Low Savings, Bad Investments

The article below first appeared in our Washington Post column yesterday. I’m reproducing it in full here because there is an important correction, thanks to a response by Andrew Biggs. I’ve fixed the mistake and added notes in brackets to show what was fixed. Also, I want to append some additional notes about the data and some issues that didn’t fit into the column.

Recent volatility in the stock market (the S&P 500 Index losing almost 50% of its value between September and March) has led some to question the wisdom of relying on 401(k) and other defined-contribution plans, invested largely in the stock market, for our nation’s retirement security. For example, Time recently ran a cover story by Stephen Gandel entitled “Why It’s Time to Retire the 401(k).”

However, the shortcomings of our current retirement “system” predate the recent fall in the markets, will not be solved by another stock market boom. The problems are more basic: we don’t save enough, and we don’t invest very well.

We ran several scenarios of what a typical two-adult household that entered the job market last year at age 22 might expect to receive on retirement at age 65 in 2051. For each scenario, we assumed that our household would earn the median amount for its age group every year. We began with data from the U.S. Census Bureau on 2008 earnings by age group, and assumed that real incomes would grow by 0.7% per year (the average growth rate for the 1967-2008 period). According to analysis by Andrew Biggs, medium earners typically accumulate Social Security benefits equivalent to 52% of their pre-retirement income, which comes to $40,265 per year. (All figures are in 2008 dollars.) For our scenarios, we used different estimates of the household’s savings rate and of the rate of return it would earn on its savings. [Correction: I initially used the online Social Security Social Security benefits calculator, which says it provides estimates in “today’s dollars,” but actually uses wage-indexed dollars. See Biggs’s explanation of the difference.]

For the first scenario, we assumed the average economy-wide savings rate of 2.4% over the last ten years (1999-2008) and a real rate of return of 6.3% — the long-term average real return for the stock market. (In his book Stocks for the Long Run, Jeremy Siegel calculates the annual real rate of return from 1871 to 2006 as 6.7%; updating that figure through 2008, we get 6.3%.) At retirement, this yields accumulated savings of $298,064. Today, a 65-year old couple could convert $298,064 into a joint life annuity of $18,467 (we did an online search for annuity rates), meaning that they would receive that amount each year (not indexed for inflation, however) as long as either person were still alive. (Anything other than buying an annuity is gambling that you won’t outlive your money.) $18,467 is only 24% of the household’s income at age 64. Combined with Social Security, the couple would receive $58,732 per year, or a respectable 76% of its pre-retirement income of $77,432. [Correction: Originally this was 59%; all later figures were also 17 percentage points too low.]

Savings were unusually low over the past decade. The current savings rate (first three quarters of 2009) is 3.6%. Plugging this into our spreadsheet, we get an annuity of $28,092 and retirement income of $68,357, or 88% of pre-retirement income.

But this overlooks the fact that people do not earn the rate of return of the stock market. Even assuming that people are investing in stocks, most do so via stock mutual funds which, on average, do worse than the stock market as a whole. For example, in the 1990s the average diversified stock fund had an annual return 2.4 percentage points lower than the Wilshire 5000 Index (which reflects the performance of the overall market). The main reason for this underperformance is that mutual funds have to pay fees to their managers — who, on average, do not earn those fees through superior stock-picking (to put it mildly).

If we use a 3.9% annual return instead of a 6.3% annual return, now our annuity is only worth $15,347 per year, and combined with Social Security our household is only earning 72% of its pre-retirement income. But wait — it gets worse.

The average investor in mutual funds does not even do as well as the average mutual fund. The reason is that investors tend to chase returns. They take money out of funds that have recently done badly and move it into funds that have recently done well. Because of mean reversion (the tendency for trends away from the average to return back to the average), this means they take money out of funds that are about to go up and put it into funds that are about to go down. Among large blend stock funds (the category that includes S&P 500 index funds), research from Morningstar shows that the gap between mutual fund performance and investor performance ranges from 0.9 to 2.2 percentage points, depending on fund volatility. (It can be much higher — over 10 percentage points — for other types of funds.)

Taking an average gap of 1.6 percentage points, our expected annual returns are now just 2.3%. Now our cumulative savings are only $172,853 and our annuity is only $10,709; combined with Social Security our household is only earning 66% of its pre-retirement income.

