid-40s. If possible, in your early 20s. To which you reply, "But, young people don’t have any money." To which I reply, "Balderdash!"
Like so many of their elders, a preponderance of young folks lack the discipline required to save. And many of them develop those million-dollar habits I mention from time to time, most of which are money-chomping habits. And, too, young people have a litany of excuses not to save, some perfectly understandable and others – well – just handy excuses.
In the next few blogs I will reveal the various generational excuses people use not to save. Remember, these are the same excuses, real or imagined, that wage a holy war on The Amazing Power of Compounding by gutting the act of saving (money) of its most important component, time! We’ll begin next week with the 20-somethings.
Quality is often in the eyes of the beholder. Webster’s dictionary has a whole slew of definitions for quality, most of which simply cloud the issue. I like a simple little Internet definition: The standard of something as measured against other things of a similar kind. When it comes time for selecting an investment vehicle, help is so plentiful as to be confusing. When seeking information about a mutual fund – managed or Index – I always like to know what Morningstar (they specialize in mutual fund investing) thinks of a given fund. But my favorite information source is Vanguard’s trove of their own funds’ histories and investment guidance (yeah, I’m biased), particularly the “pitfalls that investors should avoid.”
Here’s a quick summary of those pitfalls:
Being human, we’re all vulnerable to the lure of past performance (stocks, funds, racehorses, whatever). And though many of us have learned important lessons in doing so, it’s an oft repeated mistake. Generally speaking, investing based “strictly” on past performance is a quick ticket to mediocre results or failure. Keep in mind that superior past performance might be based on excessive risk-taking, luck, or other factors having nothing to do with quality. Of course, superior performance can also be based on good management, but be cautious, managers come, and managers go.
A mutual fund investment is accompanied with management fees – a lot in some cases, very little in others (index funds fall in the latter category). Vanguard research has found that less expensive funds, even actively managed funds, have a better chance of beating their benchmarks than more expensive funds. The reason is obvious. Lower fees simply allow investors to keep a greater portion of the fund’s return. Pay for good performance, but don’t pay too much! You don’t have to. Do your homework. The information is out there, much of it free for the taking.
If you’re like me, you don’t like losses. The simple fact is, no matter how good fund managers are, they will underperform the market from time to time (usually quite often). Vanguard reported that of the 2,202 “active” equity funds that existed in 2001, only 476 outperformed the market. And 98% of that 476 group underperformed the market in at least 4 out of the 15 years ending December 31, 2015¹. This Vanguard-provided history is a bit dated, but it reinforces several of my PDQ Principles of Investing. And more recent studies support the data. Be patient. Don’t abandon a fund during a downturn or setback. Have reasonable expectations about the fund’s performance, whether managed or unmanaged. Diversify. And give index funds a hard look versus managed funds. In short, dare to be average.
If you decide to invest in a broad market index fund, you’ve bought quality. According to S&P Global, more than 80% of U.S. actively managed equity funds underperformed the S&P Composite 1500 in the decade ended 2018 – or no longer exist. Small wonder that droves of investors have abandoned active funds in favor of passive index funds, and the trend continues. In fact, today’s Wall Street Journal carried this news. “Funds that track broad U.S. equity indexes hit $4.27 trillion in assets as of August 31, 2019. Funds that try to beat the market had $4.25 trillion as of the same date.” This is a major investment event and another recognition that it’s hard to beat the market.
As I summarized in my book, The Generation-X Files (Dare to be Average), even if you decide not to go the index fund route, any investment technique worth its salt should do several things, including: provide a competitive rate of return over time relative to other available investment opportunities; offer reasonable diversification among stock, bonds and cash; be tax-friendly when not under the umbrella of a tax-deferred retirement plan; have a low maintenance cost (whether it be an annual expense ratio or an advisory fee); and require minimal oversight (to avoid those sleepless nights). Index funds offer these characteristics, but who am I to judge what’s best for you? Check it out for yourself!
¹Data are as of December 31, 2015. Vanguard’s analysis was based on expenses and fund returns for active equity funds available to U.S. investors at the start of the period.
You’ve heard me say this before, but I’ll say it again. For small investors simplicity is the key to successful investing. Building a complicated investment portfolio can lead to confusion, greater expense, a lot more fretting (worry), and not infrequently, it can cause us to second-guess the choices we make.
Dwell on this contention for a moment: The most important aspect of wise investing, in my opinion, is BEHAVIORIAL, NOT FINANCIAL. I’m talking about the ability to save and invest on a continuous basis while ignoring perfectly normal human compulsions – compulsions to “bail out” in a down market fearing a loss – temporary though it might be – or to change those consistent buying patterns fearful of missing out on the “next big opportunity”.
Remember this, folks. The decision trigger is hard to pull when a market is surging – up or down. So, to avoid these compulsive behavioral issues, I suggest implementing a consistent buying pattern of… hopefully… quality investments and stay put. Yeah, I know, staying put in a “big ole pullback” is very difficult, but a great deal of money is lost when folks flush like a spooky covey of quail early in a major downturn, and not necessarily because they are saddled with a poor investments.
Speaking of positions, let’s talk about my old friends, the index funds. I know, I know, you’ve heard me talk about them, ad nauseam, but a brief retelling of some reasons for investing in index funds is on my mind today. Remember diversification, the “D” of the PDQ Principles of investing? The S&P 500 Index Fund¹ is a very low-cost way to gain broad exposure to the domestic equities market. The S&P 500 Fund creates ownership in 500 of the largest U.S. companies spanning many industries that, collectively, account for more than 75% of the U.S. stock market’s value. An associated risk, of course, is exposure to an occasionally volatile stock market. Just remember that old saying, “stocks fluctuate”. Since the S&P 500 Index Fund (or if you prefer, a Total Stock Market Fund) is so broadly diversified, I consider it “the” core equity holding for my own piddling little pile of quarters.
Recent history has proven that low-cost index funds result in superior long-term yields for small investors versus a scattergun approach – superior even to yields attained by other perhaps more experienced investors. And I’m including the big boys: pension funds, institutions, and many affluent folks who seek the help of pricey financial Wazoos. You just can’t beat the price. Index fund fees are as inexpensive as it gets. For example, combined, a 90% mix of stocks and 10% short-term bonds purchased through Vanguard would result in annual operating fees in the neighborhood of 0.055% of the account balance, amounting to $55 per year per $100,000 of investment, if you invest in the least expensive variant of the funds.
By contrast, the average “Wazoo-managed” fund is 20 times more expensive than the previously mentioned two-fund solution touted by none other than that penniless old vagrant from Omaha, Warren Buffet (i.e., he deals in billions, not pennies). I personally invested 10% of my stray dimes in short-term government bonds and 90% in a very low-cost Standard & Poor’s 500 Index fund years ago to establish my core investment portfolio.
The S&P 500 Index Fund seeks to replicate the performance of the benchmark index by investing in the S&P 500 companies with similar weights. This fund employs a passive investment strategy and invests all or a substantial amount of its total net assets in common stocks included in the benchmark index. Still not buying this business about index funds? Studies show that two-thirds or more of active managers underperform the S&P 500 Index. Studies also reveal that during the most recent 15-year period, more than 90% of active managers underperformed their benchmark indexes. The picture that emerged from one such 15-year study was attention-grabbing, to say the least: 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2%, respectively.
In short, the odds that a managed fund will beat the yield of an index fund are only about 1 in 20. And in a given year, you never know who that 1 of 20 managers is going to be. Keep in mind, too, that passive index funds are more efficient than managed funds. Most managed funds trade stocks frequently; thus, they tend to not necessarily earn more while realizing more taxable gains each year. Passive managers simply add or subtract companies in their funds less often, creating fewer capital gains tax liabilities.
