Three Little Pigs: The Good, The Bad, The Ugly

This is a story about Three Little Pigs – you’ve just met The Good Little Pig in this video …

The Good Little Pig

He belongs to (in fact, is the “official spokespig” of) a wonderful organization called Feed The Pig: a worthy and noble cause sponsored by the American Institute of Certified Public Accountants (AICPA) and The Advertising Council with the aim of encouraging and helping Americans aged 25 to 34 to take control of their personal finances.

Unfortunately, in their enthusiasm to bolster the meager savings rate of our next generation of movers and shakers, they seem to forget a Very Important Piece of Information …

… but, first let’s meet the 30 year old ‘Wolf’ [AJC: actually, he's just a bachelor ... but, as far as the girls go, he's a wolf alright ] earning $50k a year.

The Good Little Pig – in his Sunday Roast Best Pink Suit – asks the Wolf to set aside 5% of his gross (or $2,500 this year), with the following assumptions:

The Good Little Pig then tells the Wolf that if he agrees NOT to blow his little house of straw down, that he would show the Wolf how this will make him rich … accounting for all sorts of different life events …

… the Wolf thinks it’s a great idea!

The Good Little Pig makes good on his promise and shows the Wolf how just saving $2,500 a year (5% of his salary) can mushroom (goes nice with pig) to anywhere from $179,000 (even if he loses his job, takes time out to go back to school, then starts his own business pretty late in life) …

… to a massive $555,000 (if the Wolf gets a job and promotions pretty quickly, followed by a bonus here or there).

The Wolf promptly blows the little house of straw down and eats the Good Little Pig.

He’s still hungry so he looks for another pig.

The Bad Little Pig

Fortunately (for the Wolf, not the Pig), the Wolf chances on The Bad Little Pig who has heard all about what happened to the Good Little Pig on the pig grapevine (vine goes very nicely with pig … particularly a nice Cabernet very slightly chilled below ambient) and admonishes the Wolf saying “how could you eat my bro’, when he showed you how a measly $2,500k could become anywhere from $179k to $555k over 35 years?!”

The Wolf was surprised: “Why?” he said, “it’s clearly because I would be stuck in some lousy job, sucking up to my boss to get the max”.

To which the Bad Little Pig responded: “But, if you did nothing but save $2,500 a year and increase it just with minimum pay increases (nothing fancy, no promotions, no sucking up to the boss,) then I can show you how to get $678,000 over 35 years … surely, you’d like that?! But, only if you promise not to blow down my little house of sticks …”

Before the Bad Little Pig could finish his sentence, the Wolf blew the Bad Little Pig’s house of sticks down, finishing him off in just one bite (hic!).

But, not quite stuffed (unlike the pigs … in more ways than one), the Wolf went searching for more pig.

The Ugly Little Pig

Being Pig Season, the Ugly Little Pig was easy to find; he was honest and gave the Wolf the plain, ugly truth:

“Look, if you really promise to spare me – not that you can do much damage to my bricks & mortar financial stronghold (after all, the Lehpig Brothers have been around for a hun’erd and a score years or more) – I’ll tell you that you can’t get anywhere saving just 5% of your salary, no matter how many promotions you get. You can (and should) save at least 3 times that … $7,500 of your salary now and keep increasing it as your salary goes up …

… that will give you over $2 million when you retire in the lap of luxury in 35 years. Easy, simple … and (almost) guaranteed.”

The Wolf asked: “Wow! I’ll be a multi-millionaire … is that it, the best you can do?”

To which our very Ugly Little Pig answered, smug behind his brick facade: “What more do you want?! Start your own talk show if you want more, Wolf, now leave me alone”.

I don’t think that I need to tell you, what with the poor quality of mortar and workmanship these days, this was the easiest of all the pigs to get to and eat.

You see, our Wolf wasn’t as Good, Bad, or Ugly as the Three Little Pigs …

… he was an average Joe who didn’t just buy into the financial hype spruiked by the financial ‘professionals’ and the ‘do gooders’; at least not without also checking the numbers with a simple spreadsheet himself.

That little spreadsheet showed him just what I’ve been telling you all along: because of inflation (even if it only averages 4% for the next 35 years), $2 million in 35 years is only worth $507,000 today, which provides the Wolf a fairly ‘safe’ retirement income of just $25k a year (in 2009 dollars) … just half his current salary!

When asked why he ate all the pigs who were there to help him, the Wolf simply looked back at the numbers, and sighed:

“Why go without pig today, just to have the same or less pig tomorrow?”

Why indeed?

Disclaimer: No pigs, advertising exec’s, or accountants were harmed in the making of this post.

Building a better retirement account …

If I say “retirement account” what do you say?

“401k”?

