CHAPTER 1
Set Your Goals and Wake Up Rich
The Wall Street Journal published an article titled "Waking Up Rich—Retirement Accounts Stashed in Stocks Make Employees Millionaires." The article's author stated, "The retirement plan rich are changing their lives. Quitting jobs early, taking extended holidays, starting new careers—or restructuring jobs to make them more fun." These retirement-plan millionaires are people who never thought of themselves as having any personal wealth and suddenly they realize that they do. They are feeling good about it.
Another interesting insight for the article was this: "For some people who thought they wanted to retire early, having a financial cushion has a curious effect ... for many people the security of a nest egg allows them to relax and enjoy work more."
Today, many people approaching retirement have had an opportunity to participate in a 401(k) plan for the past thirty years. The first plans were rolled out in the early 1980s, and almost all major companies adopted them immediately. Even most small companies offered some retirement-plan opportunity, even if they could not afford an employer matching contribution.
Most people who have been contributing for this entire thirty-year period have somewhere between $300,000 and $1 million in a combination of their current, company-sponsored retirement plan and the rollover IRA account (or accounts) formed as they changed jobs over the years.
If these numbers sound high, consider the example of someone who earned $40,000 a year back in 1980 and who saw steady increases in pay until reaching $70,000 a year today. These are rough average pay levels for American workers over this period. At an average contribution level of 6 percent of pay per year (the nation's average retirement-plan voluntary contribution), and assuming an average rate of return of 10 percent per year, this typical employee would have accumulated just over $500,000.
In most cases, the employer has been contributing at least some amount of additional money over and above the voluntary contribution from the employee, so the total percentage contribution would have been higher than 6 percent of pay. Moreover, the average mutual fund through the '80s and '90s actually increased in value at a rate of more than 15 percent per year instead of the 10 percent historical average stock-market return used in our calculation above. Factor in these reasons for improved results, and we can see why a $1 million account balance is within reach for many people.
The underlying facts speak for themselves. Today $3 trillion is invested in 401(k) plans, and an estimated $3 trillion more is invested in rollover IRA accounts resulting from previous retirementplan contributions. The total amount in all mutual funds today is $9 trillion, so we can assume that two-thirds of that figure is attributable to the 401(k) plan phenomenon.
If you're young, with thirty years of work ahead of you, those numbers should be inspirational. If you're older and partway up the ladder, you can assess what course correcting, if any, you may want to do to reach your intended goal. If you're close to retirement and these numbers seem unreal or certainly not applicable to you, then you have made one or more of three mistakes along the way.
1. You're not committed enough to saving.
2. You've spent big chunks of what should have been rollovers when you left your job.
3. Or you've made some bad investment decisions.
The purpose of this book, regardless of your retirement-plan stage in life, is to provide you with the tools you need to make constructive, informed decisions that will help you reach your goals.
Identifying Goals: An Important Consideration for an Investor
Let's start with Warren Buffett, who says, "You shouldn't buy any stock that you're not prepared to hold for ten years." In the meantime, the stock market can be volatile for reasons having little to do with the intrinsic value of the companies in which our mutual funds have invested. When J. P. Morgan was asked what he thought the stock market would do, he answered, "It will fluctuate."
To invest intelligently then, we need to understand the following: a fundamental cornerstone of investment decision-making is the time frame or length of time that the money can be committed to an investment.
Without a clear understanding of our goals, it is impossible to know for certain how much time we are allowing an investment to meet our expectations.
There Can Be Confusion about the Time Frame of Goals
For young people, a common misconception is that the company-sponsored retirement plan is exclusively for retirement savings and that their only investment goal is long term, thirty-five to forty years. In fact, younger employees can often have short-term goals for portions of their retirement-plan money, thanks to the fact that retirement-plan loans offer access to what is generally long-term retirement money. Down payments on homes, educational expenses, and many other financial objectives short of retirement can be reasons for using the retirement plan, since the pretax dollars make this the fastest way to accumulate wealth.
The Young Are Different ...
Younger people are also different in that their lives are in flux. This means that they can expect to be unemployed from time to time until they get settled in a career. Between jobs, it's not a sin to tap retirement-plan accounts to pay for rent and food. Moreover, retirement-plan money can be a source of support while taking a year or more to go back to school.