In summary, passive index funds are not burdened with researchers and stock pickers, which results in low annual expense ratios (fees). And since they follow a market measuring index they are very transparent. And equally important, buying index funds is a simple approach for new investors, and boy do I love simplicity. For a slam dunk primer on the pros… and cons… of index fund investing, I recommend reading this carefully researched article by Motley Fool contributor Jason Hall. It may be more than you ever wanted to know about index funds but take a peek anyway. It’s very enlightening.
Remember old Ben Franklin’s sage advice: "An investment in knowledge pays the best interest."
¹The S&P 500 Index consists of 500 of the largest U.S. companies listed on the New York Stock Exchange or NASDAQ, selected by the Standard & Poor's Index Committee based on market capitalization. It is a widely recognized barometer of the U.S. equity market. An S&P 500 Index fund seeks to provide investment results that correspond to the price and yield performance of the S&P 500 Index, its benchmark index. To achieve this objective, an indexing strategy invests nearly all its assets in stocks with approximately the same proportions as the weightings.
This is probably one of the least followed pieces of advice out there, particularly among new investors. Think about these statistics. Back in the 1930s, the average holding period of a NYSE-traded stock was 10 years. By 2010 (according to NYSE data), the average holding period had dropped to 6 months. The reasons are many – advanced computer technology and social media among them – but plain old human impatience is probably the biggest factor.
As mentioned in last week’s blog, we’re going to take a deeper dive into each of the three components that make up my personal investing approach – what I refer to as the PDQ Principles: patience, diversification, and quality. Because I’m not big on dawdling, let’s get right to it. The “P” in my PDQ Principles stands for Patience, which I’m told, is a virtue.
An overbought market (a possible scenario since the Great Recession) or a market that becomes suddenly volatile can be unsettling for investors. What is an overbought market? When folks are optimistic about the future – maybe the economy is on the upswing or there is an expected tax code revision in the works – they tend to take more risks. During such times, we see lots of buying, buying, buying in the market, and this can cause us to forget that stocks fluctuate. Overbought markets make me think of my old amusement park experiences, where the excitement level peaked just as the roller coaster seemed to be reaching its highest point. In short, what goes up… well, you know the rest. But generally speaking, if you own quality products, recovery is imminent.
Many folks grow impatient during such times and decide that the market has exceeded their comfort level; thus, they move from a “buy and hold” mentality to “buy and sell”.
If you’ve read my earlier posts, you know where I stand on the subject. And judging by the fact that my first PDQ principle is “patience”, it isn’t hard to guess that I’m partial to the “buy and hold” strategy. There are many reasons for it, but one biggie is that the anxious investor – particularly one who is quick to sell or make trades – often gets dinged by capital gain taxes.
As you know, when you sell an investment, you either have a gain, a loss or you break even. If you sell for a gain, you’re most likely going to be paying a percentage of that gain to Uncle Grabby, as I like to call old Sam. And often, the resulting tax bill is greater than the perceived protection (reduced risk) that bailing out might offer.
The truth is, we don’t live in a world of absolutes, and there are moments in our lives when necessity trumps best practices. If ready cash (that rainy day fund) isn’t available, selling stock to send a kid to college, or repairing or replacing an aging vehicle, or even providing the basics like food and shelter is just what we have to do. And it’s completely understandable.
On the flip side, I’ve seen many investors (including myself, in my younger, less patient days) hop on the “buy and sell” train for reasons that are much less justifiable, like:
• I have to sell (when you really don’t).
• I want to sell (in which case you’ll find a reason).
• I really want to sell (meaning you are scared to death and any abrupt down-market will cause you to flare like an old Canadian goose, dodging shotgun pellets above a southern Arkansas rice field).
• Or worst of all, I simply must do something (an oft-used excuse to join a thundering herd of wild-eyed, Wazoo-influenced investors heading for the exit).
Outside of pressing financial matters, much of the reasoning investors provide to justify outright selling is purely psychological. The truth is, unless you are confronted with an inescapable financial need, patience is your best friend – whether you’re dealing with a temporary market downturn, the more contemporary terrorist attack, or waiting for a golden buying opportunity to present itself.
If you think you MUST seek professional financial advice, do so based on your needs, your goals and your own time horizon, not on another person’s market forecast. Speaking from my own experience – listening to others or trying it myself – it’s next to impossible to predict the peaks and valleys of the stock market. Odds are, the Wazoos won’t be any better at predicting major market moves than you.
So, take it from a fellow that’s been around the block a time or two…some say three… unless you have no choice, at least consider the “buy and hold” approach. If you’ve done your research and purchased quality products in a diversified manner, patience is your best friend. Sit back and relax. Based on the historically upward trend of long-term markets, you’ll end up where you want to be.
And remember, too, those highly-diversified index funds can be solid investment options with a track record to prove it. We’ll talk about diversification in next week’s blog. Until then, don’t just do something, stand there!
“Even the intelligent investor is likely to need considerable will power to keep from following the crowd."
--- Benjamin Graham.
You’ve heard the term Time is Money. Well, in a very real sense, it is. The most valuable thing you have in life is your precious time – and it’s finite. It’s up to you how valuable it becomes. The young fellow that co-founded and currently leads Facebook, Mark Zuckerberg, certainly added value to his time early in life. You see examples of friends and neighbors enhancing its utility every day. Time is not meant to be wasted but so often we do just that. Because wasting time comes naturally.
First, let’s create a proper environment - at least initially - an achievable world in which to develop the simple plan we intend to pursue. Let me be more specific. My objective for you – the Millennials, Gen-Zers, and that budding Alpha Generation – is to plant in your minds the importance of time as it relates to money. Because, if not yet obvious to the youngest two generations, money will become integral to most of your major decisions in life. This involves two other vital concepts already mentioned in previous blogs: It’s Never too Late, but Early Is Best and The Amazing Power of Compounding. Like the PDQ Principles of Investing, these concepts feed on one another.
My ultimate objective for this blog is to create situations where even while wasting time, our adopted plan is adding value despite our wasteful propensities. A successful Millennial recently told me that before she became the master of her own destiny (FIRE), she worked 50-60-70 hours a week for pay – often good pay – but earned little more. She still works a lot, doing what she enjoys, but now earns money while she works AND while she sleeps or pursues other interests. This is the world many of us hope to achieve – where we, too, become masters of our own destiny. It necessarily involves the productive use of time and money. It can include adolescent years (it did in my case thanks to my parents), teenage years, young adulthood, and later, those middle years when folks finally begin to consider the possibility of “an end in sight”.
My plan is simple, but as mentioned earlier, simple things are often very difficult to achieve. In its simplest form, and as early in life as possible, we begin to swap our precious time (labor, brain power, etc.) for money. The point is to save as much as circumstances permit, invest those savings in a disciplined, diversified manner, and then patiently go about our business as our future becomes increasingly secure.
So, let’s continue this journey down a more enlightened path, which means it’s time to elaborate on my PDQ Principles of investing: Patience, Diversification and Quality implemented under the guiding light of a simple financial plan – one that begins TODAY (It’s never too late, but early is best) and that optimizes the amazing power of compounding. Remember, a single dollar invested today at 10%, compounded quarterly, for 45 years will produce $85 at retirement; whereas, the same dollar invested 20 years later at 10%, compounded quarterly, for 25 years will produce only $12 at retirement. This illustrates the startling difference between beginning to save at age 20 versus two decades later. And for all kinds of reasons, that’s what far too many people do… wait until their 40s to start seriously investing for their future retirement.
We’ll begin next week with the “P” portion of the PDQ Principles – that is, if you can muster the “patience” to wait until next week. If not, you can sneak a peak at You, Me & the Tree where I introduced the principles back in 2018.
