From the weekend reading, I learned about a few awesome blogs on the topic of (very) early retirement. There seem to be several folks out there making a go of living financially independent lives in their 30s. They generally have a few things in common:
- A high-paying job in their 20s (e.g. software engineer), usually in concert with a high-paid spouse.
- True dedication to savings – most are socking away 50-70% of income during working years. Experiences vary on how to achieve this – some are more ascetic than others.
- Good financial sense – just solid practices, such as maxing out retirement savings, sticking with cheap index funds, etc. Nothing particularly fancy, though some pretty sweet tax planning to be found.
In any case, here are the 3 new blogs on my list. I’ve already picked up a few tips to save on my taxes, so worth every penny of reading!
- Go Curry Cracker – a couple doing the early retirement thing in Mexico/US. Great transparency on their finances/expenses for how to make things work.
- Mad Fientist – brilliant resource for tax planning.
- Jim Collins – a resource for investing basics, particularly stock investing.
You tell ’em, tea-bagger. Source: Google Images.
This morning I read a Huffington Post article by Nancy Altman, which piqued my interest. It advocates shifting away from privatising Social Security, or indeed advocating 401(k)s or IRAs, and applying additional taxation towards extra funding and benefits from the existing Social Security system.
I see that Ms Altman has a book out, as well as a lobbying group named Social Security Works. In lieu of buying the book – which I may yet do, given the thesis is far from my understanding of the status quo – I read a few of the lobbying group’s memos. My thoughts:
- Isn’t Social Security going broke? Well, yes and no.
- Social Security’s income comes from (source: the lobbying group)
- Current taxation: around 85%
- Investment returns: around 15%. FYI, ‘investments’ are 100% US Treasury notes and bonds.
- So what? Well, lower yields for Treasuries means lower future returns for Social Security. So that item will need to be supplemented by additional tax, or else benefits will come down. Also, the large cohort of (working) baby boomers leaving behind a smaller workforce will lower the current taxation component.
- And… that leads to projected deficits, and loss of benefits, beginning around 2033 under status quo. Technically, the loss of any benefit would be a default – therefore bankruptcy or ‘going broke’. The group claims this isn’t the case, as taxation will still be coming in. If only personal bankruptcy worked that way, right?
- How to fix this? The group suggests abolishing the cap on income subject to Social Security tax – right now income over $117k isn’t subject to SS tax. No mention of removing the cap on SS benefits however – those remain. The progressive in me thinks this is generally OK: maybe the US can follow the UK National Insurance scheme, and tax the extra income by a lesser rate, like 2%.
- Why not privatise and/or encourage IRAs and 401(k)s?
- Cost differential? Your run of the mill IRA + fund management charge is probably around 1-2% of assets in the retirement account, per year. Social Security spends about 0.5% of trust fund assets in Administration costs, per year. So one can plausibly argue that Social Security is a more cost-efficient way to save for retirement – though I wonder what is the administrative cost of collecting SS taxes.
- Return differential? I’ve written before about how good a deal Social Security can be for current retirees, particularly against expectations for future generations. So here’s a thought, keeping in mind where the money for SS payments comes from (see above): given a slowdown in demography (i.e. fewer workers paying in) and investment returns explicitly limited to US Treasury returns, how can there be enough money to go around in future?
- For example, 30-year Treasury bonds currently yield 2.63% per year. That means $100 of Bonds purchased today will be worth around $220 in 30 years. If we assume the Fed can achieve 2% long-term inflation, and SS benefits continue to rise in line with inflation, that’s hardly any real return at all. And that’s the maximum investment return allowed by Social Security.
- How to fix it?
- Sadly, the mathematics just don’t add up unless taxes are raised – hence I absolutely see why the group wants to remove the cap on earnings subject to SS tax.
- I suppose the amounts sent to ‘auto-enrolled’ 401(k) plans could just be reframed as additional SS tax to help keep up the program, and possibly increase benefits?
- The only other method I can think of would be to massively increase population through either more lax immigration policy or through discouraging the use of contraception.
In sum: I was absolutely intrigued by the idea that, instead of thinking of Social Security as a slowly fading institution of old-time, New Deal America, we should consider the program as a better option for our future pensions. The cold mathematics, however, means pretty unpalatable choices to make this happen. But, as I’ve written before, the millennial generation faces stark mathematics regardless of how pensions are handled – there just isn’t enough money to go around.
So I read an interesting blog post on Noahpinion today, regarding whether ’tis better to ditch active fund management (e.g. follow Jack Bogle’s advice and stick with index-tracker ETFs, which charge very little fees), or to save more, in terms of retirement savings. The article gets a bit economist-like, involving some basic utility functions and the like, to come up with a tentative ‘better to ditch active management’ conclusion. The short blog post + comments are worth a read.
