Tag Archives: Retirement

MPT and retirement planning

In a previous post, I questioned how diversified a portfolio of just three assets could really be.  This wasn’t really fair, since the whole point was to avoid such an analysis.  To provide a fairer test, I will use 15 assets for this analysis, all of which are choices taken from an actual retirement plan. The 15 securities listed here consist of 14 mutual funds and a stock.  Choices are predominately focused on US equities, though is a REIT fund (FARCX), two international funds (RERGX, VTRIX), a bond fund (PPTRX), and a money market account.  Given this expanded universe of choices, what will theory tell us is best?

I used Matlab and it’s financial toolbox to retrieve four years of monthly prices for each of the funds.  Since one of the funds is a target date fund, data was not available for it before then.  The data was provided free of charge by Yahoo Finance.  These prices where used to calculate monthly returns, which were in turn used to get means and covariance of the assets.  Once this was done, Matlab’s financial toolbox was used to find the optimal weights.  If you really want to get in to the details of such a calculation, this book explains it well, but be warned:  linear algebra and calculus is required, so in practice, this problem is best left for software.  Below is a screen capture of the results, as well as a graph of the efficient frontier.


The results of the analysis show that fewer assets are better, but raise a few questions as well.  Efficient portfolios generally consist of 3 assets.  This seems to support the idea that a few assets will do.  Yet while these portfolios are efficient with respect the risk reward trade off, they take no account for where the return comes from.  In this case, the funds are for the most part positively correlated over the time period, so funds that would provide diversification are ignored for the higher yielding choices. This points to the period being too short, or more importantly, the number of choices is too small.  The needed number of assets to consider may be close to 100! This seems to indicate that for retirement planning, MPT may be a nice theory, but it’s real value is as a lesson about the value of diversification.

But what’s this say for our choices? There is no substitute for true diversification.  Getting exposure to assets that are uncorrelated is key.  Considering the 15-asset universe, almost every portfolio on the efficient frontier consisted of 3 assets, but a truly diversified portfolio consisting of the choices offered may be better off with a couple more funds.  In this case, examining the top holdings of the funds would provide as much insight as this analysis did!

Income, Life Expectancy and Social Security

We are well aware of the fact that economic status has a direct correlation to life expectancy. The rich are expected to live longer than the poor. Recently, though, the gap between rich and poor people’s  life expectancy has been widening. Especially for women, economic status is having a more significant influence over life expectancy each year. Interestingly, life expectancy for poor women has actually been decreasing by generation, indicating that it is not only growing at a slower rate than that of the rich, but that it is actually decreasing. An article from the Wall Street Journal, “The Richer You Are the Older You’ll Get”, outlines the results found from surveys conducted by the University of Michigan, and points to the complex implications this has on social security.

The data used comes from the University of Michigan’s Health and Retirement Study, a survey that tracks the health and work-life of 26,000 Americans as they age and retire. According to the data, men of all incomes are living longer. But the data shows that the life expectancy of the wealthy is growing much faster than that of the poor. Looking at the graph below,  for a man born in 1940 with income in the top 10% for his age group, if he lives to age 55 he can expect to live an additional 34.9 years. This is six years longer than a man also in the 10%, but who was born in 1920. Men who were in the poorest 10%, can expect to live another 24 years, only a year and a half longer than his 1920s counterpart. That’s a huge difference. when we are talking about life expectancy.

Screenshot (22)

However, the story is different for women. While the wealthiest women from the 1940’s are living longer, the poorest 40% have a declining life expectancy from one generation to the next. ““At the bottom of the distribution, life is not improving rapidly for women anymore,” said Mr. Bosworth. “Smoking stands out as a possibility. It’s much more common among women at lower income levels.”” This is an interesting observation, which has some logic to it (smoking kills), but it’s hard to believe that this is the sole cause. I would also add that drugs play a big role here.

Looking at the following graph, we can see how life expectancy for the poorest women is declining, while that of men is still increasing (though not as significantly at that of rich men).

Screenshot (24)

Though I can’t immediately think of any explanation for this, it is worth thinking about. Perhaps the increase in cancers affecting women has something to do with it, but it is hard to tell.