We’re hearing a lot of chatter these days about a looming recession¹. They do happen, and you will experience one or two… or more… along the way. So what the deuce is a recession, you ask? Well, it can mean different things to different people, but common traits are a decline in consumer confidence (experience-based or rumor-based) due perhaps to job loss and reduced or stagnant wages that encourages folks to change their shopping habits. When those things occur, the natural result is moderated shopping and a decline in business investment activity. In short, the economy shrinks, and the Gross National Product (GNP), the broad measure of a country’s economy, goes negative. There’s no approximate period for how long recessions lasts, but they often linger for more than 6 months². The early 1990s recession lasted 8 months causing a GNP deterioration of 1.4%. Ten years later, the early 2000s slump lasted 8 months resulting in a GNP decline of 0.3%. Six years later, the mortgage crisis-inspired Great Recession reared its ugly head, driving the GNP down 5.1%. That recession ended 10 years ago.
So, if you feel a recession coming on, what do you do? I’m guessing you already have a plan, but if not, make one and stick with it. Here are some tips based on my own experience.
So how do we protect our assets from these dastardly recessions? In response to this question, I’m inclined to bring up my PDQ Principles of investing –Patience, Diversification and Quality. Hopefully, as an investor, you already practice some or all three of these principles as part of your plan. But allow me to elaborate beginning with patience. Patience is such an important personal trait to exercise during a recession. It manifests itself in several ways. Stay calm. Follow your plan. Don’t let surging emotions take over, which often lead to irrational and impulsive decisions. Just remember, if you’ve made quality investment choices, once the economy begins to recover – and it always does – those wise, diversified investments you made prior to the recession will also recover.
But what if I need my money very soon, you mutter? I would answer, do you need it all right now? If not, don’t be impulsive and sell everything if you need only some smaller portion of your investment dollars. Just remember, in a declining market your fear of loss is stronger than usual, and impulsive decisions can lead to a much greater financial setback than the situation might warrant.
As to that diversification principle, particularly in an economic downturn, it helps limit losses and often creates opportunities for a quicker recovery. I’m inclined to favor broad market index funds for young investors. But as an individual matures and is financially able to afford a broader scope of investing, a diversified portfolio might also include – in addition to stock funds – bonds, real estate (usually a young investor’s home), even some small-scale exposure to other real estate and… mmm… commodities. And, of course, whether young or old, six months to a year or more of rainy day funds (cash) will come in very handy – possibly enabling you to avoid selling any of your investments to meet unexpected short-term needs and/or emergencies. If you’re not inclined to go the fund route to achieve diversification, at least try to identify investment-grade bonds and/or companies with quality assets, little debt, and good cash flow. And in that same vein, look inward because the same rules apply to your own household. Your chances of outlasting a recession are much more likely if you have that rainy day fund, a small debt load, and steady employment (cash flow) to cover those dastardly bills that keep on coming.
Trust your judgment. If you’ve saved that important rainy day fund (cash or near-cash), and if you stick with your quality investments, you can ride the usual recession back to prosperity. And please keep in mind, bailing out of your investments in the face of a downturn can lock in untimely gains, triggering taxes, or real losses – or both. If you trust that “quality” portfolio, and if you exercise patience, those “paper losses” are most likely to be temporary in nature. And ask yourself this question. If I do decide to sell, when do I buy back in? During the inevitable recovery, most of the folks who do get back in, often do so late in the recovery cycle, suffering what I call “opportunity losses” as well as those real ones incurred by selling during the downturn. Timing your way in and out of a market is a losing game. Don’t fall victim to it unless uncontrollable circumstances force the issue.
If you feel a recession coming on, consider making small, frequent automatic investments – perhaps in your 401(k) or 403(b) retirement plan at work. And keep doing it throughout the recession and beyond. It’s called dollar-cost averaging, a system that buys you more shares when prices are lower. And keep reinvesting any surplus earnings (like dividends) for the same reason… lower share prices. Remember, if you’re either anticipating or experiencing a recession, don’t join the thundering herd and become a seller. Recessions create buying opportunities. Don’t miss out by selling out.
¹Recession: A period of general economic decline defined as a contraction in the Gross Domestic Product (GNP) for a period of six months (two consecutive quarters) or longer. Much milder than a depression, a recession often doesn’t last too far beyond a year and is marked by high unemployment, stagnant wages, and a decline in manufacturing, retail sales and the aforementioned GNP, a measurement of economic output.
²The average duration of the 11 recessions between 1945 and 2001 was 10 months, compared to 18 months for recessions between 1919 and 1945, a period that included the Great Depression (NBER Business Cycle Expansions and Contractions).
While anticipating the pending stampede by high schoolers to institutions of higher learning this fall, let’s dwell a bit on how to help youngsters earn a degree without accumulating huge debt that could burden their future for decades. This is increasingly important because, based on my studies, a college degree doesn’t represent the value it once did. And why not? According to the Labor Department, salaries for college graduates have remained essentially flat since the turn of the century (adjusted for inflation). And the price of that degree has soared relative to other cost of living items (a reduced bang for your buck, thanks to Professor Izzy the Inflation Monster). Also, those earning degrees seem not to be accumulating wealth on par with previous generations. The media often proclaims that today’s young adults are less well-off than their parents and grandparents were at various important signposts along life’s journey.
I’m not suggesting that a college degree doesn’t improve one’s opportunity for a bigger paycheck than, say, a nongraduate. On average, it most certainly does. What I am suggesting, however, is that the yield on “earning a degree” is not what it used to be. If true, that should spur folks to look for ways to reduce the cost of an education investment – directly and/or indirectly. A couple of years in a local junior college might be in order. Being a good student and graduating in four years would also help. And a student might even consider working part-time while in school (review Reagan’s Journey Begins in the Wynn$ights "Past Posts"). Or indirectly, some financial assistance from Gramps and Grams could reduce the long-term burden of student debt.
Last week, we talked about Hypothetical Henry and how his parents were preparing for those expensive college years. This week, let’s explore a few more details of a 529 Plan – and another alternative, the Direct Pre-Payment of tuition to an educational institution. According to AARP, in addition sharing wisdom and experience, grandparents spend in the neighborhood of…gasp… $179 billion annually on their grandkids. The figure includes money spent for higher education as well as on other life expenses… even groceries and vacations. No wonder Gramps and Grams are so special.
Let’s focus for a moment on how many grandparents do help alleviate some of the financial burden. There’s a world of information on the internet about 529 Plans and Direct Payment of tuition, but some unique factors require discussion when grandparents get involved. For instance, might grandparent assistance jeopardize the grandchild’s need-based financial aid, and how well does it mesh with the grandparents’ own financial planning? And being conservative sorts, grandparents often don’t want to give money directly to their grandchildren. Or perhaps they don’t want to cede control of the funds to others until the funds are actually disbursed. As mentioned, a downside to grandparents owning the plan (particularly in families seeking need-based aid), the distributions from elders count as student income on the Free Application for Federal Student Aid (fafsa); a designation that weighs much more heavily than parental income in the aid formula.
Still, many grandparents – me included – would rather make contributions annually to a parent-controlled 529 Plan. By ceding, they lose control of the money but gain the benefit of not having to worry about maintaining the account. Some states allow grandparents to own the plan and then cede its ownership to the parents just before the student heads for college. This practice allows grandparents to mostly have their cake and eat it too.
