CPA Gone Mad Issue 14: March 6, 2017
The Market Is On a Tear; Your 401(k) Alone Is Not the Answer
After President Trump’s address to Congress last Tuesday, everyone thought he sounded “presidential.” The market took off.
Later in the week, a company with $1B in revenues and no profit (Snap, parent of Snapchat) went public and quickly rose to $30B in market value.
This is not rational, but markets are not rational. This could be the start of the euphoria I keep saying will come before the ultimate crash. But that’s not what we’re discussing this week, although the timing is perfect.
This week’s topic is (again) your savings, and why your 401(k) is not sufficient. Your 401(k) might be rocketing higher right now. And you may think everything is rosy. If you’re capturing these gains in your portfolio, great!
But what if the market crashes tomorrow? Are you protected? Will you be disciplined enough not to sell? Are you structured to profit through this rise, survive a crash, and be ready to deploy cash when the market is cheap?
In the coming weeks, we’ll get to some theories I’ve been reading about the market. For now, let’s talk about why you should save outside your 401(k).
A 401(k) Alone Was Not Meant to Be Your Main Source of Retirement Income
Based on feedback I’ve received and various conversations I’ve had with my target audience, I’m hearing that many of you do a really good job of investing in your 401(k), especially with maximizing the percentage that your employer contributes.
If this is you, congratulations! That’s fantastic. You are definitely preparing for your retirement, and taking advantage of free money is something I totally recommend.
But for many of you, that and emergency savings tend to be the end of it. (If you have emergency savings, congratulations — that’s important.) If you’re making your regular contributions to your 401(k) but spending everything else that comes in your paycheck, I’m going to explain why your 401(k) alone may not be sufficient for your retirement.
My goal with this article is to encourage you to plan so you can save more than just what is going into your 401(k). Two weeks ago, I touched on one way to begin looking at this, when I talked about finding 12 ways to save $500 a year starting immediately.
Your 401(k) Was Meant to Be a Supplemental Tool
I recently read an article on wsj.com titled “The Champions of the 401(k) Lament the Revolution They Started.” The main idea behind the article was that the 401(k) was not designed to be a primary retirement tool. It was a tool to supplement a pension plan.
How many of you have pension plans? My guess is not many. Your parents may, but if your parents are younger, like mine, they most likely do not have a pension plan either.
The idea behind a pension plan was that it should cover most of your basic needs in retirement. Then the 401(k) would allow you to save in order to have the money you want in order to live an exciting and enjoyable retirement.
So the idea behind the 401(k) makes total sense. But what happened after the plans were actually implemented is that companies used them as an opportunity to cut costs by eliminating pension plans, which they justified by giving you a company match on a percentage of your 401(k) contribution.
Please don’t interpret this as my being an advocate of pension plans. I’m just trying to explain that your 401(k) was intended to be a supplement to pension plans, not a replacement for them.
The article shares that the problem with 401(k)s is that they expose workers to big drops in the stock market (which you know I expect after the euphoric rise) and high Wall Street fees.
I know this personally. My dad was a religious contributor to his 401(k), but he knows nothing about investing. He trusted the advisor from his 401(k) plan sponsor.
I actually thought my dad was in good shape for a quality retirement. Then 2008 came and his 401(k) tanked. It’s not just the drop in 2008 that hurt my dad. It’s that his emotions couldn’t handle the drop, so he moved all his money out of stocks and into a money market fund.
The stock market today is at all-time highs. Had my dad stayed invested, with the same allocation and contributing the same percentage, he would have recovered all he lost and more, because the additional contributions would have been buying in at low prices that have since risen significantly.
But he didn’t. So today, even though the stock market is much higher than it was in 2007, my dad’s 401(k) is not. He’s now changed his mind-set about how long he needs to work.
And my biggest fear is that as we go through this current euphoric rise, he will hear about how the market is on a tear and decide to put his money back in. Right before a crash …
I’m not trying to pick on my dad. I totally get why he did what he did. But this is the problem with 401(k)s alone as a retirement tool. Most of us are not emotionally disciplined enough to manage our investments through the drops in the stock market.
Will You Be Disciplined Enough Not to Sell at a Bottom?
I’ve written about this a lot before, but I have to say it again. If you’re in my target demographic, you probably didn’t have enough money in your 401(k) in 2008 to be significantly impacted by the crash. So you may not have experienced what my dad did.
But now you probably have a decent amount in your 401(k). And since you’re reaching peak earning years, you’re probably going to substantially add to your 401(k) over the next three to seven years, which is the period during which I expect a crash.
If the market crashes, let’s say you have $200k in your 401(k) and it drops by 75%, down to $50k. Will you be disciplined enough not to sell at the bottom? You can’t answer that until you actually see your balance drop. My guess is that most people will not be, but hopefully you’re different and will be disciplined enough not to sell.
Let’s assume you do sell. This means you’re now starting at $50k that you have to grow over a shorter period in order to reach your retirement goal. According to that same article from wsj.com, “financial experts recommend people amass at least eight times their annual salary to retire.”
Getting $200k to eight times your salary in 20 years is realistic. Getting $75k there in 20 years is not. Especially if you take the $50k out of the market and don’t capture the recovery in the early stages as the market climbs back to where it was.
This is the reality of our emotions, and it’s why I’m trying to get you to read my book and allocate your 401(k) accordingly. I’m trying to get you to understand how this works so you do not sell after a crash but instead take the cash you have from selling some overvalued investments now and buy in right after the crash.
Will Your 401(k) Reach Eight Times Your Salary?
