What percentage of my income do I need to save for retirement?

In the past, retirement income came from three sources; government social security, company pension, and personal savings - the three legs supporting the stool.  But now most young people do not work for a company with a pension plan and they do not trust social security to be around for them.  The stool now has only one leg - personal savings.

A young person today will work for about 40 years (age 25 to 65) and perhaps live another 30 years (to age 95).

So what percentage of annual income does this young person have to save for retirement?  Roughly 50%.  What, you say?  My financial advisor says 10%.  How do you get to 50%?

I was born in 1939.  Since 1939, the annual average yield on the U.S. Government long-term security was 5.47%.  Subtract 25% for income taxes and you have 4.10%.  The average annual inflation rate was 3.91% leaving a real, after-tax return of 0.19% - after taxes and inflation basically nothing at all.

But 1939 was a long time ago.  Consider 2011-2012.  The average annual yield on the 30 year U.S. Government security was 3.41%.  Subtract 25% for income taxes and you have 2.56%.  The average annual inflation rate was 2.35%, leaving a real, after-tax return of 0.21% - still basically nothing at all.  (And that 3.41% average annual yield sure looks good compared to the 0.01% Chase paid me on my checking account balances in 2011-2012.)

So if you want to have $1 after you retire, you better save that $1 while you are working.  In cash - money you can spend at the grocery store - not in home equity.

But how can money have no time-value?  How can a dollar saved and invested at age 25 be worth only a dollar after inflation and taxes at age 65?  Strange, isn't it?  But why should a dollar saved and invested at age 25 be worth more than an inflation-adjusted dollar at age 65?  They just electronically create dollars, don't they?

Seventy years ago, a single dip ice cream cone was five cents.  Now it is $3.00.  An average inflation rate of 6%.  Save most of your money.  Hard times are coming.

Is Jane Bryant Quinn (and every other "financial expert") an idiot?

Jane Bryant Quinn is on the cover of the December 2010 AARP Bulletin. "Make YOUR SAVINGS Last a LIFETIME", it says.

Her article describes "Three smart ways to make your savings last as long as you do".

From this article, we learn several things:

1. "Jane Bryant Quinn is a personal finance expert and author of Making the Most of Your Money NOW".

2. Even though she is "a personal finance expert", she has a "personal planner".

3. Ms. Quinn, a "personal finance expert" (with her own "personal planner", who I assume is also an "expert"), and her husband last year ran a "how are we doing" test "given the hit that the equity portion of our investments has taken in the past decade".

4. COMMENT: I am not a nationally recognized "personal finance expert", and I do not have a "personal planner", but I can assure you that my investments - equity or otherwise - have not taken a "hit" in the past two decades. I retired 20 years ago and my net worth has increased every year.

5. Ms. Quinn describes three "different ways of creating a life-long stream of income". First, there is the "total return strategy" in which you diversify your investments over stocks and bonds in the usual way". Second, there is the "bucket strategy" in which you diversify your investments into cash, certificates of deposit, or an annuity, bonds, and stocks. Third, there is the "income floor strategy" in which you invest in an annuity, bonds, and stocks.

6. COMMENT: Ms. Quinn does not explain why she still likes stocks, even after the "hit" she "has taken in the past decade". The Nikkei average is 74% lower now than it was in December 1989. The NASDAQ average is 49% lower than it was in March 2000. These numbers are not adjusted for inflation; that only makes things worse.

7. Regardless of which of the three "different ways of creating a life-long stream of income" you employ, Ms. Quinn says that you can withdraw 4% per year, adjusted for inflation, from your portfolio. "The magic number is 4 percent. You should plan on withdrawing no more than 4 percent of your total savings in the first year, ... In the following year, raise your take by the percentage increase in inflation. This way your money should last for 30 years, assuming you start with a portfolio invested half in diversified stocks or stock mutual funds and half in diversified bonds, with dividends reinvested".