In case you missed what was footnoted in the previous blog (Hypothetical Henry), 529 Plans are operated by state or educational institutions with certain tax and other advantages to ease the burden of saving for college and other post-secondary training. Likewise, they can be used to pay for tuition at elementary or secondary public, private, or religious schools for the designated beneficiary. Earnings are not subject to federal tax and typically not subject to state tax when used for qualified education expenses such as tuition, fees, books, as well as room and board at eligible education institutions and tuition at elementary or secondary schools. Although contributions to 529 Plans are not deductible for tax purposes, they offer tax-deferred growth and tax-free withdrawals. You won't pay any income taxes on the amount your account earns while it's growing, and if you use the money for qualified education expenses, those earnings will be tax-free when you withdraw them.
Grandparents, if still married, can contribute as much as $30,000 a year to a 529 Plan (per grandchild) without triggering gift-tax consequences. And if they’re into downsizing their estate, or simply feeling extra generous, they can do a “bunch” – contribute five years of annual gifts into the plan in one year without triggering a taxable event. This is often done when establishing the plan to enjoy five-fold, the Amazing Power of Compounding.
We’ll discuss 529 Plan investing in a future blog, but for a quick preview, check out the Vanguard 529 Plan age-based options (conservative, moderate, aggressive) for some ideas. A quick peek will open your eyes to all kinds of investment options.
Grandparents can also write checks directly to a school without triggering Uncle Grabby’s gift-tax rules. In short, they can prepay tuition directly to a university and at the same time, give the grandkid an additional tax-free gift (currently $15,000 per year per grandparent). Unfortunately, this gift tax exemption only applies to tuition expenses and not to those myriad other expenses (countless fees, room and board, books, supplies, etc.).
A word of caution, this prepayment of tuition is typically NOT REFUNDABLE should your grandchild decide to change schools. So, don’t get overly zealous and ante up for all four years. And, yes, this type of grandparent assistance can negatively impact the student’s eligibility for needs-based financial assistance, too. By the way, Gramps, the money you prepay to an institution for a grandchild’s tuition is not a charitable deduction, so don’t get any funny ideas along those lines. Uncle Grabby can be a rough customer to deal with when tested.
There are many other ways to help a kid go to college, but I lean toward the 529 Plan. Still, whatever choice you make, the key is getting started. You’ve heard it before and you’ll hear it again: It’s Never Too late, But Early is Best.
As I often preach, wealth is created by saving and investing over long periods of time. For a youngster to get the biggest bang for the buck – and because most of them have little or no disposable cash – parents and/or grandparents can build wealth for their kid or grandkid by investing money at the youngster’s birth or early in his/her life.
Hypothetical Henry’s situation offers an example of planning ahead.
You’ve heard the numbers, $1.5 trillion of mounting debt and counting. And the stories that Millennials are so bogged down in student loan debt that many of them postpone marriage, home buying, family creation, etc. Henry is a Gen-Zer and thank goodness for that – unless he follows in the footsteps of so many of those Millennials and older Gen-Zers. There’s a glimmer of hope for Henry. He’s only 13. He still has five years to plan for college if he chooses to go. Wait a minute… 13 years old… isn’t it a little late in the game to start making plans to finance a college education? I agree, it is a bit late, but I firmly believe in the saying: It’s Never Too Late, But Early is Best!
Henry’s case is a hypothetical situation presented to demonstrate what can happen if planning for the college “financial” experience is addressed early on. And because it is hypothetical, let’s begin with the usual theory that Henry was very careful in choosing his parents.
For starters, Henry’s parents opened a 529 Qualified Tuition Program¹ shortly after his birth. They immediately started depositing $2,000 per year in the plan, invested every penny in an unmanaged Total Stock Market Index Fund…and as [bad] luck would have it, during the plan’s third year, the Great Recession reared its ugly head (every story needs a bit of drama). The plan’s excellent first year return,15.63%, looked fantastic when compared to year two, 5.57%, then – ouch! – here came year three…the Great Recession… a (negative) -36.99%. But Henry’s parents were true believers in index fund investing for the long haul. They stood strong, and the next two years rewarded them with double digit returns of 28.83% and 17.26%, respectively. Henry’s 529 Plan was back in business. And over the next eight years, it enjoyed five years of double digit returns, two years of – argh! – less than 1%, and only one more of those negative years, down 5.17% in 2018.
To summarize, Hypothetical Henry’s 529 Plan experienced on the front-end, the Great Recession, and has since enjoyed several years of an extended bull market – a mixture of more good times than bad. He also enjoyed a mom and dad who faithfully employed the PDQ Principles of investing: Patience… Diversification… Quality. Reminds me of that conservative old gentleman, Benjamin Graham, who said, “The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a simple financial plan and are exercising a behavioral discipline that is likely to get you where you want to go.” We’ll discuss those PDQ Principles of investing at length in future blogs.
Before we get back to Henry, though, if a parental plan is to minimize college debt, a big first step might be to have a college-bound youngster attend, if circumstances permit, a local junior college to enjoy cheaper tuition and fees and “free” room and board – while taking core curriculum courses. But that’s another topic. The 529 Plan Henry’s parents created years ago, barring a market meltdown, will probably enable him to attend a large state institution away from home.
Let’s review Henry’s situation with some facts. In doing so, let me introduce you to a wonderful program called the College Savings Planner that helps parents determine whether or not they are on course to meet financial goals. Developed by Vanguard, it’s user friendly and among other things, provides general information about the cost of attending various institutions around the country.
In Henry’s case, after investing $2,000 per year for 13 years, earning approximately 9.25% per annum, his plan currently holds $52,265 despite the slow start. His parents plan to continue investing $2,000 per year but because the current bull market is getting long in the tooth, they decide to adopt a more conservative 6.2% annual yield outlook until Henry graduates – not the 9.25% they’ve enjoyed so far (despite the Great Recession).
Based on the current plan balance and assuming an annual college expense of $28,400 (tuition, books, room & board, etc., plus a 5% inflation factor), they currently have about 2.5 years (60%) of Henry’s education covered. To get to 100%, they would have to contribute an additional $5,800 per year, assuming a 6.2% annual yield. By the way, if their index fund continued to yield 9.25%, they would only have to contribute $3,500 per annum to reach 100% coverage. Vanguard also has good information on 529 plans.
In summary, Hypothetical Henry is in good shape financially because his parents started planning for his college experience very early in his life. Consider the alternative of doing nothing or starting too late in the game to avoid those crushing student loans. Perhaps this information about 529 plans and the Vanguard planning tool will help you avoid membership in the $1.5 trillion student debt club. And remember my mantra about getting started: It’s Never Too late, But Early is Best.
¹529 Plans are operated by state or educational institution with certain tax and other advantages to ease the burden of saving for college and other post-secondary training. Likewise, they can be used to pay for tuition at elementary or secondary public, private, or religious schools for the designated beneficiary. Earnings are not subject to federal tax and typically not subject to state tax when used for the qualified education expenses such as tuition, fees, books, as well as room and board at eligible education institutions and tuition at elementary or secondary schools. Note: Although contributions to 529 Plans are not deductible, they offer tax-deferred growth and tax-free withdrawals. You won't pay any income taxes on the amount your account earns while it's growing, and if you use the money for qualified education expenses, those earnings will be tax-free when you withdraw them.
Today I introduce to you a promising member of my Gen Z audience. Raegan is a bright, shiny new penny with energy and intellect to burn and appears to be well on her way to a successful future.
My mission with this blog is to show Raegan and her friends that if they consistently save and invest early in life, they can accumulate mind-boggling sums of money thanks to The Amazing Power of Compounding. It requires nothing more than a simple plan, a few bucks, and a truck-load of patience, but starting NOW is the key! And in my humble opinion, core equities for the average young investor are index funds. They offer quality, low-cost, highly diversified products that yield market rates of return – all the investor provides is a steady flow of savings and the patience to stay put while others run for the hills during volatile times.
