A different way of thinking about retirement

[IPAfan]

If you look at retirement calculators they will ask you to project an annualized return, years to retirement, and annual contributions.

The inherent problem with a system like this is that no one can really predict what their annual contributions or investment returns will be over the long term. It's very unrealistic to think that someone will contribute a flat contribution annually until retirement especially when accounting for inflation.

I think another reasonable way to plan for retirement would be to look at current net worth, and look at compounding that net worth at a given % annually while ignoring annual contribution altogether. Therefore the annual contribution would be included in the compounding NW figure. This will be made up of investment returns, business income, and salary.

Perhaps I tend to look at numbers this way because I derive all my income from business income. There's no way to predict my future income, but it will likely grow as along with my net worth as much of my net worth will be invested in various business entities which will provide my only source of income.

The average company in the S&P500 earns about 20% return on equity (or net worth). If I were to compound my net worth at 20% I'd be worth $66 million at 67 ;D

I think that compounding net worth at 15% is a more conservative assumption (although certainly very high if this number were derived purely from investment gains). I assume 5% annual inflation which is probably a quite conservative estimate for 40 years, but I think inflation is often understated in retirement calculations. This would put me at an inflation adjusted $1.7 million at age 67.

This is possibly sufficient for retirement, so in order to afford retirement I'd need to target a 15% return on equity rather than targeting a specific level of return from investments or a specific level of savings. Maybe this is all semantics, but this approach makes more sense to me.

[Sum Dum Gai]

Maybe this is all semantics, but this approach makes more sense to me.

Weird. I'm going to have to read it twice to figure out what the heck you're talking about.

[resolution]

You are very blessed if your net worth is growing at 20% per year. Unfortunately I am just about back to where I was in 2007 after some years of substantial losses.

[formerexpat]

looks like you should invest 100% in Greek debt!

[Deleted]

I'm a little luckier. I look at it as replacing a percentage of income with my pension as a major factor. Because of a late start, it will be 50% of my best 3 years out of my last 10 years or something like that. I have saved some money in retirement accounts (mixture of IRA, Roth IRA, and 457) but not nearly enough. I project that if it doesn't decrease in value (and I am still contributing 5% of my salary in addition to the pension contribution), it will be a minimum of $300,000. It isn't a ton of extra, but it will help.

The big variable is social security. Will it become income based so I won't receive any? Will I have to divorce my DH, who has no retirement income other than ss and some savings, because my pension/retirement savings will threaten his ss? His is rather substantial . . . I think it's $2300 a month or whatever the maximum is.

The other variable is the house payment. It won't be more than apartment rent by the time I retire (approximately 9 years from now) at $800. We are good about maintenance so that will have been kept up with. But I don't want to be poor in retirement. I spent $30 today keeping my two grandsons. We hit the thrift store and bought every paperback book that the oldest, who is seven and a great reader, wanted. That was $15 for almost 20 books. We then did fast food, which was another $15. I want those to remain no-brainers.

So income replacement is my marker, and it is really hard to work with given inflation, the tendency of state government to reduce employees' earnings, etc.

[IPAfan]

Jun 17, 2011 17:03:14 GMT -5 resolution said:

You are very blessed if your net worth is growing at 20% per year. Unfortunately I am just about back to where I was in 2007 after some years of substantial losses.

Growing much faster than that as I think it would with most people my age. At this point I can grow net worth 20% just through savings. Obviously that won't continue for the next 40 years, but I think I can grow my earnings by 20% a year for at least the next 3-4 years. I suspect my business income will plateau or at least the growth rate will greatly diminish at that point. Still, I can start removing capital from the business to keep ROE steady.

My investments have returned 71% since 12/2007 so I highly doubt I'll have that kind of tail wind over a long period of time. Still, I think 15% compounding in net worth is certainly possible over a 40 year period (there have been investors who have accomplished better than this just through investment returns with value strategies) when including savings.


expat,

Again, the point is that I'm not referring to investment gains. I'm referring just to the overall change in net worth annually. I'm not interested in greek debt, but I have invested in distressed corporate debt before with some great success.


SS,

I have no pension, and I don't anticipate any social security when I retire. I don't trust any pension in the world for the next 40 years so I'd prefer not to place my security in the hands of others.

