Tag Archives: retirement

What would you do if you won the 2010 World Series of Poker – Part II?

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Last week I gave some unsolicited advice to those who may have finished 6th, 7th, 8th, or 9th in last years’s World Series of Poker – Main Event – pocketing a tidy sum in the range of $1.2 to $1.5 million.

Sounds like a lot, but not if you are aiming to retire on a helluva lot more than $57k a year (plus a $60k ‘one off’ spending spree’) …

… so, what if you finish 5th, where the prize money jumps to a tidy $1.9 million?

Well, where this poker-listings article suggests that you could buy a 1977 Learjet 36A, it’s probably not a smart idea if you want to use it more than once or twice 😉

Well, you now have a $95,000 spending spree on your hands (of course, you don’t have to spend it all), and you could just retire and live off $90k a year.

Job done!

But, if you are still chasing that $7 million in 7 years, then you still need to follow the advice from last week’s post … but, I would tend towards investing more in real-estate (commercial RE with a good spread of tenancies) and, I would not risk too much of such a ‘once in a lifetime’ windfall in my new/existing business (it’s best to start/stay lean ‘n mean, anyway).

But, if you come 4th (picking up a tidy $2.5 million, in the process) then you can afford to live this $100k lifestyle (and, still have $125,000 – once off – to splash around to help you celebrate). Similarly, if you make it all the way to the final 3 before busting out with $3 mill. jangling in your pocket …

Next week, I’ll tell you what to do if you come 1st 🙂

So, who’s missed the point?

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Philip Brewer, a freelance writer for Wisebread (I presume, amongst others) has had a couple of mentions here, lately; this one for a comment that he made on his review of the book: Your Money Or Your Life [AJC: snappy title]:

The book has a very simple investment program that many people have taken issue with. The authors want you to invest your surplus money (a growing amount, once you make some progress on maximizing income and minimizing expenses) in long-term treasury bonds. More than a few people have criticized the program on the grounds that a diversified stock portfolio would produce higher returns. These people have missed the point: The goal of the investment portfolio is to produce a very secure stream of income. Long-term treasurys are a perfect choice.

Since I haven’t yet read the book, I can only say that I disagree if the authors – hence Philip – were talking about investing for retirement; after retirement – Making Money 301 – I wholeheartedly agree that the “goal of the investment portfolio is to produce a very secure stream of income.”

I also agree that “Long-term treasurys [sic] are a perfect choice”, especially if they are inflation-protected (e.g. TIPS in the USA), and perhaps laddered in some way; alternatively, you could try:

– income producing real-estate purchased in whole or in large part for CASH,

– index funds (although, you open yourself up to a certain volatility),

– Covered calls, perhaps protected by PUTS (if the option pricing allows).

But, not when you are still trying to build up your nest-egg unless you have such a low required annual compound growth rate (which probably means that you came by the page accidentally and are about to click off, never to return) that bonds / treasuries will do the job.

Until you do get within a few years of retirement, the goal of your investment portfolio is simple: it should be to produce your Number 🙂

A Vacation Question – Part II

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But, what about the other financial question that my son asked while we were on vacation?

Well, we were walking along the beach and Bill, the shaved ice vendor, drove past with his little all terrain vehicle pulling his ‘shop’ behind only to stop a few yards up the beach to tempt my son – and, the many other children running along the sand and swimming in the warm surf.

Naturally, I  quickly became $3.50 poorer and my son had his paper cone filled with shaved ice with various color sweeteners poured over it (he chose ‘rainbow’ flavoring), which got us talking:

You see, it’s popular folk-lore that Bill, who has been selling his flavored shaved ice along the beach for 20 to 40 years, owns many of the apartments in the vacation rental buildings all around [AJC: check out the aerial shot in yesterday’s post] … if true, then Bill is the poster-child for the Wealth Alchemist i.e. turning temporary cashflow into long-term assets.

It’s not hard to see that Bill turns over thousands of dollars a day, most of it costing him nothing (little staff, few overheads, little-to-no-cost-of-goods-sold), after all, how much can ice cost to make?!

Instead of spending all of that money, it’s not a great leap to assume that Bill saves up enough for a deposit to buy a property every now and then; we figure $1 million worth of property each year (with 20% initial equity).

Here is my son’s question:

“Would he pay cash for the properties, or would he just save up enough for a deposit and borrow the rest?”

Now, this is a seemingly simple – yet terribly interesting – question; one that we could labor over for many posts … instead, we’ll look at this another way, by asking:

“Does Bill need the property for income now or for its future value (hence, future income)?”

The answer is clear: Bill has plenty of income now, but what does he do if his income stops?

Presuming that he can’t rely on being able to sell his business (for example, the council could decide that they no longer want people peddling ice on their beaches), then Bill will probably want his properties to generate a replacement income “one day”.