8. She goes on to say, in the last paragraph of her essay: "What if you realize that your money won't last? There are other options - working longer or returning to work, cashing in the house, adding an apartment over your kid's garage".

9. COMMENT: From "Make YOUR SAVINGS Last a LIFETIME" and "Three smart ways to make your savings last as long as you do", then to "should last for 30 years", then to living in an apartment over my kid's garage"?

In a 977 word essay she has taken me from guaranteed financial independence then to maybe-30-years and then all the way to living over my kid's garage? What the hell happened?


PS: If Ms. Quinn, "a personal finance expert", with her own personal financial planner, can't avoid a major "hit", what chance do you have? Well, you can stay away from stocks, for one thing. My money is in I bonds, TIPs, and bank CDs (just two years ago you could get five year CDs paying 5.25%).

What is wealth? Money or stuff?

Consider two 52-year old men each earning $75,000 per year.

Mr. A lives in a $150,000 house (with no mortgage) and has $750,000 in the bank for a total net worth of $900,000.

Mr. B lives in a $500,000 house (with a $400,000 mortgage), owns a $250,000 vacation house (with a $200,000 mortgage), and has $100,000 worth of stocks (with $50,000 in margin debt), for a total net worth of $200,000.

Why does Mr. A have a higher net worth than Mr. B? Because Mr. B - with five times as much real estate - has been paying five times as much in mortgage interest, property taxes, insurance, and upkeep for many years. And then, of course, there are the travel expenses between houses.

Now suppose they both lose their job, house prices drop 30%, and stock prices drop 75%.

House prices don't just drop; the buyers just all seem to disappear. (One house in my neighborhood has been for sale off and on for more than 10 years and 32% of the houses in nearby Flint Michigan are vacant.)

Stock prices don't just drop 75%; they drop 75% and are still down 75% after 20 years like they are in Japan.

Now Mr. A has a net worth of $855,000 (house worth $105,000 and bank deposits of $750,000) and Mr. B has a net worth of minus $75,000 (house worth $350,000 with a $400,000 mortgage, vacation house worth $175,000 with a $200,000 mortgage, and no stocks (he was sold out to meet his margin call).

Remember, Mr B still has property taxes, insurance, and upkeep costs that are five times as much as Mr. A. And Mr. B still has two mortgage payments each month. Who has wealth and who just has stuff? Who has enough cash to go to the grocery store? Would you rather be Mr. A or Mr. B?

When you drive past an expensive house with an expensive car in the driveway, do you think "that guy has money"? Or do you think "that guy had money"?

What is the money you slave so hard to get actually for? To trade for a bunch of "stuff"? Or to pile up so you can live without fear?

Remember, you do not have to spend money to enjoy it; owning a pile of it is very satisfying. Money won't buy happiness, but is does let you suffer in comfort.


PS: Here are some facts:

1. The Nikkei average was 38,957.44 on December 29, 1989. Today it is 10,285.88. Down 73.6% - 21 years later.

2. The NASDAQ average was 5,132.52 on March 10, 2000. Today it is 2,611.11. Down 49.1% - more than 10 years later.

3. On September 2, 2009, on page R1, The Wall Street Journal published an article that explained that from February, 1969 through February, 2009, investors in 20-year Treasurys, rolling to the nearest 20-year bond and reinvesting the income, would have beaten buy-and-hold investors in the S&P 500 - a 40-year record of bonds beating stocks.

4. On December 6, 2010, on page R1, The Wall Street Journal published an article about investment return projections. And I quote: "Long-term expected annual returns (net of expenses) are 8.79% for stocks and 5.77 % for the remainder of the portfolio, which is invested in bonds.". The Wall Street Journal did not explain how stocks could return 8.79% on average or how bonds could return 5.77% on average or how stocks could beat bonds by 3.02 points - 52% more - when their September 2, 2009 article explains that bonds beat stocks in the past 40-year period.

