Tag Archives: FIRE

F.I.R.E. – Ignited By The Bull, Extinguished By The Bear

Do you remember this commercial?

The Etrade commercial aired during Super Bowl XLI in 2007. The following year, the financial crisis set in, markets plunged, and investors lost 50%, or more, of their wealth.

However, this wasn’t the first time it happened.

The same thing happened in late 1999. This commercial was aired 2-months shy of the beginning of the “Dot.com” bust as investors once again believed “investing was as easy as 1-2-3.”

Why this trip down memory lane? (Other than the fact the commercials are hilarious to watch.)

Because this is typical of the mindset seen at the end of extremely long “cyclical” bull market cycles. 

Investing is simple. Just throw you money in the market and it goes up. Its so easy a “baby can do it.”

Here is something else you see at the end of bull market cycles:

 “This couple retired at 31 with $1 Million: Want to retire early? How “going against the grain” allowed this FIRE couple to ditch their jobs and travel the world.

How did they make this happen? Shen and Leung, who was also a computer engineer, are part of the FIRE movement — which stands for Financial Independence, Retire Early — where the goal is to save a lot so you can retire early. The couple retired at 31 with roughly $1 million in the bank. They’re currently withdrawing 3.5% a year from that nest egg, and say they can easily travel the world on that money — as they’ve got lots of practice being frugal.”

First, I want to give the couple a “fanatical thumbs up” for saving $1 million by their 30’s. That is an amazing feat which deserves respect and acknowledgment. 

Secondly, they are very budget conscious and willing to sacrifice the luxuries most people long for to live their dream.

Another “thumbs up.”

However, the rise of the “F.I.R.E.” movement is symptomatic of a late stage bull market advance. More importantly, we can also predict how things will turn out for Shen and Leung.

For this discussion I want to use the data provided by Shen and Leung to build our examples.

  • Invested asset value:  $1 million
  • Annualized withdrawal rate: 3.5%
  • Annualized return rate: 6% (Not specified but a reasonable estimate)
  • Living needs: $35,000 annually.
  • Life expectency: 85-years of age.

With these assumptions in place we can begin to do some forecasting about how things eventually turn out. However, we also have to assume:

  • The couple never has children
  • Never requires serious medical care (hopefully)
  • Never considers buying a house
  • Has no major life events, etc.

First, we need to start with the cost of living. As I showed recently in Part 1 of “Everything You’ve Been Told About Savings & Investing Is Wrong” is that the cost of living rises over time due to inflation. However, for most the increase in living costs rises dramatically more as needs for housing, children, education, travel, insurance, and health care occur through stages of life.

For this exercise, we will assume our example couple never changes their lifestyle so only inflation is a factor. We will use the historical average of 2.1% and project it out for 50-years.

Understanding this, we can now take their $1 million, compound it at 6% annually (the preferred mainstream method), and deduct 3.5% annually adjusted for inflation over their 50-year time horizon.

We need to assume that since our couple is in their 30’s, the investable assets are in taxable accounts. Also, if this is the case, and they are not touching the principal, then we need to adjust the annual withdrawals for capital gains tax. The bottom two area charts adjust for 2.1% annual inflation and inflation plus a 15% tax on withdrawals. (Tax is paid on the gains taken to fund the withdrawal and the dividends paid in on an annual basis)

Not surprisingly, if our couple can indeed live on $35,000 a year, even when adjusting for inflation and taxation, a $1 million portfolio growing at 6% annually can indeed support them for their entire lifespan.

Reality Is Different

In Part 3 of our recent series on “saving and investing,” we laid out the issue, and importance, of variable rates of return. To wit:

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what happened to their money is substantial over long-term time frames.”

The chart below is exactly the same as above, however, this time we have used the average annual 50-year returns from previous periods in history where starting valuations were greater than 20x earnings as they are today. (High starting valuations beget lower future returns historically speaking.) 

Over a 50-years, our couple will get the benefit of complete valuation and market cycles. In this case, since they are starting with high valuations at the outset, the first 30-years contains a long-period of lower returns, but that last 20-years receives the benefit of higher returns due to valuation reversion.

Due to market volatility and periods of negative growth, the original $1 million portfolio only grows to $3 million when including nominal spending. However, when accounting for volatility, inflation, and taxes, the survival rate of the portfolio diminishes sharply due to two reasons:

  1. Down years reduce the growth rate of the portfolio over the given time frame.
  2. Withdrawals in down years exacerbate the decline in the portfolio. (i.e. Portfolio declines by $65,000 plus the $35,000 annual withdrawal increases the 6.5% decline to 10%.)

Obviously, not accounting for volatility when planning to retire early can have severe future consequences. In this case they will run out of money in year 47.

The Big Bad Bear

As I said at the beginning of this missive, the “F.I.R.E.” movement is the result of a decade-long bull market cycle.

