Why do we save? I mean really, why do we save? When I think of saving, I think of the coffee can that I used to put my money in when I was a kid. This was before passbook savings accounts. My baby brother used to put his quarters in a big green “piggy” bank. Someone broke into our house one day and stole it. I think that was when I started putting money in a coffee can. When I was a kid, I think I just liked having a can full of money. Heavens knows I never really felt free to spend it on anything. In my twenties, I discovered the easy money credit allowed and thought “why bother” with saving when I could just whip out a card. I remember telling a classmate friend of mine, who had been around the financial block once or twice, about this new thing I discovered, the credit card. I thought it was great that I could spend one hundred dollars and pay back forty. That I could spend two hundred dollars and pay back fifteen. Yippie, I thought I had found the money tree! My friend was not so sure. Now I am older and wiser. I save today to buy choices in the future. And here’s me thinking I am being older and wiser when I find in Wikepedia:

Within personal finance, the act of saving corresponds to nominal preservation of money for future use

Humm. And there we have it. Except, well, we don’t exactly save the way we used to.
Years ago we used to save by putting money into bonds and savings accounts, paying dependable interest guaranteeing the money would be there for future use. Today, savers have become investors. No longer content with saving money, we’ve become obsessed with the growth of money. The idea of diversification is simple: A portion of your savings goes into a safe investment earning dependable interest so you can have it for future use while another portion goes for investment understanding that you might not have it for future use. Once again from Wikepedia:

In terms of personal finance, saving specifies low-risk preservation of money, as in a deposit account, versus investment, wherein risk is higher.

What does all of this mean? Well there has been a fundamental shift in the way we save money and I am concerned that not all of that shift has been good. Millions of people did not recognize the inflationary spiral in the housing market and, believing the popular wisdom that housing prices always go up, paid too much for houses they could not afford. Millions of people, believing that the stock market will always go up, have chosen to place money intended for future use in a vehicle they have no control over: the stock market. Recently I read a blog post in which the author hailed the 401K as the great equalizer allowing the average Joe to participate in the stock market like the big boys. If the stock market actually translated into “free money” I might agree.

The financial world is changing, affecting how we think about something as basic as saving money. I am afraid that if we don’t stop and consider what we are doing, the money we save won’t be our own.

Please comment. What are your thoughts?

I’ve been thinking, which is always dangerous, about the 401K. What really started me thinking was a conversation that I had with a friend of mine over a Cashflow game. She invests in real-estate as do I. With a young family and being the primary bread-winner,my friend spent countless nights up reading personal finance books. The conclusion for her: That the 401K as a retirement vehicle made no sense for her. Why? Because the 401K turns gains that would qualify as capital gains into gains taxed as ordinary income. The only way to “win” the 401K game in retirement is if you plan to be in a lower tax bracket in retirement than you were during your working years. Some folks call that planning to be poor. I think I can be a bit more generous than that. Honestly it only makes sense to me to plan to be in a lower tax bracket if you can guaranty the following: 1) you will own your home free and clear. If you don’t own a home and there are many good reasons not to, you will have an ongoing housing expense in retirement 2) Your children grow up, leave the house and never, ever need financial assistance from you 3) You are extremely healthy in retirement and will never need a hospital, assisted living or long-term care facility. 4) tax rates will not increase in order to offset growing budget deficits. In other words if you can guaranty that your expenses in retirement will be lower than your expenses during your working years, it may make sense to plan on retiring on less income than you are accustomed to earning. It is important to understand what the 401K is and where it came from. 401K simply refers to the section of the IRS code that allows for the creation of the 401K deferred income savings plan. Deferred compensation means that you defer receiving some of your income today and in exchange for that you lower your immediate tax burden. In exchange for lowering your immediate tax burden you agree to pay ordinary income tax on the money you withdraw from the plan. The truth is that prior to the creation of the 401K, deferred compensation arrangements were in existence and were created to allow high income wage earners to defer non-scheduled income to reduce their overall tax burden. If you are in the 35% tax bracket when the money goes in and you remain in the 35% tax bracket when the money comes out, you will pay 35% tax on the money. If you are in the 35% tax bracket when the money goes in and you are in the 25% tax bracket when the money comes out, you pay 25% on the money in your 401K. If you are in the 25% tax bracket when the money goes in and in the 35% tax bracket when it comes out you pay, guess what.
The 401K is a savings vehicle. A savings vehicle with many strings attached. Withdrawals prior to 59 1/2 are subject to an early withdrawal penalty of 10% in addition to ordinary income tax. While there are ways to avoid the early withdrawal penalty, but unemployment is not one of them. As a savings vehicle, the 401K is pretty illiquid. If you are unemployed and your primary source of savings is your 401K, you will with- draw at ordinary income tax rates PLUS pay a 10% penalty. The employer match is supposed to be the be all and end all of the 401K. In other words the employer pays you to save by giving you free money up to a certain percentage of pay. For those employers who offer a match, that match can range from 3-4% of pay. But employers don’t have to offer a match and many employers will suspend their match during hard economic times which is exactly what happened during this most recent downturn. For those companies offering a match there may be a vesting period of 3-5 years before employees can keep the matched funds. I have had many friends over the years who have suffered intermittent unemployment, with the 401K often being the largest if not the only source of savings, it gets tapped with now unemployed person responsible for penalties and income taxes. Given that the 401K is a type of deferred compensation savings vehicle originally designed for high income individuals, I have been wondering if this is the right vehicle for everyone especially middle income individuals or individuals with spotty employment histories for whom liquidity might be the most important concern.