5. The S&P/Case-Shiller Composite 20 Home Price Index was 206.52 for July 2006. For April, 2009, it was 139.18; down 32.6%. The most recent data is for September, 2010; the index is 147.49. Down 28.6% from the peak. More than four years later.

6. About 20 years ago, I was a 52-year-old man earning about $75,000 per year and living in a house worth about $150,000. I worked in Bloomfield Hills in the corporate headquarters of a publicly-traded multi-national company with about 5,000 employees. My title was Director of Taxes. There were 21 of us at corporate headquarters. The company was acquired by a competitor. All 21 of us were terminated.

Are Stocks The Best Investment?

"One of the loudest critics of the idea of investing in stocks for the long run is Rob Arnott, chairman of money manager Research Affiliates in Newport Beach, Calif. Mr. Arnott, a veteran financial analyst and market pundit, recently wrote an article for the Journal of Indexes that highlighted that bonds have outperformed stocks over long stretches. Mr. Arnott found that from February 1969 through February this year, investors in 20-year Treasurys, rolling to the nearest 20-year bond and reinvesting the income, would have beaten investors in the S&P 500 - a 40-year record of bonds beating stocks." The Wall Street Journal, September 2, 2009, page R1.

Well, OK then. Bonds are better than stocks for the long run. But are bonds good enough?

For the 40-years ending in 2008, the 20-year Treasury returned about 7.73% on average, and the inflation rate measured by the CPI-U (which many experts claim greatly understates true inflation) was 4.55% on average.

So how did the lucky investor who earned that generous 7.73% for the past 40-years actually do? Not very well, as it turns out, as detailed below:

Amount invested (say): $1,000, times 7.73% rate of return, equals $77.30 in annual interest, less income taxes (say 41.14%) in the amount of $31.80, equals interest after taxes of $45.50, less 4.55% inflation in the amount of $45.50, equals the return after taxes and inflation of exactly zero.

Please note that the government has the ability to shear sheep - I mean citizens - two ways; taxation and inflation.

In the example above, income taxes took 41.14% of your return and inflation took the remaining 58.86%. The government got it all!

I used a tax rate of 41.14% in this example because, in 1990, while I was still working, my incremental tax rate was 33% (it would have been 50% except for the Tax Reform Act of 1986) and I believe that the tax rate I used is reasonably representative for this 40-year period.

But if bonds are better than stocks for the long run and if the government takes most, if not all, your investment return through taxes and inflation, how can you ever afford to retire?

Well, if you plan to work for thirty years and plan to be retired for thirty years, all you have to do is save at least half of the money you earn while you are working.

Should I buy an annuity?

An annuity is an insurance company product.  An individual gives money to an insurance company that promises to make payments over some stated period of time and under certain conditions.

A good explanation of the different types of annuities is at www.answers.com, keyword "annuity". Annuity price quotes without having to enter personal data and suffer through numerous telephone calls from salespeople are available at www.immediateannuities.com.

The big risk to the annuity purchaser is that the insurance company will not be able to fulfill its promises. Insurance companies do fail. In 1999, A.M. Best published their research into the failures from 1969-1998 of 640 U.S. insurance companies. Of the 640 failures, they were unable to determine the primary cause of failure in 214 of the cases. Of the remaining 426 failures, the primary cause was "insufficient reserves" (145), followed by "rapid growth (underpricing)" (86), "alleged fraud" (44), "overstated assets" (39), "catastrophe losses" (36), "significant change in business" (28), "impaired affiliate" (26), and "reinsurance failure" (22). Insurance companies don't publicize this risk of failure. One large insurance company has only this one sentence deep inside the fine print: "Any guarantees under annuities issued by TIAA are subject to TIAA's claims-paying ability". In plain language this means: "If we run out of money for any reason, we won't be able to give you any".