Take a look at these very simple scenarios. Most likely none fits your situation exactly, but that’s not the point, because the facts remain the same no matter what your exact scenario and point in time. If you have better facts, you improve your situation. If you have worse facts, you hurt your situation. And by facts I don’t mean starting salary. I mean annual raise, employer match, your contribution. The point is to show you what your 401(k) returns could look like.
Both scenarios assume you receive a 5% raise every year, that you contribute 6% of your salary to your 401(k), and that your employer matches these contributions 100%. In reality, it’s unlikely that all these factors will occur.
| Salary w/ 5% Raise | 401(k) w 4% Annual Return | |
| Starting Salary $50,000 (23 years old) | $50,000.00 | $6,000.00 |
| Year 5 (28 years old) | $63,814.08 | $35,777.20 |
| Year 10 (33 years old) | $77,566.41 | $89,190.21 |
| Year 20 (43 years old) | $126,347.51 | $277,304.74 |
| Year 30 (53 years old) | $197,519.77 | $642,248.52 |
| Year 40 (63 years old) | $321,738.88 | $1,320,638.10 |
| Current Salary $100,000 (30 years old) | $100,000.00 | $12,000.00 |
| Year 5 (35 years old) | $121,550.63 | $71,554.39 |
| Year 10 (40 years old) | $155,132.82 | $178,380.41 |
| Year 20 (50 years old) | $252,695.02 | $554,609.47 |
| Year 30 (60 years old) | $411,613.56 | $1,294,253.84 |
I’m hearing that fewer and fewer employers are matching 100% of your contributions, and it’s doubtful most individuals will consistently receive a 5% raise. So these numbers are probably much loftier than many folks will actually experience.
But in both scenarios, when you’re 60 years old you have approx. $1.3M in your 401(k). You’re supposed to have eight times your salary. That means you’d be making $162,500 a year at retirement, which may be a realistic salary in retirement. However, in these scenarios, in order to obtain this $1.3M, your salary grew to a much larger amount. If you max out at $162,500, you’re not going to get to $1.3M of savings. You’ll get to only about $1M, or only six times your annual salary.
That’s not all. If you read my asset allocation guide, I mention how the Stansberry Digest referenced an investment advisory firm, Research Affiliates, which stated there’s a 0% chance that you will earn a 5% return on a balanced portfolio (60% stocks/40% bonds) over the next 10 years.
I completely agree with this. If we experience a crash, even if you don’t sell at the bottom, it may take 10 years for the market to fully recover the losses and for you to get back to where you are today. Remember, I believe bonds and stocks are massively overvalued. This doesn’t mean they will not go higher, but it does mean they could collapse at any moment and take a long time to get back to this point.
For instance, the market could go up 100% from today over the next six months, which I’ve heard some people speculate. That would be amazing. But it could then fall by 75%. The odds of you knowing when the crash is coming and getting out are not good. Remember 2001 and 2008.
If this were to happen and then the market returns 10% on average for the next nine years, you’ll be up only 12% from where you are today. That’s 1.2% a year — not enough to achieve your retirement goals. This is why I recommend you allocate 20% of your total portfolio to an extremely cheap asset that can offset a market crash and give you the confidence to remain invested and to buy more at the bottom. My book has all the details.
Side note: If you haven’t read my book, even though it was free because it was only in PDF format, it is now on Amazon. You can get the paperback delivered to your door in two days for only $18.99. And it will be available for Kindle download in less than two weeks.
If we assume 0% return on average for 10 years — which could occur if we have a euphoric rise and crash, and then a 4% annual return — you’re getting to approximately $1.2M of savings. This may not sound too bad but that’s because it occurs early and there’s many years left to compound. But it’s no longer eight times annual salary. And again, this is with a consistently rising salary that ultimately reaches over $300k. If we again cap this at $162,500, you only get to approximately $1M, which is only six times your salary, not the eight that financial experts say you should have.
This is also assuming you don’t sell at the bottom. If you sell at the bottom, your chances of getting to a $1M of savings by 60 are slim to none.
Even if you take the current salary of $100,000 for someone 30 years old and assume that they already have $100k saved in their 401(k), the result does not change drastically. You’d get to $1.4M under this 0% average return for 10 years — but again, only if you don’t sell after a crash.
The point of all this is not to scare anyone, but to drive home the point that consistently contributing to your 401(k) is a great start to retirement planning, but it is not going to allow you to achieve the financial freedom you desire.
Achieving financial freedom is going to take the discipline to save money on top of your 401(k). The examples I show would allow for financial freedom if they were in addition to a pension plan paying you a monthly income along with providing health benefits. But realistically, that’s not going to happen.
Regardless of how old you are today or your current situation, you can still achieve financial freedom. But you have to begin implementing steps and making the choices today in order to make it a reality. And every year you put it off, the harder it gets, because you lose the power of compounding.
In the article two weeks ago, I shared how saving $6k a year starting today for 30 years can compound into $336k. That alone could bridge the gap from your 401(k), which is why I was so passionate in that article. But I think you can do better by allocating your assets in a unique manner.
I hope you read this with an open mind and understand that I’m only trying to show you examples to help you understand why saving today is so important.
My book and these newsletters give you a guide on how to save, invest, and create the best opportunity to maximize long-term wealth building. If you want or need more help, please check out my asset allocation guide, Let Your Asset Allocation Build, or the Palm Beach Research Group’s Wealth Builder’s Club.
I’m going to continue to share and write more articles about how you can get wealthy, because it’s not just by working and saving through your 401(k). It’s a mind-set change.
To your health, wealth, and personal freedom.
Chad A. Walker, CPA, MBA