Average Joe on the Path to Retirement

According to Census Bureau data, the real median income of a household 10 years ago was $65,000.  This is where we 'll start our average Joe. Today, Joe's household income, adjusted for inflation, again from median Census Bureau data, is approximately $67,141.

The following simple exercise shows how Joe has done on the path to retirement if he followed some basic guidelines.

Tables from the book Your Money Ratios by Charles Farrell show that a 40-year-old on track to achieve an 80% income replacement at age 65 should have a nest egg of 2.4 times his income.  In average Joe's case, this amounted to 2.4 * $65,000 = $156,000.  This is what his nest egg should have been 10 years ago.

Farrell's tables also show that Joe should have been saving roughly 12% of income or $7,800/year (.12 * $65,000).  In case you're interested, Farrell also says that Joe's mortgage should have been 1.8 * $65,000  = $117,000 and his household education debt should have been zero.  Given these stipulations, at 40 years old, Joe would have been on a path for a successful retirement.

But how is Joe doing today at 50 years old given market performance over the past 10 years?  Most studies show that the average investor underperforms the market by a significant amount.  This is because the average investor jumps in aggressively when prices are high and panics when prices are low.  For our purpose, we'll assume that average Joe isn't like the average investor.  Instead we'll assume Joe invests in low-cost, well-diversified index funds.

For our performance data, we will use the chart produced by BlackRock.  The chart shows annual performance for a diversified portfolio comprised basically of 65% stocks and 35% bonds.  This is the portfolio whose performance we update each quarter.

For the purpose of the analysis, I used $7,800 as the amount Joe saved each year.  This amount would ratchet up according to plan because Joe's salary increased but also because Farrell suggests the saving rate be ramped up to 15% at age 45. I  kept it simplistic at $7,800/year.

Joe's goal, as given by Farrell's tables, is to have 5.2 * $67,141 = $349,133 to be on plan at age 50.  The following table shows the year-by-year results:

Start of Year	Amount  in Nest  Egg	Diversified Portfolio Performance	Annual Saving
1/1/2005	$156,000	+5.4%	$7,800
1/1/2006	$172,425	+13.0	$7,800
1/1/2007	$203,117	+6.0%	$7,800
1/1/2008	$223,327	-23.0% *	$7,800
1/1/2009	$177,967	+20% *	$7,800
1/1/2010	$222,087	+13.0%	$7,800
1/1/2011	$259,236	+1.8%	$7,800
1/1/2012	$271,770	+12.2%	$7,800
1/1/2013	$313,174	+20.0%	$7,800
1/1/2014	$384,335	+8.1%	$7,800
1/1/2015	$423,566

The results in the table were obtained using a bankrate calculator.  I used the calculator to calculate year-by-year returns assuming Joe contributed $300/week to a qualified, 401(k) type plan.  The calculator doesn't handle negative investment performance or returns exceeding 20%.  For those years, I used rough estimates to calculate by hand.  The performance numbers came from the aforementioned BlackRock chart obtainable from the link above.

The diversified portfolio is weighted as follows:  35% Barclay's Aggregate bond index, 10% MSCI EAFE index, 10% Russell 2000 index, 22.5% Russell 1000 growth index, 22.5% Russell 1000 value index.

The bottom line is that Joe is not doing badly, with a portfolio above target by approximately $73,000. In fact, Joe would have probably done better because most 40-year-olds would be more aggressively invested than with a 65% stocks/35% bonds portfolio.

Disclaimer:  info here is for educational purposes only.  Individuals should consult a professional and do their own research before making financial decisions.

Your Investment Horizon Should Probably be Longer Than You Think and What it Means

The biggest obstacle to people investing in stocks is, understandably, the fear of losing money.  But the possibility is reduced the longer the investment horizon.

In my conversations with new clients, I find that most people think of their investment horizon as the time to when they plan on retiring.  Thus, a 50-year-old is thinking in terms of needing a nest egg in 15 years.  Which is, of course, the case; BUT he or she will need the nest egg to last not 15 years but another 30 years, potentially, past that.  Thus, most investors need growth for much longer than they typically think.

This is just considering the "I want to die broke" crowd.  Others have an explicit goal of leaving assets to their heirs.  Their horizon automatically extends a bit to account for younger heirs.

The good news along these lines is that risk, defined as the potential for a portfolio loss, is reduced the longer the investment horizon.  This is typically presented via a chart like this:

Source: Dana Anspach/ Money Over 55

Simply stated, the chart shows that holding stocks, which are most volatile as a sector over the short term, is actually quite safe the longer the investment horizon. The chart shows that, over the period examined, rolling returns for both the 15-year and 20-year periods were always positive as shown by the positive performance of their worst periods!