One interesting aspect of the annuity industry is their terminology. Whenever they give you any money - even your own - they call it "income". Suppose you put $100 in a savings account at the local bank and one year later you close the account and receive $103. The bank says you have income of $3. The annuity industry says you have income of $103.

All this can be illustrated by a simple example. Immediate Annuities is currently offering a 5 year period certain annuity; you receive payments for 60 months and your beneficiaries will get this payment if you die within the 60 months. If you invest $100,000, your "monthly income" is $1,770. So in 60 months you will receive $106,200 in "income". This is a rate of return of about 2.39% per year. In contrast, Bankrate.com shows a five year FDIC insured certificate of deposit yielding 5.23% - at the end of five years you get back $129,032, an extra $22,832 more than the annuity. If you want to withdraw monthly from the CD, you can withdraw $1,898 per month, not the $1,770 that the annuity would pay. If you withdraw $1,770 per month from the CD, you will have an extra $8,734 at the end of the five year term. In simple terms, choosing the $100,000 five year annuity over the five year monthly withdrawal CD puts all your money at risk and takes $8,734 out of your pocket and gives it to the insurance company.

Would you rather invest $100,000 in a 60 month FDIC insured bank CD with an APR of 5.23% and "monthly income" of $484 or would you prefer to invest $100,000 in a 60 month uninsured annuity with an APR of 2.39% and "monthly income" of $1,770? If you chose the latter, start at the top and read this piece again.

There may be situations where an annuity is appropriate; but I don't know any. There is nothing that the insurance company can do for you inside an annuity that you can't do for yourself outside an annuity - and outside the annuity you save the 2 or 3 points per year (2.84 points in the example above) that the insurance company charges you and you also avoid the risk of insurance company failure.

What, after all, is the value of FDIC insurance to you? Suppose you go down to your local bank to get a 5 year CD and they offer you two products; the first is 5.23% CD backed by the FDIC and the second is a CD not backed by the FDIC. Your friendly banker tells you that with the second product you might lose all your money. How much more yield would you demand to take this risk?

Is this really a risk you want to take at any price? For me the answer is "no". I would not touch an annuity (or any other product where I might lose all my money) with a ten foot pole even if it was someone else's pole.

Buy A House Or Rent One?

The New York Times reported today (July 19, 2008) that: "from 1985 to 2002, the average American home sold for about 14 times the annual rent for a similar home, according to Moody's Economy.com. By early 2006, home prices ballooned to 25 times rental prices. Since then, the ratio has dipped back to about 20 - still far above the historical norm."

I say that the price to rent ratio should be about 8; not 25, not 20, and not 14.

This ratio of 8 depends on the value of money and the direction of house prices. Here is how I calculate the ratio of 8 and how you can adjust the calculation for future events. By the way, I learned this ratio of 8 rule from some very experienced people about 50 years ago when I was selling real estate.

Imagine you are an investor. The investor currently needs monthly rent equal to 1% of the house value. Yes, 12% of the house value per year. The 12% goes roughly this way: 6% or 7% for the money (investor provided and/or mortgage) 2% or 3% for property taxes (depending on local law), 2% or so for repairs, maintenance, insurance, and vacancies, and 2% or so for the investor to cover management, profit, depreciation, and risk. 100 divided by 12 is roughly 8.

If you, the investor, believe that the property will increase in value, you may be willing to take less rent to get the property appreciation. For example, in the farm land boom a couple of decades ago, the farmer could sell his land (no repairs, maintenance, vacancies, building insurance, or building depreciation) to a big city investor and then lease it back for less than the amount of the property taxes. Many farmers sold. Many big city investors were very sorry later.

Suppose you are trying to decide whether to buy or rent a $200,000 house. If you can rent that house for $2,000 per month (1% of the value) you are probably dealing with an investor who expects no major value appreciation (or depreciation). If you can rent that same house at $1,000 per month, you are dealing with an investor who expects 6% annual appreciation and can handle a negative cash flow while he waits - or a desperate owner (perhaps already in foreclosure) who figures that any rent is better than no rent at all.

