Ten percent solution

What does it mean to have protection from market changes?  Let me give you an example.  First, I will take an investment that pays me 10% the first year, loses 10% the next year, pays another 10% the next year and so on.  If you were to take five years at plus 10% and five years at minus 10%, the average return should be zero.  That is, you should have as much money at the end as you started with ten years ago.  That would be nice, but it is a little like hoping your one A in Art is going to compensate for your two C's in Math and Science. 

Start with $100.  The first year you make $10, and let's assume you don't have to pay taxes on the growth.  That leaves you with $110.  The next year you lose 10% or $11.  Now you are down to $99.  In my graph below, I carried that logic out for 14 years. 

My $100 shrank to $85 losing $15 from my beginning balance.  I don't like that result. 

What if I were able to get something that always let me have the positive 10% growth when it happened, and then didn't pay anything when the return was negative.  How would that look?  In my first year I earn $10 and the next year I earn nothing, but I keep my $10.  The next year I earn $11 bringing my balance up to $121.  I like that much better.  Let's see how that looks over 14 years again.

In just 14 years, with protection, my account grew to $177.  How does that look in comparison to my other result?  I think it looks a whole lot better.  But 10% each year isn't really possible, is it?  In my next article I will give a real world example.

The four cornerstones of a strong investment

What makes a good investment?  I want it to grow, be safe from market fluctuations, have a tax advantage so I can keep as much as I can, and I want to protect my family. 

I want it to grow at a reasonable rate so my money will keep up with inflation.  I want to know that I will be able to have at least what I am earning now without having to work at a job.  If that isn't possible, then I will at least want to have enough to cover the basics like housing, whether I am renting, paying property taxes and upkeep on my own house or wandering the country in a motor home. 

I have learned that the Rule of 72 tells me how quickly my money will double, assuming I can get a consistent rate of return.  If I depend on the market, my return is going to flucuate between making me rich one day and making me work into my twilight years just to stay alive. 

That means I also want some safety and consistency of growth.  If I am going to depend on some nest egg of cash to tide me through to old age, I want to be sure I have enough and that it won't disappear due to something I have no control over. 

I want a tax advantage.  I have shown that money that grows without taxes is far better than being taxed as it grows.  That eliminates things like CDs and savings accounts and even dividends received from mutual funds.  All are taxed as I receive income.  I want my money to keep up with inflation, too.  I have seen that inflation can eat up value of my money. 

Finally, I want my family protected if I die early and my wife and I protected if I live too long.  To get all that, I need a very well-rounded and well-managed portfolio of investments, plus some life insurance for protection.  Or do I?  Let's look at this one level at a time.

For growth, I can put my money into a savings account or some other type of cash account, and let the interest accumulate.  The best most banks and CDs pay, though, is about 2%, and we have seen that I need at least 5% to beat taxes and inflation.  I can invest in mutual funds and even hire a manager, but that can be both risky and expensive.  Still, not a bad idea, if I have enough money to start with.  Banks call such managers Wealth Managers and they like to work with people with large amounts of cash they don't know what to do with.  I am not one of those people, though, so count me out.  What I would really like it something that guarantees me growth every year that beats inflation and taxes.

For safety, I would also like something that protects me from markets crashes.  Again, savings accounts do that, though I still don't keep up with inflation.  I have been told that bond funds are good in a lowering market so that is a possibility.  But when the market goes back up, I need to run in and sell the bonds and move back to stocks.  Who has time for all that?  I want something that always keeps me above the market or at least doesn't deduct from my value when the market is poor.

My tax advantage comes with my 401k.  I even get free money from my employer up to a certain percentage of my income.  Maybe 401k's aren't so bad, after all.  I can also buy a Roth IRA which lets me have tax free growth and tax free withdrawals.  The trouble there is that I am only allowed to pay $5000 a year.  In my case, since I am over 50, I can invest $6000, but that won't really grow fast enough for my needs.  Remember, I need a million.  What I want is something that allows me to invest as much as I want, let's my money grow tax free and also lets me take it out tax free.

In my next few articles I will show the type of growth I can get with and without the protection of market safety.  I will also show how I can withdraw a living wage from my savings and still have it grow.  Such safety isn't free, but the consequences of no safety net is like driving down the freeway without a bumper and seatbelt.

A note to my readers from around the world

As a blogger, I get to see the sources of people viewing my blog and I thank all of you for reading my story so far.  I would like to get some comments from my readers either directly on the blog or to me at floreyroy@gmail.com  In just a few weeks I have had almost 200 hits on my site so that makes me feel good about my writing. 