Or, is there a better way …

MoneyMonk thinks that there may be, but only once you’re a millionaire:

I’ll turn this over to Scott, who addresses both of these issues very nicely:

No matter how much tax you pay next year, Scott, by investing in income-producing, appreciating assets – and, holding for the long-term in the right types of structures (trusts or companies) – I have absolutely no doubt that you will (a) pay less tax and, (b) return more than the average Doctor on the same salary who doesn’t …

… and, since you are one of the 7 Millionaires … In Training! I will show you exactly how to do it … and, anybody who wants to be a fly on the wall (better yet, participate in the open discussion) will be able to learn some valuable lessons, as well.

And, you can take that to the piggy-bank!

The 401k fallacy …

The objective of this blog is not to challenge your thinking on so-called ‘investment truths’ or ‘common investment wisdom’ …

… that’s just a means to an end.

The objective is to help you become rich [AJC: after all the title of this blog IS "How to make $7 Million in 7 Years"], but in doing so we MUST challenge your thinking on so-called ‘investment truths’ or ‘common investment wisdom’!

Do you see how one is the means and the other is the end?

So it is with many of these personal finance ‘myths’ … so many are treated as an end in themselves, rather than the means that they simply are; none more so than the Mighty 401k.

If we are to become rich, we must slay the temptation to lay at the feet of this great Financial Idol and see it not for what it promises (future financial freedom) but for what it really is: simply words written on a piece of paper.

That’s it, the 401k is just a tax-advantaged savings TOOL … it’s not even a scheme, as there is NO guidance as to what you should put in it (other than restrictions to tell you what you MUST NOT put in it).

Therefore, I have NO OPINION on whether a 401k is intrinsically good or bad for YOU … just as I have no opinion as to whether a stone carving is intrinsically good or bad for a pagan civilization … it’s what belief in its purported ‘power’ does for (or against) your [financial] future that concerns me.

It’s not the tool, but how you choose to use it that counts …

Now, I covered the 401k in many posts, but I thought that I would pick up on a great discussion going on over at my other site, where Scott says that he has no use for a 401k:

I can’t utilize many of the retirement accounts because of my income level and the ones that I can, I max so quickly that it just seems moot. For example, right now, I’m saving up cash as fast as I can to purchase the entire building that my practice is located in. This building also has another business next door that will be paying me rent, and in essence, will drop my personal mortgage significantly, while it’s getting paid off in a few short years, then I own the commercial building, not pay rent, AND receive passive income!

So my question to you would be; Should I delay the purchase date to buy this building and all the above said benefits to first max out retirement accounts that I can’t touch for 30+ years, AND get taxed on them when I do.

Which gets me to my Number faster? Purchasing commercial real estate NOW as fast as I can in my 30’s, particularly one’s that I would normally have to pay rent on and actually begin RECEIVING rent on as well, or fund a retirement account to shed some tax now?

After a bit of discussion around the possibility of finding other tax-advantaged investment vehicles, depending upon your financial positions, Jeff summarized the discussion quite soundly:

The only reasons I can come up with right now to not invest in these types of accounts first is either:

1. The amount you want to invest is greater than the annual contribution limits.

Or

2. You don’t like the age restrictions and early withdrawal penalties that go along with these accounts.

Those are both very valid concerns and certainly reasons to not use typical retirement accounts.

Absolutely, Jeff!

If you can achieve your investment goals, at the same time taking advantage of the legitimate tax-shelters available to you (e.g. 401k, self-directed IRA, etc.), then you would be a fool not to do so.

However, if you divert from a financial course that stands a reasonable chance of meeting your financial objectives – the type of course that Scott seems set to take – just so that you can take part in, say, an employer-sponsored 401k, that may not achieve your financial objectives (in the timeframe that you require, not the timeframe that the employer/government offers) then, in my opinion, you are making a huge mistake

401k … a means or an end?

There’s still this general expectation that if you earn an income then you will have a 401k … it’s seen as an ‘end’ rather than the ‘means to an end’ that it really is.

Let’s look at the advantages:

1. Tax free on deposits into your 401k … ‘boosts’ your investment buying power by up to 25% to 35%

2. Possible employer ‘match’ … further ‘boosts’ your investment buying power by up to 50% to 100%

Now, let’s look at the disadvantages:

a) Generally, limited investment choices (e.g. managed funds)

b) High fees (both explicit and hidden)

c) Restricted access to your money until government-managed ‘retirement age’

d) A fairly low ‘cap’ on amounts that may be invested

But, similar lists of advantages and disadvantages can be draw up for ANY form of investment, tax scheme, etc. etc. …

… it’s just that we mostly don’t bother. We blindly accept the 401k as the ONLY way to go.

Ryan says:

I share your distaste for 401Ks, and their fee’s and penalties, but I have to believe that there is some advantage to having tax shelters (be them 401k or not). Otherwise, won’t the government just take all of your hard earned (and passively earned!) money?

Ryan’s right … the Government WANTS you to pay tax, but only the minimum that you NEED to pay … they don’t expect a penny more. The problem is, the government is only interested in the tax portion of your personal ‘Profit & Loss’ … YOU should be concerned with all of it!

