Thursday, May 28, 2015

1099 Income - A Potential Retirement Savior

You have likely seen reports about how financially unprepared the average American is for retirement. According to the Federal Reserve, the median balance of retirement accounts held by Americans who are savings for retirement totals less than $60,000. The same report states that the median value of retirement accounts for families whose head of the household is between ages 55-64 is $103,200, while the median value of retirement accounts for families whose head of the household is between ages 65-74 is $148,900.

Clearly, these median account balances are insufficient to fund a retirement. A 65-year old with a retirement account balance of $148,900 who is withdrawing 4% of that balance each year (a common withdrawal rate) is receiving less than $500 per month. Although most individuals will have Social Security and perhaps a pension to supplement this retirement income, it is likely that many people will need to significantly scale back their standard of living during retirement in order to not outlive their retirement savings.

So what is the best way to give your retirement accounts a boost? Obviously, the basic answer is to save more. However, this is easier said than done for most people.  First, many people simply don’t have money left to save after subtracting expenses from their income. Second, even those who have extra funds face a restriction on the amount of tax-advantaged money that can be saved each year because retirement accounts have contribution limits: individuals under the age of 50 can only contribute $5,500 per year into traditional or Roth IRA accounts (individuals over age 50 can save an additional $1,000). Similarly, employees under the age of 50 who have access to an employer-sponsored 401k plan can only contribute $18,000 to the plan each year (individuals over age 50 can contribute an additional $6,000). These 401k contribution amounts are in addition to any deposits made by the employer.

Due to both a lack of income and retirement account contribution limits, it may be hard for some people who feel behind on their retirement savings to get caught up. However, allow me to suggest a potential way to bump up your retirement account balances – 1099 income.

Income from self-employment is classified as 1099 income. Self-employment income can come from sources ranging from consulting, to providing a service in which you possess a unique skill, to driving for Uber. It is frequently a perfect second source of income in that by definition, you can earn 1099 income on your own schedule. While an employer can require you to work at a certain time, you can literally earn 1099 income whenever your schedule allows. Of course, assuming your expenses remain constant, a second source of income would create more money that can be saved for retirement.

More importantly, 1099 income allows you access to unique retirement plans such as a Solo 401k or a SEP (simplified employee pension). These retirement plans enable you to save a tremendous amount in tax-advantaged retirement accounts – up to $53,000 in 2015! This is incredibly useful, particularly to individuals who don’t have access to employer-sponsored retirement plans like a 401k or 403b. In these instances, the amount that can be saved in tax-advantaged retirement accounts suddenly increases from $5,500 (the IRA contribution limit) to as much as $53,000 per year.

A Solo 401k enables the person who generated the 1099 income to make a tax-deferred contribution to the retirement account as both an employee and an employer. Contributions as the employee are limited to the lesser of the amount of income earned by the individual or $18,000, the 401k contribution limit ($24,000 for people over age 50). Additionally, as the employer, the individual can contribute up to 25% of the employee’s compensation. Combined, the contributions as both the employee and the employer can’t exceed $53,000 in 2015.

For example, consider a 55 year-old that can’t afford to save any of the income from his primary job but also generates an additional $30,000 of 1099 income. This individual would be able to contribute $24,000 of this income to a Solo 401k as the employee, and would be able to contribute the additional $6,000 to the plan as the employer (as $6,000 is less than 25% of $30,000, the employee’s compensation). Consequently, this individual would be able to save the entire $30,000 earned for retirement in a tax-deferred account, which would prevent their tax bill for the year from increasing.

It should be noted that the individual would still need to pay the payroll tax, which consists of both the Social Security and the Medicare tax. Further, as both the employer and the employee, the individual would have to pay the entire amount of both taxes, which totals 15.3%. However, the point remains the same – the additional 1099 income created a significant amount of extra money, of which an unusually high percentage could be saved in tax-advantaged retirement accounts.