Raegan is 20 years old, a university junior pursuing a challenging double major. She also works to help fund her own education, and behold, SHE’S SAVING A FEW BUCKS A MONTH, TOO! Raegan also carefully selected her parents (jesting) who provide encouragement and occasional financial support along the way. With parental assistance and by working 25 or so hours a week, Raegan just might graduate from college without that burdensome anvil called a student loan hanging around her neck, and maybe… just maybe… an IRA in her handbag of early financial accomplishments.
Here’s some brief insight into her thinking. Because she works and has “earned income” (a must in order to contribute to a Roth IRA), she is carefully researching the possibility of opening a Roth, saving $100 per month while in college (including a couple of years in graduate school), and possibly investing some of her initial savings in a Vanguard Target Retirement 2060 Fund¹. This fund invests in Vanguard index funds beginning with an allocation of approximately 90% of assets in stock and 10% in bonds.
To buy into this very low-cost (currently .15% per annum), relatively high-risk fund (four on a scale of five), Raegan will initially have to accumulate the required minimum investment of $1,000. As to the risk factor, she’s young and the Target Retirement 2060 Fund will assure that she’s properly diversified with a collection of domestic and international stock and bond index funds. As to the potential reward, over its eight-year life, this fund has yielded just over 9%, but this yield might be a bit deceiving…its total history is bounded by the current 10-year bull market. For this reason, the cautious, conservative Raegan is assuming that her long-term investment yield will likely be a more moderate 6% or so. But who knows for certain.
Raegan also understands that money saved and invested within the confines of a Roth, unlike a bank savings account, has certain limits on future access². For a terrific summary on IRAs, she might suggest that her fellow travelers check out The Motley Fool's Beginner's Guide to Understanding the Roth IRA (for beginners). For a review of IRAs in general go to Vanguard's Size up the basic IRA types.
Ultimately, Raegan will make up her own mind about how much to save and how and where to invest, but more importantly, she has begun her personal “private investor” journey at a very young age. So, let’s take a look at a couple of hypotheticals she might very well experience along the way, starting with the seed money of $1,000 and a monthly Roth IRA savings plan.
Let’s assume that Raegan saves the $1,000 minimum and invests it plus a $100 per month for the four remaining years of her college experience, and that she does, in fact, earn 6%, compounded quarterly, on her Target Retirement 2060 Fund. Upon graduation, four years hence, she checks her Roth IRA and finds an accumulated balance of $6,700. Thrilled with this result, she decides to stick with the $100 per month saving commitment for an additional 40 years (Note: Raegan will no doubt expand her portfolio to include many other retirement assets during those 40 years, but let’s concentrate for the moment on her Target Retirement 2060 Fund). What will the fund be worth after the initial $1,000 investment and after 44 years, earning 6%, compounded monthly? Wow! $271,100. Surprised! Don’t be. You’re witnessing the amazing power of compounding.
Next, let’s assume that instead of sticking just $100 a month in the Target Retirement 2060 Fund, post-graduation, Raegan decides to increase her savings rate by $100 per month at the turn of each decade. She’ll start off with the same $6,700, post-graduation, but over the next 10 years she will invest $200 per month, then $300 per month, then $400 per month, and finally $500 per month (for the last 12 years), earning the same 6%, compounded monthly. You’re going to be surprised. Upon retirement, her Roth balance could total a whopping $725,500. And what if she had been too conservative in her yield estimate, and it turned out to average 7% instead of 6%? In the 7% case, she might end up with almost a cool million bucks ($959,000 to be more precise) in her Roth IRA that she will be able to take out TAX FREE.
Of course, we’re speculating on long-term yields in the above cases, but nice going, Raegan, if you are able to meet these wonderful goals!
¹Target Date Funds are designed to shift to a more conservative blend of investments as the investor grows older.
²Because Raegan will have already paid taxes on her Roth IRA contributions, qualified withdrawals from the account in retirement are 100% tax-free as long as it's been open for at least five years and the account’s owner is age 59 ½ or older. Raegan also is aware of an obvious downside to a Roth…its lack of an immediate tax benefit. Why? Earned income contributions to a Roth are after-tax.
You’re familiar with the three-legged stool, aren’t you? It’s an unsteady device often employed to reach seldom-used items stored on the pantry’s top shelf. It’s likewise a fading metaphor used by older investors to describe the primary components of a well-rounded retirement plan. In times quickly waning, the plan consisted of an employer-sponsored pension plan (commonly called a Defined Benefit Plan¹), supplemented by personal savings and Social Security. In that largely bygone era, an approach lacking any of these primary components raised the fear of dog food consumption in one’s future.
This week's blog will focus on the rapidly transitioning “employee pension plan” leg of the Three-Legged Stool – a financial phrase that describes the most common sources of retirement income for many individual investors. When I suggest in my blogs that investing should be simple, I’m not just discussing social security, or an employee plan you might be participating in at work. Rather, I’m focusing on the individual’s personal savings effort that, today, is having to replace those rapidly disappearing employer-sponsored Defined Benefit Plans or DBPs (commonly known as pension plans). In short, with the steady disappearance of company pension plans, the management of retirement packages is becoming YOU, the individual investor’s responsibility.
Things are always evolving. That old three-legged stool looks increasingly different in today’s financial world. Those DBPs once offered by many employers are becoming relatively scarce. I’ve read that only about 20% of America’s Fortune 500 companies offer some variety of DBPs to new employees when, barely a generation ago, that number was closer to two-thirds. More and more companies have replaced DBPs with what are called Defined Contribution Plans² or DCPs, popular examples being 401(k) and 403(b) plans. In short, the old DBP leg is morphing into and becoming part of the personal savings leg, dropping into the individual saver’s lap a much greater responsibility for accumulating and managing an even larger portion of retirement savings.
In today’s world, many generous employers contribute funds to their workers' retirement by matching a portion of what employees contribute to their 401(k) or 403(b) plans, within specified limits. Top limits of 3-6% are not unusual, but remember, it’s FREE MONEY. Consider this employer match, this free money, as today’s partial pension replacement – a much smaller leg of your three-legged stool with the caveat that it exists only when YOU contribute dollars to be matched.
Next, let’s address the increasingly “iffy” Social Security retirement program leg of the stool. The financial media is filled with all sorts of projections and opinions about whether this important component of your retirement stool has a leg to stand on (poor attempt at humor). According to recent 2019 Social Security and Medicare Boards of Trustees projections, without legislative changes, the Social Security Retirement Trust Fund is projected to deplete by 2035, at which point retirees will receive only about 75% of their scheduled benefits. On a brighter note, the Disability Trust Fund will not deplete until 2052, a 20-year improvement over last year’s forecast due to continuing significant declines in disabled-worker applications and lower-than-expected disability-incidence rates.
No, Social Security benefits will not completely disappear in the projected 2034-35 time-frame, but without political intervention, beneficiaries will face an immediate across-the-board 21% benefit cut that will grow over time to 26% by 2090. Why, you ask, would any benefits be available? Payroll taxes paid by younger workers after 2034 and trust fund interest will be enough to fund about 79% of scheduled benefits, but at an ever-declining rate. So, without a major political fix – reduced benefits, increased retirement ages for full benefits, higher earnings limits subject to tax, etc. – you should anticipate an increasingly spindly Social Security leg to your stool after 2035. To add to your somber mood, on the healthcare side of things, the 2019 report also mentioned that Medicare’s hospital insurance fund would deplete in 2026.