What are your thoughts? Do you have a 401K and do you believe it is the right savings vehicle for you?

You have been diligently saving into your 401K looking forward to funding your retirement. You are 57 years old and you open your statement. You’ve lost half of your retirement investment. Suddenly retirement has been pushed back beyond age 65 and you are facing the prospect of having a part-time job when you retire. You have been diligently saving into your 529 college plan. Junior is about to turn 18 and instead of the one hundred thousand dollars you expected based on what you were told were the historic returns of the market, you have less than half of that. Now you have to have the conversation with Junior, valedictorian of his class, about going to the Junior College.

What if the first thing that your financial planner told you after the usual obligatory greeting was that you were about to embark on a great experiment? That experiment would require you to set a consistent amount of money aside for 30 years in a lock box controlled by investment banks and the United States Federal Government, limit your investment options to mutual funds and bonds, and hope that certain beliefs about long term historical returns hold true until you need your money at the end of your working life.

That is exactly the first conversation that I had with my financial planner 7 years ago. She said to me, “Ouida, these mutual funds, 401Ks and 529 college plans…this is all a great experiment Large groups of people have never retired or planned for college in this way before and we won’t know how this experiment is going to turn out for another 10 years or so.”

When I heard that, I thought how silly the television pundits and financial authors are who teach and preach that investors should invest for the long haul and dollar cost average. They simply articulated unproven strategies in an overall experiment that began in the late 1970’s when corporations began to shift the responsibility for retirement planning and pension funding onto employees. I thought about the meaningless conversations that I had with my erstwhile plumber about the latest hot mutual fund and whether or not he should buy Google. The Great 401K Experiment has turned the majority of employees into investors and turned the man on the street or the salesman behind the desk into a financial guru.

Wikipedia defines an experiment in the following manner:
In scientific inquiry, an experiment (Latin: ex- periri, “to try out”) is a method of investigating causal relationships among variables. An experiment is a cornerstone of the empirical approach to acquiring data about the world and is used in both natural sciences and social sciences. An experiment can be used to help solve practical problems and to support or negate theoretical assumptions.

I wonder who ever thought that by diligently placing money in their 401K that they were “trying out” their retirement plan?

In scientific inquiry we use an experiment to determine an outcome. As a physician, I rely on the outcomes of well-designed experiments to determine the best therapeutic strategy for my patients. In health care, by the time an experiment involving a therapeutic intervention is carried out on human test subjects, basic assumptions about the therapeutic intervention have already been formulated and tested in the laboratory. In medicine, we know what the variables are and we control for them, we have specific outcome measures and, most importantly, we can stop the experiment if the outcome is out of line with expectations and proves to be harmful to patients.

Despite involving human test subjects, the goings on in the world of finance and retirement planning have nothing to do with a safe controlled experiment. No, in the world of personal finance and retirement planning, we have what is known as an observational study. In an observational study, people participate in a series of activities and we follow them long term to the, uh, end. Whatever that end is. We are simply along for the ride waiting to see what happens. In terms of retirement planning, that could mean a retirement lived in poverty or a retirement in which all of the financial needs are met. But this experiment does not guaranty the latter outcome.

