Category Archives: Investing

I read this Reuters article concerning talk of capping the point where you can contribute pre-tax dollars to an IRA or 401(k) if the account value hits certain balances, which also re-raised the 2012 election issue of how Mitt Romney could possibly accumulate as much as $101 million in his Individual Retirement Arrangement (IRA) account.

I remember reading about Mitt’s IRA and the questions of how an account can grow that much with an annual IRA contribution limit capped at $5,000 a year or so.  Individuals who have some financial education know that 401(k) accounts have much higher contribution limits (at least triple that), and a 401(k) rollover to an IRA can easily result in an IRA with a balance many times that of a simple $5k-per-year calculation.  If you are self-employed and manage a SEP-IRA you could have contributed $52,000 last year.  The “$5k per year” number is only one (and the lowest) of the various annual contributions you may be able to make depending on your employment circumstance.

But $100 million did seem a little high.  At the time I reasoned that with some simple math, say $20,000 per year total contribution for a 65-year-old guy like Mitt who has been contributing for 45 years, he could have $900,000 of investment principal.  At 10% gain per year reinvested, over time that’s around $14 million.  A 15% per year reinvested that’s about $72 million, 20% gets $365 million.  Ah, compounding.  So Mitt’s balance, by above-average returns, is possible.

After President Obama’s 2015 State of the Union Address, business news was abuzz concerning proposals to cap contributions to IRA and 401(k) accounts when a retiree’s balance hits a certain dollar amount.  The caps may seem high to someone who isn’t a heavy retirement investor ($2.5 million to $3.5 million, depending on interest rates), but to a super-saver this may seem a bit low.

The first linked Reuters article above states “The argument here is that IRAs were never meant for such large accumulations”.  That may have been true when the IRS formalized 401(k) rules in 1981, but the retirement picture is much different today.  Retirement pensions were common in 1981, so millions of dollars of tax-advantaged growth, on top of a pension that paid a reasonable percentage of your pre-retirement salary, may have been more than the average American needed.  But what about in 2015?  Pensions for most younger public- and private-sector employees are a historical curiosity, so workers need to accumulate large amounts of money to last many years.  $3.5 million may sound like a lot, but if you are making $100k at retirement and want to fund a 20-year sunset, it will take at least that much when you factor in inflation over those twenty years plus the health costs of keeping you alive and healthy during that time.  And instead of market returns you’ll probably get more conservative after your cushion of earned income during rough market years goes away.  Plus you still owe income taxes as you withdraw that money.

The GAO reported that high-balance IRAs got that way “likely by investing in assets unavailable to most investors – initially valued very low and offering disproportionately high potential investment returns if successful.”  We know the range where the cap is being discussed, and we know that general market index funds are hardly limited to most investors.  In my view it just didn’t seem crazy for serious retirement savers to end up with what the GAO calls “mega IRAs” after 35-45 years using common investment vehicles.

So I wanted to settle the question for myself… if you took a 23-year-old worker that socked away the maximum pre-tax amount they could legally contribute at the birth of 401(k) accounts in 1981, maintained legal maximums through 2014, applied various company matching scenarios, and assumed every dollar contributed was put in an S&P 500 index fund with reinvestment, what would the now-56-year-old’s 401(k) account look like?  It turns out it looks like this:

In my employment experience, a 3% annual salary match contribution from your employer to your 401(k) account (assuming you contribute at least 6% of your salary) is typical.  “IRS Max” in my chart above is the IRS maximum for how much per year can go in from all sources to a defined contribution plan.  That line assumed you contributed the max to a SEP-IRA (or had a real generous employer), an unlikely scenario for a 23-year-old but I wanted to see the range of possibilities.

