Earlier this week, President Obama directed the Department of Treasury to create a new, government-back retirement account dubbed “myRA”. It aims to help lower income Americans begin saving for retirement who are not covered by a plan at work. So the question is “will it work” or is the concept of “myRA” simply a nice talking point to include in a political speech? From my perspective, the answers are no and yes, although I definitely agree with the President that we need to help all Americans save more so they can retire successfully. Here’s a brief overview of how a myRA will work:
- Employers can setup these accounts without cost and don’t have to contribute to them
- The account will basically work like a Roth IRA – money goes in after-tax and can be withdrawn tax-free in retirement
- Like a Roth-IRA, contributions can be made up to $5,500 annually and the same tax/penalty rules apply
- The accounts will be solely invested in government savings bonds (paying historically low yields) and are principal protected (meaning they cannot lose value)
- The accounts are portable meaning they can be kept when switching jobs
- There are no administrative fees
- Once an account reaches $15,000 or is open for 30 years it gets converted into a Roth IRA
- Initial investments can be as low as $25 and as little as $5 for subsequent contributions
Sounds nice, but will it work? In my opinion, there are a number of issues, namely that the types of people these accounts target (lower income and part-timers) simply don’t make enough money to save. With no automatic enrollment requirement and no required employer contribution what is the incentive to contribute? The issue these workers face is the same even when they are covered by a plan at work, even if the employer makes a matching contributing – they either don’t have the money to save or don’t join the plan because of inertia. The ONLY thing that can get these people to participate is automatic enrollment. Also, it’s ironic that a myRA basically flies in the face of the Pension Protection Act of 2006 (PPA). Under PPA, companies were encouraged to adopt automatic enrollment, automatic escalation and a “qualified default investment alternative” suitable for long-term retirement savings (such as a target date fund, balanced fund or managed account – but not a principal protected bond fund). The myRA approach includes none of these things.
I applaud the President for his intent with myRAs, but like many things (political and otherwise), the devil is in the details. Given the fact that these workers could simply open a Roth IRA do we really need another type of retirement account? While some companies may adopt these I fear the utilization rate will still remain very low.
If you have read this blog in the past you know that we don’t know the answer to this question. In fact, no one does. Since January 15th the S&P 500 is down over 4% and the news coming from many of the emerging economies continues to deteriorate. Many investors are wondering if this could be the start of another sell-off in the stock markets. If history is any guide, I wouldn’t be surprised if it was. About two months ago I posted the chart below in a post I called, “One Of The Greatest Charts I Have Seen“:
As you can see from the chart title, the average intra-year drop in the market has been 14.7%, so a 4% drop could have further to go. On the other hand, this market could turn on a dime and erase its losses. The point here is that no one has any idea what the market is going to do next. The good news is you don’t have to. If you just accept the fact that markets are going to drop periodically (sometimes a lot) you’ll be in a much better position to generate positive returns over time. This chart is great evidence of that. There are many years where the market loses 10% or more intra-year, but still generates a positive return for the full year. Those that persevere and block out the noise have been handsomely rewarded when you look at it from the long view.
After 2008 it seems all the talk is focused on risk management strategies. How do you limit downside risk? What is your strategy for volatile markets? Over the past five years we have seen a plethora of new products hit the market that attempt to do just that (hedge funds, long-short, absolute return, variable annuities, etc). They promise equity like returns with limited downside risk. I am here to tell you that this is the wrong approach to investing. Not only are these products black boxes, the almost always are laden with excessive fees. Over time the investors who are willing to accept risk are the ones that are handsomely rewarded. Let’s look at the statistics:
|Asset Class Index Return (1927-2013) Risk (SD)|
|Large Cap Stocks CRSP 1-2 9.43%% 17.86%|
|Small Cap Stocks CRSP 9-10 12.52% 32.52%|
|Bonds 5 Yr T-Notes 5.29% 4.39%|
While small cap stocks have generated much higher returns than large cap stocks, investors would have to be willing to accept almost twice the volatility to achieve those gains. When compared to bonds, small cap stocks are over 7 times more volatile. Those who are willing to stomach the most risk, were the ones who saw the largest gains. So should you just go find the riskiest investments to put your savings into? No, investors need to determine how much volatility they are able to accept and design their portfolio accordingly. Scaling back risk does not mean investing in some sort of hedging strategy or sophisticated product. The simplest way to reduce risk is by adding more cash or bonds to your portfolio. Risk can be your friend in a portfolio if you accept the inevitable volatility that comes with it.
When it comes to stock returns, size matters. Historically, small companies tend to outperform large companies. This was ground breaking research in 1981 by researchers at the University of Chicago and led to the development of the first micro-cap mutual fund. The data is compelling. From 1927 through 2012, Dimensional Fund Advisors have found that small companies have generated a 3.58% annual premium over large companies. While this premium does not exist every year, over longer periods of an investors lifetime, the probability of it appearing increases. For example, the same research found that over rolling 5 year periods, small companies outperform large 60% of the time. When we change it to 20 year rolling periods, small companies outperform 88% of the time.
So why should company size matter to stock returns? Investors only tend to part with their money when risk is commensurate with return. If a small company only offered the same return as a large company, investors would most likely stick with the more stable, reliable large cap stock. Small companies have to offer higher rates of return to investors to compensate them for the risk they are taking. Unfortunately, the extra return is not free. You have to be willing to stomach more volatility to realize this higher potential return.
What does this mean for an investor? Portfolios should have some weighting to small company stocks. Obviously, every investor is different, but the decision of how much of your equity exposure is allocated to small companies is a key decision when constructing a portfolio.
Being successful at saving and investing is linked more to behavior than knowledge. I have no proof of that statement, but one that I believe from my experiences in working with clients over the years. In thinking about ways to help people save more, I have found that budgets have a lackluster track record. Probably right up there with diets. What does seem to work well is anything that automates the savings process and doesn’t require ongoing effort from the investor. An automatic monthly draft from your checking account to investment account is a good example of this.
If you are an investor who is looking to increase his savings rate, here is another idea. Change your 401k election at work from pre-tax to Roth (if available). Don’t change the dollar amount, just the “bucket” that it is going into. You might be asking yourself, if the same dollar amount is coming out of my paycheck, how would I be saving more? When you invest in a pre-tax 401k, all of the contributions are going into an account with an embedded tax liability. At some point in the future, when money is withdrawn, you will have to pay taxes, thereby decreasing the value. With a Roth 401k, the contributions will grow tax-free, giving you 100% of what they are worth at the time of distribution.
Unfortunately, this doesn’t come without some pain. Pre-tax 401k contributions give you an immediate tax deduction. By changing to a Roth 401k, you will miss out on those, effectively lowering your net pay each period. Now, is this strategy for everyone? Probably not. It is best utilized by those investors that expect to be in the same or higher tax brackets in retirement. But, if your main goal is trying to maximize after-tax wealth this could be a good strategy for almost anyone. It comes back to behavior. If you are currently participating in a pre-tax 401k and all of your net income is being spent, you may be a good candidate. Switching to a Roth 401k will automatically lower your net income. This may be painful at first, but if you figure out a way to live on the rest, it could help you grow your after-tax wealth substantially.
For those considering this type of strategy, you should first consult your advisor and/or accountant to discuss it in more detail.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.