Please note that there are limits to this 12% of the value per year rule. Suppose you are the investor and you buy a house for $20,000. Do you then ask for $200 per month in rent (the 1% of value)? Absolutely not, you ask for $600 per month. Why? Because the local welfare agencies will pay $600 per month on behalf of their client and the welfare agency pays this amount directly to the landlord. This welfare agency rent amount becomes the local rental minimum amount. This is why slum landlords get rich.

There are other limits to the 12% of value per year rule. Suppose you are the investor and you buy a house for $250,000. Do you then ask for $2,500 per month in rent (the 1% rule)? Absolutely not. Why? Before you bought the house you checked the local rental market and you know you can get much more than 1% per month. This is how landlords in tight rental markets get rich.

With housing, there are two important things to remember. First, a house has no intrinsic value. Nothing, Nada. Picture one of those western mining towns where the building are all still standing but all the people left after the mine closed. No jobs, no people, no value. Second, an income producing property that does not produce income has no value. Nothing. Nada. Picture Detroit. The population was over 2 million. Now the population is under 1 million. Half the people left. Roughly half the houses are empty and abandoned.

Owning a house is said to produce wealth. This is fiction. Renting a house for less than the landlord cost transfers wealth from the landlord to the tenant.

One last point: Do not be fooled by the many "rent vs. buy" calculators available on the web. All the calculators I saw ignore the cost of upkeep, repairs, and maintenance; they just compare the mortgage payment and property taxes to the rent payment amount. If you rent and the roof leaks, or the roof need replacement, or the furnace stops working, or the house needs painting, or the driveway settles, or the carpet needs replacing, you call the landlord and he pays for it, not you.

One more last point: Do not be fooled when someone says "but you can deduct mortgage interest and property taxes if you buy and you can't deduct anything if you rent". People with lots of mortgage interest and property taxes are generally in very low tax brackets such that the tax deduction has little value if they itemize (and no value at all if they take the standard deduction).

One final point: The New York Times article also says that "by the reckoning of Economy.com, enough houses are on the market to satisfy demand for the next two-and-a-half years without building a single new one" and that "in Los Angeles, San Francisco, Phoenix and Las Vegas, house prices have in recent months declined at annual rates of more than 33 percent". I do not want to be the landlord renting at 1% per month - or at any other percentage - in these uncertain times. Do you?

How Much House Can You Afford?

A nation can't be financially strong if most citizens are financially weak. And we all want to live in a financially strong nation. And we all know that most people work their whole life and reach retirement age with little or nothing more than they started with. And we all know that the largest purchase people make is their house. Could too much house mean too little financial security at retirement? So how much house can you really afford?

There are many affordability calculators available. But let us try an independent source; the U.S. Government. At www.hud.gov, there is a linked affordability calculator. If you enter an annual income of $100,000 with no debts, it tells you that you can afford a house that costs 3.8 times your annual income. If you enter an annual income of only $10,000, it again tells you that you can afford a house that costs 3.8 times your annual income. (Need I mention that a person who makes $10,000 per year can not afford a house?) Their definition of housing expense is mortgage payment, property taxes, and property insurance. They ignore utilities, repairs, and maintenance. After accounting for these additional expenses, and considering the annual income tax deductions for property taxes and interest, HUD thus says that a person can afford to pay more than 50% of their net income for housing - a preposterous amount.

I should add that at age 69, I have never purchased or lived in a house that cost or was worth even two times my annual income. I have a fairly big house now, but the happiest time in my life was when 6 of us were in a 864 square foot house. How many square feet do you really need to lie on the bed and watch TV?

At first I thought that the HUD information was merely stupid but now I think it is worse than stupid - I think it is evil. I think that the government wants everyone up to their eyeballs in debt; after all, if everyone is working two jobs to try to avoid foreclosure, who has time to complain about bad government or stupid wars we can't possibly win?