Most likely, our young couple will be met with a “bear market” sooner, rather than later, in their early retirement. If we use the return model from our recent article on “investors and pension funds,” we see a rather dramatic shift in life-expectancy of the portfolio.

“The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected ‘average’ returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)”

The benefit of this model is that it shows the impact to portfolio returns when bear markets are “front-loaded,” as will likely be the case for most the “F.I.R.E.” followers. (Note, in the return model above the “bear market” is 5-years into the future)

The reason for the dramatic short-fall is that a major, “rip your face off,” bear market will cut asset values by 50% very early on. All of a sudden, the annual withdrawal rate of 3.5% becomes 7%, which outpaces the ability of the portfolio to grow fast enough to catch up with the withdrawal rate and the loss of principal. In this more realistic example, our couple will run out of money in 30 years.

This is the exact problem “pension funds” face currently.

The Other Problems From “Playing With F.I.R.E.”

While we have mainly addressed the issues surrounding assumptions being used by the ‘F.I.R.E.” movement in having enough assets to retire, there are some other important issues which should be considered.

  1. Loss of your skill set. In retirement it is probable your skill set erodes and becomes outdated over time. New technologies, trends, innovations, etc. are running at a faster pace than ever.
  2. Becoming unemployable. One of the things seen following the financial crisis was employers preferring to hire individuals who were already employed rather than hiring those out of work. The reasoning was that if you were good enough to keep your job during the recession, you obviously have a valuable skill set. Once you are out of the “labor force” for a while, it becomes more difficult to regain employment as employers tend to prefer those with a very steady work history, a growing career, and relevant skill sets.
  3. Life. Besides simply running out of money sooner than you planned because of a bear market, a rising cost of living more than you counted on, or higher taxes (all of which are very likely in the near future) there is also just “life.”  It doesn’t matter how carefully you plan; “S*** Happens!” More importantly, it always happens when you least expect it and at the worst possible time. These things cost money and impact our best laid spending and saving plans. The problem with “retiring early,” is that it leaves plenty of time for things to go wrong. 
  4. Unplanned Accident/Medical Problem. Young people suffer from an “invincibility syndrome.” They tend to not carry insurance, due to the cost, because they “never get sick.” While we certainly hope it never happens, a major accident or health issue can extract tens to hundreds of thousands of dollars of capital critically impairing retirement plans.
  5. Too Old To Do Anything About It. The biggest problem for “F.I.R.E.” practitioners is that running out of money late in life leaves VERY few options for the rest of your retirement years. If our math above is even close to correct, which history suggests it is, then our young couple will be faced with going back to work in the 70’s. That is not exactly the retirement most are hoping for. 

As I stated in our previous series, retiring early is far more expensive than most realize. Furthermore, not accounting for variable rates of returns, lower forward returns due to high valuations, and not adjusting for inflation and taxes will leave most far short of their goals. 

While it sounds like I am bashing the “F.I.R.E. Movement,” I am not. I am for ANY program or system that gets young people to save more, stay out of debt, and invest cautiously. The movement is a good thing and it should be embraced.

But, it is also a symptom of a decade-long period of making “easy money” in the financial markets.

These periods ALWAYS end badly and the next “bear market” will quickly “extinguish the F.I.R.E.” as losses mount and dreams have to be put on hold.

It will happen. It always appears easiest at the top.

And, given one of E*Trade’s latest commercials, the next bear market may be coming sooner than we expect.

The One Lesson Investors Should Have Learned From Pension Funds

Just recently I ran a 3-part series on the variety of things individuals believe about saving and investment which is either erroneous or misunderstood. (Part 1, Part 2, Part 3)

The feedback I get when challenging some of the more commonly held beliefs is always interesting. In almost every single case, the arguments against “mathematical realities” comes down to either:

  1. An inability, or unwillingness, to sacrifice today to save more for the future, or;
  2. A “hope” that markets will continue to create returns which will offset the lack of savings.

Okay, it is just a reality that most people don’t want to sacrifice today, for the future tomorrow.

“Live like no one else today, so that you can live like no one else tomorrow.” – Dave Ramsey

Unfortunately, that is the same problem that plagues pension funds all across America today.

As I discussed in “Pension Crisis Is Worse Than You Think,”  it has been unrealistic return assumptions used by pension managers over the last 30-years, which has become problematic.

“Pension computations are performed by actuaries using assumptions regarding current and future demographics, life expectancy, investment returns, levels of contributions or taxation, and payouts to beneficiaries, among other variables. The biggest problem, following two major bear markets, and sub-par annualized returns since the turn of the century, is the expected investment return rate.

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating returns, it has artificially inflated future pension values and reduced the required contribution amounts by individuals and governments paying into the pension system

Pensions STILL have annual investment return assumptions ranging between 7–8% even after years of underperformance.”