Readers have been mostly from the US, though I see some from Malaysia, France and Thailand.  From the people I have known over the years, I have an idea who those folks might be.  I am curious about my reader from Germany.  Are you enjoying this blog, as well? 

I have a number of ideas about where I want this to go.  Taxes and retirement are always a challenge is dealing with inflation, fluctuating markets and other disasters.  I also want to meet with other people dealing with my issues and interview them.

From there, I plan to talk about businesses I have tried over the years and other investments and how they panned out.  Each sounded very good on the surface and each took their toll on my finances.  I believe I have found the best business for me now so that will be a topic in coming days. 

I look forward to seeing more readers and followers to my blog.

Roy

Keeping up with and above the market

I started this story asking how much is too little.  That is, how do I know if I have enough money for my future or is it too little?  If it is too small, what do I need to do now?  Life is supported by income streams.  When we are born, we depend on our parents to pay for our food, clothing, home and so on.  Then we leave home and start our own streams with a job or business or both.  That stream needs to cover a number of things and how we approach those things is the real trick. 

We need to know what we need versus what we want.  If what we need exceeds our stream, we will do what we can to improve matters.  We might get assistance from the government or family or we might find a second job or even just a better job.  No matter, each has its own consequences and costs.  Ideally, you want to find an income stream that meets your needs for the present and future.  Along the way you would also like to have something you find interesting and challenging enough to keep you interested over the years.  Reaching retirement is, afterall, a long journey, especially when viewed from our youth.

I have found that a general rule for retirement money is to take 5% from whatever savings I have and combine that with any pensions I might also receive.  To do this assumes I will live another 20 years, and then I won't need any more.  It also assumes that there will be an equal amount of money from year to year.  What happened to retirees when the big crash hit is that they might have been on just year 10 or so with less than a few years left of funds.  And when they took money out, it actually cost them more than when they had more value.  For example, let's say I have $100,000 and I am taking my $5000 out each year.  The first year I draw my account down to $95,000 then $90,000 and so on.  But then the market crashes and my $90,000 is only worth $50,000.  What can I do?  I could just take 5%, or $2,500, but I need 5.  That means the money I take out is going to cost me double what I would have had to take out when I had my value.  That also leaves me with an even smaller fund to grow back when the market recovers.  Doing this is called annuitizing the fund, or taking out a set amount annually.  Unfortunately, I have no control over the value of the account as I draw against it.

I also need to be aware that taxes and inflation can eat up what I have earned. I need to find something that stays ahead; basically I need to row faster than the flow of the stream o rI will be pulled under.  The most common savings plans available now are the pre-tax accounts such as 401k, 403b, and IRAs.  These are all methods of saving as defined by our tax code.  We are allowed to take a certain percentage of our pay before taxes are applied and save it in an account we can't touch.  The rules of engagement are such that if we do take money out we pay a high penalty in taxes as a way to prevent us from using it too early.  Saving and growing pretax is always better than allowing my earnings to be taxed each year.  If you had one dollar and it was able to double every year for 20 years tax free, it would be worth over $1 million.  (If you want to check the math, take 2, the first double and multiply to the 19th power.  Isn't math fun?)  If you did that with another dollar and taxed it at 35% at each growth, you would only have about $27,000.  Big different, huh?

I like the tax free growth, but what I don't like is that my only choices are the mutual funds to invest my money.  Mutual funds are basically clusters of stocks with different types of risk.  Looking at the market in the last five years, though, it seems that all are just different ways of approaching a slot machine.  A gamble, no matter how you look at.  Or is it? 

Enter my annuity.  An annuity is a savings plan with a life insurance company.  I can give them money that will be invested in a number of different ways and at some time I can begin to withdraw a payment from it.  The beauty of the annuity is that I can have it pay me until I die, even if the original fund runs out of money.  I can also set it up so that should I die before my wife, she will also receive a payment until she dies.  Try to do that with a 401k.  There are a number of different plans, depending on where you are financially.  Annuities can be set up as traditional IRAs or Roth IRAs. 