Lastly, the article points towards the implications this has on social security. If people at the bottom are not experiencing increases in life expectancy (the graphs show predictions based on actuarial data), this means they are getting less social security benefits since they will receive it for less years. This might indicate that the retirement age should be lower. But then there is the case for those not in the lower class: for example, a wealthy man born in 1920 who retired at age 65, could expect to draw social security for 19 years. His son, born in 1940 and retired at age 67, could expect to draw benefits for 24 years. He retired at a later age, but he’s living longer. But this is obviously not true for men and women at the bottom. They would draw social security for less years, if the retirement age rises, and their longevity does not. Clearly, this poses a dilemma for setting appropriate policies as life expectancy rises (for all except women in the bottom 40%).

MyRA – The Good and the Bad

During his State of the Union address in January, President Obama introduced  the “myRA.”  A myRA is a retirement savings account targeted primarily towards low income-workers without access to a work-sponsored 401K account.  According to the White House, the ultimate goal of the myRA is to foster retirement savings across all income levels.  Given that only 57% of American save for retirement, and that only 49% of all works have access to sponsored retirement savings (like a 401K), this is a very caring goal.  Given that social security is expected to go insolvent by 2033, this is a very practical goal as well.  That said, the nuances of the myRA are extremely limiting, making it a half-hearted attempt to fix a very important problem.

Before addressing the negative aspects of a myRA, it is important to understand the benefits.  Most importantly, the myRA account offers a way for low-income workers to develop a habit for savings.  The myRA account is essentially a modified Roth IRA; deposits are made after-taxes, and earnings grow tax-free.  Unlike a Roth IRA however, myRA’s have very few barriers to entry: the minimum balance to open a myRA savings account is only $25, and additional deposits can be made in increments as small as $5.  Furthermore, there are no fees associated with a myRA account.  Finally, for those risk-averse investors, the principal is guaranteed (much like a traditional savings account).  All of these qualities make the myRA an attractive savings vehicle.  Given its ease of use, I agree with Obama that, given the write promotion campaign, a myRA can encourage better savings habits among low-income workers.

That said, it is important to understand the difference between savings literacy and investment literacy.  It is one thing to save money for retirement.  It is another thing to wisely invest this savings so that it earns a reasonable rate of return.  While the myRA program may foster savings literacy, numerous restrictions greatly inhibit its ability to develop good investment literacy.

The two most important of these restrictions are a savings cap and a requirement investment asset.  Firstly, all myRA accounts are limited to $15,000.  If someone’s myRA account has a value that exceeds $15,000, the excess must be rolled over into a Roth IRA (given that the principal is guaranteed, this makes logical sense; the FDIC can only afford to insure so much money).  While $15,000 is a good start, it is, under almost no circumstances, a sufficient nest egg.  It is my fear that this cap will signal to myRA investors (who will  likely be rather savings illiterate), that the $15,000 is a sufficient quantity of retirement savings.  Unless the White House develops an excellent transitions program to help individuals roll over their myRA to an IRA, this cap will likely result in many grossly underfunded retirement accounts.

The second and most important myRA restriction is its lack of investment options.  Whereas a Roth IRA allows individuals to invest in nearly any security, myRA’s can only be invested in a US government savings bond called the Government Securities Investment Fund (more informally referred to as the “G Fund”).  Since 2003, the G Fund has offered an annual, nominal rate or return of 3.61%.  During that same time frame, inflation has averaged 2.5%.  This means that the real rate of return of the G Fund has barely topped 1% in the last decade.  While this return is higher than a traditional savings account, it is well below what a standard index fund (ie: Russell 2000 or S&P 500) is capable of earning.  I understand that Obama wants to protect investors from making foolish investment decisions (like buying all penny stocks).  But by limiting investment to the G Fund, I fear that myRA’s will foster too much risk aversion and prevent investors from growing their nest eggs at a reasonable rate.

Ultimately, the myRA is a step on the right direction.  It is about time that the US Government address private savings in order to supplement social security.  That said, it is important to realize that savings literacy and investment literacy are not the same thing.  Thus while the myRA has the potential to foster better savings habits across low income levels, it seems to have very little potential to foster intelligent investment habits.  I believe that a modification to the current social security tax would accomplish this goal much more efficiently (see my post: “Should Social Security Switch to a Defined Contribution Plan?”).  Whatever happens though, it is crucial that policymakers begin to address savings and investment literacy before social security becomes insolvent.

