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Why Simple Savers Lose in the End
- By Travis Echols
- •
- 29 Jul, 2017
Originally written on 1/20/2017.
Most
people can never save enough money to fund a long retirement. We need
our savings to grow. Without growth, the rising cost of
living erodes our purchasing power and renders our savings worth less
and less over time.
Even if we were saving in a perfect world (no taxes, no inflation, never any setbacks), we couldn’t save enough for a long retirement. For example, a person earning $100,000/year, saving 20% faithfully for 30 years, would run out of money in 7.5 years ($600,000 / $80,000). This is the math for any salary.
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Inflation is the investor's #1 enemy
But as we know all too well, this is not the perfect world. There are taxes and the cost of things we need to live do rise as depicted in Chart 1 below.
Chart 1. The rising cost of living
To combat this problem, most investors need their savings to not only keep pace with the rate of inflation, but to substantially exceed it. In other words, we need real growth.
Another way of depicting the impact of rising costs on savings is to calculate the deterioration of the purchasing power of $100,000 over a 30-year period.
Chart 2. The deterioration of $100,000 over 30 years
The problem of inflation creates an extra drag which must be overcome just to maintain the same purchasing ability year after year. This inflation risk requires investors to resist overweighting their portfolios with low-yielding investments which could effectively cost the investor multiples of their savings in lost earnings potential. This is why simple savers lose in the end. But there is a strategy to prevent this and it is informed investing in stocks.
Stocks have provided investors strong long-term growth
The major asset class that has the best track record for growth over the long run, by far, is common stocks. In retirement therefore, stocks are often used to give investors a higher probability of outpacing inflation over long periods.
For 87 years, from 1/1/1928 through 12/31/2014, the compound annual returns for stocks compared to bonds are as follows:
The reason so many financial advisors recommend stocks for meeting long-term goals is because of stocks’ historical double-digit average returns over long periods. Stock investing is ownership in companies. And unlike investing in precious metals like gold, companies can adapt to changing economic conditions. Companies can change their products, change their target market, hire more people, lay off people, hire different people, etc. Companies harness human ingenuity to provide goods and services that other people need or want to buy. Companies are the well-spring of our economy. There would be no government taxes to collect if people didn’t have jobs and companies didn’t earn profits.
To show the growth potential of stocks, let’s look at American Funds’ oldest stock mutual fund, The Investment Company of America (ICA), which was started in 1934. The fund has persevered through market highs and lows, world conflicts and ever-changing technology. Over the 82 years ended December 31, 2015, a hypothetical $1,000 investment in ICA would have grown to $10.8 million and earned an average total return of 12.0% per year — more than three times the rate of inflation (3.6%).
The story of the Boones and Klausens
The ICA guide to investing presents the hypothetical investments of two fictional couples, the Boones and the Klausens, over a 20-year period of their retirement to see the difference stock investing can make.
Margaret and Harry Boone. Twenty years ago — at the end of 1995 — the Boones and the Klausens retired. Each couple had $200,000 to invest. The Boones put their money in a 20-year U.S. government bond that paid a guaranteed 6.01% a year. They were satisfied with their “safe” annual income of $12,020. Twenty years ago, you may have been able to get by on that. But it takes $18,522 today to buy what $12,020 bought in 1996. Even worse, when the Boones’ bond matured at the end of 2015, they went to buy another and found the rate on 20-year Treasuries was 2.67%. That would provide them with only $5,340 a year. Of course, the Boones are guaranteed their original $200,000 nest egg — although that won’t buy as much as it used to either. The Boones’ “safe” investment, it seems, wasn’t so safe after all.
Vivian and Joe Klausen. The Klausens invested their $200,000 in ICA and decided to take monthly withdrawals at an annual rate of 5% of their account value at the end of each previous year. That meant they took $10,000 in 1996, representing 5% of their original investment. In 1997, they took 5% of their account balance as of the end of 1996, and so on. Because the value of their investment has gone up and down from year to year, their income has varied. They started out living on less than the Boones. But the Klausens’ income generally outpaced the Boones’ over time — and their original investment increased substantially.
Over the
long term, they enjoyed greater rewards than the Boones because, by
investing in a portfolio of stocks, they chose to accept
greater volatility, recognizing they could lose money. Despite recent
volatility, the last 20 years were generally good for stocks and for
ICA. In all 63 of the 20-calendar-year periods in ICA’s
lifetime, in fact, the Klausens would have done better than the Boones.
I am not recommending this fund to anyone, but I am using this story of the Boones and Klausens to show the difference between informed investing versus simply saving. Certainly not everyone needs to be a stock investor, and most people cannot endure the volatility of owning a 100%-stock portfolio. But most people need some stocks for growth to hedge against, and outpace, inflation.
Correlation of stock returns and interest rates
But what about inflation and rising interest rates? Won’t rising rates hurt stocks if inflation returns to more normal levels in the coming years? Correlations between weekly stock returns and interest rate movements going back to 1963 show that when the 10-year treasury yield is below 5%, rising rates have historically been associated with rising stock prices. When yields go above 5%, there is a negative correlation between interest rate movements and stock prices. As of this writing, the 10-year treasury yield is 2.38%. This is not a predictor of stock market movement, as there are many other variables at work, but it would suggest that interest rates are not at the level to necessarily impose a damper on stock prices.
Consider the opportunity cost of not owning a balanced portfolio including stocks
Finally, investing behavior studies reveal that investment losses make people feel bad more than investment gains make people feel good; so people tend to avoid volatile investments; but mathematically not having what you could have had is the same as having it and losing it.
What are you losing by avoiding all market risk while
immersing yourself in inflation risk? The key is balance. Owning the
right mix of stocks, bonds, and cash (and rebalancing periodically) is the right way to keep all your risks in check...and this is all the more important if you are retired or approaching retirement.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
