The Census Department estimates that over one million baby boomers will live to be more than 100 years old! Unfortunately, few of them have even begun to save for retirement, or even know how much it will cost. Like two trains hurtling down a track toward each other, savings rates have fallen, and life expectancy is increasing. The resulting crash will not be pretty!
Boomers wishing to avoid the financial disaster of outliving their money have two realistic options: They can beat the odds and die early, or begin saving now in a serious manner. As we shall see, any delay in beginning to save is not a viable option. And, when boomers save and invest, they had better get close to a market rate of return. Otherwise, there are going to be a lot of very old, very broke people wandering around. Given demographic trends, it’s not likely the government is going to be in a position to bail boomers out.
One of the most powerful financial concepts assisting investors is the magic of compounding. It looks like magic because rather than increasing in a straight line, compounding investments increase geometrically. Not only does principal increase each year, but this year’s earnings become next year’s principal and accrue even more earnings. The process repeats as long as the money is left to grow. As a result, what seem like small differences in input generate giant differences in the final result. In other words, what appears to be a small change in rate of return, or slightly longer time period, will make the difference between poverty and comfort in your old age.
Let’s have a little fun with numbers to see how compounding can work for us. Applying what we can learn about compounding will give us some “no-brainers” to guide us in our accumulation planning.
First Things First
Before you start a long-term investment plan, you must have your basic financial house in order. No one should invest until they have a 3- to 6-month cash reserve for emergencies, the proper insurance protection, and the basic legal documents. It won’t do you or your family any good at all to get a 30% rate of return if you lose your job, wreck your car, die, or get disabled tomorrow. In a very real sense, life and disability insurance buy you time.
Put Time on Your Side
Here’s an example of how compounding can put time on your side:
Suppose on the day you were born your parents wanted you to have a nice retirement when you turned 65. Each year for 10 years, they deposited $1,000 into an account for your retirement. Assuming that they earned a reasonable 10% net, your retirement plan would grow to $15,937.42 by your tenth birthday. At this point, your parents stop making contributions. The fund continues to earn 10% net, and you are able to resist the overwhelming urge to cash it in for a new Corvette when you reach 21. The fund grows to $3,013,115.83 over the next 55 years!
To adjust for inflation, we assume that about 3.5% of the nominal yield was eaten away. The “real value” of the accumulation in terms of dollars when you were born is $322,027.60. The “real value” of the inflation-adjusted income available to you is $20,931.79 for the rest of your life. We are assuming that you withdraw 6.5% beginning at age 65, and leave 3.5% to grow to hedge the inflation rate. All of this was accomplished with a total cost to your parents of only $10,000. Compounding had worked its magic.
Now let’s assume that your parents waited until your tenth birthday to begin a savings program for you. If they deposit $1,000 a year for the next 55 years, they will “only” accumulate $1,880,591.43 for your retirement. Waiting 10 years has cost the accumulation more than $1.2 million, even though they have contributed $55,000 to the program.
If they still want to accumulate $3,013,115.83, they must contribute $1,602.22 per year for 55 years at 10%, and the total cost of the program has grown to $88,121.94.
Let’s change the example again. You are now 20 years old, just out of college, and want to save for your own retirement. How much must you save each year at 10% to accomplish the same goal at age 65? A few seconds with a calculator will show you that it takes $4,191.26 per year. The price is going up, but it’s not out of reach. However, since you are entitled to a new car, and you don’t have a stereo yet, you put your savings plan off for a little while.
At age 30, you briefly toy with the idea of starting a retirement plan, but you now have two children, a spouse, and a new condo. You are a little distressed to see that the annual cost of meeting your goal has grown to $11,117.51.
Age 40 finds you with a new home in the suburbs, and for your birthday you fulfill the right of every American to own a wide-screen TV. At half-time during the Superbowl, you pull out the old financial calculator and find that with 25 years remaining to age 65, your cost to fund your retirement supplement is now a serious $30,637.58 per year. The shock sends you to the refrigerator for another brew. As the half-time show winds down, you tell yourself you’ll think about it next year.
Fifty finds the kids away at college and a new Infiniti in the driveway. Your company may lose a big contract, and there is disconcerting talk about downsizing, so now doesn’t look like a great time to start a serious savings plan. You’re too stressed out to check, but if you had, you would have been shocked to see that with only 15 years to go until your planned retirement, you will need to deposit $94,823.14 each year!
Age 60 finds the “children” living at home again. They don’t seem to be in any big hurry to leave, although there has been a trial balloon floated to “borrow” the funds for a down-payment for their own condo. The $189,059.14 required each year to fund your retirement plan is clearly out of the question, and you are wondering how it will feel to still be working at 80. You catch yourself daydreaming about winning the lottery.
Lesson No. 1: Start Early
The first lesson we learn from our little exercise is to start investing early. Put time on your side; the earlier you start, the easier the burden, and the more likely you are to have a successful outcome. It’s never too early to invest for retirement, but it can get too late. It’s easy to put it off. There is always a good excuse. Don’t let it happen to you. The cost of reaching your goal goes up each day.