As Scott says:

Robert Kyosaki states that the wealthy aren’t the one’s paying the lion’s share of the taxes. The middle and upper middle class do.

A 401k, ROTH, ROTH IRA, etc., etc. are all simply methods of protecting assets from taxes to a greater or lesser extent …

… the problem is not with these ’shelters’ in themselves, it’s in their design. You see, they were designed for the ‘average American’ to encourage them to save for retirement.

You and my other readers are probably NOT average Americans – if you are like me, you are aiming for a Number in the millions – and will surely hit the ‘roof’ (i.e. the maximum amount that the Government ‘allows’ you to sock away during any one year) of these vehicles very quickly, as your income starts to sky-rocket from Making Money 201 activities …. then, once you achieve your Number, the limits that you can have socked away will mean little to your Making Money 301 wealth preservation strategies … it’s why I don’t even bother!

It doesn’t mean that you shouldn’t tax-protect your money …

… it’s merely that Scott has hit the nail on the head: these aren’t the ONLY tax shelters available, or even the BEST tax shelters available.

For example, and as Robert Kiyosaki suggests, investing in income-producing assets via corporate structures (LLC’s; trusts; C- and S-Corporations; etc.; etc.) and taking advantage of all the tax deductions available to you (e.g. depreciation, 1031 Exchanges; etc.; etc.) will blow away any ‘tax advantages’ of 401k’s and similar (even WITH the ‘free’ money from the employer match factored in).

So, let’s not put the cart before the horse:

- FIRST look at the types of investments that you need to make in order to reach your financial objectives – be they long term (i.e. your Number) and/or short-term (e.g. flipping a house / trading some stocks and options)

- THEN look at the best ‘vehicle’ to house them in.

As an extreme example, if you decide that a business is the way to go – and, put up 100% of your savings as ’seed’ capital’ – then having a 401k is hardly going to help you, is it?

Blindly setting up a 401k first, then seeing what investments you are allowed to make in them is putting the cart well before the horse!

Retirement Accounts: 7 Case Studies

Everybody has a slightly (some – like me – dramatically) differing view on the whole subject of 401K’s, ROTH IRA’s, and other forms of so-called ‘retirement accounts’.

If you are in a job, then it might be an easy decision: pull the trigger on maximum withdrawals from your salary and attract the generous employer match. Or, is it?

But, if you are self-employed – or, you have more flexibility in how you choose to handle your retirement accounts than the typical employee – then it becomes a bit more confusing: do you outsource or self-manage? Do you try and save your tax now (on deposits) or in the future (on your withdrawals)? Do you even bother …. ?

Well, if you are still confused, let these 7 ‘case studies’ from our 7 Millionaires … In Training! ‘grand experiment’ guide you:

Scott – Not everybody chooses to have a 401k – or, any type of retirement account, for that matter – and some even do it because they feel that they have an even better ‘retirement plan’. Scott is one such example … what do you think? Is he doing the right thing?

Lee – Is at (or past) typical retirement age for most of us. He thinks that he has made some (a lot?) of mistakes with his finances, yet he at least has some money put aside. But, it’s not enough to meet his goals … and, is it really enough to live off?

Josh – On the other end of the age/work scale is Josh, who still has the ‘luxury’ of living at home with his folks: free rent = more to save (or spend?). Should Josh even be saving in a system that doesn’t allow him free’n'clear access to his money until he is 3 times his current age? And, should Josh be using his ‘retirement account’ in the Grand Casino that is the Options Market?

Ryan – Is a highly paid rep. for medical equipment with some ideas of his own. He is exploring the options as to whether he should be investing INSIDE his 401k etc. or OUTSIDE, both for him and/or his wife. What advice could you give him?

Diane – Is currently assessing her options; while she does so, she is drawing down on her retirement account. Should she take the penalties and pay down debt and/or continue to draw down her living expenses?

Mark – The title of his post is 201k in reference to the beating that the stock market has given it recently, but Mark has a long-term view; it seems to me that he hopes to reach a large Number through investments, etc. and leave his retirement accounts simmering along nicely … if the meat’n'potatoes of his Wealth Strategy don’t pan out, then perhaps he’ll have a nice hot financial stew waiting for him when he reaches 60?

Jeff – Here is an example of a reasonably well-salaried government employee who has one foot in each camp: his Grandpappy once told him to invest in his 401k so that he does, as well as have a couple of residential properties. How much money – in today’s dollars – does a high-saving guy expect to accumulate by the time he reaches 60? Is it worth the wait?

You be the judge … be sure to read the comments and add some of your own

Your employer may be stealing from you!

Intrigue over at 7m7y.com! Who’s the Millionaire … In Training leaving? And why? Click here to find out …

___________________________

“Oh, little 401k, how I hate thee … let me count the ways” (2008, Anon.)

