Saturday, May 31, 2008

“Magic” Cull

Participant education meetings have long touted the “magic” of compounding; that apparent miracle of finance whereby income earned on investments becomes part of an account balance, and earns more income that in turn adds to the account balance, which earns more income, and so on. The net result, of course, is that at the end of a savings career, you wind up with a lot more money than you ever thought possible.

The funny thing is, I’ve known about this magic for so long, I had almost forgotten how impressive the results could be. Or had, until Russell Investments published a short paper with a long title— “The 10/30/60 Rule: Where Do Defined Contribution (DC) Plan Benefits Come From? It’s Not Where You Think.” This paper wasn’t about compounding per se—if it had been, I doubt that I would have taken the time to read it. In fact, now that I’ve brought up the subject of compounding, you may have already gone on to other things—but stick around.

We all know that compounding is a good thing—something that works on our behalf even when we aren’t doing anything. Sort of like having a good metabolism that keeps your portfolio in fighting trim without requiring any physical exertion (I still remember those days fondly). As a consequence, we tend to take it for granted.

“Post” Script

However, the point of the Russell paper wasn’t the magic of compounding. It was a message about the importance of investment—particularly investment after retirement. How important? Well, important enough that a reasonably simplistic spreadsheet included in the paper showed that nearly 60% of one’s total retirement distribution can come from investment returns attained after retirement (age 65 in the example). How much comes from individual contributions? Well, in the Russell example, a relatively miniscule 10%, and the rest from pre-retirement earnings—about 30%.

Now, to get there, you have to embrace several assumptions—and the paper’s authors are clear on that point. They assumed a 7.8% annual rate of return and applied it consistently over the period in consideration (each year’s contributions were half-weighted). Granted, some might argue that 7.8% is a tad “optimistic,” certainly when one considers that return applied over a 64-year period without interruption (1). However, they also assume a 4.75% annual increase in the contribution. That assumption is doubtless expected to account both for wage increases and deferral growth—but still seems wildly optimistic in a 40-year savings “career.” However, if that is optimistic, then it only serves to accentuate the point of the Russell paper—that investment returns play a significant role in account accumulations (more on that in a minute). The paper’s authors also factor in distributions—again, in a consistent stream—that increase by 3% each year, designed to draw the account balance to $0.00 at age 90.

What that means for the baseline scenario presented is that, if you start by saving $1,000 when you are 25, by the time you get to 65 (under the assumptions noted above), you will have an account balance of nearly $470,000, of which only about $113,000 would have come from contributions. However, the real “magic” is that, by the time the sample participant exhausts his account at age 90 (2), he would have been able to withdraw more than $1.1 million. In other words, even after money starts being drawn from the account—and even after contributions are no longer made—those post-retirement years add nearly $700,000 to that account balance at retirement.

We all know that in the “real” world, nothing moves in a consistently positive direction. Investment returns are generally unpredictable, if not downright volatile; contributions (even “escalated” designs) tend to plateau at some point; and account balances are depleted, for a time anyway, by things like loans and withdrawals. However, the message—that your investments keep working for you even after you quit working—is timeless, and one well worth keeping in mind, IMHO, as we work toward a financially secure retirement.

- Nevin E. Adams, JD

(1)The paper’s authors examined a couple of different investment return scenarios—one where the annual return is 5% and another where it moved from 7.8% to 5% post-retirement. They did not, however, factor in any negative returns.

(2)The paper’s authors acknowledge that 90 is “slightly beyond the average life expectancy,” but explain its usage as a reflection of the need to “build in a margin against the uncertainty introduced by longevity into retirement planning.” However, if death is assumed to occur at age 85, rather than 90, the authors note that the 10/30/60 rule shifts to only 12/36/52.

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