A traditional IRA is similar to a 401k in that it is funded with pre-tax money.  A Roth IRA lets me invest with after tax money, my take home pay from work and invest it.  The growth is tax free as it grows and, better still, all the money comes out tax free, assuming I follow the rules of the plan.  If you have money from a previous employer, you can roll your money over as a rollover IRA.  In my case, I rolled over money I had in previously rolled over money that was shrinking rapidly in the market.  My plan lets me invest my money in the same sorts of mutual funds so I can still take advantage of market growth.  But here is the real beauty of the plan.  When the market value of my account drops, the insurance company keeps my fund at that highest amount and then pays interest.  When the market recovers, the company allows my fund to grow again.  What that means is I not only stay with the market as it grows, I also don't have to suffer the losses when it shrinks. 

As my money went in from previous money I had invested pre-tax, I will have to pay taxes on the money someday when I withdraw it.  Still, it is a far better solution than just praying the market will protect me.  I am using the power of a company worth ten times the value of Microsoft.  I think that is a pretty good deal. 

Isn't a 401k enough?

I got the annuity which let me roll my IRA money over tax free.  It works just like any other rollover IRA.  In case you don't know, a rollover IRA is when I move my old 401k money from a former employer to an IRA, or Individual Retirement Account, that I can manage myself.  A funny thing about all these IRAs and 401k's; they are both based on investing in mutual funds and similar security-based vehicles.  Take a look at the Dow Jones Average over the last 40 years. 

Before 1980, a worker had limited choices for saving for retirement.  He had Social Security as some protection, but that was never intended to be the total amount needed.  As I said earlier, many large employers had pensions for employees.  Some were generous while others were not so, but all had the same thing in common.  They provided a retired worker with a lifelong paycheck.  Trouble was businesses didn't like having to keep so much money around that they couldn't use.  In fact, the AICPA, the folks who do all the external audits of corporate books, wouldn't even allow businesses to put the balances on their financials; at least, not as an asset or even a potential liability.  Meaning they couldn't tell investors that they were worth possibly billions more than they could show as their value as a business.  The reason was because companies were not allowed by the federal government to touch such funds.

One group, a union, got in trouble back then for spending the money on expenses other than retirement, while a few other pensions just disappeared over night.  The government, back when regulation was considered something good for the country, made it very difficult for companies to play with that money.  To this day, companies with pensions have very strict rules as to how to invest and spend pensions.  Then suddenly, businesses got a Get Out Of Jail card.  Along came the 401k.

Pensions allowed companies to reward their employees with free money after doing a number of years of service.  As the pension was based on salaries, everyone was able to get substantial lifetime benefits.  The money was saved tax free until it was paid out to the retiree. 
Then a lightbulb went off.  I am not sure where, but someone suddenly realized that companies could get rid of pensions altogether.  A pension had to be held by the company but a 401k was managed by a third party.  That meant that they could dump pensions forever and leave the employees on their own to figure out how to invest.  On paper that sounds very good, I suppose.  Do you have any idea what that did to the market?  Take a look at the Dow Jones Industrial Average, DJIA, from 1950 to now.

The DJIA is used as the baseline for the market.  We hear about it every day.  The Dow is up today, the Dow is flat, the Dow is plummeting.  From the 30's to 1980, the Dow went from 200 points to 900.  In that 50 years, the market increased by 7% per year (that is ((200-900/200)*100)/50).  Not bad.  From 1980 to 2000, it grew to almost 11,000 or about 56% per year (same math).  How did that happen?  401k's. Before 1980, only large companies like insurance companies and pensions were the major buyers in the market.  Ordinary people were just small potatoes.  We might buy a few hundred or a few thousand shares.  Some might have bought even more, but they didn't have any real effect on the market.  Only the big buyers had any influence.  And since the big buyers wanted stability and growth, the market slowly moved up.  Buying a stock and following required a certain level of sophistication and knowledge to do well.  Most small investors were lucky to make any money.  When I was growing up, we talked about the market like we talked about Las Vegas.  Investing was a gamble. 

401k's started a whole new game for Wall Street.  Suddenly millions, then billions than trillions of dollars were being thrown at their feet by unwitting buyers who only wanted to have something for their old age.  Wall Street exploded and the market grew exponentially.  And the market suddenly became far more volatile. 

After the big growth in 2000, the market crashed down to 9000 in 2002, the time after 9/11.  Again by 2007, it almost hit 14,000 when it all came tumbling down again.  Where were the 401k's during all that?  They were riding this roller coaster of value every day.  In 2009, it was down below 8,000.  All this volatility hurt millions of Americans of every age.  I lost almost half my money in a few days.  From 2000 to 2010, my balance stayed exactly the same value even though I had been adding to it all along.  The Rule of 72 says that I will never see my money double.  According to a fellow I know who is pretty good at investing, in any market, someone is making money.  Just not folks like me.