However, why do pension funds continue to have high investment return assumptions despite years of underperformance? It is only for one reason:

To reduce the contribution (savings) requirement by their members.

As I explained previously:

“However, the reason assumptions remain high is simple. If these rates were lowered 1–2 percentage points, the required pension contributions from salaries, or via taxation, would increase dramatically. For each point of reduction in the assumed rate of return, it would require roughly a 10% increase in contributions.

For example, if a pension program reduced its investment return rate assumption from 8% to 7%, a person contributing $100 per month to their pension would be required to contribute $110. Since, for many plan participants, particularly unionized workers, increases in contributions are a hard thing to obtain. Therefore, pension managers are pushed to sustain better-than-market return assumptions, which requires them to take on more risk.

The chart below is the S&P 500 TOTAL REAL return from 1995 to present. I have projected an average return of every period in history where the market peaked following P/E’s exceeding 20x earnings. This provides for variable rates of market returns with cycling bull and bear markets out to 2060. I have also projected “average” returns from 3% to 8% from 1995 to 2060. (The average real total return for the entire period is 6.56% which is likely higher than what current valuation and demographic trends suggest it should be.)

This is also the same problem for the average American faces when planning for 6-8% annual returns on their investment strategy.

Clearly, there is no reason you should save money if the market can do the work for you? Right?

This is a common theme in much of the mainstream advice. To wit:

“Suze Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement.” 

Ms. Orman’s statement, while very optimistic, requires the 25-year old to achieve an 11.25% annual rate of return (adjusting for inflation) every single year for the next 40-years.

That certainly isn’t very realistic.

More importantly, as I explained previously, $1 million today, and $1 million in 30-years, are two very different issues due to a rising cost of living over time (a.k.a. inflation.) 

Pick a current income level on the left chart, the number on the right is the current income inflated at 2.1% (average inflation rate) over 30-years. Then pick that level of income on the right chart to see how much is needed to fund that amount annually in retirement at 4% (projected withdrawal rate.) Click to enlarge

What pension funds have now discovered, and unfortunately it is far too late, is that using faulty assumptions, and not requiring higher contributions, has led to an inability to meet future obligations.

“Pensions across the U.S. are falling deeper into a crisis, as the gap between their assets and liabilities widens at the same time that investment returns are falling, according to Bloomberg

The average U.S. plan has only 72.5% of its future obligations in 2018, compared to more than 100% in 2001. The Center for Retirement Research at Boston College attributes the deficit to recessions, insufficient government contributions, and generous benefit guarantees. Importantly, the underfunded status is still based on 7% annual return assumptions. 

Unfortunately, the problem will only get worse between now and 2050, according to Visual Capitalist:

“According to an analysis by the World Economic Forum (WEF), there was a combined retirement savings gap in excess of $70 trillion in 2015, spread between eight major economies…The WEF says the deficit is growing by $28 billion every 24 hours – and if nothing is done to slow the growth rate, the deficit will reach $400 trillion by 2050, or about five times the size of the global economy today.”

It isn’t just Pension Funds

Importantly, this is the same trap that individual investors have fallen into as well. By over-estimating future returns, future retirement values are artificially inflated, which reduces the required savings rates. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.

Using the long-term, total return, inflation-adjusted chart of the S&P 500 above, the chart below compares $1000 compounded at 7% annually to the variable-rate of return model above. The bottom part of the chart shows the difference between actual and compounded rates of return.

This is the “pension problem” the majority of individuals have gotten themselves into currently.

As I wrote previously:

“When imputing volatility into returns, the differential between what individuals are promised (and this is a huge flaw in financial planning) and what actually happens to their money is substantial over the accumulation phase of individuals. Furthermore, most of the average return calculations are based on more than 100-years of data. So, it is quite likely YOU DIED long before you realizing the long-term average rate of return.”

Excuses Will Leave You Short

I get it.

I am an average American too.

Here are the most common excuses I hear:

  1. I “need” to be able to enjoy my life today. 
  2. I have “plenty of time” to save up for retirement.
  3. “Budget,” what ‘s that?
  4. I have social security (or a a pension plan), so I don’t really need to save much.

Let’s talk about that last point.

If you have a public pension plan, congratulations, you are in the 15% of workers that do. Future generations won’t be as fortunate. Moreover, with the underfunded status of pensions funds running between $4-5 Trillion, this may not be a “safety net” to bet your entire retirement on.

Social security is also underfunded and payout cuts are expected by 2025 if actions are taken to resolve its issue. The same demographic trends which are plaguing pension funds also weigh heavily on the social security system.

As stated above, the biggest problem for Social Security is that it has already begun to pay out more in benefits than it receives in taxes. As the cash surplus is depleted, which is primarily government I.O.U.’s, Social Security will not be able to pay full benefits from its tax revenues alone. It will then need to consume ever-growing amounts of general revenue dollars to meet its obligations–money that now pays for everything from environmental programs to highway construction to defense. Eventually, either benefits will have to be slashed or the rest of the government will have to shrink to accommodate the “welfare state.” 