The significance of this is that the investment horizon is a key input in figuring out the percentage to invest in stocks. 


Behavioral finance tells us that our brains aren't really adept at thinking longer term; but, in this instance, we should remind ourselves of the data when setting up our investment strategy.  The ability to withstand short-term ups and downs of a roller coaster market pays off for those thinking in terms of a longer horizon.

How to Boost a Target Date Return

Paul Merriman of MarketWatch has written an interesting article,

How to double your target-date retirement fund's return in a single move, 

that is worth reading and considering by target fund investors, especially younger investors, many of whom have been opted into target date type funds.

The gist of the article is straightforward:  put the bulk of your automatic 401(k) contribution into a target date fund, but also put a percentage in a small-cap fund. 

Why small-cap funds?  Although small-cap funds are volatile (will remind you of Jack Nicholson going beserk at various times!), they make up for it with exceptional long-term performance.

A couple of important points:  you need to be able to handle the volatility.  The article doesn't really spell out the asset allocation over time for Jessica, the fictional investor; but it would have been interesting to see where she stood on 1/1/2008 with a "free falling Tom Petty," off-the-cliff experience immediately ahead.  In 2008, stocks fell 37% and then in early 2009 dropped another 50%!

Sadly, the best laid plans many times are trashed in the real world of investing.  It is hard for most people to see something they have built up over a number of years crumble in front of their eyes.

Also, keep in mind the long term covered by the study.  A quick glance at the 

BlackRock sector returns 

(see page 2) for the past 20 years shows that Large Cap Core achieved an average annualized return of 10.5% versus 9.6% for Small Cap.  Standard deviation was 15% for the former compared to 19.6% for the latter!  Thus, you would have slept better and been ahead using Large Cap.

By the way, if you can only stand to read one person in the investment arena,  

Paul Merriman 

would be an excellent choice.  He stands out even among all the other excellent "Retirement" writers at MarketWatch.

Update: 1st Quarter Performance of BlackRock Diversified Portfolio

Regular readers know my favorite investment chart is the BlackRock 20-year sector performance.  It details the relative performance ranking of asset classes on an annual basis as well as the performance of an easily replicated low-cost diversified portfolio comprised basically of 65% stocks, 35% bonds.  The diversified portfolio returned 8.7% on an average annualized basis over the 20-years ended 12/31/20114.

The diversified portfolio allocation is an appropriate benchmark for many individuals in their 40s and even early 50s, depending on their specific risk tolerance.  The chart contains sufficient data, however, to construct a benchmark and analyze performance for any specific allocation; and, in fact, the allocation can be changed over time using the data in the table--as it should be as an individual ages.

Voluminous data from unbiased academic studies have been presented over the years showing that a diversified portfolio of low-cost funds outperforms upwards of 70% of active managers over the longer term, after all costs are taken into account.  These studies cover various time periods, countries, asset classes, and investment methodologies.  In line with this data, the low-cost diversified approach warrants consideration as a benchmark for investors.  It shouldn't go unnoticed that the approach economizes on the investor's time.

Below is an update showing the approximate performance of the diversified portfolio's sectors for the 3 months ended 3/31/2015.  Overall, the portfolio returned approximately 2.17%.

For the quarter, sector performance was mixed with the international (EFA) doing best and large and mid-sized value (IWD) lagging. The bond market (AGG) achieved a positive return as yields dropped over the 3 months.

Weight (%)	Fund	Return (%) 3 months ended 3/31/2015
35	AGG (Barclay’s Aggregate Bond Index)	1.63
10	EFA (EAFE Index)	4.85
10	IWM (Russell 2000)	4.33
22.5	IWF (Russell 1000 Growth)	3.79
22.5	IWD (Russell 1000 Value)	-.76

Disclosure:  This post is intended for educational purposes only.  Past performance is not indicative of future performance.  Individuals should consult a professional or do their own research before making investment decisions.

Clements on Index Fund Investors

Here's a nice piece by Jonathan Clements at MarketWatch on index fund investor performance versus active fund investor:

Are index-fund investors smarter?

The article presents interesting findings by Morningstar on dollar-weighted returns for active fund investors and index fund investors that support what we present here on an ongoing basis.

What interested me was his observation on why indexers tend not to jump in and out of the market at the wrong time.  He observes that indexers have a single worry - the performance of the market whereas active fund investors have two concerns - the performance of the market and the worry of the active fund they are invested in.

Although he didn't mention it, this combined with the risk averseness of investors clearly makes active fund investing for many investors a real challenge - especially in volatile markets such as we have experienced recently!

