A fairly recent article was published here on the issue of why baby boomers have so little in retirement savings. The thesis was that Wall Street has duped investors into falling for a myth that their returns will sufficiently compound over time. I’d like to offer my own take on the reasons for this situation, first by showing historical returns of a hypothetical investor who consistently used buy and hold investing in the S&P 500 in three different thirty-five year periods. This will show how much an investor would have really made by sticking to long-term buy and hold investing. Then I’ll name the top three culprits for why the generation of boomers found themselves in this situation.
So let’s take three individuals whose working career spans from 1980-2015, 1970-2005, and 1974-2009. We’ll assume that this investing is done in addition to a decent pension from their job and paying off a mortgage during the same time frame. They contribute $250 per month into their IRA, investing in a single S&P 500 index fund for the duration. Yes, saving $250 every month on the median income in 1980, $12,513.46, is not nearly the same as saving $250 in 2010 assuming higher wages. The amount is held constant for simplicity. In the hypothetical situation, we are assuming the retiree will have a decent pension, social security, owns their home by time of retirement, and the index fund is an addition to their portfolio.
Here are the results of each investment journey, with taxes being deferred since the individuals are using their IRAs.
In the beginning of each case, the rise in portfolio value will come mostly from inputs of additional capital. This is like a pendulum that swings the other way when you look farther down the line, as the majority of the rise in value will be from the performance of the asset rather than adding additional money.
The bear markets always hurt, but buy and hold in these scenarios won’t work unless there is both reinvestment of dividends and continually adding to the base. Some of the most potent compounding actually happens when dividends are reinvested during bear markets. This effect becomes more dramatic the longer the duration of the investments.
The problem with buy and hold is that most people can’t dollar cost average their way through every bear market without feeling the need to sell to avoid further losses in market value. It has long been the case that even the biggest passive funds see investors flee when performance is bad and return once things bounce back, missing out on the total returns in the process. This is not the fault of buy and hold, it's an issue of implementation. If you understand why you are going about the strategy, you’ll be more likely to stick to it. The stock market is volatile, but understanding that this is the case and having a plan and sticking with it does work. An unrealized loss is exactly that, unrealized. The numbers speak for itself, holding on during the tough times pays a reward. Patience really does pay off.
The truly painful periods were after investors were already ten or twenty years into their compounding journey, to suffer a big decline and still stick through it. For Case A, the popping of the tech bubble would have been extremely tough. As would have leading up to the bubble when many others were (seemingly) getting rich quick with tech companies.
In Case B, 1970 was the start they ended their journey with a higher return than the investor starting in 1980. The problem is the inflation adjusted returns in the 70s would have been bad. However, the solution would not have been to get out of the market and start timing the gold or forex markets. Not selling, and consistently adding to the portfolio each month would have still paid off in the long run.
I’m not denying how hard it would have been to stick to this during such an inflationary time period. During the 80’s, it might have been hard to be bullish on the stock market when CD’s or even muni bonds were offering double digit interest rates at times.
Case C got the worst treatment of all. Starting off with six years of harsh inflation, and ending their career right after the tech bubble. Since this is still a passive investor though, they didn’t need to switch to gold, or bonds or anything else. Being a passive investor means accepting the return that the market gives through continuous participation.
I’m obviously not advocating that this hypothetical portfolio alone would be sufficient to live off. The dividend payments will fluctuate when a bear market comes around, you wouldn’t want your standard of living to entirely revolve around the dividend yield of this single index fund. But assuming this hypothetical boomer also has a decent pension, social security, and has paid off their mortgage, this additional portfolio income can make quite a lifestyle difference.
So think of it this way. Over the course of their career, sacrificing $250 a month to invest for the long run results in roughly one million dollars to provide additional retirement income.