So, there you have it, folks – why it’s becoming increasingly important that YOU, personally, save as much as you can during pre-retirement. That personal savings leg is fast becoming the strength of today’s three-legged stool. But a greater onus is now on you. Are you saving enough to meet your retirement goals as 2035 approaches? The legs of your personal stool absolutely must include a strong DCP leg (your personal savings), supported by two increasingly wobbly legs: Social Security and those employer (FREE MONEY) contributions to your 401(k) that may or may not be there when you need them.
I would be remiss, of course, if I didn’t mention the increasing presence of “geezers” like myself in the post-retirement workforce. Does that mean our stools have sprouted yet another leg in today’s world? Well, yes and no. People have worked full or part-time beyond retirement age in the past. But with more baby boomers reaching retirement age lacking adequate funds to live comfortably – some, of course, just want to keep working – this older segment of the work force seems to be expanding, thus, this fourth appendage. And then, there is state and local aid going to lower income retirees, but that’s another story. In short, we do whatever is necessary to avoid those dog food dinners, or to avoid moving in with one of the kids… or a grouchy nephew (an inside story).
So how do we beef up those personal savings? Keep reading my blogs and I’ll present some simple options.
¹A Defined Benefit Plan (DBP) is such that the benefit formula is defined and known in advance. It is a type of pension plan whereby an employer/sponsor promises a specified pension payment (or lump-sum or combination thereof) on retirement that is predetermined by formula based on an employee's earning history, tenure of service and age, rather than depending directly on individual investment returns).
²A Defined Contribution Plan (DCP) is a plan whereby the employer, employee or both make contributions on a regular basis. Benefits are credited to an employee’s account (resulting from those contributions) plus investment earnings on the money in the account. The primary difference between a DCP and a DBP is that with a DCP, the employee is not guaranteed a certain amount of money in retirement. The employee makes his or her own investment choices and assumes all of the risks involved.
Without careful, long-term planning, investing is a fool’s game. And folks reading this blog are certainly not fools. Obviously, my readership – aware of the looming pitfalls out there – is looking for a better way. I take no credit for inventing a so-called “better way”. Still, I found something that works pretty well for me. But let me first remind the young wannabe investors of a few hazards in this seemingly complex investment game.
Does it really have to be complex? There are folks out there that would like to convince you that it’s certainly too complex to navigate alone. I call ‘em Wazoos. I don’t mean for the word Wazoos to be a disparaging term. It’s just my way of lumping a faction of like-minded people together to refer to them collectively.
From my rather biased perspective, Wazoos are the folks attempting to separate you, the perhaps untutored young investor, from a meaningful chunk of the ultimate yield on your investment dollars – their bony fingers busily clutching at a piece of YOUR pie. Wazoos come in many forms: fee-based and fee-only investment advisors, money managers and marketers, brokers and investment bankers, accountants and lawyers, etc., all aided by the necessary back-room operations that support their myriad activities.
And investor outlays to Wazoos come in just as many forms: flat, by the hour, and annual percentage fees, brokerage commissions, transactions costs, custodial fees, annual operating expenses, legal, advertising and marketing costs, and yes, self-help books and internet blogs. Each in its own unique fashion trying to separate you, the investor, from some of your precious nickels and dimes.
In addition to the aforementioned Wazoos are those unavoidable market risks that await all investors, exacerbated by the inevitable erosion of Izzy the Inflation Monster who, over the long haul, has historically taken an enormous bite out of the diligent investor’s purchasing power. Makes you want to cry… or look for a simpler, cheaper way to approach long-term investing.
Let me start that journey with a couple of slogans, the first of which is: Financial Planning: It’s Never Too Late, But Early Is Best! The second slogan involves a very basic investment approach I practice and sincerely believe: Iinvesting should be simple for the average young investor. No mincing of words here. I mean very simple – as in four easy steps.
1. By necessity, you must SAVE…particularly, once you have “earned income”.
2. Create a Roth IRA, which requires the aforementioned earned income.
3. Invest all or a portion of those savings (without fail every month) in an Index Fund, preferably a Total Stock Market Index Fund. (I emphasized "or a portion of” your savings because this simple plan is intended to initially represent only one important leg of an investor’s Three-Legged Stool. We will discuss the stool in a later blog).
4. Don’t stop saving and investing until you retire, which requires discipline and patience – things we’ve already talked about – and cost avoidance, which we will address in future blogs (no actively managed funds please and avoid those Wazoos, including Squeezy the Syphon Python, who I will fully introduce later).
The late mutual fund industry giant, John Bogle’s approach to investing was even more pithy. Short and concise enough to be jotted on the palm of your hand:
1. Bogle advised investors to diversify by owning the entire stock market (a good example would be to own Vanguard’s Total Stock Market Index Fund, but then, Vanguard’s founder, Bogle, was biased).
2. And then to exercise boundless patience. “Don’t just do something, stand there,” he constantly reminded people.
3. And finally to invest at the lowest possible cost (in short, if possible, avoid Squeezy and the rest of those Wazoos).
Both approaches seem almost too elemental, don’t they? Elemental, indeed, but even simple things can be difficult to achieve. In any event, having gained your attention – if only for a moment – let’s review a couple of options. If you don’t wish to read any further, take a discerning look at my four-step program above, hop aboard or not, and get on with the rest of your life. It’ll work without constant monitoring. All you have to do is save a few bucks a month, invest those dollars in a broad market index fund, and then exercise a ton of patience. And…and…dare to be average! More about being average later.
However, if you don’t mind reading future blogs, allow me to elaborate a bit on those four simple steps to gain a better understanding of why this long-term strategy might work for you. I’ve already discussed an important first step in the saving cycle (see my July 5, 2019 “Rainy Day Funds” blog in the Past Posts section), an important protective shield for an investor’s long-term savings plan. But first (next week), let’s discuss a long-term plan that seems to be the fundamental approach of many investors in today’s world, the [Tottering] Three-Legged Stool. To my subscribers, look for an email announcing its arrival. To those who are not subscribers, please consider subscribing!
But before I close, how about a HYPOTHETICAL example of the potential of this simplistic approach to investing for retirement. Suppose an individual was gifted $3,000 by his/her parents (to meet the minimum investment requirement), started saving $100 per month right out of school, and then invested the $3,000 minimum and the monthly $100 (and all fund dividends and long-term gains) in Vanguard’s Total Stock Market Index Fund until age 65, compounded quarterly, assuming a yield of 6.82% per annum – the fund’s average yield since inception. This hypothetical plan would produce $416,300 before inflation and taxes, after 45 years. Double the monthly amount saved (but not the initial contribution) and the amount accumulated at age 65 becomes almost $770,000. Do I have your attention? This simple investment approach as one leg of your Three-Legged Stool might be worth a second glance. All you have to do is Dare to be Average…and save, save, save!
I crossed paths with this fancy-pants term - Exponential Growth-Bias - while reading an article¹ by Dr. Shlomo Benartzi, a professor at UCLA’s Anderson School of Management. The good doctor explained this type of bias as “the tendency of people to neglect the effects of compound interest in their thinking”. So, why do I start bloviating about the potential impact of compound versus simple interest (I call it The Amazing Power of Compounding) in a blog about saving and investing? My reasoning is that a basic understanding of compound interest is at the very core of developing an optimal long-term saving and investment program…and it’s the very reason why my target audiences are our younger generations. Simply put, they have more time to benefit from compounding.
To not appreciate the impact of compounding on a saver’s long-term investment program can have lifelong implications. I will mention compounding time and again in future blogs, but I wanted to highlight it early in my blog’s life, with examples, hoping my youthful audiences will come to appreciate its important role in reaching long-term goals.
Later examples will come but allow me to use a Dr. Benartzi example because it gets right to the point. He asked the simple question, “How much money will you have in your retirement account should you invest $400 a month at 10% for 40 years, compounded monthly?” The correct answer – which adds the interest earned each month to the principal sum, and then calculates the following month’s interest on that amount – is approximately $2,530,000 using Bankrate’s simple savings calculator.