So, which would do that better? When Bill moves into MM301, it’s likely that owning the properties outright and living off the rental treams that they throw off will be best …

… until then, Bill has to (in my opinion) work on the strategy that will produce the most properties by the time he wants to retire.

So, I had to explain the concept of leverage to my son:

SCENARIO A: If you purchase a property for $100k CASH and it doubles in 10 years, then you have $200k of property. Well done!

SCENARIO B: But, if you purchase TWO $100k properties, putting $50k deposit into each and borrowing $50k for each from the bank, then in 10 years (assuming they both double), you now have $400k of properties, of which you owe the bank $100k (assuming that you haven’t paid down any of the loan in the meantime), leaving you with $300k of property … a $100k improvement over Scenario A.

At least, that’s what the property spruikers would have you believe …

… because, they have conveniently forgotten that in Scenario A, you also have some rental income (after, say 25% costs) coming in, whereas in Scenario B that income would be largely offset by interest owed to the bank.

The question is, is that differential in income ‘worth’ $100k over 10 years?

Let’s assume that we can get a 5% return from our Scenario A property (after costs), giving us $5k a year initially (when the property is worth $100k), increasing over time to $10k a year (when the property increases to $200k in value). It doesn’t take a genius to figure that this comes to less than the extra $100k that Scenario B gives us (if you assume an average $7,500 per year rent for the 10 years, we are comparing $75k in rent for Scenario A to $100k in additional capital gain for Scenario B).

Now, add the benefits of:

– 80% gearing (i.e. only making a $20k down payment in our example), which should buy you 5 properties instead of Scenario B’s 2 properties (cost = $500k; worth in 10 years $1 mill., less $80k loan on each = $600k v $300k for Scenario B and $200k for Scenario A. Get it?),

– Increasing rents offsetting fixed interest rates (possibly producing some positive cashflow from each of our 5 properties as time passes),

– Tax deductibility of any excess of interest over income in the early years (a.k.a. negative gearing),

– And, any additional tax and depreciation benefits of 5 properties v only 2

… and, it’s just possibly a ‘no brainer’, even if that does make some of those scummy spruikers right 😉

But, how does Bill pay his bills?

Well, that depends on how much excess of income the properties produce by the time Bill is ready (or has) to retire …

… if  insufficient to pay Bill’s bills, he can sell enough properties to pay off the bulk (or all) of the bank loans, thus forcing a positive cashflow situation (assuming the properties aren’t total dogs, which is highly unlikely in this well sought after tourist area, which boasts near 100% year-round occupancy) and that (after a reserve to cover costs of vacancy, property management, and repairs and maintenance) is his infltation-protected income for the rest of his life.

Then Bill can spend the rest of his days lazing on the beach … buying shaved ice from the next shmuck who chucked in his chance at earning a college degree for the life of a beach bum 🙂

Will a million dollars be enough when I retire?

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1MillionDollarBill01

It seems like we have visited this question a lot … on the other hand, we have new readers every day, so it’s important to revisit the basics – and, I hope, it never hurts us to refresh our point of view either.

So, I couldn’t resist jumping in when Peter of Bible Money Matters posed the question: “Will a million dollars be enough when I retire?”

I told Peter that I love this question because it’s such a loaded one …

… we’d love to BELIEVE that it will be enough, but for most, it won’t.

Why?

Simple mathematics:

If you have $1 million (by the time that you retire in, say, 20 years) and inflation is averaging 4%, then the first 4% of your return goes just to keeping up with inflation. So, now just keeping your money in the bank isn’t enough.

So, let’s say that you can earn 9% on your money (in the stock market … crashes – and, ridiculously high mutual fund fees – aside? Hopefully!), then that’s ‘just’ $50,000 a year after inflation.

But, if you’re retiring in 20 years, $50k is (again, ‘just’) like $25k today [AJC: remember, 4% inflation roughly halves your buying power every 20 years] … so the real question becomes:

Will $25k a year be enough when I retire?

Now, that’s up to you to decide …

… all I can say is that, in my own retirement years, I’m ‘struggling’ to live off $250k a year ;)

What if you don't want to exit?

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I wrote a post about the real (nay, ONLY) succession plan for any small business: sell it!

But, Steve asks about the alternative:

What if you don’t plan to leave? I mean, Maybe the plan is to run it till you can’t any longer, then the wife runs it till she is ready to sell, or pass to the kids(if they are even interested in that type business). My idea is to find Businesses that provide (mostly Passive income) where you don’t need to spend much time at the shop daily. Where your biggest job is probably gonna entail paperwork.