Keep in mind that these returns all came from a single, passive, index fund. This requires no individual analysis, no researching companies, no reading of financial statements, no reading quarterly and annual reports, no technical analysis, no communicating with IR/management, no site visits, no touring factories and facilities, no attending annual shareholder meetings, no consulting fees, and no advisor fees. The list describes the workday of many bright and hard working individuals in Wall Street and around the world who work 100+ hour workweeks and are paid high salaries, yet can’t actually beat the market. All of this effort can and should be avoided by the person who has little to no interest in learning about how to pick stocks, but does want to invest their savings for retirement. This person can easily sit on their butt and generate roughly 10% CAGR by completely passive investing for the long run. IMO this is an easy barometer for those who plan on picking stocks. The long term returns do vary from 9%-11% depending on the time period, so 12%+ CAGR should be any stock picker’s own personal hurdle rate.
Now I’d like to address the primary reason why today’s retirees have so little in retirement savings.
The mentality for boomers has been predominantly to rely on a pension from their job at a huge, blue chip company like GE, GM, Ford or IBM or work in the public sector to receive a similar pension and the same kind of job security. Any additional income would be taken care of by Social Security and they likely owned their home at retirement. This idea seemed noble at the time, but in hindsight I think it was quite naive to just assume that middle class job growth can and must continue indefinitely. The US labor market is more technical and specialized than ever.
Nevertheless, this mentality was widely accepted, and it did work for a large number of people. The idea of putting additional money aside to invest for retirement, outside of their pension, when one was already years into their career at GM would have seemed quite unnecessary.
The situation couldn’t be more different for millenials today. There are zero industries which are trending towards increased full time employment (unless you include entrepreneurship, which of course means self-employed). Automation and robotics will prevent middle class employment from growing the way it did in previous generations, which cuts the number of employees paying retirees. Add the fact that Americans are living longer, yet unhealthier lives, which means more SS payments and much more on Medicare from a smaller tax base.
The punchline is that millenials have no choice but to save and invest to create their own private pension. Relying on the federal government for SS and Medicare makes no sense for millenials the way it did for their parent’s generation. Building up a storehouse of wealth is the only way to have a much more reliable income source in retirement.
Financial principles are timeless. The biggest fundamental problem for the boomers is the same for millenials, a lack of sound financial habits, which stem from a lack of financial education passed down from parents. To be specific, the habit of always saving a portion of one’s income, the habit of investing and then reinvesting those savings for the long run, and the habit of avoiding debt. The national rate of personal savings dropped from over 13% in 1981 to barely above 2% in 2005.
Credit card debt per household increased over 1200% while the median household income growth increased only 300% during the same time period.
The rate of stock market participation did increase also, but it was mainly concentrated to higher net worth households here.
One current issue that muddies the picture for anyone looking to truly build a habit of savings is the fact that the biggest retail banks have been paying rather pathetic interest rates ever since the last financial crisis. Take Wells Fargo for example, currently paying 0.01% on their standard savings account. Yes a single basis point is the best they can do for you. As for alternatives right now, many of the leading online banks offer at least 2.00% on their savings and money market accounts, as do 3-month T-bills.
George S. Clason's classic book on finance and investing, “The Richest Man in Babylon” is very popular in financial circles, unfortunately those circles aren’t that large in relation to the general population. A couple of popular children’s fables actually show prudent financial habits as well: the Ant and the Grasshopper and The Tortoise and the Hare. While most people learned these stories, the lesson in each one has not manifested when it comes to the modern financial behavior of the average American. The ant was a saver while the grasshopper a spender. The hare was chasing the quick speculative returns while the tortoise exemplified the saying “slow and steady wins the race.” AKA passive investing versus active investing/speculating.
In summary the three factors I consider to have affected boomers current retirement landscape are
The mentality of relying on a pension, SS, and a paid off mortgage as being all that was needed for a solid nest egg.
An overall declining personal savings rate.
An increase in credit card debt vs median household income.
I would also argue that number two and three are largely side effects of number one.
There are two additional factors I’ll briefly mention. I consider them minor factors and not major.
-Don’t forget the inflationary 70s
Many boomers were starting their first, full-time jobs in the mid to late 70s. Starting your working years out with double digit inflation was a major drag, even to the dedicated savers. Yes, they were gifted with double interest rates on fixed income securities in the early 80’s, but the inflationary scare of the 70’s surely left many people confused as to exactly where their money could be least affected by inflation. While the solution was still to stick to the buy and hold strategy, there’s no doubt that this was a tough period for almost any investor, let alone a young adult starting their career. This also applies to those that had their first part time jobs in the 70s before working full time in the 80s. Thrifty behavior in their teen years would have been damaged by inflation.