Real World Investment Fees

Here is what advisors see.

C.P. is 74 years old.  Her assets are at a popular brokerage, E.J., where she has an advisory relationship.

C.P. is not high net worth.  She has $112,666, of which $47,497 is with E.J. She has $62,600 in savings at a bank that is earning a pittance that she wants to get invested.  This is her nest egg!

Cursory reading has convinced her that having the $62,600 with E.J. in high-cost funds is not in her best interest.

Here is a list of her current investments with E.J.:

Fund/Ticker Symbol	Load	Mer	Invested Amount $s	12 Mo. Performance (%)	Rank
ABALX	Front/5.75	.59	6,798	8.70	19
ANCFX	Front/5.75	.61	9,507	10.46	60
AFRCX	Back/1.00	1.53	2,388	1.49	54
ACTFX	Back/1.00	1.62	3,290	11.71	19
HYMCX	Back/1.00	1.53	1,438	9.37	66
LWSCX	Back/1.00	1.96	7,634	6.55	39
ISFCX	Back/1.00	1.91	5,536	2.38	78
CAIBX	Front/5.75	.62	4,275	5.96	11
AEPGX	Front/5.75	.84	2,057	1.70	40
AGTHX	Front/5.75	.66	2,316	9.40	61
AIVSX	Front/5.75	.59	2,253	10.52	60

 
Note that the Mers, annual expense ratios, range from .59% to 1.96%/year.  Note, as well, that the largest investment is in a front load Fund that takes 5.75% right at the get-go.  Hmm!

The ranks shown are from Morningstar.  They average out to 46, which means the performance numbers are roughly average; and because Funds tend, on average, to underperform their respective  market sectors after all expenses over the long term, it is likely that C.P. would have a difficult time getting good performance with this setup.  This is especially the case when you understand the impact of the loads which put the client significantly behind the starting line.

Her asset allocation, obtained by putting the above ticker symbols and dollar amounts into the Morningstar X-Ray utility, shows:

4% cash
46% U.S. Stocks
15% Foreign Stocks
31% Bonds
3% Other

I'm not sure, on top of everything, whether C.P. pays an advisory fee.  If she does, it obviously just digs the hole deeper.  She, then, would be paying a fee to be put into high-priced funds - a recipe for building an advisor's account but not the customer's account.

To add insult to injury, there is a charge of $95 to terminate each account.  The above listing is for two accounts:  a regular account and a small IRA.  Ooch!!  Think about this.  If they do a bad job and you want to fire them, they charge you for sending info to another custodian. 

Do You have a Good 401(k)?

In today's world where we are responsible for our own retirement, a good 401(k) is extremely valuable.  If you are young and you have a good 401(k) and you take advantage of it, you are on the track to spending the last third of your life in really, really good shape.

Don't know how to do it?  Read this blog or hundreds like it, or read Millionaire Teacher by Andrew Hallam or The Elements of Investing by Malkiel and Ellis.  These books will take you two weekends, at most, and will put you on the aforementioned path.

But how do you know if you have a good 401(k)?  One thing you might want to do is visit www.brightscope.com where you may find your company 401(k) listed and rated.

Another approach is to read

 7 Clues That Your 401(k) Plan Sucks by Robert Berger.

Incidently, his website Dough Roller is one of my favorites that I check weekly for the articles he lists!

In this article he wrote for Daily Finance, Berger has the following important points to examine on determining the quality of your 401(k):

• employer match - in just about every instance, a match should be taken advantage of.  How do you find if you have a match?  Ask Human Resources or look at a recent statement.  Statements will have "employee contribution" and "employer contribution"(if any) listed.
• Roth 401(k) - if you have a Roth 401(k), it is good; and consideration should be given to using it.  Know that you won't get the upfront tax break for using it; but, going forward, you'll never worry about taxes again (assuming Congress doesn't change the law ;).
• Index Fund offerings - generally, if you don't have low-cost index fund offerings, then you should limit your contributions to the company match and use an IRA elsewhere.  If you aren't sure of what a low-cost index fund is, read the above mentioned books.  If you have low-cost index fund offerings (example: Fidelity Spartan Funds), then your path to a successful retirement is straight forward.  Use them to the fullest extent allowed!

Berger's article lists other important considerations.  One important point to note is at the very beginning where a lawsuit is referenced concerning a Plan Administrator.  If your 401(k) has only high-expense fund offerings, you may want to highlight the case mentioned with a yellow highlighter and drop it off in your Human Resource person's mailbox.  The days of clueless administrators choosing poor fund choices for plan participants is slowly coming to an end.