Now, you can get close to that 6.3% expected return through a simple strategy: buy a stock index fund and don’t touch it. But this has another problem — you are 100% invested in stocks, the riskiest of the major asset classes. Whatever your expected cumulative savings, there is a 50% chance that your actual savings will be lower, and they could be a lot lower.

Since we’re talking about survival in old age, ideally our household would not take any risk at all. The closest you can get to this is to invest in inflation-protected Treasury bonds. 20-year TIPS (Treasury Inflation-Protected Securities) currently yield 1.96% on top of inflation. [Note: In the Post column I used 2.4%, the yield at the latest auction; however, that was back in July, and long-term bond yields have come down since then, so this is the current yield according to Bloomberg.] This provides a final annuity of $9,925; combined with Social Security, that’s 65% of pre-retirement income. That’s not very much. And the only way to get higher returns is by taking on risk.

Bear in mind that we’re assuming that Social Security will be around in its current form, as will Medicare (or else seniors will have sharply higher health care costs than they do today). Also, we’ve made a number of optimistic assumptions along the way: that life expectancies do not increase by 2051 (this would reduce the annuity you can get with the same savings); that median-income households save money at the average rate for all households, which is untrue (richer households save at a higher rate, making the average savings rate higher than the median savings rate); and that the savings rate is constant over age (since older people in fact save at a higher rate, the money has less time to build up). In addition, we haven’t started talking about below-median households, who save at a lower rate. [Note: I assumed you can get an annuity yielding 6.2%, from this online site; Biggs, who probably knows better than I, uses 5.4%, which yields lower annuities for the same amount of savings.]

The problems, in short, are that we don’t save enough and we don’t invest very well. One could argue that these are a matter of choice. People could save more, and they could make smarter investing decisions. But given that they don’t, we could very well see tens of millions of seniors without enough money to live decently in retirement. Given that prospect, perhaps we should question leaving retirement security to individual choices and free markets.

***

Andrew Biggs argues that the numbers show that the retirement system is doing OK. After all, if you assume just a 2.4% savings rate and a 6.3% real return, you get 76% of your pre-retirement income. The system is doing better than I thought it was before Biggs pointed out my error, but that’s almost entirely due to Social Security. Social Security is replacing 52% of pre-retirement income (not 35% as I initially calculated) and private savings are replacing anywhere from 13% to 24%, depending on the scenario. I think the 13% scenario is the most accurate, since is the lowest-risk option; anything else is not retirement saving, it’s retirement gambling.

Biggs also thinks (email to me) that my savings rates are too low, especially with auto-enrollment into 401(k)s on the rise. This is a plausible point; we don’t really know where the savings rate will end up after this recession. If the median worker is auto-enrolled in a 401(k) — and, even better, if he gets an employer match — he may be OK. Then we may be talking about a problem that affects a significant number of lower-income households (who are less covered by 401(k)s and employer matches than higher-income households), though not the median household.

This is the spreadsheet with the scenarios. WordPress.com won’t let me upload an Excel file, so I embedded it in a Word file and uploaded that.

There’s a legitimate question about 2008 vs. 2051 living standards. For example, in our most pessimistic scenario, we still end up with an annuity of $50,190 in 2008 dollars. That might not seem so bad. After all, median income in 2008 was only $53,303, and this is all in real terms, right? However, I don’t think that’s the right approach to take. Living standards will improve on average between now and 2051, and therefore an income of $50,190 2008 dollars will feel very different in 2051 than it felt in 2008. This is why I think the right comparison is to pre-retirement income; that tells you the drop in living standards that people will suffer at retirement. (In practice, most people probably won’t buy annuities, and won’t adjust their living standards down immediately — but that just means they have a higher chance of outliving their money.)

Another possible objection is that we’re leaving out capital gains from housing. Even if the average return that investors get from stock mutual funds is only 2.3%, the fact is that many people invest in their houses and seem to get higher returns. However, I think that we can’t count on these higher returns. First, these returns are largely a product of leverage and subsidized interest rates; real housing prices underperform the stock market. Second, a given house doesn’t really change in real value (the utility it provides to people), even if its price changes; in general, its value goes down, unless you put money into it for maintenance and improvements. If the price of equivalent houses goes up in real terms, that just means that (on average) one generation of home owners is taking money from the next generation of home buyers in the form of higher prices. In other words, it’s a multi-generational Ponzi scheme that can’t go on forever. Third, of course, not everyone owns a house.

