Crack in the Foundation #2 - You believe that your 401K/IRA, etc. is important to your retirement. Unfortunately this is rarely true. Your 401 K/IRA is a very important RAINY DAY FUND.
You can't do this Life Test today but over the next few weeks, just ask friends or relatives you have that are over 60 years old, "If it takes $40,000 per year to live before taxes, and you have to pay taxes on your 401K and IRA's, how long could you survive without social security?"
If you succeed in finding TWO of 10 people who don't live in the same household that have $120,000 stashed in their retirement accounts...you will have defied the odds. Congratulations. You have TWO friends who can live THREE years. Excellent...until the third year...or not at all if it's the other friends.
Most people don't realize that they really do need $1,000,000 stashed to live 20 years at $50,000 per year; and that million bucks is 100% taxable by Uncle Barak.
But wait, does that mean that having a 401K or an IRA is a BAD THING?
Certainly not. Having stashed a few bucks away is a very good thing indeed. BUT...People have this funny brainwashing problem going on that "compound interest" "over time" will make them rich.
It won't.
It can't.
Anyone who tells you compounding will make YOU rich is suffering from a simple mathematical delusion. They get the concept of compounding, but they are compounding at the incorrect percentage rate.
Let's say that $20,000 was put into a magical investment for you that guaranteed 7% per year over 20 years. How much would you have at the end of the 20 years in your company 401K, assuming they didn't skim from or straight out steal your money?
Well, you know about The Rule of 72 better than I do. Take 72 divide it by 7(%) and you end up "doubling your money" in 10.1 years. So you QUADRUPLE your money in 20 years! WOW.
That SOUNDS SO COOL!
1 dollar turns into 2 and 2 turns into 4. Sounds cool in theory...
Except that isn't real and it can't happen.
Nope, you see there are three things that you don't know about...at minimum that caused that to not happen. (There's one devastating bonus disaster too...but I'll come to that in a minute)
The Rule of 72 is REAL BUT IT IS ALSO A MATHEMATICAL DELUSION.
Here's what was missed...
Inflation. Let's say inflation was 3% per year just for argument sake. I know it's not. JUST PRETEND.
Fees of the company running the 401K. Let's call it 1%. It's often more, but PRETEND it's 1%.
Fees of the mutual funds the company running the 401K is putting the money in, including the sales commissions paid to the company from the mutual fund companies? 2% and often waaaaaay more. BUT
PRETEND it's only 2%.
...and let's also pretend there are no sales charges for the funds...another stretch but work with me....
and the most painful of all?
These fees are all annual....not one time shots.
GULP.
Now, do NOT get me wrong. People DESERVE to get paid to take GOOD CARE of your money.
Companies that are steadfast, loyal and true, DESERVE to be paid to invest your money.
If people take GOOD CARE of your money, they deserve to be paid. Agreed? I LOVE FINANCIAL PLANNERS. THEY ARE THE NUMBER ONE READERS OF Coffee with Kevin Hogan. I respect...the very good ones.
Obviously, most financial planners are like most doctors or teachers or dog catchers or motivational speakers.
They are....average.
Now, I could show you the real numbers as to how this completely breaks down, but it gets a bit disheartening.
The fact is if you put your $20,000 in and then strip out all the fees and inflation, you end up with nothing at a "7% guaranteed return." (Really, you end up with A LOT less, but all that for later.)
Nothing. Zip. Nada.
3% inflation + 1% fees + 2% management fees = 6% lost which offsets 7% gained.
And NOW YOU MUST PAY TAXES ON THE $20,000!
These are just pretend numbers. I'm telling you that. Did your planner?
The next crack on this side of the foundation is that 7% is high. Way high.
No one can guarantee you 7% per year. (They can, but they will go to jail and their company will go bankrupt like so many pension funds and 401K "plans" do...Your money will go POOF.)
Real life?
I'm going to speculate that the market, (The DOW) will be at 10,000 by the end of the week.
So the DOW "mutual fund" ends the week at 10,000.
Using the numbers we just ran through, what would the market have had to have been 20 years ago to make 10,000 dead even? No gain. Not losing money...not gaining money.
Take the 10,000 and divide by 4. (Quadruple remember?)
Right.
2500 in October of 1990 would make 10,000 on the DOW dead even 20 years later.
Simple so far?
2500 on the Dow in 1990, plus inflation, plus mutual fund fees, plus corporate planner fees, plus 20 years = 10,000.
And that's exactly where it was!
So in a sense the market did "return" 7% per year!
TWENTY years ago, you stuck ALL of your retirement money in the DOW, the safest of all the stock investments, and you end up 20 years later with the same purchasing power as that day 20 years ago.
You are sitting pretty with $80,000 (plus any dividends!) in 2010 and feeling....well...that's two years of life...and now you have to pay taxes on that $80,000.
Taxes will strip away about 1/3 to 55% of that, depending on where you live.
Let's say you earn no other money from anything in retirement. So you only pay taxes on $40,000 for two years which is about 28%. You still end up living for two years with about $30,000 for each year.
Then, whether you are going to have to use...social security? Well that's for another day. I guess it's possible. My step dad gets $900 per month from Social Security. That's living pretty high on the hog...
The fact that becomes clear in this Crack in the Foundation (#2) is that:
Everything you BELIEVED about investing turned out to be wrong.
This was the most painful "I was wrong" in my life. I quoted compounding and taught that back in the 90's and I "believed" it like I believed religion because MATH is MATH except when you forget to factor in INFLATION and TAXES and the STABILITY of the CURRENCY and MARKET CRASHES.
I was wrong. I did the math PROBLEM...I just skipped the next FIVE PROBLEMS on the other side of the paper. I was wrong. I've said it a million times. I'll say it a million more. It's humbling.
In fact, it's not just you and me, it's Corporate America, too. They started promising workers "pensions." A pension is free money that is given to someone in return for doing nothing. The idea is that the company will stash money in investments that will return 10-12% per year.
And I tell you what...if anyone could do THAT you could get wealthy....but it isn't real. And that's why pension plans have lost all their employees/client's money.
For whatever reason, seemingly smart people were caught off guard and shocked that they had been lied to for decades....the market doesn't return 10% per year.
Turn the page for Crack in the Foundation #3: The Big Disaster ...before a Solution
Coffee cup photo appears under license agreement with Stockexpert.com. Stock photography for the article on this page appears under license agreement with istockphoto.com/Nustock.
Cool Article?
Get Coffee with Kevin.
Articles, events & more!
+ 2 Free e-books today!
E-zine delivered Mondays.
"Every week, Coffee with Kevin Hogan is a must read. I particularly liked your article on the Can-Doers and the No-Doers. Thanks!" Sharon McGann, Sydney
You can't do this Life Test today but over the next few weeks, just ask friends or relatives you have that are over 60 years old, "If it takes $40,000 per year to live before taxes, and you have to pay taxes on your 401K and IRA's, how long could you survive without social security?"