-The 4% rule and living off dividends
The 4% rule has been touted for decades but there are issues with it. One is that that the number four is rather arbitrary, and there is usually no emphasis on whether this 4% comes from dividends/interest or from principal. Selling off principal makes no sense in an index fund, due to general market volatility and the inevitable corrections and recessions which do routinely happen in spite of stock market growth in the very long term. Retirees shouldn’t have to time the market in order to maximize their “income” by selling shares. Simply living off the dividends isn’t the total solution either, it’s a matter of not requiring ALL expenses to be funded by a single index fund.
The other issue with the 4% rule is that it doesn’t usually address what happens to the principal of the underlying asset over time. Let’s say you do apply the concept of living off the interest/dividends and never touch the principle while staying true to the 4% rule. The results would be quite different if we take the scenario of a 100% bond portfolio that yields 4%, versus a large cap stock index ETF that also yields 4%. The growth of principal will no doubt be higher decade after decade with the stocks, as opposed to the bonds.
This mostly affects whomever these securities will be passed to. With the retiree living off the dividends, the rate of compounding will obviously slow down as dividend reinvestment no longer occurs, so the growth of share price of the indexed companies will determine the rate of compounding for the principal. Assuming the retiree lives until age 95, their beneficiaries would probably rather receive 30 years' worth of compounding stocks versus bonds offering varying market prices but no underlying compounded growth. Of course if the retiree dies at age 67 and the market is undergoing a correction or recession, there would be far more losses in market value with stocks than with the bond portfolio, which means far less for the beneficiaries. My opinion is that the risk of missing out of the long term returns of stocks by sticking with a fixed income portfolio is too high even at the upper age range. .
What to do with this information
The main point is to stick to the fundamentals of long term, buy and hold investing. A passive investor has no control over whether the compounded returns will be 9% or 11%, but they do have control over sticking with the strategy, even during bear markets. One must realize that most people who bash buy and hold have some kind of vested interested in actively managed funds or fee-based advice. It’s not very easy for a financial advisor to tell their clients to simply dollar cost average into the market every month for a multi-decade investment journey while receiving a commission for doing so. Advice this simple and consistent would eventually seem valueless since it never changes. Building the financial habit is the outcome that we are looking for, and fee-based advisors are literally not looking to help build these habits for you.
It can be literally free to invest these days, in the case of Fidelity zero expense funds, that also have zero trading costs.
Current Net Assets
August 2nd, 2018
August 2nd, 2018
September 13th, 2018
September 13th, 2018
In less than a year, we see over five billion dollars of inflows to funds for zero expense. This shows how strong the passive trend is right now. The trend isn’t going away, but this doesn’t mean that most equity funds won’t see outflows when another correction or recession hits. Many people who are passive investors today will make an unplanned detour into active investing once their index fund takes a massive hit, by selling and switching to another asset.
If today's generation of workers takes advantage of their Roth IRAs, and more employers offer Roth 401Ks to their employees instead of traditional 401Ks,
If even 25% of millennials began maximizing their Roth accounts with index funds and always kept their savings rate high and debt balances low, then kept these habits up for a minimum thirty five year working career, the financial impact on society would be huge.
One of the biggest advantages of the Roth IRA is that there are no RMDs, required minimum distributions during the account holder's lifetime. Which means the tax free compounding can extend beyond just a 35 year working career. The compounding effect will be in full force if left to work for that long with dividends reinvested, but even assuming all dividends were taken for income, it still gives the investor a chance at leaving modest wealth to their heirs.
Once someone has truly built the financial habits of saving, investing those savings, and avoiding debt, they build more than just the habits, and more than the wealth produced by the habits. They also build core skills necessary to be an active investor, an entrepreneur, or a manager. Whether the person takes these skills into another arena is up to them, but either way the financial habits benefit the individual and their dependents, and society as a whole.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.