In doing the research for this column I came across a paper by Andrea Frazzini and Owen Lamont called “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns.” They find that, at least when looking at historical data, you can make money by doing the opposite of what investors do with their mutual funds. That is, money flowing into mutual funds is a valid predictor that the stocks in those funds will, on average, go down relative to the market. The real beneficiaries are corporate issuers of stock, who are able to issue stock at high prices when demand for it is high. I also like the way they put their findings into context: “These facts pose a challenge to rational theories of fund flows.  Of course, rational theories of mutual fund investor behavior already face many formidable challenges, such as explaining why investors consistently invest in active managers when lower cost, better performing index funds are available.”

Finally, I hate making mistakes. So I wholeheartedly endorse Biggs’s call for the Social Security Administration to fix its misleading calculator.

By James Kwak

56 responses to “Low Savings, Bad Investments

  1. The important thing is you caught the mistake James, and you CORRECTED IT. There are many so-called journalists who work at newspapers who won’t even ADMIT or CORRECT mistakes. So you have shown yourself to be better than many print journalists and done blogging proud. It stings to admit a mistake, but in the end you can be proud.

  2. By using current real data you are ignoring inflation that would make the situation worse than you describe.

    You are assuming a savings rate of 2.4%.

    If you ignore inflation that yields a constant saving stream in real terms.

    But in an inflationary environment of for example 2% to 3% annually, and go back and apply a 2.4% savings rate to nominal earnings some 20 years the dollar savings you get are only about half of current earnings in real terms. To achieve the 2.4% average real savings in an inflationary environment in savings rate in earlier years has to be higher to offset the impact of inflation on averages wages.

  3. When you assume the financial future will be roughly like the past, you disregard the sea change in financial markets caused by swaps and OTC derivatives: over leveraged risk is a guerrila army bearing nuclear grenades moving in quantum jumps through the investment landscape. They can blow up anywhere, any time. Exposure is entirely hidden. No published financial statement of any bank or public corporation is anything but a trap for the gullible, a convenient fiction, an outright fantasy. Any investment decision is nothing but a bet, and we might as well all be monkeys throwing darts at the financial pages.

    In the past ten years, a stock index fund returned nothing. To the extent corporations achieved growth in profits, the dough was siphoned off in executive stock options. Today, you get nothing in government bonds, unless you want to take thirty year risk. If you want a good investment, buy a laundromat (and a gun).

  4. I think the biggest mistake in your estimate is that you assume people will begin saving at age 22. From what I have seen of the typical college graduate, they will often spend maybe six months unemployed and often spend the first couple of years paying off debt and getting on their feet. Alternatively, there are many young people (like myself) getting graduate degrees which means more years of no saving. If I did such a calculation I would assume no saving begins until at least age 25, maybe 28. This will really crunch your already low values.

  5. I think James’ point was, which everybody seems to be missing was “I am taking a mostly rosy scenario, and it still comes up short in savings”. IF (I say IF) I am misleading about the gist of James’ post I preemptively apologize to James.

  6. “combined with Social Security our household is only earning 72% of its pre-retirement income. But wait — it gets worse.”

    72% of pre-retirement income should be plenty. You don’t have the work related expense and you will be in a lower tax bracket than when working. You don’t have the expense of raising children. By the time you retire you should have no mortgage. Future medical cost are unknowable but that is the same for both working and retires.

  7. “…perhaps we should question leaving retirement security to individual choices and free markets.”
    While as Jake Chase points out, past experience is not necessarily a good predictor of future events, please take a look at the Galveston Plan. Several Texas counties opted out of Social Security thirty years ago before Congress closed the loophole. The retirement income for an employee earning $75,000 of pre-retirement income (close to the above example)is 275% of Social Security income. Add $54480 to any of the paltry projected returns from measly private savings outlined above and recalculate total retirement income. Individual choices and free markets worked for the folks in Texas.

    http://www.ncpa.org/pub/ba514

  8. A very important subject.

    A significant point for aging societies (like Europe, Japan) is the rate of inflation in the future, so the purchasing power of the annuity. This is the variable that really determines premia to pension funds. Because you are forecasting far into the future, small changes in rates have very large impacts.