It is highly unlikely the latter will happen.

Demographic trends are fairly easy to forecast and predict. Each year from now until 2025, we will see successive rounds of boomers reach the 62-year-old threshold.

Excuses aside, continuing to under-save, and counting on social security and a pension fund to make up the difference, may have very different outcomes than many are currently planning on.

Simple Is Not Always Better

“All you have to do is buy an index fund, dollar cost average into it, and in 30-years you will be set.”

See, it’s simple.

It is why our world has been reduced to sound bytes and 280-character compositions. Financial, retirement, and investment planning, while complicated issues in reality, have become “click bait.”

But a “simple and optimistic” answer belies the hard-truths of investing and market dynamics.

It’s what Pension Funds banked on.

Simple isn’t always better.

Currently, 75.4 million Baby Boomers in America—about 26% of the U.S. population—have reached, or will reach, retirement age by 2030. Unfortunately, the majority of these individuals are woefully under saved for retirement and are “hoping” for compounded annual rates of return to bail them out.

It hasn’t happened, it isn’t going to happen, and the next “bear market” will wipe most of them out permanently.

The analysis above reveals the important lessons individuals should have learned from the failure of pension funds:

  • Lower expectations for future returns and withdrawal rates due to current valuations, interest rates, and long-run economic growth forecasts.
  • With higher rates of returns going forward unlikely, increase savings rates.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered; it’s better to overestimate.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • Future income planning must be done carefully with default risk carefully considered.
  • Most importantly, drop compounded, or average, annual rates of return for plans using variable rates of future returns.

The myriad of advice suggesting one can undersave and invest their way into retirement has a long and brutal history of leaving individuals short of their goals.

If even half of the mainstream commentary on investing were true, wouldn’t there be a large majority of individuals well saved for retirement? Instead, there are mountains of statistical data which show the majority of American’s don’t even have one-year’s salary saved for retirement, much less $1 million.

Yes, please be optimistic about your future and “hope for the best.”

However, if you plan for the “worst,” the odds of success become much higher.

It’s a lesson we can all learn from Pension Funds.

Everything You Are Being Told About Saving & Investing Is Wrong – Part 3

Click Here For Part 1 – The Savings Error

Click Here for PART 2 – You Don’t Get Average Or Compound Returns

This final chapter is going to cover some concepts which will destroy the best laid financial plans if they are not accounted for properly. 

Just recently, CNBC ran a story discussing the “Magic Number” needed to retire:

“For many people who adhere to the mission, there’s a savings target they want to hit, at which point they will have reached financial independence, as they define it. It’s called their FIRE number, and typically, it’s equal to 25 times a household’s annual spending, invested in low-cost, passive stock funds. Many wannabe-early retirees aim to save between $1 million and $2 million.”

This was the savings level we addressed in part one, which is erroneous because it is based on today’s income-replacement level and not the future inflation-adjusted replacement level, as it requires substantially higher savings levels. To wit:

“The chart below takes the inflation-adjusted level of income for each bracket and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.”

“If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.”

The Cost Of Miscalculation

As noted in the CNBC article above, it is recommended that you invest your savings into low-cost index funds. The assumption, of course, is that these funds will average 8% annually. As discussed in Part One, markets don’t operate that way. 

“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.”

During strongly trending bull markets, investors tend to forget that devastating events happen. Major events such as the “Crash of 1929,” “The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, the “Dot.com” bust, and the “Financial Crisis,” etc. often written off as “once in a generation” or “1-in-100-year events.” However, these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on an individual’s “plan for retirement.”

It doesn’t have to be a “financial crisis” which derails the best laid of financial plans either. An investment gone wrong, an unexpected illness, loss of job, etc. can all have devastating impacts to future retirement plans. 

Then there is just “life,” which tends to screw up things without a tragedy occurring. 

Making the correct assumptions in your planning is critical to your eventual success.

Your Personal Returns Will Be Less Than An “Index”

One of the biggest mistakes made is assuming markets will grow at a consistent rate over the given time frame to retirement. As noted, there is a massive difference between compounded returns and real returns as shown above. Furthermore, the shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.

The chart below shows what happens to a $1000 investment from 1871 to present, including the effects of inflation, taxes, and fees. (Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio.)

There are other problems with chasing an “index” also:

  • The index contains no cash
  • An index has no life expectancy requirements – but you do.
  • It doesn’t have to compensate for distributions to meet living requirements – but you do.
  • It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
  • It has no taxes, costs or other expenses associated with it – but you do.
  • It has the ability to substitute at no penalty – but you don’t.
  • It benefits from share buybacks (market capitaliziaton) – but you don’t.