This is the ‘pipe dream’ of many a small business owner – and, was certainly my father’s ‘dream’ … bring the kids into the business and then pass it on to them. After all, look at the advantages:

– Continuing ‘passive’ income … your kids will eventually run the business and look after you

– You’ll be smart enough to keep a chunky % of the business for yourself to ‘guarantee’ a healthy share of the ongoing profits

– No issues around selling the business, finding the right buyer, or handing it over

– It’ll keep the kids off the streets (probably, my father’s greatest motivation)

And, that’s certainly the central theme of a book that I reviewed some time ago, called Get Rich, Stay Rich, Pass It On: where the authors suggest that the ONLY way to ensure that your wealth carries on through the generations is to have roughly 50% of it in “continually innovative enterprise/s” a.k.a. a business:

What we mean here by a continually innovative enterprise is one that either offers a product or service that breaks new ground or changes a traditional product or service so much that it becomes virtually new.

As I said in my review: “that is something that you do before you retire so that you can retire rich … you take risks, you innovate, then you sit back and reap the profits (or sell)”.

But, there’s a serious flaw in this logic: 99.9997% of small businesses are inextricably tied to the owner; large companies know this, that’s why when they buy a small business, it usually comes with an employment contract to tide them over until they can ‘wash out’ the Owner/Founder Effect:

This is the truism that the business IS the owner/founder and the owner founder IS the business!

The reality is that owner/founders and their businesses cannot be parted so easily and these large companies should NEVER buy small businesses because of the Owner/Founder Effect … inevitably, the owner falls afoul of the new management, leaves disappointed [AJC: hopefully, with bundles of cash in her pocket to help console her 😛 ], and the business goes downhill thereafter.

Eventually, the business becomes ‘absorbed’ in the overall enterprise and they conveniently ‘forget’ that they totally stuffed it up … and, more often than not the old owner eventually buys back his own business for 25 cents in the dollar.

Friends of mine started a computer company and sold/bought it three times … each time selling high, buying low and making a heap on each subsequent sale 😉

Do you think it’s any different, Steve, when you ‘sell’ your business to your wife and/or children?

Because that’s exactly what you are doing: selling it to the least qualified purchasers; you may be able to teach them some of what you know … perhaps even a lot … and, there’s a VERY slight chance that you will be able to teach them (assuming that they have the will and ability to take on what you teach) 98% of what you know …

… but, you can NEVER pass on that last 2%: the Owner/Founder Effect ‘magic’ that made your business one of the few small-to-medium business success stories.

That’s why I called the book’s concept of encourage people to start/buy, then keep, these innovative enterprises “the most dangerous idea in retirement planning that I have ever read”, because that last 2% – the bit that is IN you and ONLY in you – is the bit that you CANNOT pass on and will eventually send your family broke.

Of course, there’s at least (my best guess) a 0.0003% chance that your business COULD become the next Walmart and pass on to at least ONE more generation, but I wouldn’t be willing to bet my family’s financial future on that.

So, instead of trying to fit your business into your Life, here’s what to do:

1. Find Your Number, the one that allows you and your family to live their Life’s Purpose

2. Apply a FULL 100% of YOU to molding the business into something that can be sold for at least Your Number (LESS the value of any investments that the excess cashflow that you truly outstanding business has been able to fund)

3. Spend your free time TEACHING your kids how to fish for themselves

… that’s what I’m doing for you, and that’s what I suggest you do for them 🙂

7million7year's April Fools Day Joke!

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april-foolOK, I promised myself that after my March Fools Day joke-with-a-message (you know, the horse racing system one) that I would NOT do an April Fools day post …

… apparently, promises are made to be broken 😛

So, yesterday’s April Fools Day Post was another joke-with-a-message: no matter how much you have, you can always spend more.

Yesterday’s post is actually (slightly) rooted in fact; I have made some errors recently, and the market has turned, so let me come clean:

– We bought our current home for about $1.6 Mill.; naturally, we paid cash.

But, after we cashed out on the second part of our 7m7y journey (the part that I have NOT yet written about on this blog, because it’s a business success story, not a personal finance success story like my 7 million 7 year journey), things took a turn for the ‘worse’:

– We upgraded to a $4.5 mill. home (plus $1 Mill. renovations to come: house/swimming pool/tennis court), and again paid cash … unfortunately, the market correction has probably wiped $500k – $1 mill. of value … but, this is ‘value’ that will only be realized when we sell (hopefully, we’ll be there for at least 10 to 15 years).

– We bought $300k of cars (for cash) but also managed to sell the Maserati

– I did indeed lose $600k in the stock market; this is the ‘cost’ of my experiment in letting somebody else manage a small part of my portfolio for me, and trying to time the market (bad AJC … bad boy!)

– And, I was due to receive a $3 Mill. ‘bonus’ from my ex-employer, that was to be delivered in cash, but ended up being delivered in now-reasonably-worthless stock (that 30 pence to 7 pence slide is real).