    The US still has a growing population so Social Security should stay “affordable” for some time to come. In the Netherlands, where I work, pension schemes are collectivized (and mandatory) so participants share investment risks and generations cover for each other. Still people pay 15-20% of their gross income in premia, employers contribute much of this. The target income is an annuity of 70% of a participants average income, inflation protected.

  9. There are several additional problems here.

    First of all this is inflation (Spenser already noted this) which realistically can be assumed around 3% per year.

    That means that for all practical proposes real 401K returns for investors using cost averaging returns will be zero or negative.

    The second problem is that losses of 401K investors using stocks (even without self-defeating moves like selling low and buying high) for the last 15 years are substantially higher that you assume.

    My calculation had shown that for 401K investors who started in Jan 1996 and used cost averaging investing 100% in S&P500 underperformed Vanguard stable value fund approximately 30% (assuming today S&P500 value 1100). For PIMCO Total Return it’s even more. That tells us something about Siegel.

    If we assume that stable value returns matches on average inflation that means the those investors will lose close to half purchasing value of their saving before retirement.

    So assumption of positive returns in 401K in my view is pseudo-science and assumption of positive returns in S&P500 in case of cost averaging is even worse (Lysenkoism ?)

  10. If buying a gun is a prerequisite then we have failed as a society; There will be no joy, only suffering in that situation..

  11. I’m going off topic here, but I hope James will humor me, because this deals with finance reform. This is a very good video from MSNBC’s Dylan Ratigan. I don’t have cable but Ratigan seems like a rockin’ cool dude. Ratigan is keeping the pressure on these basturds. If you care about America please watch this link. http://www.msnbc.msn.com/id/31510813/#33855467

  12. Hmmm. I project out earnings out through 2051 in real dollars and take 2.4% of each year. Doesn’t that solve the problem?

  13. Yes, but if you do that then you have to use a higher savings rate in the years that you are employed. 2.4% (or 3.6%) is the economy-wide savings rate. So to be realistic you should use a lower rate in your 20s, but then a higher rate in your 50s.

  14. “Individual choices and free markets?” You’re talking about a mandatory, government-sponsored plan that offers no choice of investment options. That is, it forces people to participate, and it prevents them from making dumb investment decisions.

    Why do anti-government people insist on denying that successful government programs are government programs? (See Medicare for the most obvious example.)

  15. Joe in Morgantown

    Interesting article. Thanks.

    Its great that social security is replacing 52% of income. But that is with tax of 12.4%. If that 12.4 percent had been saved instead the family would have about as well off without Social Security.

    Of course, even Social Security is not without risks:
    its tax rate has historically gone up 1% every six years. http://www.ssa.gov/OACT/ProgData/taxRates.html

    If that trend continues today’s 22 year old will be paying 18% before retirement.

  16. Agoraphobic Kleptomaniac

    Only if you discount the direction of wages vs. inflation. From most data i’ve seen, purchase power has been decreasing slowly over the past 30 years. I’m no economist, but I think pegging your %savings – %inflation as a flat 2.4% is contradictory to what’s been happening to wages, right?

  17. I think the title of this blog says it all, Low Savings, Bad Investments. Statistics have shown that, before our current economic crisis hit, savings in this country had dwindled to nothing, in fact, individual debt far outpaced individual savings as the hard pressed middle class had to borrow more and more money to keep up it’s standard of living and support the U. S. economy. Over the past 25 – 30 years, true earning power of the middle class has fallen as more families became two wage families and more and more overtime was required to keep up the standard of living.

    As for investing in the stock market, much of middle class investing is done through mutual funds and IRA’s or in 401k’s offered by their employers. Individual investment takes much time to do it right, time spent on research and analysis, time spent digging through financial reports or tracking industry trends. Truth be told, the vast majority of average investors don’t have an understanding of what it takes to really succeed in investing.