As an individual you have very little in common with a “benchmark index.” Investing is not a “competition” and treating it as such has had disastrous consequences over time. 

Financial Planning Gone Wrong

I know, you still don’t believe me.  Let’s use CNBC’s example and then break it down.

For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

Over the last 120-years, the market has indeed averaged 8-10% annually. Unfortunately, you do NOT have 90, 100, or more years to invest. All that you have is the time between today and when you want to retire to reach your goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, which happens with some regularity, the odds of achieving goals are massively diminished.

But what drives those 12-15 year periods of flat to little return? Valuations.

Understanding this, we can use valuations, such as CAPE, to form expectations around risk and return. The graph below shows the actual 30-year annualized returns that accompanied given levels of CAPE.

The analysis above reveals the important points individuals should consider in their financial planning process:

  • Expectations for future returns and withdrawal rates should be downwardly adjusted.
  • The potential for front-loaded returns going forward is unlikely.
  • The impact of taxation must be considered in the planned withdrawal rate.
  • Future inflation expectations must be carefully considered.
  • Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
  • The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
  • Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.

Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.

  1. Save More And Spend Less: This is the only way to ensure you will be adequately prepared for retirement. It ain’t sexy, or fun, but it will absolutely work.
  2. You Will Be WRONG. The markets go through cycles, just like the economy. Despite hopes for a never-ending bull market, the reality is “what goes up will eventually come down.”
  3. RISK does NOT equal return. The further the markets rise, the bigger the correction will be. RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
  4. Don’t Be House Rich. A paid off house is great, but if you are going into retirement house rich and cash poor, you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
  5. Have A Huge Wad. Going into retirement have a large cash cushion. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining. This compounds the losses in the portfolio and destroys principal which cannot be replaced.
  6. Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plans, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.

Most likely what ever retirement planning you have done is most likely overly optimistic.

Change your assumptions, ask questions, and plan for the worst. 

The best thing about “planning for the worst” is that all other outcomes are a “win.” 

Everything You Are Being Told About Saving & Investing Is Wrong – Part 2

Click Here For Part 1 – The Savings Error

Click Here For PART 3 – Flaws In Financial Planning

It is always interesting reading article comments as they are generally full of excuses why saving money and building wealth can’t be done. The general thesis is that as long as you have social security (which is threatening payout cuts over the next decade) and/or a pension (which only applies to 15% of the country currently,) then you don’t need to save as much. 

Personally,  I don’t want my retirement based on things which are a) underfunded 2) subject to government-mandated changes, and 3) out of my control. In other words, when planning for an uncertain future, it is always optimal to hope for the best but plan for the worst.

However, the premise of the article was to clear up the disconnect between the cost of living today and 30-years into the future, as well as the amount of money needed to be financially independent for the entire lifespan after retirement.

Yes, we can all get by on less, in theory. But an examination of retirement savings statistics and the cost of healthcare in retirement (primarily due to poor healthcare habits earlier in life) doesn’t necessarily support those comments that saving less and being primarily dependent on Social Security is optimal. 

The Investing Problem

While “Part One”  focused on the amount savings required to sustain whatever level of lifestyle you choose in the future, we also need to discuss the issue of the investing side of the equation. 

Let’s start with a comment made on Part-One of this series:

“If you want to play it safe just buy a no-load, low fee, index fund and index into it regularly. Pay yourself first. Let the power of compounding do its magic.”

See, it’s so easy. Just buy and index fund, dollar cost average into it, and “bingo,” you have got it made. 

Okay, I’ll bite. 

If that is the case, then why this?

“More than half of Americans who were adults amid the Great Recession said they endured some type of negative financial impact, Bankrate found. And half of those people say they’re doing worse now than before the crisis.”

Or this:

“According to a brand new survey from Bankrate.com, just 37% of Americans have enough savings to pay for a $500 or $1,000 emergency. The other 63% would have to resort to measures like cutting back spending in other areas (23%), charging to a credit card (15%) or borrowing funds from friends and family (15%) in order to meet the cost of the unexpected event.”

As I stated in the previous article, I am all for any program and process which encourages people to save and invest for their retirement. My hope is that we can clear up some of the “misconceptions” to improve the chances that retirement years are not spent collecting food stamps and shopping at the local “Goodwill” store, 

Let’s start by clearing up the numerous erroneous comments on the previous article with respect to returns and investing. 

Compound & Average Are Not The Same Thing

” Markets have returned roughly 10% per year of compounded growth, INCLUDING the down years.”

What the commenter is confused about is, as stated previously, is that markets have variable rates of returns. Historically, over the last 120 years, the market has AVERAGED roughly 10% annually. (6% from capital appreciation which is equivalent to the long-term economic growth rate, and 4% from dividends. Today, economic growth is averaging 2%ish since 2000 and dividends are 2% so do the math for future return expectations. 2+2=4%. (Since 2000, average growth has been just a bit more than 5% and the next bear market will roll that average back to 4%)

The chart below shows the difference in nominal values of $1000 invested on an actual basis versus a compounded rate of return of 6% (For the example we are using capital appreciation only.)