Lesson No. 2: Plan for a Reasonable Rate of Return
The next lesson we can learn from an exercise like this is the importance of getting a reasonable rate of return on our investments. While I used 10% as a “fair” rate, I don’t think many Americans actually come close to this as a net rate of return over time. Far too much money is committed to “safe” low-rate-of-return asset classes, and far too little to the higher-risk, higher-return classes.
Let’s go back to the time you were a 20-year-old. It took $4,191.26 each year for you to reach your goal at 10%, but if you expect to make only 9%, you must save $5,729.90 per year. Of course, if you expect to earn 11%, you can reduce your funding cost to only $3,053.92. So a 1% change in earnings has a huge impact on funding costs.
Given that we know that risk in an equity portfolio falls as time horizon increases, and that a retirement plan certainly has a long-term horizon, investors should consider shifting assets to where they will get higher rates of return. That means fewer bonds, CDs, and annuities, and more stocks. Within the stock classes, research would indicate that a tilt toward value and small-cap stocks, and international and emerging markets, will increase rates of return. Properly mixed, these asset classes should generate handsome increases in return without undue risk. In later chapters, we will construct a portfolio to demonstrate the possibilities for both increasing rates of return and reducing risk.
Lesson No. 3: Control Costs
Rate of return is not exclusively a function of risk. Cost can have a major impact on an investment program. Markets are reasonably efficient, and it is not likely that you can beat them by much or even at all. Each market can only return so much. That return is reduced by cost. You must adopt an effective cost control program as part of your overall strategy. We will have much more to say about how Wall Street can get in your knickers later. But for right now, I will state that the average client of a full-service brokerage house could save an easy 3% per year by dispensing with its dubious advice.
Lesson No. 4: Control Taxes
One of the least-understood costs in an investment portfolio is tax. In the real world, most of us have to pay tax, and many times our investment plans increase our tax burden. Each time we receive a dividend, interest payment, or capital gain, Uncle Sam has his hand in our pockets.
Tax can become a very serious drag, but it doesn’t have to be. In many cases, taxes on investments are voluntary. Or perhaps we should say they are a tax on ignorance, because they can easily be avoided.
If we go back to our example, suppose the 10% rate of return we spoke of was all dividends or interest, and we received all of it each year as we went along. If we traded the portfolio each time we made a profit on a trade, we create a tax liability. Even if we are in a very modest tax bracket, taxes could reduce our return by 25%. That would mean that our net return is only 7.5%, and we will have a much harder time reaching our goal. Either we invest more or we fall short.
In real estate, the prime considerations are location, location, and location. In tax strategy, the prime considerations are defer, defer, and defer. The longer we can defer paying a tax, the longer we have investment dollars compounding for us rather than going to Uncle Sam. If you buy a stock and never sell it, you will never have to pay a capital gains tax. When you die, your heirs will receive the stock on a new basis from your estate. (They may or may not have to pay an estate tax. That is a separate consideration.)
Mutual funds present a couple of interesting wrinkles. I want to preface my remarks here by clearly pointing out that I am neither an attorney nor an accountant. As such, I never give tax advice. You should check with your professional tax advisor about the implications of the following information. Also, since the Net reaches so many international investors, understand that the following pertains only to U.S. taxpayers. (Almost all other countries have more favorable tax treatment for investors than does the United States. We seem intent on punishing investors here.)
Many mutual funds have huge portfolio turnover. As you are probably aware, each time a fund manager sells a stock in his portfolio, you get a pro-rata share of the gain or loss. All the transactions are totaled at the end of the year, and you get a 1099 tax form for your share. A copy goes to your favorite uncle, Sam. This can often result in a tax to you even in a year when you have losses in account value. The cumulative effect of taxes each year can seriously erode the returns that equity funds can generate. Some of the mutual-fund rating services have included information on tax efficiency. This is a very rough estimate of the capital gains already built up by a fund. Few investors are aware that when they buy a fund that has a substantial unrealized gain, they may soon have to pay taxes on the gain as if they had held the fund from the time it first bought the stocks. This is hardly what we would consider an optimum outcome.
But help is at hand. By their very nature, index funds don’t turn over their assets. So taxes will be minimal compared to an actively managed portfolio. Some index funds have even taken this a step farther. They have a stated objective of never incurring a capital gain for the shareholder. The only time they expect to incur a capital gain for the account is when a company is acquired for cash. In that event, they expect to be able to sell sufficient stocks with a loss to prevent a net gain for the shareholder. So only dividend income and nominal interest income are subject to tax. In an equity portfolio, this should be a very small amount compared to the total appreciation over time.
Just over the horizon are even more tax-efficient index funds. These funds would manage themselves so that dividends and interest were smaller than the funds’ expense ratio, so shareholders should never have to pay a tax until they sell their shares. (We can presume that the implied strategy will favor growth and smaller companies.) When it comes time to sell, if the holders meet the capital-gains holding period, they should get the more favorable capital-gains rate. I expect these funds to be available during the next 12 months.