Changes for an equal opportunity retirement


Over the past few decades, how Americans prepare for retirement has changed, shifting the responsibility for things like portfolio choices and risk management to workers.  In response to these changes, the American retirement system should be modernized with means testing for social security benefits and mandatory saving for workers above a threshold.  While ultimately the responsibility will always rest the individual, these changes would ensure availability and access to a minimum of retirement planning for all.

A logical way to begin this modernization of the American system is to implement some sort of means testing in for social security benefits.  The top 10 countries already do some sort of income/wealth based benchmarks for benefits.  By phasing out the benefits with income, the top earners would be forced to save more.  This is especially attractive option given the expected short falls of social security, though there are political considerations due to what would essentially be a transfer of wealth.

Adjusting people’s social security payments won’t be enough by itself to make up for the deficit.  The most direct way to increase saving for retirement is to make people save more.  The United States should update the current system with the addition of mandatory saving for all workers above some poverty threshold. The groundwork for such a program has already been laid.  In January, shortly after the state of the Union address, President Obama announced the MyRA.  The account can be opened with a minimum of $25, and is effectively an IRA that is invested only in treasuries. The account allows for the accumulation of $15,000 over 30 years until it is rolled into a Roth IRA.  The Marketwatch article mentions that a key difference between workers with savings and those without is access to such an account.  This account is a sort of IRA on training wheels, allowing savers time to learn and gain experience building wealth for the future.

There are some drawbacks to a mandatory savings program however.  As seen in Australia, who use a similar program has resulted in lower wages.  The United States certainly doesn’t need lower wages, but this can be avoided by not implementing Australia’s mandate that employers contribute at least 3% of pay to the plan.  Instead the a portion of the amount of social security that is phased out due to means testing can just be discounted back to its present value and then saved.  In this way, the United States can ensure American’s that make enough money to be saving are saving something for their futures, with out effecting wages.

Americans are not prepared for retirement.  Roughly a third don’t even have $1000 saved, and the majority have less then $25,000.  It should come as no surprise that when world rankings of retirement preparedness were released in February 2014, the United States ranked 19th.  Part of the problem is that people don’t understand the complex plans and decisions that need to be made.  However the United States can reverse this trend by implementing policies that have already been proven to work in other countries.


In search of diversification

In this past weekends Wall Street Journal, I came across an article entitled Funds Investing:  Make More Money and worry less.   At first glance this article seemed to be stating the obvious.  However, after reading it, I began to wonder.  Can one really get diversification from as little as 3 assets?  After some rough analysis, it seems people may need to worry a little bit more then the article suggests.

The article is actually a summary of ways “lazy” people save for retirement.  Lazy, here does not indicate sloth, but rather to retirement ideas named “the margarita”, “the coffeehouse” and “the no brainer”.  The idea of these “lazy” portfolios is that they don’t require a lot of attention or financial know how to set up.  Given the state of most people’s retirements, lets compare the ideas of these retirement plans, requiring little more then your contributions, to conventional wisdom about what it takes to have a solid retirement.

But suppose we have some time, as well as a computer with Matlab or Excel installed on it.  The question I want to ask is:  given these small quantity of assets that make up these lazy portfolios, what do other philosophies about portfolio management say about theses savings ideas?

What follows is based Modern Portfolio Theory, as told in Burton Makail’s “A Random Walk down Wall Street”.   The mathematical analysis, carried out in Matlab, can be done by hand using a general optimization technique called the method of Lagrangian Multipliers.

Modern Portfolio Theory says that the best portfolios lie along the efficient frontier.  This is a line representing the portfolios that invest all the available funds lie on a hyperbola.  The top half of this hyperbola represents what is called the efficient frontier.  These are the portfolios that invest all money, and receive a higher return then the one that lies on the bottom half.  The portfolio located at the “point” is called the Minimum variance portfolio.  The efficient frontier for a portfolio consisting of the 3 mutual funds is shown below.


Taken from Matlab 2012

So consider the portfolio mentioned specifically in the article.  It is a portfolio of 3 vanguard funds, (40% VTSMX (Total Stock Market), 40% VGTSX (Intl. Stock Index), and 20% VBMFX, a bond fund). Using Matlab to calculate things like mean, variance, and covariance of the three assets, using data from Morningstar, we can optimize the weighting of the assets to get the optimal combination.  The weights of the portfolios that lie on the efficient frontier are listed below.