I don’t know who first uttered these words but, they strike a chord with me; here are some (admittedly, slightly cynical) reasons NOT to like the humble 401k:

1. Little or no choice of investments

2. Have to wait to traditional retirement age to receive the benefits

3. Stuck with low-returning investment choices

4. Little or no opportunity to ‘gear’ (I guess the employer match and tax benefits counts as a kind of gearing)

5. Fees

6. Your employer may be ‘stealing’ from you

Stealing?!

Yeah, in a way … but, first let’s take another quick look at fees [AJC: Inspired by a comment left on a post by Dustbusterz ... thanks 'Dusty'!]; in 1998 (!) the Department of Labor received and published an independent Study of 401(k) Plan Fees and Expenses.

It found the following average fees being charged by the larger 401k funds:

Total Annual Plan Fees

Lowest       0.57%
Mean         1.32%
Median      1.28%
Highest     2.14%

(Source: Butler, Pension Dynamics Corporation, in Wang, Money, April 1997)

Now, this goes back to 1997, but I just covered some very recent work by Scott Burns, noted financial columnist, and published in his new book, Spend ’til the End, which points to the fees continuing to trend up, citing average (mean? median?) fees of 1.88% now.

Remember that, according to Scott, even a “1% increase in a fund’s annual expenses can reduce an investor’s ending account balance in that fund by 18% after twenty years”!

I calculate that a 1.88% fee reduces your returns after 20 years by a whopping 38% …

But, do you know how your employer actually chooses your funds / 401k provider? On the basis of better returns to you? Given the possible 38% ‘hit’, you would assume at least on the basis of lowest fees for you?

Right?!

Nope … not a chance. In fact, the study quoted an earlier report that found that “78% of plan sponsors [employers] did not know their plan costs” (Benjamin) …

… Great! You are putting your financial future into the hands of your employer, 3/4′s of whom don’t even know what the plans that they are choosing will cost you!

So how do they choose the plan that’s right for you [AJC: ironic snicker]?

The study found, one of two ways:

1. In my opinion, an unethical way: The Study of 401(k) Fees and Expenses quoted a prior report that found employers most often choose “the institutions that furnish the firm other financial services – banking, insurance, defined benefit plan management – to provide their 401(k) plan services and may not make an independent search for the lowest cost provider.”

Your employer feathers the bed of their own business relationships with your retirement money. Nice!

2. In my opinion, a criminal way: That would have been enough for me, if I hadn’t accidentally come across what is regarded as the Retirement Industry’s ‘Big Secret’ … it’s a doozy: it’s where the 401k provider shares some of the fees that you pay them with your boss!

Think about it; your employer provides you with a match to encourage you to remain employed then gets back some of that in fees, rebates, ‘free’ services, or just good old ‘relationship building’ at your expense, literally!

How do the funds and your bosses get away with this? Simple, nobody’s looking: “Revenue sharing is a poorly disclosed and relatively unregulated practice, which falls into the gap between Department of Labor and SEC oversight.”

OK, so does this mean that you shouldn’t participate in your employer’s 401K?

Not at all … it just means that you should do the following:

1. Decide if the 401k is going to do the job for you … will it get you to your Number? At a maximum ‘investment’ of $15,500 per year and a compound annual growth rate of 8% – 12% less fees, this is highly unlikely … you run the numbers then make your choice!

2. If not, is it still wise to continue your 401k (consider it a backup plan) as well as more aggressively investing elsewhere?

3. If you can’t do both, you have no choice but to decide which investing strategy is going to have to give way to the other?

4. If you do decide to continue with the 401k, choose any ultra-low-cost Index Fund option that may be on offer over any other selection; if not available, choose a ‘no load’ fund (be careful … some ‘no loads’ are actually just ‘lower load’). And, do your own homework on fees, because you just know your employer ain’t doing it!

5. Lobby your employer to pass back any revenue-sharing back to the employees

6. Insist that your employer choose funds that work best for you over the funds that work best for them.

What you do with this information is entirely up to you; I don’t need a damn 401k … never have and never will

Define 'long term'?

That was the challenge set to me by Diane, one of the applicants to my 7 Millionaires … In Training! ‘grand experiment’ in response to a post that I wrote, exploding the myth of diversification that the the 401k jockeys seem to hold on to so dearly … I guess that their financial lives do depend upon it

In that post I said that “diversification is only a mid-term saving strategy ..”.

Why?

As I mentioned in that post: “it automatically limits you to mediocre returns: The Market – Costs = All You Get … period!”

But, Diane is right: a key question is market timing. For example, does diversification help you over shorter time frames? Define short, medium, long … ?

Well, typically financial texts will define short term as anything less than 1 to 5 years; medium as anything between 5 and 10 years; and long-term 10 years+

But, it depends upon who you speak to: Warren Buffett would probably define short-term as anything less than ‘for ever’ … because that’s how long he aims to hold his acquisitions for, and often regrets having sold out of other positions too ‘soon’.