The two mistakes that we made were:

– We tried to time the market … however, $1 Mill. represents a small’ish % of our total portfolio

– We spent money on a house that we assumed that we would have, but didn’t get (i.e. the UK cash-to-stock thing).

So, right now, we have broken the 20% Rule … but, I counted cash, and after all of this (including completing the renovations) we still have a LOT of cash in the bank, plus the houses, plus equity in a number of apartments / commercial property, not to mention a ‘passive’ business or two floating around … I won’t have to ‘downgrade’ my $7 million 7 year mantle anytime soon [AJC: because, say, $3 million in 11 years just wouldn’t have the same ring to it, would it?] 🙂

Still, how are we going to ‘correct’? After all, we have broken so many Rules, it hurts me to think …

Well, exactly the same way that you would:

Some of it will come from simply waiting for the market to correct (that $600k stock loss will partially reverse, as will the 30-pence-to-7-pence UK stock slide) … some of it will come from making long-term buy/hold investments in this soft-to-recovering market over the next year or three … some of it will come from applying a large portion of the equity in the home (and selling the old one, when the market recovers) to investments (thus bringing us back within the 20% Rule).

But, the lessons are clear: always obey the Rules … do NOT speculate … and, heed Rick Francis’ Making Money 301 advice:

You really should [not] have to worry about affording needs anymore- you just have to control your wants. Also, you can afford to be more conservative in your investments. Making Money 301 should be a lot less risky as you only need to maintain your principle against your spending and inflation.

Where were you when I needed you, Rick? 😛

PS: In case you didn’t get to see the masthead that went with yesterday’s post, here it is … I’m particularly ‘proud’ of the by-line (something to do with noses, white powder, fast cars/girls) … unfortunately, all-too-true for too many people (but, definitely NOT me! Well, the fast car – singular – maybe). I don’t even know who the photo is of? Do you?

picture-1

Building a better retirement account …

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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:

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

Agree, 401k is the best way I can shelter tax

Once you are a millionaire, I see why a person like yourself Adrian have no need for it.

Essentially, Money Monk is saying two things:

1. You would be a fool not to have a 401k if you can achieve your investment goals, and

2. You probably don’t need one once you are a millionaire

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

I think that’s the big point that many people are somehow still missing. The point is that you did not BECOME a multimillionaire by putting money in your retirement accounts. You BECAME a multimillionaire by focusing on building successful businesses(which required you to put all your available cash into developing those business, not stacking it away in 401k’s, Roth IRA’s etc..), as well as buying stocks and real estate.

I think many folks keep forgetting that the purpose here is to learn how to make 7 million in 7 years, not 2 million in 40 years and then get taxed on it anyhow when you withdraw it at ‘government declared’ retirement age.

And, Scott is right: if I had put money away into my 401k instead of investing it back in the businesses and in real-estate (I invested in stocks, at that time, mainly with what little was in my 401k-equivalents, which were self-directed), I’m pretty sure the blog that I would be writing today would be Frugal Living Until You Are Just On Broke … and, I WOULD be advertising: I’d need the extra $4 a week 😛

But, pursuing tax-savings – as part of a Making Money 201 wealth building program – is a noble, worthy …. and MANDATORY … goal if you truly want to become rich(er) quick(er) … it’s just that the 401k is typically not the right vehicle to foster an ‘early retirement strategy’, and the other government-sponsored programs also have their limitations (how long your money is tied up; what you can invest in them; and, more importantly for the BIG Number / SOON Date brigade: how MUCH you can invest in each) …

…  so, by now, we know what NOT to do … but, what should we do to manage our tax expense (after all, if we pay less tax, we have more to invest)?

Well, let’s turn back to Scott who was your typical 35%+ tax bracket high-income earner:

As far as using retirement accounts to shelter tax,just to help the readers understand a little better, after my wife and I did our taxes at the beginning of the year, we realized that after all business deductions, real estate depreciation deductions and rental mortgage interest deductions, we only paid around 25% tax for the year on our income, which is substantial. This was about 10% LESS in taxes than we paid the previous year when we didn’t own such investments. Needless to say, that 10% savings over last year equals approximately the savings we would have made by putting money into a retirement account, but instead, we now have multiple business ownership and extra real estate. This was simply from our first year of dipping our foot into investing and being part of the 7 millionaires in training.

And this is only the beginning. I wonder how much less in tax we’ll pay next year by buying up appreciating assets and/or small business ventures?

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!

Your employer may be stealing from you!

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

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“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'?

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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:

Worst 30 Year Return  $ 1,065,277
Average 30 Year Return  $ 2,062,369
Best 30 Year Return  $ 4,140,507

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):

10 Years -0.9%
20 Years 4.0%
30 Years 8.5%

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!

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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” ;)