There are extremely important reasons, well short of retirement, to be saving money. There is no more powerful savings "machine" than a 401(k) or 403(b) plan with automatic payroll deductions, tax savings, and even employer matching contributions in many cases. Any young person who would rather not move back in with parents or live on a friend's couch, should jump at the chance to sock away some retirement-plan money. Anyone who has an occasion to tap this lifeline will never again have any doubts about the value of the retirement-plan opportunity when settled in a future job.
If my spouse and I are in our thirties, both contributing the maximum, can we retire at age fifty?
Relatively young people have been able to retire in recent years long before what is normally considered to be retirement age. This doesn't mean they quit working altogether. But more important, they have been able to consider career options for reasons other than earning enough to support their lifestyles.
Two spouses contributing an annual $10,000 each will have a total of $1 million in twenty years if their investments earn an average of 10 percent per year, the stock market's average annual return. That $20,000 total contribution for a two-income couple costs their family unit about $13,000 in take-home pay.
It's that simple.
If we're in our fifties now, aren't we within ten or so years of our goal of retirement?
Ten years to retirement may be true, but if you are in good health and have parents who lived long lives, there is a possibility that you will need money for many years. While retirement itself is just around the corner, a portion of your retirement money is still subject to a long-term goal.
Someone fifty years old today may still need their money to be growing at age eighty-five, the same thirty-year time frame that a thirty-year-old employee is considering.
Here's a formula that some investment advisors suggest: divide your age by one hundred, and that will indicate what percentage of your assets you should have in bonds. Does age sixty-five over one hundred indicate that 65 percent of your money should be in bonds and 35 percent in stocks? Hold on a minute. That won't work for someone who might reasonably live to age ninety, and it ignores the equity someone may have in their home. Home equity amounts to a combination of a stock and a bond. (It's more like a bond.) These common formulas that define many package retirement investments (target or lifestyle funds) are much too simplistic for most situations.
The information in this book will arm the retirement-plan participant with a broader understanding of what they need to know to better meet their retirement goals.
We talked about young people, but what if any of us lose our jobs?
Is retirement the only reason for retirement-plan savings? Who knows? Many of us are employed in volatile industries that periodically subject us to layoffs and extended periods of unemployment. This might be the most effective reason to be building a nest egg, our retirement plan. Between jobs, we can tap this money at any time and use it as our personal unemployment compensation. While the money is taxed just like job income, plus a 10 percent penalty for anyone younger than fifty-nine and a half, receiving it in a year when little or no work has reduced income may mean that the only "tax" will be the penalty itself. Moreover, there are no social security or Medicare taxes (8.5 percent) on what would be distributions from a rollover IRA, so this helps soften the blow of the penalty. Later, back at work at the next job, anyone who has experienced the "lifesaver" that the retirement plan represents will need little convincing to participate with the highest voluntary contribution possible.
Investment Decisions Start with Identifying Goals
Goal-Setting Exercise
Write down all the reasons you can think of for why you would want to save money.
• one- to five-year goals
• ten-year goals
• twenty-year goals
• thirty-year or longer goals
The longer a goal, the greater the boost from the "invisible hand" of economic forces.
The reason goal setting is so important is because investments offering more volatility will outperform more stable investment types. If we clearly identify a longer period for some of our retirement money, we can be comfortable with the risks that will yield a higher return over time.
While the overall stock-market yields an average of 10 percent per year, small companies grow on average at a rate of 12.5 percent per year. What's it worth to take the risk of investing in them? On a $10,000 annual investment, the small stocks will be worth an extra $200,000 in just twenty years ($572,000 versus $763,000).
The longer a goal, the less a financial crisis matters.
The collapse of stock prices in 2008 and early 2009 was in response to a failure of the financial services industry, primarily the banks who had made and packaged bad loans. So what? The time before that, the market crash was due to the bursting of the Internet "bubble." Before that, in 1987, it was the invention and then the failure of "programmed trading," where computers newly introduced for investment management all freaked out and decided to sell at the same time.