He is also reported as saying that he wouldn’t care if the stock market was only open once every 5 years.

But, I have a different viewpoint, and it begins with a question that I posed to Diane:

Di, the ‘pat’ answer is MINIMUM 10 years. The real answer is: depends why you need to know?

Let’s say that you found an individual stock that you want to buy; when I set out to do this, I set no minimum/maximum time-frame that I would hold the stock for. For me, the holding term is entirely driven by price …

… when I buy the stock, it’s only because I believe that it is well undervalued and the underlying business is one that I understand and love. I’m buying the stock and patiently waiting for the market to catch up with my thinking.

When the market eventually does catch up … I’m outta there!

That process can take months or years … if it takes years, then I am reevaluating how ‘cheap’ the stock still is every time an annual report comes out (if the company’s financials no longer make the current price look cheap, then I am outta there early … whether I need to book a profit or a loss).

So, time-frame is just not an issue here …

But, when I ask this question of others, most people are aiming to ensure that they are building their retirement nest-egg correctly, so for them time-frame seems more important … and it is.

When you plan for retirement, you need to work backwards:

1. How much do I need to ‘earn’ as a replacement-salary from my investments in retirement?

2. How big does my supporting nest egg need to be?

3. How long before I want to stop working?

4. What market return can I bank on getting for that period?

5. Therefore, how much do I need to sock away (in lumps and/or dribs and drabs) to ensure that I get to #2 by #3?

You will most definitely need someone to crunch these numbers for you … just make sure that they crunch the numbers that you provide for #1 thru’ #4, not just the numbers that they will try and ‘sell you’!

Because, ‘they’ will tell you:

… well LONG-TERM the market has RETURNED an AVERAGE of 12% -14% on stocks and only … yada yada …

The problem is that YOU are most certainly not AVERAGE and YOU only get ONE SHOT at this nest-egg-building business. Unless, you can find a way to turn back time and try again

So, you need to choose ‘guaranteed’ numbers for #4 …

Here’s where I like the research that Paul Grangaard did for his excellent book, The Grangaard Strategy, specifically aimed at planning for (Book # 1) and living in (Book # 2) retirement:

Using the research done by Ibbotson Associates (published annually in their authoritative ‘Stocks, Bonds, Bills, and Inflation® Valuation Edition Yearbook’), Grangaard found that over the 75 year period between 1926 and 2000, large cap stocks averaged and annual return of 11% (small cap stocks did a little better at 12.4%), but he also found:

The average annual return [through that 75 period] bounced around all over the place, just like you would expect – between a high of 54% in 1933 and a low of negative 43.3% percent in 1931.

So, clearly planning on holding stocks for just one year has to be counted as extremely short term.

However, if we hold those same stocks for just 5 years, Paul tells us that we get a 6i% reduction in volatility …

… this means that every 5 years period within that time frame (e.g. 1926 to 1931; 1927 to 1932; etc.) still has a chance of being wildly different to the average, but 61% ‘less wildly’ than simply holding a stock for 1 year.

And, it makes sense: wouldn’t your 5 year return have been dramatically different if you bought at the end of 2001 and sold at the end of 2006 than if you bought at the end of 2002 and sold at the end of 2007?

10 year holding periods reduce volatility by 83%; interestingly, we need to move to 30 years before we see another major reduction in volatility (20 years is only few points lower in volatility than 10 years) …

… even so, holding stocks for 30 years means that we should achieve the 11% average return on large cap stocks; but there is still some significant volatility; Paul says:

The best thirty-year holding period delivered a 13.7% average annual rate of return between 1970 and 1999, while the worst thirty-year period delivered an average annual rate of 8.5% between 1929 and 1958.

So, while your “odds” may be high that you will get an average 11% return over 30 years, who do you want to be?

The guy who invested $100,000 and locked it away for 30 years for a ‘safe, secure retirement’ in 1970? 1929? or in an ‘average’ year? Let’s see:

It’s clear that you would be stupid to ‘bet’ your retirement on ending up with $4 Mill. (BTW: a lovely number … worth about $1.3 Mill. in today’s dollars, if inflation averages just 4% over that period).

But, I equally think that you would be stupid to bank on $2 Mill. either …

… I would use 8.5% in all of my retirement calculations, because 75 years of history  (including buying the day before the biggest crash in Wall Street History, then holding regardless for the next 30 years) says that’s what I will get … not might get, and certainly not hope to get.

And, I will be thankful if I am mildly pleasantly surprised … and ecstatic if I end up winning the Wall Street Lottery!

So, let’s look at time frames in terms of what Wall Street will ‘guarantee’ me:

If I hold for ….. I will get (as a minimum):

So, Di, in terms of being certain of your retirement nest-egg; I’d have to say that 30 years is long-term.

20 years doesn’t even keep up with inflation (4%) and mutual fund fees (1%) … and, anything LESS than 20 years is down-right dangerous!