  18. People do tend to conveniently forget the good things that government does for us. It is worth noting though, that is a municipal government program and not a federal government program. Some people think local governments do a better job of spending taxpayer’s money. Although I’m sure there are also many examples of municipal governments that wasted money.

    But actually Jessica’s example shows us government sometimes does a good job. You probably won’t see Newt Gingrich highlighting this Galveston program anytime soon. He’s too busy talking about the boogeyman.

  19. I think what the article was seriously missing or not factoring in, is that it is applying a concept of savings and investment for the middle class from a time when the middle class could afford to sustain its necessary living expenses without credit, and still have enough cash left over, in order to place into savings or investments. We live in a time when the middle class is paying for subsistence at the level of the lower realm of the richer classes. The financial bar has been raised for a lot of Americans, and a larger part of the economy, the middle class, that is preparing to save and invest, is simply disabled by the lack of cash on hand, and prices being blown through the roof. Investing nowadays is strictly reserved for the “superconsumer”, those that have been enabled to invest at the cost of those who cannot keep up with the uber-jonses.

  20. 401k’s are a joke. they are a con to a) get rid of the defined benefit plan and b) have people dump all their current earnings into wall street.

  21. To follow up on the points made by Jessica and Joe in Morgantown:

    This is an interesting analysis of investing options. But to the extent it wants to make some sort of policy analysis in favor of Social Security, it misses the mark. Savers, left to their own devices, might do poorly. But Social Security as it currently exists does even worse.

    Social Security currently faces $15.3 trillion in unfunded liabilities. By 2017, it will not be taking in enough in revenues to cover its outlays. The Social Security Trust Fund (the “savings account”) currently contains nothing but meaningless IOUs. Unless in 8 short years, the government can find a way to redeem those bonds, it will be insolvent. Even in the staggeringly unlikely event that those bonds are ever redeemed in total, insolvency is forestalled only until 2041.

    In other words, by the time my generation reaches retirement age, the program will be relying solely on current payroll taxes. Young workers will be taxed to pay the benefits they have promised to me. This means my “investment” actually earned a rate of return of less than zero.

    Even worse, at current rates, the benefits promised to my generation cannot be achieved. Contrary to popular belief and the assumption made in your analysis, Social Security does not function as a forced savings account – not even one with atrocious returns. It is not even a ponzi scheme. It is something much more sinister.

    It is used as a general source of revenue for out of control government spending. And even after plundering our nation’s savings, we still have national debt of $10 trillion and yearly deficit spending now approaching $2 trillion. Which will all eventually have to be repaid – with interest – by those young workers we are presumably counting on to also fund my retirement.

    As Bill Clinton himself pointed out, the only ways to keep Social Security solvent are to: 1) raise taxes; 2) cut benefits; or 3) get a higher rate of return through private capital investment.

    You say we cannot count on the third. Okay then: to make Social Security solvent for the next 75 years, either a permanent 15 percent increase in payroll income taxes, a 13 percent reduction in benefits, or some combination thereof would be required. If either of these occurs, your analysis changes dramatically. Yet you do not take this glaring problem into account.

    Anyone who thinks that the nation is going to reign in spending, balance the budget, pay off the deficit and create a solvent Social Security program in the next couple of generations is off their rocker. The inescapable fact is that Social Security will not continue to exist in its current form.

    Against that backdrop, meager personal savings, even consisting of nothing but cash and vulnerable to inflation, is vastly preferable.

  22. And your answer for people’s savings is…..????

  23. Your question implies a false dichotomy. Either I have to have a better solution or else I have no business challenging the current configuration of our Social Security system. In fact, it’s perfectly valid to point out the flaws in one system without purporting to be an expert on another.

    But that aside, I already said I thought that personal savings comes out better. My own analysis was confirmed by Jessica’s link to a real world experiment.

    In my perfect world, we would have only sustainable government spending, we would not use credit in excess either as a nation or as individuals. Taxes would be lower and the economy would therefore have better opportunity for actual rather than illusory growth. The Fed would not apply monetary policies that lead to the dot com bust and the real estate implosion, which wiped out trillions of dollars in individual investments. Etc., etc.