Mathematically, both of those lines equate to a 6% return.

The top line is what investors THINK they will get (compound returns.) The bottom line is what they ACTUALLY get 

The difference is when losses applied to invested dollars. The periods of time spent making up previous losses is not the same as growing money. (Bonds, which mature at face value and have a fixed coupon, have had the same return as stocks since the turn of the century.)

This “math problem” is the reason there is a pension fund crisis in the U.S. The massively underfunded pension system was caused by depending on 7%-annual returns in order to reduce saving rates. 

Variable Rates Of Return Change The Game

In Part 1, we laid out a simple example of various current incomes adjusted for inflation 30-years into the future. I am presenting the chart again so the subsequent charts have context.

Now, let’s look at the impact of variable rates of returns on outcomes.

Let’s assume someone starts a super aggressive program of saving 50% of their income annually in 1988. (This was at the beginning of one of the greatest bull market booms in history giving them every advantage of front loaded returns and they get the benefit of the last 10-year long bull market.)  Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

Wow, they certainly saved a lot of money, and they met the amount need to completely replace their inflation-adjusted living standards for the rest of their lives.

Unfortunately, our young saver didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

Given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is likely unrealistic. If it wasn’t then we would not have statistics like this:

Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually. (Which is theMagic Number” for success)

Okay, it’s not so “Magic.” 

There are two important things to note in the charts above. 

The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 13-year period from 2000 to 2013 which left individuals far short of their retirement goals. 

What the majority of investors misunderstand when throwing around numbers like 6% average returns, 10% compound returns, etc., is that losses matter, and they matter a lot.

Here are the TWO most important lessons:

  1. Getting back to even is not the same as making money.
  2. The time lost in reaching your financial goals can not be recovered.

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is during these long periods where valuation indicators “appear” to be “wrong” that investors dismiss them and chase market returns instead.

Such has always, without exception, had an unhappy ending. 

Things You Can Do To Succeed

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting”events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. As an example, the chart below shows how using a simple 12-month moving average to avoid major drawdowns can impact long-term returns. We used the same 10% savings rate as above, dollar cost averaged into an S&P 500 index on a monthly basis, and moved to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually. It doesn’t matter what methodology you use to minimize risk, the end result will be same if you can successfully navigate the full-cycles of the market.  

You Can Do This

Last week, we laid out some suggestions on what you can do to build savings. This week will add the suggestions for the investing side of the equation.

  • It’s all about “cash flow.” – you can’t save if you don’t have positive cash flow.
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over spending is “social media” and “keeping up with the Jones’.” If advertisers were getting your money from social media they wouldn’t advertise there.
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Expectations for future returns should be downwardly adjusted. (You aren’t going to make 6% annually)
  • The potential for front-loaded returns going forward is unlikely.
  • Control investment behaviors and emotions that detract from portfolio returns is critical.
  • Future inflation expectations must be carefully considered.
  • Account for “variable rates of returns” in your plan rather than “average” or “compound.” 
  • Understand risk and control drawdowns in portfolios during market declines.
  • Save money regularly, invest when reward outweighs the risk. Cash is always an alternative.

Lastly, remember that “time” is your most valuable commodity and is the only thing we can’t get more of. 

Everything You Are Being Told About Saving & Investing Is Wrong – Part I

Click Here for PART 2 – You Don’t Get Average Or Compound Returns

Click Here For PART 3 – Flaws In Financial Planning

Let me start out by saying that I am all for any piece of advice which suggest individuals should save more. Saving money is a huge problem for the bulk of American’s as noted by numerous statistics. To wit:

“American have an average of $6,506 in credit card debt, according to a new Experian report out this week. But which expenses are adding to that balance the most? A full 23% of Americans say that paying for basic necessities such as rent, utilities and food contributes the most to their credit card debt. Another 12% say medical bills are the biggest portion of their debt.”

That $6500 credit card balance is something we have addressed previously as it relates to the ability of an average family of four in the U.S. to just cover basic living expenses.

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’ However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is a $3200 annual deficit that cannot be filled.”

This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.

Flawed Advice

The media loves to put out “feel good” information like the following:

“If you start at age 23, for instance, you only have to save about $14 a day to be a millionaire by age 67. That’s assuming a 6% average annual investment return.”

Or this one from IBD:

“If you’re earning $75,000, by age 40 you need 2.4 times your income, or $180,000, in retirement savings. Simple as that.” (Assumes 10% annual savings rate and a 6% annual rate of return)

See, it’s easy.

Unfortunately, it doesn’t work that way.