[Sum Dum Gai]

Wouldn't your percentage return dwindle over time? In the early years your contribution alone will give a gigantic return. Say in the first year I put away $10k in a retirement account. The next year I put in another $10k, and my original $10k made $500. I have over a 100% return for that year the way you're calculating it. The next year I put in another $10k, only this time the contribution is worth a bit less than 50% plus whatever my $20,500 made. Fast forward a few years and it gets really hard to keep that 20% return going, especially for those of us who don't have business income. Our salaries should grow over time, but not nearly at the same rate as a business will.

[IPAfan]

Yes the percentage return will dwindle over time for sure. Right now, and for the next several years, I should grow my net worth much faster than 15% a year. However, I think 15% a year is a reasonable assumption (I think 20% would be the absolute top of the range). Keep in mind that the inflation adjusted equivalent at the end of 40 years would be 1.7 million. This would mean that near the end of my career I'd need to be growing net worth by about $200,000 a year with more than half of that coming from investment returns. This assumes that I was growing net worth at a flat 15%, when in reality it's quite likely that I'll grow net worth by 30% annually for the next 5 years. Fast growth earlier in my career will make it easier to accomplish long term returns of 15% (before inflation).

For instance, if I compound net worth by 30% for the next 5 years, 20% for the 5 years after that, 15% for the 10 years after that, and 11% for the 20 years after that. I will have compounded my net worth at slightly over 15% annually.

EDIT:

Also, I agree that this approach would be designed for someone running a business. At this point I'd be better off with a steady job, but there are really two options:

1) I will continue to grow the business until I'm earning more than a wage earner from business income; or
2) I will remove capital from the business to keep my return on equity high. Then I will try to start another business or find other investments to earn an adequate rate of return.

[Sum Dum Gai]

I'm just wondering how projecting a dwindling return like that is easier than projecting a flat contribution, percentage return on investment, and inflation factor, like most retirement calculators do?

[thyme4change]

It all seems like a Silly-wild-ass-guess to me. You can guess each component, or you can guess the sum of the components. You are still highly likely to get it wrong in detail, but in a range if you adjust as time goes along.

[IPAfan]

I agree that it's a silly-wild-ass-guess. However, I feel like the conventional retirement calculator requires me to make TWO silly-wild-ass-guesses.

[midjd]

I kind of feel the same way. Maybe the conventional calculators will make more sense when I'm older and have a better idea of my retirement expenses and my average or expected career income... I have no idea what healthcare or property taxes or gas will be like (maybe we'll finally have hovering cars , and I don't know what I'll be earning in 5 or 10 or 20 years. So I am just aiming high(ish) for now and hoping for the best!

[thyme4change]

I made a bunch of guesses. I guessed that my salary would rise a steady 3% every year from now until I retire. I guessed that my contributions would remain steady at 15% of my salary (which would mean the 401k limit would have to increase by 3% every year also - although I guess I'm not counting my brokerage funds.) I guessed that I would need 75% of my last year's earnings the first year of retirement, and that my needs would grow at 3% each year beyond that, and I put in a random percentage for returns for each year that never went below zero (unrealistic) but never went above 10%, and averaged more like 5% than 8% over my lifetime.

Do you know how many of things assumptions are wrong? I do! All of them.

[Sum Dum Gai]

I just take the median household income now, figure it grows 3% a year forever, and that I want to always be over double that amount. Prior to retirement, during retirement, whatever, I want to be making double or more what the average US household does and I figure I'll be alright. That to me seems like a pretty safe assumption for what I'll need in retirement.

All the assumptions you have to make about investment return and whatnot to get there... well your guess is as good as mine. I put away my 15% and hope for the best.

[dancinmama]

Jun 17, 2011 19:22:19 GMT -5 Sum Dum Gai said:

All the assumptions you have to make about investment return and whatnot to get there... well your guess is as good as mine. I put away my 15% and hope for the best.

darkhonor: I think you're on the right path. from 1981 until 2005, we contributed the max to DH's 401k. We reduced it in 2005 to 8% to get the max company match. If we had not done the max early, we would not have had the flexibility to cut back when we did and we would not be financially prepared for retirement now.

It is important to be very aggressive with retirement contributions when you are young. The more you can put away, the better. You can always dial back your contributions, if need be (like we did); but many times it is hard to catch up.

[dancinmama]

As far as actual retirement planning - how much you'll need etc. We are just months away from retirement and it's really easy to project what we'll need in the next year to five years; but what is really going to happen with inflation, specifically when it comes to medical costs? We will not be 55 until 2012 and under the Ryan plan we will not get full Medicare, and as a result we have no idea how to plan for our future medical insurance.