    But just so *you* don’t get caught up in any false dichotomies, here’s a novel one. How about having a Social Security system that actually functions as the forced savings account that it is intended to be? :-)

    Here’s a free market approach to reform: http://www.cato.org/pubs/handbook/hb111/hb111-17.pdf

    And here’s some ideas that are more to the left:

    http://www.nytimes.com/2004/10/02/opinion/02sat1.html

  24. Consider in future using Google Docs to import your Excel spreadsheet. You’d be able to embed it directly in your page more easily.

  25. Compare what you get from delaying social security retirement to age 70 versus buying an inflation-adjusted annuity with the social security benefits received between your normal retirment age and and 70, and you’ll see that social security blows the private sector annuity out of the water. Also, this comparision doesn’t take into account that the US government can’t go broke while a private insurance company most definitely can. (AIG hasn’t defaulted on its annuities, but that was due to a massive bailout, but there is no guarantee of massive bailouts in the future.) The reason social security does so well in this comparisioon is partly lower overhead but mostly adverse selection–only people who expect to live a longer than average time buy annuities. If you can be sure you will die at an earlier than average age (easy enough to arrange that), then you’d be better off managing your money yourself, rather than using either social security or an annuity.

    Sarah writes “Social Security currently faces $15.3 trillion in unfunded liabilities”. Well, if the entire US stock market were owned by retirees, then it would effectively be facing similar liabilities. That is, those retirees would have to sell their stocks to younger people, who would thus be forced to reduce their consumption and have a lower standard of living than if they didn’t buy the stocks. Same result as if the young were taxed to pay social security. If the young were either unable or unwilling to buy the stocks, then the elderly who will have to lower the price until the young were willing to buy, meaning the elderly would have to reduce their standard of living. This corresponds exactly to the young refusing to pay additional taxes, with the result that social security benefits get reduced. There are no free lunches in economics. The only way all Americans can consume at a very high level is if the rest of the world subsidizes us via a massive trade deficit, and I don’t see that continuing forever.

  26. Many, many problems with this analysis although I admire your decision to correct your mistakes and try to tackle the issue. I am also going to miss many other things I’m certain.

    You mention the below median earners quite a bit and how these things are worse for them, that’s actually not the case when it comes to retirement savings. I am certainly not going to say the working poor get any kind of good deal, but the reality is that the lowest level of social security income replaces 70-80% of pre-retirement income for the lowest tier workers. This still doesn’t address the viability of Social Security as a system.

    I don’t believe in using your house as an investment, but for many older people it is a very viable option regardless of it’s actual return. The principal payment on their mortgage works like an additional savings vehicle and while they will still need housing in retirement, the “downsizing” aspect is a very large part of retirement planning for many people.

    Almost all 401K plans have some kind of corporate matching, so that 3% savings rate becomes 6%. That changes the equation quite a bit.

    Finally, the averages mean nothing. This analysis you’ve done has basically been the reality for the last 20-25 years as it is and yet people are still finding a way to retire. The assumption that everyone retires at 65, lives the average life expectany after that, and has to fully support themselves in retirement is a falacy. That has always been the image, but never the reality. Retirement is a new concept in the first place, the WWII generation being the only one that actually retired in large numbers. People move in with family and help take care of the grandkids. They work part time until they are 70. They rent a room in their house. They save 10-20% of their earnings the last ten or fifteen years before retirement. etc.

    The govenment needs to do a better job of educating people about their future, and encouraging a higher savings rate. This recent shock will probably do that for them over the short-term. Social Security provides enough to keep retirees out of poverty, the govenment should be concerned with keeping that viable, and educating on the rest.

  27. Sarah,
    You have lots of interesting theories. The Federal Reserve’s monetary policy is to blame for the dot-com bust??? Wow, you are a bevy of information.

  28. What has been the annual inflation rate since the US savings rate went negative, and how true are the accusations by people like John Williams that the US government has been understating the rate of inflation using devices like hedonic pricing?

    This has to be the start of any discussion about savings. Because in a high inflation environment, its a bad idea to save. A high inflation, easy credit environment advantages debtors.

    OK, if you take the reported inflation numbers at face value, the US has been in a low inflationary environment, so maybe economists have to back up a bit and figure out how accurate are the reported statistics and how comparable they are from one decade to the next.