Throughout all this, one type of company has managed to survive and grow.  And the reason for this is because they have only one job....to protect the people who buy their products.  Insurance companies.  I want somebody on my side.

How much protection do you need?

I want to have money to retire on.  That is the plan.  But how much do I need?  And before I retire, I want to be sure my family is protected in case I die too soon.  The quandary is what if I don't live long enough and what if I live too long?  For the first, I need to figure out what I would not want my family to have to pay for if I were to go.  I heard about the DIME approach which I will share here. 

D is for debt.  How much debt do I have?  If I were to go, I would not want my wife to have to pay for that debt, so some sort of protection is order.  Fortunately I don't have a lot of debt. For an example, I will say I have $10,000 in debt, counting credit cards and auto loans.

The I is for income, or how much income would my wife need to get back to a normal life.  Typically, it takes about ten years to recover from a death.  If my income were $50,000, I would want her to have ten times that or $500,000. 

The M is for mortgage.  In my case, I have none.  If I had a home here, I would probably owe around $200,000.  In California, it could be more like $300,000 or $400,000 or even more. 

Finally, E is for Education.  If my kids were younger, I would want to set aside money for their education.  A state school costs around $15,000 a year.  For one child you need $60,000.  My kids are grown, but it would be nice to set aside money for grandkids. 

Putting it all together I would need:

D -   $10,000
I  - $500,000
M - $200,000
E -  $120,000 for two kids, be they my own or grandchildren. 

Total  $830,000.  A lot to set aside on my own.

My savings in my 401k would be taxable to my children as would my pension.  Assuming there is only 25% withholding, I would need well over $1 million in savings to protect my family.  However, a life insurance policy would pass to my heirs tax free, at least income tax free.  Congress is still playing around with the inheritance tax.  The last time I looked, the family would have to get over a million dollars to pay taxes.

I bought insurance for my wife with my sons as secondary, should we both go at the same time.  Surprisingly, only about 40% of Americans have any sort of life insurance, and most of them are underinsured.

Managing my debt allows me to buy less protection or at least have the protection go directly to my family instead of creditors.  Debt is another animal that will be considered later.

And then if I live too long, I have another issue.  What sort of protection did I buy?  Did it have any savings included?  That is something else to ponder as I continue my blog.

Starting Early, Starting Late

I have saved most of my life.  My brother used to tease me when I was quite young.  We would receive a dollar on Monday from mom for our allowance and by the end of Monday his dollar was gone.  By Friday, I still had my dollar in my pocket.  Nevertheless, I have managed to spend money on things I need and don't need, gotten in to debt when I shouldn't and taken money from my retirement when I should have left it alone.  The mindset was there, but sometimes it is difficult to see so far in the future.  Now that I am nearing retirement, or at least the age when I would like to retire, I see that living comfortably will be a challenge.  Where would I be if I had not spent my retirement?  When is the best time to start saving?

The best time is as soon as possible.  Not tomorrow, not next year.... Now.  Here is an example.  Mr. Early Starter decides to save $300 a month every month for 7 years and is able to get 8% interest.  Where as Ms. Start Later puts off saving until she turns 32.  By the time they are both 48, they end up with just about the same amount of money.  But Mr. Early only invested $25,200 whereas Ms. Start Later had to invest $61,200 or over double the amount.

Early Starter				Start Later
Age	Annual Contribution	Total Accumulation		Age	Annual Contribution	Total Accumulation
25	3,600	3,888		25
26	3,600	8,067		26
27	3,600	12,622		27
28	3,600	17,520		28
29	3,600	22,809		29
30	3,600	28,522		30
31	3,600	34,692		31
32		37,467		32	3,600	3,888
33		40,465		33	3,600	8,067
34		43,702		34	3,600	12,622
35		47,198		35	3,600	17,520
36		50,974		36	3,600	22,809
37		55,052		37	3,600	28,522
38		59,456		38	3,600	34,692
39		64,212		39	3,600	41,355
40		69,349		40	3,600	48,552
41		74,897		41	3,600	56,324
42		80,889		42	3,600	64,718
43		87,360		43	3,600	73,783
44		94,349		44	3,600	83,574
45		101,897		45	3,600	94,148
46		110,048		46	3,600	105,567
47		118,852		47	3,600	117,901
48		128,361		48	3,600	131,221
	Total Spent   25,200				Total Spent 61,200

If you are my age, it all looks quite overwhelming, but if you are younger, I suggest you give serious though to beginning a savings plan now.