Using the Vanguard funds listed in the article, as well as data on historical returns from Morningstar, I computed the efficient frontier for the 3 assets given in the article.  This analysis shows that while the portfolio may provide exposure “…to every major equity offering in the world”, it is not exactly efficient.  The second asset (the international stock fund) seems to have very little place in this portfolio despite the unique exposure it brings.  Clearly blindly quantitatively optimizing your portfolio may not leave you diversified, but being lazy may not get you there either.

Maximizing Your Lifetime Benefits

When you’re young, you have a lifetime of earnings from employment ahead of you and so you can afford to be less risk-averse. For those in their twenties, an aggressive investment portfolio is recommended; one that is heavy in common stocks and contains a substantial proportion of international stocks which include the higher-risk emerging markets. As you get older, however, you should begin to cut back on riskier investments and start increasing the proportion of your portfolio committed to bonds and stocks that pay generous dividends. In retirement, a portfolio weighted heavily in a variety of bonds is recommended (A Random Walk Down Wall Street, 376).

Considering that less than half of all Americans have any kind of retirement account, and those who do only have about $35,000 in it, it would be best to work during your retirement years and to control your expenses and save as much as possible. Plus, it has even been shown that for those working into retirement, there are great psychological and health benefits that follow. For example, those who continue to work often have a better feeling of self-worth and connectedness and are also healthier. In A Random Walk Down Wall Street, Malkiel advises that in order to maximize annual benefits, everyone should delay retirement as long as possible and put off taking Social Security until full retirement age. Nearly half of all retirees will live longer than their average life expectancy; yet most will have failed to save adequately for retirement, given that we have tended to be a nation of consumers rather than savers. It would only be beneficial for those in very poor health with a short life expectancy to start taking the benefits at the earliest age at which you can start collecting (380-381).

So, what is the best way to maximize the benefits you receive over your lifetime? Do you start collecting in the first year of eligibility, at age 62, and accept smaller monthly payments? Do you wait until age 70, when you could qualify for the maximum payment based on your salary history? Or do you start collecting sometime in between 62 and 70? When it comes down to it in the end, the most important factors are your expected longevity and your individual financial situation. In the Wall Street Journal, two financial advisors discuss which is the smarter move: taking the sure thing now or holding out for the larger payment down the road.

For most, the objective should be to delay benefits until age 70. By waiting until 70, you will receive an additional 8% a year for every year past your so-called full retirement age. If you have planned ahead and have saved enough money to live on, you can retire whenever you wish while still delaying Social Security, thereby maximizing the amount you’ll receive over your lifetime. So for those who can wait to put off retirement, the benefits can be well worth it.

On the other hand, starting to collect your benefits early not only helps you pay your bills, but it gives you more financial choices and the likelihood of achieving the best long-term personal outcome. Collecting early could allow you to pursue investment opportunities that could possibly increase your portfolio.

So why collect early and risk putting your benefits in the stock market when you can make a guaranteed 8% a year simply by waiting to age 70 to collect? While you may have to draw on your resources more by waiting, after 70, you’ll have a greatly increased cash flow.

Should Social Security Switch to a Defined Contribution Plan?

After discussing defined benefit (DB) and defined contribution (DC) retirement plans in class yesterday, I was  intrigued to explore the issue further.  Professor Kimball mentioned that DC plans are starting to replace DB plans, but what is motivating this switch?  And are there any implications for social security?  After a little research, I’ve concluded that, given the growth in life expectancies, DB plans are unsustainable.  As such, firms are necessarily switching to DC plans to avoid insolvency.

This year, the Society of Actuaries released new life expectancies for the first time since 2000.  Since 2000, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase (Professor Kimball joked that we may be one of the last generations to die).  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these outstanding liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and paying down the above mentioned DB liabilities is no easy task.  Considering that life expectancy, and in turn outstanding DB liabilities, is expected to grow further, it’s not surprising that firms are switching to DC plans from DB.  Indeed, while some 60 million Americans are still covered by DB plans, since 1979, DB enrollment has fallen from 38% of Americans to 14%.  In the past decade alone, enrollment in DC plans has more than doubled to include over 40% of Americans.  Given the magnitude of outstanding DB-related liabilities, firms have had little choice but to initiate this switch.