Let’s start with return assumptions.

Markets Don’t Compound

I have written numerous times about this in the past.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.”

When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over long-term time frames.

Here is another way to look at it.

If you could simply just stick money in the market and it grew by 6% every year, then how is it possible to have 10 and 20-year periods of near ZERO to negative returns?

The level of valuations when you start your investing journey is all you need to know about where you are going to wind up.

$1 Million Sounds Like A Lot – It’s Not

I get it.

$1 million sounds like a whole lot of money. It’s a nice, big, round number with lot’s of zeros.

In 1980, $1 million would generate between $100,000 and $120,000 per year while the cost of living for a family of four in the U.S. was approximately $20,000/year.

Today, there is about a $40,000 shortfall between the income $1 million will generate and the cost of living.

This is just a rough calculation based on historical averages. However, the amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal.

If you are part of the F.I.R.E. movement and want to live in a tiny house, sacrifice luxuries, and eat lots of rice and beans, like this couple, that is certainly an option.

For most there is a desire to live a similar, or better, lifestyle in retirement. However, over time our standard of living will increase with respect to our life-cycle stages. Children, bigger houses to accommodate those children, education, travel, etc. all require higher incomes. (Which is the reason the U.S. has the largest retirement savings gap in the world.)

If you are in the latter camp, like me, a “million dollars ain’t gonna cut it.”

Don’t Forget The Inflation

The problem with all of these “It’s so simple a cave man could do it” articles about “save and invest your way to wealth” is not only the variable rates of returns discussed above, but impact of inflation on future living standards.

Let’s set up an example.

  • John is 23 years old and earns $40,000 a year.
  • He saves $14 a day 
  • At 67 he will have $1 million saved up (assuming he actually gets that 6% annual rate of return)
  • He then withdraws 4% of the balance to live on matching his $40,000 annual income.

That pretty straightforward math.

IT’S ENTIRELY WRONG.

The living requirement in 44 years is based on today’s income level, not the future income level required to maintain the current living standard. 

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to common recommendations of 25x current income.

If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years.

Not accounting for the future cost of living is going to leave most individuals living in tiny houses and eating lots of rice and beans.

Things You Can Do To Succeed

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

  • Pay yourself first, aggressively. Saving money is how you pay yourself for working. 30% is the real magic number. 
  • It’s all about “cash flow.” – you can’t save if you spend more than you make and rack up debt. #Logic
  • Budget – it’s a four-letter word for most Americans, but you can’t have positive cash flow without it.
  • Get off social media – one of the biggest impacts to over-spending is “social media” and “keeping up with the friends.” If advertisers were not getting your money from social media ads they wouldn’t advertise there. (Side benefit is that you will be mentally healthier and more productive by doing so.)
  • Pick up a side hustle, or two, or threeOnce you drop social media it will free up 4-6 hours a week, or more, with which you can increase your income. There are tons of apps today to let you earn extra money and “No” it’s not beneath you to do so. 
  • Get out of debt and stay that way. No, you do not need a credit card to build credit.
  • If you can’t pay cash for it, you can’t afford it. Do I really need to explain that?
  • Future inflation expectations must be carefully considered.
  • Expectations for compounded annual rates of returns should be dismissed 

Don’t misunderstand me….I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

There is one sure-fire way to go from “being broke” to being “rich” – write a book on how to do it and sell it to broke people. (See “Broke Millennial” and “Millennial Money.”– but hey that’s capitalism and you can do it too.)

But, if investing were as easy as just sticking your money in the market, wouldn’t “everyone” be rich?

F.I.R.E.’d Up – A Million Ain’t What It Used To Be

The FIRE (Financial Independence Retire Early) Movement is literally on “fire” after Suze Orman recently suggested that one would need $5 million if they wanted to retire early.

“You need at least $5 million, or $6 million. … Really, you might need $10 million,” she said — short of that, it’s just not going to be enough for most people.

“You can do it if you want to. I personally think it is the biggest mistake, financially speaking, you will ever, ever make in your lifetime. I think it’s just ridiculous. You will get burned if you play with FIRE.”

FIRE supporters immediately leapt to the movement’s defense and criticized Orman’s view.

Here is the interesting part – both are right and wrong.

The amount of money you need in retirement is based on what you think your income needs will be when you get there and how long you have to reach that goal. In other words, how much money will you need in the future, on an annualized basis, to live the same lifestyle you live today?

In other words, you have to adjust for inflation.

Suze Orman suggests that number will be a lot larger due to “life,” increased healthcare costs as we get older, etc.  She’s right, but $5 million is a number completely out of touch for most Americans and larger than most would actually need.

FIRE supporters are right in that you will need 25x your income to fund living costs, but they are also wrong in basing it on current income rather than future inflation-adjusted income.

Let me explain.