Or more telling, what would be the end result of investing a single dollar at age 20, compounded monthly at 10% until age 65...just one dollar, mind you. The answer: $88.35. If you wait until you’re 40 to invest that single dollar, you would end up with just $12.06 at age 65.
So what’s the big deal? The big deal is that most folks suffer from Exponential-Growth Bias mentioned above… the tendency to neglect or not truly understand the effects of compound interest. Following Dr. Benartzi’s reasoning, they will usually do a quick simple interest mental calculation of $400 x 12 months x 40 years x 1.1, the sum of which is $211,200. In short, people tend to overlook the potential impact of compound interest on long-term investing – much to their detriment.
And Exponential-Growth Bias cuts both ways. Those who suffer from this bias are often guilty of taking on too much debt because they underestimate the true cost of borrowing. Be assured that the Wazoos who loan us money on a long-term basis (mortgage companies, auto companies, etc.) are well-schooled on the benefits of compounding. Who among us hasn’t suffered the shock of the true cost of a home, factoring in 30 years of mortgage payments. Ignoring homeowners’ insurance and property taxes for a moment (which are usually included in a monthly mortgage payment), the ultimate out-of-pocket cost of a $300,000 home financed for 30 years at a 4.5% rate of interest comes to $497,800 (assuming a 20% down-payment). At 5.5%, the cost of that same home almost doubles to $550,600. Whew!
To guard against both sharp edges of the Exponential-Growth Bias blade – the tendency for all of us to save less and borrow more during a lifetime – a clear understanding of The Amazing Power of Compounding is in order. A power that can work both for and against us. Perhaps this brief enlightenment won’t totally solve the problem (you can lead a horse to water… blah… blah… blah), but exposure to the math just might make us consider the true consequences of certain long-term money decisions – of the high cost (and/or rewards) of venturing down such paths. To paraphrase the good doctor, “there’s magic in investing our money and leaving it alone… and of paying down debt as quickly as possible.” For more information on this topic, go to the Q&A page of this website.
Where to start? You’re just out of school. You have a new job. You finally have a steady source of income. And you feel like it’s time to put some financial order in your life. You’ve probably read or heard comments in the news media that most individuals/families would be hard pressed to meet an unanticipated $500 expense. I found that hard to believe until a couple of years ago when a major local disaster – the August 2017 Hurricane Harvey flood – damaged over 200,000 homes in the Greater Houston area. This devastating event left thousands of gainfully employed people in a major financial pickle. It compelled me to write an article that my daughter published in her informative website (http://youmeandthetree.com/). She posted it under TIPS FROM POPS and titled it “Harvey, Irma and the Importance of Rainy Day Funds”.
A rainy day fund, huh? When you’re flirting with financial insecurity – living from paycheck to paycheck – the first order of business you should tackle is to accumulate 3 to 6 months of liquidity to meet unexpected expenses. Think about it. Most young people on the front-end of their first good job with generous benefits often can’t even meet medical plan or auto insurance deductibles much less the cost of unexpected emergencies. So, they should start building a liquid rainy day fund… money that’s deposited in an easily retrievable but separate bank account.
In the case of the Harvey flood, I wasn’t referring to the Texas Legislature’s multi-billion-dollar “Economic Stabilization Fund”, a type of governmental rainy day fund used for disaster relief. I was speaking of the tens of thousands of individual Texas Gulf Coast citizens who, tragically, found themselves with flooded homes, soaked furniture, ruined automobiles, moldy clothing, and in some cases, an interrupted paycheck. Seventy-five percent of these folks were located outside the 100-year flood plain, not covered by flood insurance, and without a personal rainy day or emergency fund to help restore their lives to normal.
According to a FINRA Investor Education Foundation Study, 56% of people nationally don’t have an emergency fund large enough to cover 3 months, much less 6 months of unexpected expenses – outlays such as major auto or home repairs, job loss, medical emergencies, unplanned travel expenses and… ahem… flooded homes. Sixty-four percent of Americans don't have enough cash on hand to handle a $1,000 emergency expense, let alone an uninsured flooded home, according to a survey by the National Foundation for Credit Counseling. Twenty-five percent of Americans don’t have a rainy day fund at all. Many of these folks do, in fact, live from paycheck to paycheck, often by necessity, choosing to run the risk that no major financial disaster will uproot their lives. It’s a good bet that one week before Harvey struck, most Houston and Harris County, Texas, citizens barely gave a tropical depression in the Southern Gulf a second thought… or if they did, bet that it would not veer north with uncommon fury.
So, what happens when individuals or families without rainy day funds suffer a financial setback. They borrow from family or friends. They neglect to pay other bills. They sell or pawn other assets. They get a cash advance from a credit card company. They mostly do those things that simply exacerbate their financial woes. This is why I titled this blog, A Financial Firewall. In addition to helping meet those unexpected expenses, a rainy day fund helps avoid disruptions in meeting the goals of a long-term financial plan. More on that in later blogs.
So, how does one begin the process of building an emergency fund? First, don’t set initial emergency fund goals so high that you soon deem them unrealistic or unattainable. One hundred or one thousand dollars is better than nothing, and when you hit that mark, strive for two hundred or two thousand dollars… then three hundred or three thousand, etc. To protect yourself against the possibility of a major emergency, develop a working relationship with your local banker and establish a meaningful line of credit. Money that could be borrowed in case of a financial emergency. And in that instance, use your smaller rainy day fund to supplement the line of credit.
Where do these emergency funds come from? As sources of funds, reduce or eliminate spending on nonessential goods and services while building your nest egg. Use spare change – dimes, quarters and dollars – or an unexpected salary increase, a tax refund, or a few restaurant meals foregone. You might even have that bank mentioned above automatically shift a small amount of money ($25-$100) from your checking to your emergency account each month. After a month or two of shifting, you might not even notice the difference, and it adds up quickly!
But in getting started, ensure that basic day-to-day needs are met to avoid discouragement during the accumulation process. And be wise, keep your emergency funds in a separate account; one less accessible than your regular checking or savings accounts. And DO NOT carry a debit card tied to that account. Make it a bit inconvenient to access these funds. In short, make the account accessible, but not too accessible. Force yourself to consider your actions before making a withdrawal. Accept the fact that all of us lack a bit of monetary self-discipline from time to time.
In short, a rainy day or emergency fund is a relatively accessible stash of cash for use only in case of emergency. Don’t use it to buy an automobile or computer. Don’t buy a new piece of furniture or remodel your kitchen with it, unless, of course, you had a rainy day fund and lived in the City of Houston and Harris County, Texas, back in 2017. By the way, Houston, a bustling metropolitan area well-stocked with numerous Fortune 500 companies, is also a population of folks with big hearts in times of great stress. In addition to friends and neighbors, hundreds upon hundreds of companies, large and small, came to the aid of Harvey victims – supplying employees with temporary housing, food supplies, interest free loans, grants and volunteer cleanup crews in addition to counseling and employee time off to take care of family needs. These were voluntary acts, and not all companies participated, but let us NOT forget about those many rainy day employers, friends and neighbors who did!
To drive this “rainy day fund” point home, in December 2018 The Federal Government halted the function of many of its agencies due to a budget impasse. Some 800,000 federal workers and service providers with very secure jobs missed a paycheck or two. As is typical of government shut-downs, those workers later received the missed paychecks, accrued sick and vacation time – and their pensions were calculated as if they had been on the job during the shutdown. Still, according to news reports, many of those government workers quickly began to experience all kinds of financial chaos. In short, despite holding very secure positions with the federal government, many of them could not handle this short-term financial disruption in their lives.