But is the switch from DB to DC a bad thing?  After research, I believe it’s a wash.  That said, did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provide an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”  

That said, if you check my sources, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last 10 years, DB benefits have only outperformed DC plans by 0.86%, with most of this underperformance caused by a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will likely be similar under both options.  That said, I am in largely in favor of DC plans because they eliminate the liabilities associated with DB plans.  So how is this relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions will solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DCB plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work,  instead of paying taxes to fund social security, they will pay witholdings to help fund their own retirement plan.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe indexes (like the Russell 2000 or the S&P 500).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even profession money mangers cannot outperform indexes tracking the market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

I believe this plan effectively addresses the sustainability of social security.  It eliminates the need for the government to pay DB payments in the form of social security.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxed income with government-mandated savings.  While this is not a perfect system, I believe it is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any of your suggestions as we collectively try to address the issue of social security sustainability.

(Revised) The Best Time to Start Investing For Retirement Is Now

While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs?” when starting our savings. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.

Kelly Greene from the Wall Street Journal explains in her article “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should adopt a “U-shaped” pattern in which they invest mostly in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.

This is perhaps useful advice for those who are nearing retirement and worried about their savings, but a more practical factor to consider, especially if you have a long ways until retirement, is how early can you start investing. After inflationary effects, you might want to start earlier than you once thought. In order to illustrate, I ran a short MATLAB analysis of the S&P 500 returns from 1947 (post-WWII) to 2013 using data from the website of Robert Shiller (Nobel Winning Economics Professor at Yale). To obtain the real price level of the S&P 500 index, I first converted the historical S&P500 prices to prices in 2013 dollars using the Consumer Price Index obtained from the Federal Reserve Economic Database (FRED). Here we use the following equation to put all prices in 2013 dollars.

Screen Shot 2014-03-10 at 2.42.18 PM

If you plot the real prices alongside the nominal prices, you get something that looks like this:

S&P 500 Nominal and Real Prices

It’s pretty obvious that inflation eats away at your return. If you invested in 1947 and cashed out in 2013 you would have had only around an 803.8% return over this 66-year period after inflation, rather than the 9633.1% return you’d expect nominally. We can back out the compounded annual percent return by rearranging the equation:

Screen Shot 2014-03-10 at 2.42.30 PM

Using this equation we find that the annual nominal return over this period excluding dividends is ~ 7% and the real annual return is only around 3.35% (see my code for calculations). Therefore, holding on to a few shares of stocks isn’t going to make you as rich (as quickly) as you might think, so it’s even more important to start saving as early as possible. No wonder why Brett Arends of the Wall Street Journal thinks that a lot of amateur investors don’t understand how large their long-term annual returns are likely to be.

It’s also easy to see that when you buy matters. If you bought the S&P in 1973 and sold in 1983 you would have lost roughly a third to a half of your real purchasing power. You would find similar results if you bought in 1999 and sold in 2009, so timing and luck do matter. It also important to take into consideration what you buy. The only ways around this scenario is to a) be patient and don’t sell in a panic, and b) invest in a portfolio that’s diversified across many different markets so that if one market sinks, your entire portfolio isn’t washed away. As Professor Miles Kimball mentions in his blog post “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” this can be done by investing in a low-cost international index fund that diversifies not only across industries but across international markets.

Overall, despite all the popular investing tips that are thrown around by professionals and pundits, it appears that there’s no time like today to start intelligently planning and investing for the future.

Retirement, Savings, and your Nest Egg

Americans, both young and old, ought to be concerned about saving for retirement.  For older people, retirement is drawing near, and thus they don’t have very much more time to save before they decide to retire.  Their last few years before retirement can be the difference between financial security, and running out of money in retirement.  One of the biggest problems in planning for retirement is that as Burton Malkiel suggests in “Random Walk”, perhaps the vast majority of advice about retirement is either bad, incorrect, or bias.  Although there is a lot of debate about how a retiree should allocate their assets in retirement to stocks and bonds, there is no debate about this: people need to save more.  In this post I will very briefly review what Malkiel has to say, along with other good sources, then give what my retirement strategy will be, and finally return to the woefully state of American retirement planning.

As Professor Kimball stated in class, and the above WSJ article state, investing should start early and risky.  Almost all analysts believe that since younger people don’t have to worry about their portfolio running out during a bear market they can tolerate more risk in a portfolio.  Over time, this will bring in higher returns, which over time can make an enormous difference.  As people get older, they should put more weight into safe assets, like bonds; one rule of thumb is one percent weight for your age.  Depending on income levels, you should invest in an IRA and 401(k) to avoid taxes, and thus maximize your profits.