    The main “investment” vehicles for the average American in recent years have all been prone to asset bubbles, which in the case of high-tech stocks then real estate then crashed. I hate to come across as a gold bug, but that is pretty much the only “investment” in recent years that has generated a good return when you account for inflation, even at the reported rate.

  29. >> If you want a good investment, buy a laundromat (and a gun).

    Laundromats? Not anymore…

    http://online.wsj.com/article/SB125728737379626349.html

    so I guess that just leaves the gun.

  30. The pragmatist

    Beyond keeping up with the Joneses, for many people its keeping up with Mom and Dad. Our economy has lost a lot of good manufacturing jobs as they have been sent overseas. This was supposed to be off set by “higher value” jobs in information technologies and services. Except for the Healthcare sector this has not really happened. These “higher value” jobs are also going overseas. Many people make less than their parents did, yet they expect to live the same lifestyle, hence no savings and a lot of debt.

    And now Martin Hutchinson and Edward Hadas at breakingviews.com say that Americans make too much money and that “If the global economy is ever to get back into balance, that gap needs to be closed.

    http://money.cnn.com/2009/11/11/news/international/global_american_wages.breakingviews/index.htm

    We finally are getting to the truth. Globalization was suuposed be good for everyone and benefit people world -wide. Now it seems that people are acknowledging that we have entered a “race to the bottom”.

  31. WE LOVE AND APPRECIATE THE AMERICAN SOLDIERS!!!!! GOD BLESS ALL OF THE AMERICAN MILITARY AND YOUR FAMILIES!!!!!

  32. Much of this discussion refers not to the problems of investing in the stock market, but in the specific choices of funds and asset allocation.

    A relatively new development is the creation of low-cost funds such as the Vanguard Target Retirement accounts, which automatically rebalance as you approach retirement, moving from a 90% index fund at 25 years to retirement, to less than 50% at retirement with the remainder in cash and bonds (some inflation-protected). This for expense ratio of only 0.18%.

    Making auto-balancing, low fee plans such as this the default 401k option (possibly by federal mandate), would significantly improve both the problems of real investor returns and the excessive risks due to over-investment in equities close to retirement.

  33. I like your train of thought, but you know there are other variables than just age.

  34. A very interesting post and discussion! I’m approaching retirement age and have spend a good deal of time modeling future possibilities. Unfortunately, the post I most agree with above is that of Jake Chase.
    If you think the stock market is an investment vehicle for decent retirement returns at the rates you are using, I think you are delusional. Particularly, you seem to somehow think that better investing will raise the average investor’s return. All good intent aside, that cannot happen. (think about the definition of the word ‘average’).
    That aside, I really wish more people would pop open a spreadsheet and look at it as you have done. It is an eye-opener.

  35. some guy in a cube

    401K’s are for suckers, for patsies. Here’s a retirement mantra for you poor fools: “Fries with that”?

  36. “Oh we’re movin’ on down, mooovin’ on down”

  37. Well, you can get more money with a laundromat and a gun than you can with just a laundromat.

    Or something like that.

  38. For the elderly. I think mutual funds yield less.

  39. It is important to understand the level of risk you are comfortable with. As a 20-something, I have decades to make up for a stock-market crash. Someone approaching retirement doesn’t, and should be mostly invested in bonds. An advantage of collective plans over 401(k) is that you can share risks and stay invested in stocks (say for 40%), because higher returns for future generations can make up for your crash.

  40. The implied difference in “anything else is not retirement saving, it’s retirement gambling.” does not really exist. In fact retirement gambling could be the only available retirement saving.

    You can save a lot make good investments and still end up on the street as there are so many unknowns. At this time, when facing climate change threats, energy scarcity, the disinvestment in jobs that has paid for the low inflation the last decades and an over-indebted and overextended society, these discussions sound surrealistic to say the least.

    There´s nothing as plenty of kids you love and hope they love you back as a valid retirement plan.

  41. Actually, she’s right. Both the boom and the bust. Greenspan opened the money tap in ’98 after LTCM went bust. Y2k didn’t happen, the Fed raised rates and the tech bubble collapsed.