Let’s look at the assumptions that financial planners and employees alike have made:
1) In retirement, expenses will go down. Therefore retirees will need only 75% of their pre-retirement income. This assumption basically means that a person with an annual income of $100,000 during their working years, should set enough aside to generate an annual income of $75, 000 in retirement. This assumption has one basic flaw: it ignores inflation. Current estimates are that retirees will need $250,000 to $300,000 dollars to handle health care expenditures alone. This basic tenet of retirement planning ignores the realities of many retirees, personal illness, the need to care for a sick spouse or adult children.
2) Stock market returns average 8% per year over the long haul. This is simply untrue. A quick trip to moneychimp.com shows that the S&P has returned 8.76% since 1871. However that percentage drops to 6.56% when adjusted for inflation. If you could have been invested in the markets for the past 137 years you could have done okay. But 137 years really does challenge the idea of just what the long haul is. The long haul is certainly more than 10 years. From January 1, 1998 to December 31, 2008 market returns were 0.96%. Inflation-adjusted returns were -1.44%. As I discuss in my article, The Stock Market: The Second Greatest Financial Scam of the 20th Century, the long haul for stocks is more like 30 years. It becomes obvious, then, what you should do if you are 50, intend to retire at 65 and are contemplating putting money in the markets as an investment.
3) Home prices will always go up. This assumption made home ownership tantamount to putting money away monthly into a super-charged savings account. I’ve never seen a savings account lose value the way the housing market did during the Savings and Loan crash and this most recent financial downturn.
4) Capital gains are better than cashflow. The current economic environment is a prime example of what happens when people invest for capital gains alone. When the capital gains party stops wealth is devastated. With cashflow, however, businesses can operate as usual. It is estimated that 20 percent of real estate loans made during the housing boom went to investors. What if all of those investors had invested for cashflow? Price appreciation made cashflow impossible for most of the investor purchases that were made in the last 4 years of the most recent real-estate boom. Absent cash flow, investor money would have remained on the sidelines, fewer loans would have been made, property valuations would have remained in check and part of the speculation that drove the recent housing market would have been absent.

What happens when the basic assumptions of an experiment prove false? The experiment fails. In medicine, a failed experiment sends everyone back to the drawing board looking for answers. Not so in the world of personal finance. Personal Finance is called personal finance for a reason. You are the person and it is your finance. You are the only one who goes back to the drawing board usually with less money than you started with. The broker who sold you the stocks made his money. The fee-only planner that you were told to use by Smart Money Magazine made her money. The fund manager made his money.

What is the solution? Education. Education of the financial type. Every waking minute of every waking day. Yes this is work, but it is the only way. Those who don’t want to do this type of work should remain participants in the observational experiment to whatever end. My financial planner made sure that I stayed out of 529 plans, and that I did not invest in IRAs outside of my 401K plan. The way to wealth is simple and it is the following:
1) Live below your means
2) If housing prices in your area are too high, rent, but aim to keep total housing costs at less than 20% of income
3) Buy a quality car no more often than every 10 years and maintain that car. Car leases and frequent new car purchases are among the greatest drainers of household wealth
4) Eliminate consumer debt.
5) Obtain skills in writing, sales and marketing
6) Save
7) Invest savings into income-producing assets:
a) businesses such as network marketing
b) real-estate
Work with those assets once you do invest to make sure they produce income.
9) Protect all assets via entities
10) Find advisors and partners that you can trust who have your interests in mind. They are not hard to find
11) Understand yourself and your tolerance for risk. For many putting money into bonds and not giving financial education another thought is the best strategy.
12) Read a financial book per month and attend one business development seminar per year that teaches a specific skill
13) Stay away from mainstream financial magazines. They only offer the same pabulum that has left many high and dry, stripped of their wealth.
14) Subscribe to Investors Business Daily, The Financial Times or The Wall Street Journal
15) Stay away from personal development seminars but read personal development books
16) Implement the strategies and skills from the seminars and books

Your time investment will be at least 10 hours per week.

Are you ready to invest the time and get going?

First the Disclaimer: This is a thought-provoking article that draws upon real world examples, articles, books and websites that are readily available to the public. This article is not intended to offer investment advice. Any actions that you take in the market place should be the result of your own financial education and consultation with a licensed professional. Financial calculations were accomplished using the savings goal calculator found at Bankrate.com unless otherwise indicated.