Simply put, a rainy day fund is your first step toward long-term financial security. And it also serves as a firewall protecting your long-term plan from short-term financial chaos.
The Wynn-Fowler, Inc. experience was my final effort in the stress-filled game of energy marketing. I next decided to try my hand at what more and more of today’s Millennials (Generation Y) propose to do with their careers – retire from the eight-to-five merry-go-round by age forty and become masters of their own destiny. They call it FIRE (Financial Independence, Retire Early). In so doing, I pursued several interests. I continued to serve on the Board of Governors of the OSU Foundation; managed all aspects of my immediate family’s personal assets, including two partnerships; co-founded a real estate company; spent years volunteering in water conservation education during which time I co-founded and served as Chief Financial Officer of Water Lily Press, Inc. and SaveWaterTexas.com; wrote several fictional novels, a financial primer for Generation Xers, numerous water industry white papers, and several biographies of luminary figures in the energy, water, and southwestern art fields, a couple of “Dime Novel” series of historical Texas notables, and wrote and published a children’s book, illustrated by the celebrated artist, M. S. Franco. Together, this amazing artist and I continue to donate proceeds from the book for fundraising purposes.
Early in my FIRE-like period, I accepted as factual Woody Allen’s gag that “the definition of a broker is someone who invests your money until it is all gone”. I also adopted my own PDQ Principles of investing (patience…diversification… quality). At their core, these principles orbit around Vanguard icon, John Bogle’s industry-impacting Index Funds (Bogle died January 16, 2019). This simple approach to investing changed my life – made it more financially productive and less stressful – liberating time that I could commit to other interests. Life has been good to me. Good enough such that I developed my own personal motto: For those more fortunate, help those less blessed.
By the way, even though patience is one of my PDQ principles, and although I lean toward a buy-and-hold strategy, we, as investors, must be ever attentive. In short, don’t set-it-and-forget-it because as Bob Dylan would tell us, “The Times They Are A’Changin’.
In closing, I extend my everlasting appreciation to the late John Bogle whose inventiveness exposed retail index funds to millions of small investors like myself. As a result, those years of higher returns from investing in low-cost index funds provided me with the FIRE to leave the corporate world behind and do my own thing.
That said, it’s time to address the important business of saving and investing, never forgetting these watchwords: Financial Planning: It’s Never Too Late, But Early Is Best!
Life brings countless learning experiences, but none more impactful than those imposed by my parents before I reached my teenage years. In brief, my later experiences included working one summer on a sister’s farm in exchange for room, board and a heifer calf. Over time, that single little heifer multiplied into a small herd that helped pay for college.
I paid for 100% of my college expenses working odd jobs during summer and semester breaks and for Oklahoma State University (OSU) after class. Such an accomplishment can still be attained, but it requires non-monetary assistance. Several of those summer jobs were arranged by my brother. And my future wife, also an OSU student, played an important role in this effort. She worked as secretary for the Dean of Men who awarded Dean’s Honor Roll certificates each semester. Since I didn’t have time or money to waste, I made his list every semester. Through a Residence Council, the Dean rewarded my scholastic effort by recommending that I be appointed the first president of a new dormitory, Parker Hall, and hired me as a student assistant in the facility. The job came with important perks: a private room and telephone, twenty meals per week in the cafeteria, and a small monthly remuneration. That experience taught me to always be cordial to secretaries (and university Deans).
Along the way, I received a single $500 scholarship. Those funds helped restore my somewhat depleted savings account. Life was good thanks to the Dean and to my future wife.
Graduating with a Bachelor of Science degree in Accounting, I briefly worked in Humble’s (now ExxonMobil) Tax Department before serving two years as a U.S. Army Finance officer in Turkey.
After military service, I returned to OSU where, with the help of a hardworking wife, I earned an MBA degree. While there, I managed an apartment complex for OSU’s Housing Department. The perks of that job included a two-bedroom apartment (we needed the space, Kim had arrived), a family meal ticket good at all university cafeterias, deeply discounted tuition, a free medical plan, and a student activities pass to all campus events. A small G.I. Bill stipend also came in handy.
Upon completion of my MBA studies, I accepted a position with a mortgage company’s commercial loan department. I left the mortgage company – a good learning experience, but not my cup of tea – to join Conoco’s Management Training Program. My last position after seven years with this good company was Director-Supply & Distribution in their Natural Gas Department.
I left Conoco to join a startup firm as Executive Vice-President and part owner of Gulf States Oil & Refining Company. After selling my interest in Gulf State, I co-founded and served as President of Wynn-Fowler, Inc., an energy products marketing company. During this period, I served on the Board of Governors of the OSU Foundation for several years. While on the Board, my wife and I funded several President’s Distinguished Scholarships (PDS). These prestigious scholarships are designed to attract top high school graduates to OSU, and because they are perpetual in nature, still help to fund the education of top OSU students.
Be patient with me. I have just one more history lesson before getting to the point of what this blog is all about.
I was the last of eight kids who grew up on a cotton farm in Western Oklahoma. My parents struggled to rear their offspring during some tough times: the 1930s Depression, its evil twin, the Dust Bowl, WWII and an epic 1950s drought. Both out of necessity and by design, they used these difficult circumstances to teach us the value of time and money – in short, how to be fiscally conservative.
In those “good ole days” money was a scarce commodity. Most farmers didn’t hire field hands. They put their kids to work. When we enrolled in primary school, our father also introduced us to the cotton patch. It wasn’t slave labor or child abuse. He paid us a wage commiserate with our ability to do field work, but there was a catch. Each autumn, our mother took the younger kids to JCPenney to buy school clothes. Fifty percent of the clothing tab – the catch – was deducted from our cotton patch earnings. Anything left over, we could spend as we wished. I can’t speak for my siblings, but that 50% obligation focused my mind on how much I spent on school attire. It also taught me to carefully monitor other spending habits at a young age.
I also had other duties when not toiling in the cotton fields. These chores included milking a couple of cows, filling hay cribs for the rest of the herd, slopping hogs, pumping fresh water for my mother’s kitchen, and tending to the chickens– including securing their roost each evening to ward off night-prowling varmints. My reward for these tasks was the week’s accumulation of “surplus” eggs – a commodity that I exchanged for cash at the local produce store.
All eggs not required by my mother for the family’s breakfast or for my sisters’ desserts, were mine to keep. Once I stowed an egg in my crate, no one dared touch it but me. This egg business also taught me the rudiments of negotiation – with the produce store egg buyer and with my pesky sisters regarding their egg consumption. They deliberately tormented me about my hoarding tendencies – ordering extra eggs for breakfast or inventing fictitious recipes that required prodigious quantities of egg whites or yolks. These loving but mischievous sisters seldom followed through with their schemes, but only after some serious negotiation with their little brother. I usually ended the week with a tidy number of eggs.
Those produce store visits exposed me to more than swapping eggs for cash. My first duty was to check the store’s chalkboard for that day’s egg quotes, frequently a stomach-churning experience. I quickly learned that selling a commodity could be a risky endeavor. In hindsight, my common-sense father exposed me to these elementary business skills for good reason. To this day, I appreciate his simple but effective lessons in personal finance – and my mother’s insistence that I open a savings account at the local bank into which I made a weekly deposit before a single penny of egg money could be spent elsewhere.
Trading my time for money and having to pay for essentials (clothing) before spending a penny for pleasure introduced financial habits that would stick with me throughout life. Equally important was the discipline learned by opening and depositing money into that tiny savings account every week – money untouched and earning interest until I left home for college years later.
Stay tuned. I’ll get to what this blog is all about very soon.