The basic FIRE premise is that you need to save 50% of income until you have saved 25x your annual income. Then you live on a 4% withdrawal rate. Here is an example:

Current annual income is $50,000 x 25 = $1,250,000 at 4% = $50,000 

It’s simple math.

As I said, it’s wrong because it is based on TODAY’S income level and not that of future income requirements.

Look at the chart below and select your current level of income. The number on the left is your income level today and the number on the right is the amount of income you will need in 30-years to live the same lifestyle you are living today.

This is based on the average inflation rate over the last two decades of 2.1%. However, if inflation runs hotter in the future, these numbers become materially larger.

Here is the same chart lined out.

The chart above exposes two problems with the entire FIRE premise:

  1. The required income is not adjusted for inflation over the savings time-frame, and;
  2. The shortfall between the levels of 25x of current income and what is actually required at 4% to generate the income level needed.

The chart below takes the inflation-adjusted level of income for each brackets and calculates the asset level necessary to generate that income assuming a 4% withdrawal rate. This is compared to the FIRE recommendation of 25x current income.

Suze was right.  If you need to fund a lifestyle of $100,000 or more today. You are going to need $5 million at retirement in 30-years. For the FIRE followers, not adjusted for inflation is going to leave you short.

The FIRE Movement Fizzles For Most

A new study notes the U.S. retirement savings shortfall is worse than even we previously discussed. The study by the National Institute on Retirement Security, using data from the U.S. Federal Reserve, shows that retirement savings “are dangerously low” and that the U.S. retirement savings deficit is between $6.8 and $14 trillion.

Worse, the median retirement account balance is $3,000 for all working-age households and $12,000 for near-retirement households, the study reports.

This was also something I discussed recently in“80% of Americans Face A Retirement Crisis.”

“Those fears are substantiated even further by a new report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.”

Here are some additional findings from the report:

  • Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
  • The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
  • Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.

So, FIRE should solve that problem right.

Just save 50% of your income and you are good to go.

Maybe not.

“Why do so many Americans face a retirement crisis today after a decade of surging stock market returns? A survey from Bankrate.com touched on the issue.

’13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.’

In other words, the “inability” to save is a huge issue for the FIRE movement.

Buy And Hold Won’t Get You There

The other problem for the FIRE movement is current valuations. With the markets currently at the second highest level of valuations in history, returns going forward are likely not going to work out as planned.

However, let’s give FIRE the benefit of the doubt and assume that someone started the program in 1988 at the beginning of one of the greatest bull market booms in history. They also got one to end with one as well. Since our young saver has to have a job from which to earn income to save and invest, we assume he begins his journey at the age of 25.

The chart below starts with an initial investment of 50% of the various income levels shown above with 50% annual savings into the S&P 500 index. The entire portfolio is on a total return basis and adjusted for inflation. 

As shown, the FIRE program certainly works.

You just didn’t actually retire all that early.

Despite the idea that by saving 50% of one’s income and dollar-cost averaging into index funds, it still took until April of 2017 to reach the retirement goal. Yes, our your saver did retire early at the age of 54, and it only took 29-years of saving and investing 50% of their salary to get there.

But given the realities of simply maintaining a rising standard of living, the ability for many to save 50% of their income is simply unrealistic. Instead, the next chart shows the same data but starting with 10% of our young saver’s income and adding 10% annually.

There are two important things to note in the chart above.  The first is that saving 10% annually leaves individuals far short of their retirement needs. The second is that despite two massive bull market advances, it was the lost 20-year period from 1997 to 2009 which left individuals far short of their retirement goals. 

It should be relatively obvious the last decade of a massive, liquidity driven advance will eventually suffer much the same fate as every other massive bull market advance in history. This isn’t a message of “doom,” but rather the simple reality that every bull market advance must be followed by a reversion to remove the excesses built up during the previous cycle.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is these long periods where valuation indicators “appear” to be wrong where investors dismiss them and chase market returns instead.

Such has always had an unhappy ending.

There are many ways to approach managing portfolio risk and avoiding more major “mean reverting” events. While we don’t recommend or suggest that you try to “time the market” by being “all in” or “all out,”  it is critical to avoid major market losses during the accumulation phase. The example below uses a simple 12-month moving average to explain the importance of avoiding major drawdowns. It is the same 10% savings rate as above, dollar cost averaging into an S&P 500 index on a monthly basis, and moving to cash when the 12-month moving average is breached.

By avoiding the drawdowns, our young saver not only succeeded in reaching their goals but did so 31-months sooner than our example of saving 50% annually.

Don’t misunderstand me….I love the FIRE program.

I love ANY program that encourages individuals to get out of debt, save money, and invest. 

Period. No caveats.

In 1980, a million dollars would fund a healthy retirement.

That isn’t the case any longer as rising inflation eats away at the purchasing power of individuals.

It’s true when they say: “A million dollars sure ain’t what it used to be.”