When I entered the work force, I was offered a retirement plan, actually I was offered two. My employer was transitioning out of defined benefit plans, i.e. pensions and opting into defined contribution plans, i.e. 401ks. Because I was hired during the transition I was given a choice. I could not see working for any employer for 20 years and since the pension as I understood it was all or none, I opted for the 401K. Little did I know, I became part of a phenomenon initiated by the Federal Government in 1974 when it enacted the Employee Retirement Income Security Act (ERISA).

ERISA was created in the wake of the failure of the Studebaker Corporation in 1963. When Studebaker failed it left a pension that was so badly funded it could not provide benefits for all of its employees. ERISA did two things: 1) It provided regulation of any existing and future pension plans; 2) It provided government insurance of those pension plans in the form of the Pension Benefit Guaranty Corporation. ERISA also did something else, it virtually guaranteed a shift away from corporate-sponsored pensions and toward employee-sponsored savings plans. The 401K, intended to be a tax-advantaged benefit to corporate executives, has become the major savings vehicle for retirement for the average worker in America.

Let’s look at that statement. The 401K, intended to be a portable, tax-advantaged benefit to corporate executives, people whose income is generally north of six figures, has become the major savings vehicle for the average American worker, people whose median income is $46,326. ( This figure for median income comes from the US Census and the General Accounting Office.)

Assume the average retiree will need cash assets of one million dollars. One million dollars invested at 5% will earn an income of $50,000 per year without having to draw down the principle. This goal of one million dollars assumes the $300,000 to $500,000 dollars retirees will have to have set aside to cover health care costs. (CNNMonday February 19, 2008 “Most Americans Unprepared for Retirement”) Even if a worker earning the median income only desires to live on sixty percent of his or her working income, he would still have to save $555,912 invested at 5% to earn an income of $27,796. Add in the amount needed for health care and the goal is still one million dollars. The Savings goal calculator at bankrate.com shows that even if a worker earning the median income managed to save $10,000 per year or 21.6% of his gross income, it would take 100 years to reach the estimated million-dollar target needed for a comfortable retirement. In other words this retiree will die of old age while trying to save for retirement. Using bonds or a “high-yield” savings account with an annual percentage yield of 3.6% will put the average American worker within reach in 77 years 11 months almost beyond the average American’s lifespan. He would still die of old age while trying to save for retirement. Add a 50% employer match and the goal is reached in 34 years and 3 months. Well within the estimated forty year working life of the American worker. But an employer match of 50% is virtually unheard of. A true 50% match of 50 cents per employee dollar invested does not exist. The 401Khelpcenter reviews the common matching plans available to people who save through their 401Ks.

Because amassing the funds necessary for a comfortable retirement is virtually impossible through savings alone, employees must seek vehicles capable of higher returns in order to reach their retirement goals.

In steps the Stock Market, promising higher returns than stodgy old bonds, and money market accounts; hence, the stock market became the destination of choice for retirement savings and Wall Street responded by increasing the offerings to retail consumers through Mutual Funds. Before the year 2000 it was not uncommon to hear that the S&P returned 16% over the previous 10 years. Looking at the returns of one of the best known indexed mutual funds, the Vanguard 500, returns since its 1976 inception are 11.75%, impressive until you look at the 1 year return, -2.41%, the 5 year return, 11.89% and the 10 year return 5.06%. These are average returns not real returns. As an example let’s look at the growth of 1 dollar in the mythical High Fly Fund. High Fly posts a 50% gain in one year and your dollar grows to $1.50. The next year it posts a 25% loss, now your investment is worth $1.125. The average return for High Fly reported by the mutual company is 12.5%, but that is not your actual return. Your actual return or compound annual growth rate (CAGR) is in the neighborhood of 6% per year worse if you factor in inflation.

Is 6% acceptable given the risk that investors take on by investing in the stock market? David F. Swenson, CIO of the Yale Endowment explains investor risk in his book, Unconventional Success, when he states: “Because equity owners get paid after corporations satisfy all other claimants, equity ownership represents a residual interest. As such stockholders occupy a riskier position than, say, corporate lenders who enjoy a superior position in a company’s capital structure.” He goes on to say “the 5.0 percentage point difference between stock and bond returns represents the historical risk premium, defined as the return to equity holders for accepting risk above the level inherent in bond investments.” Mr. Swenson’s comments and calculations of the risk premium were based on a compound annual return of 10.4% in the stock market compared with 5% bond yields. 10.4%-5% equals a risk premium of 5.4%. Unfortunately I have yet to find a calculation of CAGR (compound annual growth rate) that matches Mr. Swenson’s. I found many examples of average returns that match the 10.4% average growth rate but not the CAGR. The reason that this is important is that all other savings vehicles are quoted by the CAGR. Your savings accounts, bonds and money market account are all quoted by the CAGR or its equivalent, the annual percentage yield (APY). In order to determine where to allocate your funds, you must compare apples to apples not apples to oranges. As you might guess the CAGR for the stock market is lower.