I have been playing with a retirement calculator and the two variables that I keep playing with are ROI and inflation. With the economy in such an unpredictable state, it is really hard to predict even those two factors right now.

[IPAfan]

The general consensus is to save as much as possible and invest. That's basically what I plan on doing. I don't have a steady income so I really have no idea how much I can save. That's the whole difference between self employment and being employed. If I had a steady income I could confidently say that I'm saving $x for retirement.

DH, I like your idea of always aiming for 2X the median in both retirement savings and earnings. Although you'll need a bit more than 2X in retirement savings since SS provides less benefit the more you make, so to have 2X the income in retirement will take more than 2X the retirement savings.

dancinmama,

I like your idea of maxing retirement savings for as long as possible while young. I'm already off to a pretty good start with money in ROTH IRAs. The problem now is that I've got a lot of things to invest in (like my business, DW's education, etc.) so I probably won't be able to max retirement contributions for quite some time. I'll probably move to tax deferred accounts now that my marginal rate is around 20%.

I agree that the HUGE uncertainty is the average rate of inflation. Warren Buffett said the best way to protect against inflation was with businesses that earn a high return on invested capital and have strong competitive positions. The problem is these companies are usually rich in valuation. I think one of the best inflation hedges by this standard is Phillip Morris Intl. (which earns a 150% ROE, has 8 of the world's 11 top tobacco brands, and is heavily invested in all of the world's emerging markets except China). Unfortunately, this company trades at a huge multiple of book value. However, on earnings yield PM trades in line with the s&p500 while being a vastly above average business and paying about double the s&p dividend yield.

Ratchets,

I agree that MOST people can predict their annual contributions, but I can't.

Believe it or not I actually UNDERSTATED the s&p500 return on equity. Return on equity is a different measure than profit margins. Net profit margins measure what percent of sales end up as net income. Return on equity is the shareholders equity (which is pretty much exactly the same as net worth which I was talking about) divided by net profits (AFTER TAX no less). Here's a quote from bloomberg explaining the s&p return on equity:

Return on equity for the S&P 500 has climbed since falling to 16 percent in the third quarter of 2009, the lowest in Bloomberg data going back to 1998. The measure has averaged 22 percent in the past 13 years, the data show.

So, the lowest return on equity of the last 13 years was actually 16%. The AVERAGE ROE (or return on net worth) is 22%. The reason we don't see these sorts of returns in the stock market is because the s&p 500 trades at a substantial multiple to shareholder's equity (I think it's around 2.5X, but I haven't checked lately). So the point is that these are excellent companies. If I could manage my own balance sheet with the same skill as american enterprise over the next 40 years I'd actually be looking at a net worth of $128 million. There's a reason that these companies trade at a premium to book value!!! This is also the reason that true wealth is created through creating a business. You can't earn 22% returns by passive investment as an employee. The vast majority of business owners have businesses which are much lower quality than the s&p 500 and that's why the s&p500 is comprised of the country's best companies. However, as small business owners we do have the advantage of size. It's easier to earn a high return on equity when you have a small company. It doesn't take a 22% return on equity to get rich. 15% is just fine.

Finally, american business isn't able to earn a 22% ROE with unleveraged assets. It requires a lot of financial engineering to keep a high return on equity, and many businesses maintain their high ROE by borrowing money (which gives a larger asset base with incremental profits going straight to the bottom line), and returning excess capital to shareholders through dividends and stock buybacks.

Stock buybacks aren't possible with private or closely held companies, and to compound net worth at 22% you'd need to be able to reinvest any dividends at a similarly high rate of return. That's why there are only a handful of corporations that have managed to provide 20%+ long term returns as they usually have to return capital to keep ROE high. That's what makes companies like Berkshire Hathaway so impressive because they've been able to grow at an AVERAGE ROE for 40 years without returning any capital.

So I'm not saying that I'm brilliant and am going to end up a multi millionaire. What I'm saying is that IF anyone could create a business with the same earnings quality as the S&P500 they could get very very wealthy even if they only start with a small amount of capital.

Now I will say that the last 13 year's 22% ROE is higher than average. Long term I think business has earned about 15% on equity, but increased corporate leverage, and a trend away from asset heavy businesses, has increased that number lately.