Week 19 - Really Simple Savings

Situation: Many investors want to spend about as much time planning for retirement as they would spend planning for a vacation. They can’t afford to be “dollared to death” by fees and commissions. At the same time, they need a balanced portfolio which means that the “balancer” (or hedge) will increase in value when the stock market tanks.

Goal: Find a straightforward way for a 50 yr old investor to begin to seriously plan for retirement at age 65, without an exorbitant outlay of time or money to set up the portfolio.

Most probably this type of investor doesn’t follow the markets or invest each month in separate DRIP accounts. And we would also guess that $500/mo is the most our investor will commit to setting aside. These caveats leave a Roth IRA composed of no-load mutual funds as the best investment option. The reason is because a Roth IRA is unique among retirement investment options due to its tax-free status with no taxes levied on withdrawals ever, even for the unused money that goes to heirs.

Half the monthly money allotted by our investor ($250/mo) should be used to purchase shares of an S&P 500 Index Fund. The other half should be invested in an intermediate-term US Treasury Fund (i.e., a fund that essentially buys 10-yr Treasury Notes and holds those to collect interest until the principal is returned). Why these two particular choices? Related to stock purchases, this type of investor cannot assume the risk of under-performing compared to the market. Related to bond purchases (i.e., the hedge), this type of investor needs to be in the safest possible market. That would be the asset that the entire world wants to own when financial markets collapse: US Treasury Notes.

All “no-load” mutual fund companies offer both S&P 500 and T-Note funds with low expense ratios. We’ll use T Rowe Price funds to calculate outcomes for monthly purchases made from 2/3/97 through 11/1/11 (14.8 yrs). PREIX is the S&P 500 Index Fund and PRTIX is the intermediate-term US Treasury Fund. Investing $250/mo in each would result in $52,975 in the stock fund (total return = 2.2%/yr) and $69,853 in the bond fund (total return = 5.3%/yr) for a compound annual growth rate (CAGR) of 3.9%/yr (1.5%/yr after inflation). Our investor’s out-of-pocket investment over this time would have been $86,500 and total value would be $122,828. The S&P 500 fund paid out $472 in dividends over the past 6 months and the T-Note fund paid $783 in interest (i.e., the two together currently yield a little over 2%). Since the beginning of good record-keeping practices (1926), the CAGR after inflation is 2.3% for T-Notes and 6.7% for the S&P 500 Index without factoring in expenses. The rule-of-thumb for advising investors (as to what they can expect for planning purposes) is 2% and 4%, respectively. So a 50:50 combination is expected to yield 3%/yr. However, that overlooks the fact that the CAGR drifts upward when leverage (or borrowed money) is used to fuel investments. The opposite occurs with de-leveraging. In other words, when governments/companies/individuals borrow money to make improvements in their investments, those investments grow in value at a more rapid rate than if revenues alone are used to make improvements. When that borrowed money is returned to the lender, revenues are depleted so severely that little is left for “growth” (just google “Italy” for a timely example).

Saving for retirement doesn’t have to be complicated but it does have to be sincere. If you religiously set aside $500/mo beginning at age 50, you’ll have around $125,000 at age 65 in the example above. After retiring, you can spend the $200+/mo of dividends and interest and leave the principal intact. That would allow your spending power to keep up with inflation and your heirs will be titillated. Or you can cash out the funds and purchase an annuity that pays ~$800/mo but won’t keep up with inflation or leave anything for heirs.

Bottom Line: This 50:50 Stock/Bond example is a benchmark for a simple, safe and cheap Roth IRA plan. Interestingly, the initial $500 invested on 2/3/97 held its value throughout two bear markets, though it did fall back to parity ($500) at the depths of the last bear market on 3/9/09. We’ll use that feature to help gauge the safety of other Roth IRA strategies.

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