That’s why gambling on Mr Market for my retirement wasn’t even a consideration for me. How about you?

Now, what number will you be plugging into your #4?

The Mighty 401k Fights Back!

A short while ago I wrote a post challenging the notion that you should automatically plonk your money in your 401k, because:

1. It’s ‘forced savings’

2. It’s pre-tax savings

3. You get free money from your employer!

Yesterday I wrote a follow-up saying acknowledging that these are all good things to have in an investment.

But, not the only things … in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

But, I expected to cop some flak, and here is some of it …

Traciatim said:

Historically real estate tracks inflation, not 6% annually. You’re also forgetting maintenance and property tax, water/sewage, heat, etc. When you want to retire you’re also forgetting the cost of selling the properties.

In fact, this is a really common theme amongst the detractors (there were a lot of positive comments, too) … but, who ever said that you should invest in ordinary residential real-estate in ordinary locations?

Also, those who ’remembered’ the costs of these direct investments (which I did allow for) , we tend to forget the hidden management costs and fees of the funds that your 401k invests in (which I did not allow for).

Curt said:

If you wait three years, real estate ‘good deals’ will be everywhere and you won’t have to invest the time to find them. That will likely be a better time to move money back into real estate.

This is the mistake of trying to time the market; this affects both the 401k ‘option’ and the alternatives, and probably requires a whole post in itself … if you are interested in the real-estate option (and, it is just one of many non-401k options that you could take) and you can find something that ‘works’ now, go for it!

Paul said:

One major flaw in your analysis…and I’m sure I could find others if I look hard enough:

You’re not accurately accounting for taxes here at all. The contributions to the 401(k) Plan are on a pre-tax basis. If you’re saving money in a bank account to buy real estate, that’s on an after-tax basis. To save $5k in a 401(k) Plan, you have to earn $5k. To save $5k in a bank account, you’ll need to earn $6,667 assuming a 25% tax rate.

I didn’t even talk about the risk inherent in real estate versus a diversified portfolio, or how your analysis of the return on the employer match is a bit off.

While it is good to think in unconventional ways at times, you better make sure you are accurately looking at these scenarios before you risk your entire future on them. While it could pan out, it could also blow up in your face.

Wise words, Paul. Of all the criticisms of my post that I read, Paul’s is most valid: I did not do an after-tax treatment (although, I did mention Capital Gains Tax); it’s just too damn complicated to run the numbers for a post like this … and, doesn’t change the relative outcome.

In fact, why do you think so many wealthy people invest in businesses and real-estate? It’s partly FOR the tax breaks! How much tax do you think that they legitimately pay per dollar earned compared to you, even WITH your 401k?

And, it appears that Pinyo of Moolanomey actually reran the numbers:

AJC – Interesting post, but I have to agree with the naysayers. Your analysis in scenario 1 didn’t include mortgage and other expenses. In part 2 of scenario one where you actually account for expenses and deposit everything into CD, the true advantage is only $63,000 over 30 years and this is before tax — after tax it’s virtually wiped out.

Sorry, Pinyo, on this one we’ll have to agree to disagree … unless you want to share your numbers? Then, I’m happy to do [yet another] followup.

BTW: real-estate is not the only viable alternative to saving in your 401k; my arguments apply to any investment that has the following four characteristics: leverage, depreciation, other tax deduction/s, and inflation protection.

Guys, the critical difference is this one – hardly mentioned in the comments at all: Real-estate has an apparent risk … but, the 401k option has a hidden risk.

I think we all understand the apparent risks of alternate investments v the nice, safe 401k (if you were set to retire at the end of 2007 and you ‘forgot’ to shift the bulk of your funds to the bond market, you may have a slightly different view on this) …

I’ll leave you with one thought: when was the last time that you read this headline:

‘Multimillionaire thanks the tax system for favoring his 401k … says” “without it, I would not be sitting in my beach house in Maui sipping Pina Coladas today”

The Hidden Risk of your 401k …

Recently I wrote a post that challenged the ‘Set It And Forget It 401k Brigade’ to at least rethink their strategy instead of just automatically maxing out their 401k …

… in doing so, I mentioned that there was a ‘hidden risk’ in your 401k.

Whilst the 401k proponents put forth all the wonderful, low risk arguments in favor of 401k’s (quoting long-term market averages of 12%+) they conveniently forget:

1. Fees: Figure around 0.5% – 1.5% in fees set by the funds that your 401k invests in and the fees associated with managing the 401k and the underlying funds (but, only the ones that your employer doesn’t pay). Most of these are conveniently hidden in your returns.

2. Market Dips: Did you know that while  the ‘market’ averages 12%+returns, you can only count on 8% as your 30 year return, 4% as your 20 year return, and 0% as your 10 year return from the market. My rule of thumb is: when planning your retirement, count on less … enjoy the possible upside when you are wrong!