A quick look at the CAGR calculator for the stock market on moneychimp.com shows the average return from January 1, 1975 to December 31, 2007 to be 9.71%. You only realized that return if you were invested in the market the entire time. What if you began investing in 1980? The numbers look about the same. If you started in 1985 your returns look a little better. By 1990 the CAGR drops to 8.21%. If you started in 1995 your CAGR jumps to 9.32%. If you began investing in 2000 your CAGR drops to minus 0.06%! If you eliminate the results of the past 7 years from the S&P performance and track performance from January 1, 1975 to December 31, 1999 the CAGR was 13.03%. When the stock market is good it is great, when it is bad, it is pretty darn miserable. For the record, there has been only one 9 year period from January 1, 1950 to December 31, 2007 in which the average return for the S&P was 16.14% and the CAGR was 15.32%: the period from January 1, 1990 thru December 31, 1999.

It should be clear from these numbers that your returns are dependent not only on how long you are invested in the markets but when you started investing. In fact the stodgy old bond investor has outperformed the stock investor over the past 7 years.

The 1990’s investor will have a very different view of market performance than the 2000’s investor.

Mr. Swenson’s book is a must read for anyone investing in mutual funds, he makes a compelling case, explaining why actively managed mutual funds are generally a money losing proposition for investors and why a balanced portfolio based on six solid asset classes constitutes the winning combination for investors.

How can I call the stock market the second biggest financial scam of the twentieth century if I am quoting numbers that are on the face of it pretty good? For four reasons: 1) because the true CAGR going back to 1950 is much lower 7.47%. It will take the average American worker 25 years and one month saving $10,000 per year to accumulate one million dollars in wealth as long as the market achieves CAGR of 9.71% and in 29 years 2 months if forced to accept the longer term returns of the market. These numbers leave very little margin for error for the average American worker. Retirement projections for the most part are based on returns that have existed at only one point in the stock market’s history since 1950; 2) because the same laws that facilitate the transfer of individual investor money into the stock market also mandate its withdrawal at a specific time which is tantamount to what all financial pundits have called a money losing strategy, Market Timing. In other words the laws governing tax-deferred savings mandate that withdrawals begin at age 70 and a half at the latest forcing retirees to time the market to determine their exit; 3) the time horizon for capturing meaningful gains from the market is long indeed, at least 30 years. To quote Mr. Swenson, “Returns of bonds and cash may exceed returns of stocks for years on end. For example from the market peak in October 1929, it took stock investors fully twenty-one years and three months to match returns generated by bond investors.”

Charles Farrell, an adviser with Denver’s Northstar Investment Advisors, used data from Morningstar’s Ibbotson and Associates to analyze 52 rolling 30-year periods, starting with 1926 to 1955 and ending with 1977 to 2006 “But here’s what’s interesting: The Majority of your wealth would almost always have come in the last 10 years. Mr. Farrell calculates that, on average, you would have notched 8% of your final wealth after the first decade and 32% after the second. In other words, 68% of the total sum accumulated was amassed in the last 10 years.” (Wall Street Journal, Jonathan Clements November 21, 2007); 4) because current marketing strategies by financial pundits, gurus and Wall Street treat stock market investing as a money in, money out proposition obscuring the true risks of investing and the true time horizon needed to accumulate wealth. In other words, the money needed for retirement must be invested for an extended period of time, roughly 30 years. It cannot be borrowed against. It cannot be used to buy a home, car, pay for college or a child’s wedding.
It can only be used for retirement 30 years hence. Any other needs must be paid for from an additional source other than retirement savings. Most people lack the financial education to understand this and blindly chase market returns hoping for a big score.

Fortunately there is a simple solution, but like most simple solutions this one requires work and financial education. I will introduce this simple solution in part 3 of this series.