To maximize your own benefit from this strategy, keep records of each purchase so that you can identify the shares you sell as the highest-cost ones in your portfolio. That will minimize the gain and the taxes.
Beating the Tax Man
Uncle Sam does offer us one great way to beat the tax man for long-term investors. Pension plans, 401(k) plans, IRAs or SEP-IRAs, and Self-Employed Pension Plans (HR-10) all offer total tax deferral. There are no taxes on interest, dividends, or capital gains as long as the funds remain in the retirement plan.
You should take advantage of any tax-favored retirement plans available to you. The combination of current tax deduction and tax deferral is the best thing since sliced bread. Hopefully you will pick up some employer matching contributions, which will really sweeten the deal. Stuff every penny you can afford into your retirement plans as early as you can afford it. As the ad says: “Just do it!”
What’s more, invest in equities for the long haul, and don’t get hung up on trying to time the market or be too concerned about normal market variations. They work in your favor.
Dollar-cost averaging has been described as one of the oldest, least-exciting ways of investing. But almost everyone agrees on its validity. Actually, it is a simple discipline. It requires investing a set amount of money at regular intervals in a particular investment over a period of time:
$$ Invested @ Regular Intervals x Time = Dollar-Cost Averaging
Studies show that investors who use this strategy average a lower cost per share on their purchases than those who try to time their purchases to buy at the lowest prices. Most experts agree that it takes a minimum of 18 months for dollar-cost averaging to be effective.
The advantage of dollar-cost averaging is apparent when you sell a larger number of shares at a higher price. Remember, you accrued more shares because your investment bought them over time at a lower price. Certainly, averaging works best with funds or stocks that have sharp ups and downs, since that gives you more opportunities to purchase shares less expensively.
A simple example developed for the May 1993 issue of Worth magazine illustrates the concept:
You decide to invest $1,000 in your favorite stock on the first of each month for three months. The first month, the stock sells at $100 a share; you buy 10 shares. The second month, the stock falls to $50 a share and you buy 20 shares. The third month, the stock recovers to $75. Your $1,000 investment buys you 13.3 shares.
You now have 43.3 shares that you bought at three different prices for a total outlay of $3,000. The stock is currently selling at $75 a share, so your 43.3 shares are worth $3,247.50. That’s an 8.25% profit. Also, your average cost per share is less. If you divide the average price per share by your total investment of $3,000, your average cost per share is $69.28.
Dollar-Cost Averaging Sample Month Amount Invested Price Per Share # Shares 1 $1,000 $100 10.0000 2 1,000 50 20.0000 3 1,000 75 13.3333 ______ ____ _______ $3,000 $75 43.3333 (Total) (Average) (Total) Amount Invested = $3,000 ($1,000 x 3 months) Current Value = $3,250 ($75 x 43.3333) Average Cost/Share = $69.2308 ($3,000 / 43.3333)
Of course, this is a hypothetical illustration. It does not imply a guarantee of a specific return on any particular security. It does not take into consideration taxes, inflation, and costs in purchasing stocks, which should all be factored in when you figure your return on investment.
A 401(k) plan is an excellent way in which to implement dollar-cost averaging. Since money is deducted each pay period from your earnings and placed into the 401(k) plan, you will find that you have paid less per share over time if your choice of investments remains constant for a substantial length of time.
Reinvestment of dividends and capital gains is a form of dollar-cost averaging and one of the smartest things investors can do. Also, with few exceptions, reinvesting costs you nothing in terms of loads or fees.
Finally, if you do decide to use the dollar-cost averaging strategy, you need to bear in mind that, although it has been a highly successful investment technique in most instances, it neither assures a profit nor protects against losses in a down market. Dollar-cost averaging works only if you continue to purchase systematically, regardless of whether the market fluctuates up or down. As such, you have to stick with the program to get the best benefits.
Nobody enjoys their toys more than I do. I know I am entitled to each and every one of them. So I have had to trick myself into saving. I am constantly searching for ways to keep my grubby little hands off my money. In fact, I’ve set up a process that doesn’t allow me to ever see the money. I use a maximum pension contribution to make sure I don’t convert all my earnings into boats.
The best way to make sure you have the funds when you need them is to set up a payroll deduction each month. This will put the tremendous power of dollar-cost averaging to work for you, and painlessly reinforce your wise decision to start now. One of my friends wants a bill each month for his savings goal. Another gives it to his wife to invest. Just find a method that works for you. If you need further discipline, just remember that the only thing worse than being dead may be to have outlived your money!
So, there it is: Put time on your side, start early, invest for high rates of return, control costs, control taxes, use dollar-cost averaging, and initiate a forcing system if you need to.
In the next chapter, we will start to develop an investment policy by defining our objectives, time horizon, and risk tolerance.