Anyway, this got me thinking. And when I get thinking, I get modelling. So here’s a spreadsheet which models the analysis I think of, when considering this problem. Method:
- Hypothesis: I think the time spent figuring out asset managers (whether passive or active) is probably about the same as creating a basic budget. The latter allows for increased savings. So let’s find out whether time is better spent ditching active management for passive, or creating a budget, in terms of accumulated retirement saving.
- Data: for simplicity, I use the total returns of the S&P 500, data which comes from Aswath Damodoran.
- Starting salary of $50,000.
- A savings rate, without budget, of 5% p.a.
- Salary growth of 2% p.a., which is reflected in increased savings (i.e. we save 5% of the new, higher salary).
- Performance drag of active management over passive of 2% p.a. So I assume active managers under perform a passive S&P 500 fund by 2% each year.
- Budgeting increases savings by 3% p.a. So a person who currently saves 5% p.a. can up that to 8% p.a. by making a budget.
Budget or bin the manager? Source: Damodoran Data.
- A Monte-Carlo simulation of 100 lifetimes (44 years of accumulated saving), randomly choosing years of S&P500 returns with replacement, brings the above picture.
- Each run charts the net benefit, in terms of wealth at retirement age, of choosing to budget rather than switch the active manager for passive. See the worst line there? That’s happened because the luck of the draw meant lots of good years for the S&P 500 portfolio: in that case having the fee drag is a really bad thing versus just saving a bit more (however you’d be very rich in either case).
- It turns out the ‘break even’ is around 4% for budget savings to exceed fee savings. So if the savings ratio can be bumped from 5% to 9%, in this example, better to budget.
- In brief: just choose the method that saves more. Unless your budget increases your saving by a fair bit more than active fees (2% in this example), focus on active fees first.
- In Noahpinion’s favour, one of his problems with this type of conclusion is that, because we can’t know how much more $1 today means to someone than $1 at retirement, we can’t use phrases like ‘better off’ to characterise the result. All we can say is the wealth is higher at retirement.
- Go ahead and play with the assumptions and see the accumulated benefit on the line chart, if you like!
In sum: suppose you’re holding some actively managed mutual funds, and are considering dumping them all for passive ETFs to save on fees, or even whether to dump one manager/ETF for another. Before spending time with the withdrawal forms and whatnot, consider creating a simple budget to increase your savings. The latter may pay off more in future.
Just a quick shout out to one of my favourite blogs, The Simple Dollar. Yesterday’s entry on how to retire on $1 million (or if it can be done) well-illustrates the type of basic analysis underpinning retirement planning calculators everywhere.
My only caveat with the analysis, like most of these simple ones, is the sensitivity to assumptions. This article tries several types of assumptions, which makes the thing stand out (in my opinion). But particularly when long time periods are involved, small changes in assumptions can drastically change results. Given we have basically no idea what the correct figures will be, caveat emptor for those placing too much reliance on one run of the ‘simulation’!
Sadly there isn’t a good fix for unknown parameters in the analysis, but rest assured I’ll let you know when I have a reliable crystal ball.
I stumbled across the Broken Eggs website from Marketwatch today, and immediately accessed the (free) online film. The trailer looks very promising: a good mix of statistics and personal stories to make the issues surrounding retirement in the US a bit more understandable. Though not mentioned (as far as I’m aware….I’m about to sit for the film), we can practically replace the US in the film with any other developed country (aside, maybe, Norway); the issues are the same.
I’m happy to see Mr Ritholtz take on one of my pet/favourite topics: the connection between wealth and happiness. His review of the latest Pew research is worth perusing: the findings of the recent survey agree with what’s been said before. That is:
Who’s the happiest of them all? Source: Pew Research via Bloomberg View.
- More money = more happiness, until basic needs are met. Then there is precious little correlation between the two.
- Despite having very high relative incomes, Western Europe/US/Japan just don’t seem as happy as several developing countries, particularly religiously-devout Latin American ones.
- Beyond basic needs, money spent on items gives less happiness than money spent on experiences. The latter includes charitable donations. So ‘bang for buck’ goes to buying better experiences.
- An interesting angle here: Ritholtz quotes another survey, showing the wealthy get considerable pleasure from saving/investing. Maybe part of the reason they’re wealthy…?
This all agrees with my interpretation of the ‘extreme retirement’ movement. Spending little on items, but enjoying experiences such as travel. Enjoying saving/investing, with the intention of creating a passive income. Instead of working for a fancier house/car/stereo, minimising expenditures to allow more time for those valuable experiences. Sounds like a way to maximising happiness, frankly.
I just heard this question asked again…. as a new employee, should I contribute to the company 401(k) or company pension, in order to get a company match?
This head-shaker is easy: YES. For the avoidance of doubt, my strong opinion is:
- Contribute at least as much as required to receive full match.
- From there, consider contributing more: I have read in several places (Rational Expectations among them) that young folks need to contribute about 20% of salary to feel reasonably confident of a retirement in their late-60s.