As it stands, my investment strategy will be this:

  1. Start Early: As soon as I graduate, and have a stable job, I will contribute as much into an employer matched 401(k) plan as possible.  An employer matching your 401(k) will help me in two ways.  First, I get free money, and second that free money will incentivize me to save rather than spend my money
  2. Put Equity in the things I Own: Unlike many college graduates, I want to begin investing in a home as soon as is feasible.  Although more financially straining at first than renting an apartment, immediately putting money into a home will save me thousands (or perhaps tens of thousands) of dollars by not gaining any equity from an apartment, and also from the appreciation of home prices.  I never plan on leasing or buying a new car in my life.  I don’t really care very much about having a new car, and I will save thousands over the course of a lifetime.
  3. Do my research:  Unsurprisingly, seeing as I am writing this now, I will be careful about the investments I make.  I plan on following the advice of the adherents of the efficient market hypothesis (like Malkiel), and invest primarily in index funds to achieve stable returns.  As both Professor Kimball and Malkiel suggest, I will stay away from funds that take an unreasonably high commission.  Even .1% or .2% when compounded for decade can add up to thousands of dollars.  I plan on investing in an IRA to defer my taxes to a lower tax bracket later in life.
  4. Be prepared: This is a small step, but I will probably keep a small amount of money (a few months worth) in case of an emergency situation, loss of a job, etc.

The unfortunate truth is that unlike myself, and probably many of you, many older Americans have planned little have saved less, or even nothing for retirement, whether out of necessity, arrogance, or ignorance.  According to recent research, the typical home of a 65-68 year old, “had very little savings, no defined-benefit pension plan (one that pays a set sum each month) and only about $5,000 in a defined-contribution plan (such as a 401k) or Individual Retirement Account. Their retirement basically relies on Social Security and the equity in their homes.”  I only hope that we, as a class, and as a generation, do a better job than the generation before us. 

Delaying Social Security payments: The ongoing debate

We’ve started talking a bit about the importance of saving early for retirement.  It might not be the first thing on most people’s minds upon entering their first job, but not saving for just 2 years can drastically affect how much money is available for retirement later on given the amount of interest that can accrue.  So I thought this recent Wall Street article on collecting social security payments later, would be pretty relevant.

The article is a two-sided argument which considers the merits of waiting until reaching 70 or cashing out at age 62 which is the current minimum age.  The side in favor of waiting until age 70 gave the following three main arguments:  1. Giving away free money  2. Proper financial planning and early saving makes it less necessary to cash out early.  3. A guaranteed 8% return.

The giving away free money argument is based on the premise that since Social security calculates the average of your top 30 annual incomes and pays out accordingly.  Social security also adjusts for cost of living by 1.5% annually so this would naturally accumulate and create a divergent gap than if you were to collect at 62.   The second argument is fairly intuitive in that saving on your own through private funds will allow you to still realize gains until you are 70 and then file for retirement benefits.  Then there is the notion of a guaranteed 8% return when you are 70, which is no different than when you are 62.  Drawing on personal resources from retirement up until age 70 is a bit more of a personal strain but afterwards there will be a big surge in cash flow.  This makes sense for people who are expected to live longer.

While those arguments were made, there were arguments saying that collecting at age 62 is better than age 70.  Most of these arguments were premised around risk and uncertainty, along with the fact that most people do not make enough nor are they expected to live long enough past 70 to make waiting worthwhile.  While payments could be less when collecting at age 62, the ability to collect early allows enough financial cushion to invest in private savings accounts to multiply and have for the more immediate future.  Then of course there’s the argument that social security benefits have a short shelf-life as only spouses can continue to collect on them.  Private savings portfolios can be passed along to relatives or the next generation for their benefit.   After all, social security is just an inter-generational wealth transfer and not an inheritable fund where each person saves for their own retirement.

Based on these two arguments, what matters is whether or not the money you have is enough for how long you are going to live. US citizens are living longer on average and it is possible for them to be able to work for a longer period of their life; however, there is a lot of uncertainty as to how long someone will live and based on evidence or risk-aversion some may opt for earlier payments, even if it makes sense to wait until 70.  Both sides of the cashing-out age argument acknowledge that there could be more private portfolio options for seniors, given the current state of social security and the uncertainty surrounding life expectancy.  The only question is when would they invest and when would they have a better chance of profiting by combining their Social Security benefits with portfolio returns.