We see that a normal (non-Mitt) worker that contributed the maximum pre-tax amount, with a 3% employer match, would have $2.4 million for retirement today (probably $80,000 a year or so after taxes in retirement to make it last).  Workers getting a generous 10% employer match would have $3.3 million today.  This range falls in line with 401(k) and IRA balance account contribution caps being discussed, so perhaps some policymaker ran the same back-tested scenarios that I did.  But then again the above shows the results for a now-56-year-old worker.  Getting that worker to 65 at normal market returns would probably double the above numbers come 2024.

Now how could Mitt Romney have possibly gotten to $100 million?  My above scenarios assume a 100%-passive investor, not buying and selling various things over time but just buying with plain dollar-cost-averaging into a market index fund.  If you had (or were) an investment manager with a crystal ball telling you to go to cash in 2007 you wouldn’t have taken the 2008 37% S&P 500 hit, or perhaps the 2002 22% hit.  And maybe you bought back in near the bottoms of those markets.  And perhaps  you beat the S&P a little bit the rest of those years.  Just zeroing out the 2008 and 2002 losses would have the above “IRS Max” line at $18 million, but that is still a far cry from $100 million.  So the answer would be, assuming all is legal, “a lot of risk, and even more luck”.

Mitt’s IRA balance is high, but the cap ranges seem low with normal expected performance for a 65-year-old saver.  I’d like to see those discussed caps tripled to encourage retirement investing.  The caps are supposedly driven by “current interest rates”, but 401(k)’s should be evaluated by something more like S&P 500 performance, where much of that money is typically invested, and not interest rates (2.6% to 3.0% on 10-year Treasury yields in 2014, vs 13.69% S&P 500 performance).  Indexing to inflation or interest rates don’t necessarily relate to the conditions those accounts are actually tied to.  Workers have to pay taxes upon withdrawal anyway, unless these were Roth variants where the worker contributed after-tax money.

I don’t like putting forth good advice to encourage saving but then tell workers they have to stop if they realize the benefits of what they are told is the right thing to do over a multi-decade time span.  The currently-proposed cap levels don’t even discourage outsized risk in one’s retirement portfolio if a vanilla market index fund will get you there.  It could have the opposite effect, encouraging short-sighted portfolio conservatism in order to preserve some tax exemptions, forcing workers to work longer than they may want to or force lifestyle changes if health or other reasons present challenges to working as long as they need to.

References:

Reuters “Only Small Victories for Retirement in Obama’s Speech”

Reuters “How Did Romney’s IRA Grow So Big?”

Investment Company Institute “401(k) Plans: A 25-Year Retrospective”

AllFinancialMatters “The ‘Luck Factor’ in Investing”

Jim’s Finance and Investments Blog “Historical Annual Returns for the S&P 500 Index – Updated Through 2014”

Compound Interest Calculator http://www.moneychimp.com/calculator/compound_interest_calculator.htm

This post responds to Knight Kiplinger’s piece titled “401(k)s for Everyone” found in the February 2011 issue of Kiplinger’s Personal Finance Magazine and online here.

Knight Kiplinger discusses making the 401(k) mandatory in order to give a firm nudge to employees into saving something for retirement.  The ends are noble… it is clear that financial education in the United States is awful and mistrust of the financial industry runs high.  Too often people are skeptical of bankers and other financial institutions, and skepticism leads to delaying important actions one should take as soon as they enter the workforce.

His piece outlines his arguments for making 401(k) availability mandatory, and additionally argues that employee participation should be mandatory.  But some of these proposals are not consistent with good financial planning practices.