3. Inflation: It takes time to get to the nest-egg that your 401k will give you … 20 - 40 years when you are starting out … so $1 Million just ain’t all that much money (now, let alone 20 – 40 years time!).

But, that’s not the hidden risk that I was talking about … it’s much, much more dangerous than those …

… the hidden risk of your 401k is that you may not get enough out of it to retire well.

Almost as bad, you may not care enough now to plan for what may happen then; after all, for you ’retirement’ may be still 10 – 20 – 40 years away! Although, it need not be …

So, what do I mean?

As I said yesterday, the arguments that the 401k proponents put forth center around: it’s ‘forced savings’; it’s pre-tax savings; and, the possibility that you get free money from your employer!

All good things to have in an investment. But, not the only things …

… in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.

Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.

Just remember this: there’s nothing holy about a 401k.

The purpose of your 401k investment is NOT to get a tax break, not to put aside 15% of your gross salary a month, and not to get any employer match … they are just (important) features …

Just like any other investment, your 401k’s purpose is to help you get you to Your Number so that you can live Your Dream!

Anything less is just settling for less. So, let’s consider the binary options here:

1. Your 401k will get you to your Number

You know your Number, right? And, you know when you need it?

If not, either read this and do this … or, you’ve just wasted a valuable 3.5 minutes beer drinking, relaxing time that would have had a far more beneficial effect on your life than what you have just read … or, will ever read … on this blog!

And, you know what your 401k can deliver by then, right? Not when your employer says that you retire, but by when you need The Number!

If you haven’t done the calculation yet, ask a Financial Adviser to help you (or follow along with our 7 Millionaires … In Training! at http://7m7y.com starting with this article) …

… you think knowing this might be just a tad important?

Now compare what your 401k is likely to be able to produce (now, I would not be using ‘average returns from the stock market’ for this life-critical calculation … I’d want a buffer … but, that’s really up to you and your bean-counter) with Your Number …

… if they are much the same, stick with your 401k (after all, it is ‘set it and forget it simple’). Then concentrate on keeping your job and, getting bigger and bigger pay-rises, because you’ll need ‘em!

2. Your 401k will NOT get you to your Number

If your 401k will not get you to your Number, what choice do you have but to at least consider alternates, be they instead of -  or in addition to – your 401k savings plan …

… be they real-estate, stocks, 2nd/3rd/4th jobs, marrying into money, winning the lottery, businesses … 

…. be they whatever …?

Of course, you could just give up and settle for your lot in life; who am to tell you not to give up on your dreams?

I’ll leave that little job up to Frankie

Will you ever put a penny in your 401k again?

I stuck my neck out, and made a candid admission; as expected, I copped a little flak – after all, I admitted to the world that I don’t even know how much is in my own Retirement Accounts ;) Whoo boy!

What surprised me is that I didn’t lose readers … I even gained some; Josh pointed to the reason why in his comment to that post:

Thanks, Josh. Here’s how I see it:

I’m not a risk-taker, far from it … to me, the so-called controversial move is usually not “a.k.a. taking risk” …

… blindly following Conventional Wisdom can be the riskiest move of all because you may unwittingly be risking a good proportion of your financial future!

To prove my point, and (hopefully) change the way that you look at investing in your 401k forever, let’s take this example from another comment to that same post, by Alex:

This strikes me, in a good way. I am about to be eligible for the 401k at my company. Normal people who cannot think of anything else better (and safer) than sticking their money in the funds.

Correct me if I’m wrong, what you are really saying is: instead of saving diligently and sticking $30,000 into a fund, maybe that same $30,000 can be used as a down payment for a rental property that will both appreciate and generate cash flow.

Now, I cannot advise Alex – or anybody else – on what to do with their money … that’s the job of financial advisers.

But, isn’t it Rule # 1 of Personal Finance to FIRST PUT YOUR MONEY IN THE 401K TO GET THE COMPANY MATCH?

After all, isn’t that FREE MONEY?

If the employer matches your entire contribution, aren’t you getting a 100+% return on your investment … impossible to match anywhere else?

Absolutely, which is why almost every personal finance writer (be it books, magazines, or blogs) recommends to at least invest to the limit of your employer’s matching contribution …

…. except for one problem, this thinking doesn’t hold up to scrutiny!

You see, your money is in the 401K for the long-run (isn’t it?) … your contribution – and your employer’s match is only a Year One issue; over the long run, your Contribution (with the employer’s match) will tend to a much, much lower return.

Alex’s question is: will that $30,000 be better off in the 401k or in a rental property?

The only way to find out is to run some numbers over the expected life of your ‘plan’ to see what happens … fortunately, just like a cooking show, I have prepared the numbers for you and here are some very interesting results:

SCENARIO # 1 – Assumptions

A. Let’s simply take Alex’s question ‘as is’ i.e. make a one-off $30,000 contribution to the employer’s 401k:

We will assume that the employer is VERY GENEROUS and match 100% of the entire $30,000; and we will assume that the markets are equally generous and compound an 8% return for us – tax free – for 30 years.