The great thing about these temporary disasters is that the market always recovers. They're only a problem for someone with a short-term goal who has to sell everything in the middle of the crisis or someone who just can't handle what is only a big loss on paper. A long-term goal kept in mind throughout is what allows us to just shrug off these market downdrafts. We can sleep like babies.
It may further help to realize that market crashes often coincide with a reduction in the size of the economy, which leads to recession and joblessness. But remember this fact: the average recession lasts only sixteen months, and while the unemployment rate increases, the remaining people still working tend to receive, on average, pay raises of about 3 percent. The stock market can be completely disconnected from an economic engine that may have slowed down, but that engine is still producing a huge amount of output. Think about this: the stock market dropped in value by 50 percent during 2008 and early 2009. Do you think that the total value of America's public companies and their economic output dropped by that much overnight?
Of course not.
Also, we have to remember that most market crashes follow a previous high-yielding "blowout" of increased stock prices that left investors giddy. The temptation is always to compare where we are after the crash with that unreasonable (we might say "undeserved") high-water mark that our account balance hit at the height back when we all felt like geniuses. If we compare where we are at the bottom of a crash to a time further back like five or ten years, things are never all that bad and we're clearly making progress.
With Goals Established, We Can Move on to the Basics
Investment success rests with understanding the relationship among risk, return, and time. The next section explores how these three investment components, like a three-legged stool, work together to create the wind under the wings of investment performance.
CHAPTER 2
The Fundamentals of Risk, Return, and Time
1. Risk—a self-assessment of risk-taking ability
2. Return—an appreciation of what higher returns can accomplish
3. Time—the time frame of goals
Keeping the fundamentals uppermost in mind will be a key factor in the successful outcome of retirement-plan investing over time.
The man who knows more about risk, return, andtime than anyone else in the United States is Warren Buffett, our second-richest citizen. Here is some advice from his book, The Warren Buffett Way:
"Fear and greed move stock prices above and below a company's intrinsic value. In the long run, the value of stock holdings is determined by the underlying economic business; not by the daily stock market quotations."
"If you expect to purchase stocks throughout your life, you should welcome price declines as a way to add stocks more cheaply to your position."
"The future is never clear. What we know today is that there are well-managed companies that consistently make money, and the stock market values them periodically at foolishly high or low values."
Buffett recognizes that he is neither richer nor poorer because of the market's short-term fluctuations in price, since his holding period is longer term. As Buffett puts it, he would not care if the stock market closed for ten years; it closes every Saturday and Sunday and that has not bothered him yet.
How do we apply the same wisdom to our retirement-plan money?
We need to first understand the basics: risk, return, and time are the three "engines" driving our financial success as we begin to match our goals and objectives with the investments offered in our retirement plan.
Risk
Risk is a measure of the possibility that we might lose money.
The most obvious loss of money is an actual reduction in our account balance during what might be a bad quarter (or bad year) for our investments. This experience will always be difficult for us, even when we know the loss will be only temporary.
Fear of the unknown is always lurking somewhere in the back of our minds. We're thinking, This time, it's different. This time it really is doomsday!
The key words above are "fear of the unknown." The more we educate ourselves about investments and how they accomplish their miracles, the less the fear factor will influence our thinking. (The less it will "mess with our heads.")
As President Roosevelt once said, "All we have to fear is fear itself." The underpinnings of risk have more to do with emotion than rational thought. Fortunately, there are some mathematical measurements of risk that can satisfy any one looking for more than the random "casino atmosphere" offered by stock markets in general.
When investing in stocks, there are two types of risks. The first is the risk that a single company or companies in the same industry may suffer a loss of sales, profits, and value. The second is that the entire stock market may be under assault by the herd mentality of people who want to sell in a panic.
Eggs in More Than One Basket
The first risk can be alleviated by spreading investments over several different types of companies and industries. This is called diversification or diversifying. Most mutual funds own as many as two hundred different companies, so while one company might get into financial trouble, the chance of all of them failing is too remote to bother seriously considering. Then most mutual funds specialize in investing in a certain type of company (large companies, small companies, foreign companies, etc.). While one type of company may be having trouble, other types will be thriving. We reduce risk by dividing our funds among different types of mutual funds. (Diversification is discussed again later in the book.)