  42. Yes, it was the government’s fault. It’s ALWAYS the government’s fault. Go read Newt Gingrich’s story of how he found Catholicism after being divorced twiced and Glenda Becky’s heartwrenching book about her battle with hemorrhoids. I don’t have time for displacement of responsibility for businessmen’s bad decisions.

  43. In Latin American culture that may work well, but in the USA I don’t think it’s a wise bet.

  44. Are you suggesting that Social Security is voluntary and offers a choice of investment options? Of course not. I suspect that even the most devoted advocate of big government would find it difficult to defend the management/mismanagement of the Social Security “trust fund,” considering the towering unfunded future liability.

    I was merely pointing out that the 12.4% of income contributed to Social Security (split 50-50 between employer and employee), if managed properly, would not require large additional private savings or risk taking to provide for retirement. According to the author, “we’re assuming that Social Security will be around in its current form.” I do not believe one has to be “anti-government” to point to the failures of Social Security program or to suggest that a Federal bureaucracy is not the solution to every problem. The Federalist-anti-Federalist debate is a truly American debate that does not require labels such as anti-government which sounds to me like “right wing conspirator” or “anarchist.”

    The Galveston plan was originally voluntary and 70% of employees participated.

  45. If you mean that you have to trust less your children in the US than in Latin America, then I tell you that your problem is much more serious than some retirement accounts.

  46. You just need to spin it right.

    Globalization is a redistribution program that takes jobs from the rich countries and give to the poorer ones, complete with high overhead and waste in the form of banks/corporations/stockholders.

    See, now it doesn’t sound so bad!

  47. For Americans, as Sarah has pointed out wrt remaining with the status quo there is a doom scenario over several decades that will be painful. Yet Americans will continue to be lied to by politicians of every party and the taxpaying public will vote for the greatest liars who promise no pain, ie: Morning in America again!!

  48. Yes, but what is the Federal Reserve if not “Businessmen’s bad decisions” billed as “the government”?

  49. Also, you keep (willfully?) missing these two (I’ve gathered, young) women’s point, and it is not some naive “anti-government” point.

    Their point seems to be that smaller governments closer to the constituency they are there to serve may be more in their interests than a big distant government that may well be, in fact, defrauding them.

    I don’t think we can sit here today and try to pretend that our federal government in not complicit in mass fraud that not in the interests of most of the US citizenry (but which is certainly in the interests of some).

    We need to kick the “government is good” habit. Good government is good. This government is not good.

    What to do about that *must* be a real question.

  50. It occurred to me that there is a way to quantify the risk of that hypothetical 30-year investment in the stock market; given that you have such a long history to work with. As people point out, index fund returns for the last ten years do not meet your historic average. Why not a running 30-year rate of return instead? Start with 1871 – 1901, then 1872 – 1902, then 1873 – 1903 etc. This would yield a data set from which probabilities of return could be calculated.

    Of course, I think we live in exceptional times. The certainty of uncertainty is in our faces every day. That said, to not use the past to predict the future is to fly blind.

  51. I have a 403-b plan, like a 401-k only for people who work for churches. If I didn’t get a match from my employer, I wouldn’t put one dime in it. First of all, I’ll get no tax advantages from it. I’m firmly in the next to lowest tax bracket and will stay there until I retire 11 years from now at age 67. I’ll be in the same tax bracket when I retire, so there’s no advantage to the tax free schtick here in the now.

    Second, the only options are a money market fund or a series of mutual funds, all of which are problematic based on things enunciated in this article. I would have been better off systematically investing in the inflation protected t-bills, since I only leave my money in the money market fund.

    Third, because of many of the issues identified in this article, the 401-k system is NOT about providing a secure retirement, it IS about channeling money into the stock market to be frittered away by the fools, thieves, and crooks who we pay to manage our mutual funds.

  52. I used to agree with this kind of analysis of social security, but the guys at the Angry Bear disagree and have some pretty persuasive math that indicates that social security could be fixed for a long time with a very modest tax boost.

    http://angrybear.blogspot.com/2009/05/nw-plan-for-real-social-security-fix.html (or http://tinyurl.com/yjlbl92 ). It amounts to about a dollar a week per worker. Read their math and see what you think.

  53. Nice tips. Thanks for share

  54. Now, inflation is a concern in many countries.