B. Alternatively, we can put that entire $30,000 as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by a more conservative 6% (also compound) each year. We will also assume that Capital Gains Tax (15%) is payable.

SCENARIO # 1 – Results

1. We know that in Year 1, the employer’s 100% match provides a 100% return on the 401k; but, in year two that return drops to 58% (the employer’s $30,000 ‘match’ effectively becomes a $15,000 ‘return’ over each of the two years … then add the 8% Net Managed Fund Return).

This rate drops each year - because we are looking for the equivalent compound return, it drops fast – so that it only takes 9 years for the overall compound return to drop below 20% and by Year 18 through to Year 30, it averages a compound return of ‘just’ 11% – 12%; still almost twice real-estate, though!

2. The total amount available to cash out of the 401k at the end of the 30 years is $559,000

3. However, if the entire $30,000 was used as a deposit on real-estate, even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return will be $713,000.

That’s a 28% advantage by putting the $30,000 into real-estate instead of the 401K …

… a greater overall $ return even though the % growth was half that of the 401k!

How can this be so?

The power of leverage (we borrowed 80% on the real-estate and nothing on the 401K except for the employer’s Year 1 ‘match’).

But, wait, there’s more!

The property is an investment property (if you choose to live in it, simply figure that you pay yourself a ‘market rent’ and these conclusions still hold true) … so, we can assume:

That we fix the mortgage at 5.25% (that’s $8,000 a month), and average a 5% rental return based on current market value (means that our ending-rent grows to nearly $36,000 a year!), and assume that 25% of rents will go towards expenses (other than the mortgage) and vacancies (a useful Rule of Thumb).

4. The net income (with any ‘surplus’ over mortgage and expenses being held on CD at a 30 year average of just 5%) is an additional $217,000 for the real-estate option.

Taken together, here’s how it looks:

So Alex, by (a) forgoing the exceedingly generous employer match in your 401k and (b) putting that $30,000 into a pretty tame residential real-estate investment instead, your overall 30 year return increases by 66%

Now, this is not how the ‘real-world’ usually works:

We don’t usually invest in one lump sum … we usually make annual contributions to our 401k of 10% – 20% of our salary. So, how does The Alex Plan work under this ‘real world’ scenario?

Let’s see …

 SCENARIO # 2 – Assumptions

A. Let’s adjust Alex’s question to instead make an annual contribution of 10% of an assumed annual salary of $50,000 (4% inflation-adjusted, so that the contributions also increase by 4% each year)  to the employer’s 401k:

We will assume that the employer will remain generous and 100% match the employee’s contribution each year; and we will assume that the markets are very generous and compund an 8% return for us – tax free – for 30 years.

B. Alternatively, we can simply put each year’s contribution in a bank account (earning a paltry average of 5% over the entire 30 year period):

When we save around $30,000 [Year 6] , we take that money out of the bank as use it as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by 6% (also compound) each year. We will also assume that Capital Gains Tax is payable.

Once be buy the house, out bank account is depleted, but we are still saving 10% of the employee’s salary, so we start to build the bank account up again … of course, similar properties get more expensive, so we wait until we have saved around $38,000 [Year 11] as 20% deposit and buy our SECOND property … then we repeat: saving around $46,000 [Year 16] for property THREE, and around $56,000 [Year 21] for property FOUR and final.

Why final? Well, we are within 10 years of retirement, so the BEST PLACE for our final 9 year’s worth of annual contributions is probably the 401k … 9 years is simply not long enough to chance the property market (for this reason, we could even be really conservative and also forgo the purchase of the 4th property).

SCENARIO # 2 – Results

1. The numbers are too complicated to measure the effect of the employer’s match on the hypothetical return … but, the overall numbers are far more important.

2. The total amount available to cash out of the 401k at the end of the 30 years is now $1.8 Million (now, you know why you want to make annual contributions to your investment plan!).

3. With the purchase/s of the 4 properties (the last of which we hold for just 10 years), even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return on the FOUR properties (plus the final 9 years of 401k savings) PLUS the net income for each of the FOUR properties, will be $2.4 Million.

That’s a 32% advantage by putting 10% of your salary into real-estate instead of the 401K …

Before you say, well 32% is just too much work to worry about … you’re not thinking like a millionaire. Over the 20 years, you will have built up enough equity in properties #1, #2, and probably #3 to also purchase properties #5, # 6 and possibly #7. And, so it goes until rich …

So, Alex, will you invest in your 401k? If you have a lump sum … I’d guess definitely not?

But, for your long-term savings plan: the 401k is certainly more convenient … but, is that convenience ‘worth’ $600,000 (or – a lot – more!) to you?

That’s only a choice that you – and, aspiring followers of The Alex Plan – can make