1. Make all employers provide a 401(k) plan – he gets no argument from me here.  401(k) plans allow a worker to contribute much more to retirement than IRA options, up to $16,500 per year as of 2011 for those under 50 as opposed to $5,000 per year (tack on an extra $1,000 catch-up contribution for older savers for IRAs, $5,500 more for 401(k) contributors).  There is no question that those with access to 401(k) options should be using them.  And depending on your income level you can do both.
2. Require workers to contribute 3% of earnings, automatically rising with age to 6% or more – This suggestion surprised me.  Why?  Isn’t saving more as you earn more a good thing?  Yes, but it runs contrary to what you should be doing.  At any age, you should be saving as much up to the limit as you can possibly afford if you have not yet met your retirement savings goals.  But the best time to do that is when you enter the workforce.  At a 7% market return rate (slightly lowballing for the history of the markets, even including the late 2000’s) you double your money every ten years.  Every dollar invested at age 22 has the potential to be close to sixteen dollars when the money can be withdrawn without penalty at 59 1/2 years.  Did you know that someone investing $5,000 per year at 7% return from age 22 until they turn 31 and stopping will have more money saved when they turn 64 than someone starting to invest $5,000 per year at age 32 until age 64?  Early is the key, not later.  Those investing early should not be required to invest more as they get older, they can start to spend a little then or establish an early-retirement portfolio. Forcing an older saver into higher pre-tax retirement contributions may not be in their best financial interest.
3. Default investment choice would be a “life cycle” asset allocation – This is another problem.  Life cycle funds, commonly called “target date funds,” allocate your money in percentages of stocks, bonds and cash based on the year you plan to retire.  These plans may sound good because they take a lot of decision-making away from the saver.  They are better than nothing, but they are doing a disservice.  At this moment in 2011 interest rates are beginning to come off of years-long lows, generational lows.  The absolute WRONG time to buy into bond mutual funds is when rates are rising.  The fund will generate a bond interest yield but the underlying bonds in the fund decrease in face value as interest rates rise.  You may get 5% yield on a bond fund portfolio but lose that much or more in the per-share value of the fund.  If you are close to retirement age, better to establish a CD ladder or a ladder of short-term bonds so the declining-prices bonds get recycled quicker.  But the target date funds ignore that, robotically moving you into a higher bond position than may be smart.  They also ignore how much money in other assets you may have, or worse keep your portfolio too conservative if you haven’t saved anything, taking you from nothing to a little more than nothing instead of taking on some risk to catch up on time lost.
4. All Company-matched funds would be fully vested immediately – This is a good idea, but I fear companies will game that requirement, dropping wages to compensate.  In many 401(k) plans your company will kick in an amount, say dollar-for-dollar up to three percent.  This is great for the investor and is free money… you can contribute 6% of your salary for a 9% overall contribution which offsets a lot of risk in a portfolio when you are already 50% ahead!  But most companies employ a vesting schedule. For example if you leave the company in two years but your company’s policy says you are not fully vested until three years, the company may claw back their kick-in amount when you leave.  I don’t think two or three-year 100% vesting schedules are unreasonable as they provide incentive for workers to stay with a company and decrease turnover, which in turn decreases corporate costs and maybe they can match more money.  But requiring immediate vesting will be made up somewhere, probably in compensation.
5. Early withdrawals not allowed except for cases of permanent disability – no argument there.  This money is for the future you, not the “now” you.
6. 401(k) payouts would be annuity-style, not allowing lump-sum – The saver has spent her entire life for this, why limit the money she can take out?  If the saver has been smart enough to save for forty years, she isn’t going to suddenly withdraw it all and go to Vegas with it.  Personally I’d like the choice to take a portion of that and buy a nicer house far away from where I am now, living off the rest.  I didn’t save all that money just to have it metered out at some arbitrary percentage someone else came up with.  Knight suggests the remainder go to one’s estate, but that money is for me and me alone if I want it that way.

If I had a magic wand I’d have the country focus more on making financial education a core part of our nation’s curriculum, to the degree that planning for one’s retirement in the 20’s is as obvious as needing to put on a seat belt. And like it or not, we all contribute to a retirement plan already called Social Security through payroll taxes. It was never meant to be a retirement plan and it is entirely insufficient as one one its own, but it exists and we all pay into it. Let that continue to be the fallback for those who refuse to save for retirement. It is better in my view to go for the gold instead of the bronze, educating our people on good financial practices instead of forcing some not-so-sensible requirements on them.