For those not looking to save such a large additional amount, a SEP may be sufficient. While a SEP doesn’t allow you to make the $18,000 employee contribution (or $24,000 for workers over age 50), you still have the ability to make the employer contribution of 25% of income. A SEP is slightly more simple to create and maintain than a Solo 401k. Additionally, for individuals who already have the ability to contribute to a primary employer’s 401k plan, a SEP may be a better choice. Such an individual could make the full employee contribution of $18,000 ($24,000 for individuals over 50) to the primary employer’s retirement plan, but still make the 25% of 1099 income contribution to their private SEP plan.

If you are looking to ramp up your savings rate and increase your retirement account balances, creating 1099 income may be an ideal solution. Of course, most people would welcome the second source of income, but the fact that the income can be generated on your own schedule makes this option particularly viable. Further, the access that 1099 income grants to unique retirement plans like a Solo 401k or a SEP, which have unusually high retirement account contributions limits, makes this type of income particularly appealing.

Friday, May 8, 2015

The Market Has Been Flat For Six Months -- Why This is Great News

Investors have experienced a very uneventful 2015. In fact, at market close on 5/7/15 the Dow Jones Industrial Average was at essentially the same value as it was on 12/5/14, up a total of just 0.72% over the six-month period. This lack of fluctuation has been even more pronounced over the last two months. As of the market close on 5/7/15, the S&P 500 has closed between 2,040 and 2,120 for 66 days in a row. Further, between 4/9/15 and market close on 5/6/15, the DOW hasn’t experienced a 1-month high OR low and has traded within a 2% range the entire time (always between -1% and 1%).

Believe it or not, this may be the best pattern possible for the U.S. stock market. History tells us that the market is likely to increase in value over time. If we were to plot the market's value from the time the market first opened to the current day, a chart of those two points would illustrate a return as such:

However, we all know that the market doesn’t provide a consistent return. On individual trading days, the market can either increase or decrease in value, and the range of potential gains or losses is wide. Over extended periods of time, the market’s actual value may be above or below the expected trend line. In fact, the market’s actual historical return may look more like:

Anyone who knows me or reads my blog is likely aware that I am not one to make market predictions. I have no idea whether the market is near a temporary top or is still experiencing an upward trend after hitting the bottom of an S curve in 2008. However, let’s assume the market has reached the top of an S curve and is currently above the trend line that would represent consistent growth (similar to the illustration above).

If that is the case, there are two ways the market could get back in line with the trend line representing consistent long-term growth. The first and most obvious way this could happen is for actual market performance to curve downwards towards the trend line. This would represent a market correction or even crash.

The second, and perhaps less obvious way that actual returns could become aligned with the long-term trend line is for time to allow the trend line to catch up to the actual returns we have experienced since 2008. In this scenario, the market doesn’t slump but remains stable while time enables price-to-earnings ratios, valuations, and the economy a chance to catch up.

Very few investors enjoy or take advantage of a market correction. In fact, most investors lose control of their emotions when the market experiences a drastic downturn, and do exactly the opposite of what they should do: they sell at market lows – hardly a profitable investment strategy. Consequently, if we are to avoid an over-heated market, it is likely better for most investors if the market realigns itself with the long-term growth rate by remaining flat for awhile and allowing the trend line time to catch up.

Allow me to reemphasize that I am not predicting that the market is in fact at a temporary high and above where it should be. I have no idea what the market will do tomorrow, over the next month, or over the next year. That is why I believe investors should have a well diversified portfolio that represents their risk tolerance and that they stick to through thick and thin.

However, let’s look at the other side of the coin and assume the market is still at the bottom of an S curve, below the long-term trend line, and needs to experience further growth in order to catch up. Even in this scenario, an extended period of flat market performance is hardly a bad thing – it would simply make the potential upside needed to get back to market norms all the greater.

It turns out that an extended period of flat market performance may very well be a positive for investors in any environment, regardless of whether the market is currently over or under-valued.

Friday, April 24, 2015

Attention Investors: Don't Get Soft

Do you realize how easy investors have had it lately? There is almost always something happening in the world that can serve as justification for selling investment positions or not investing new dollars. Yet, there hasn’t been many spooky events impacting the markets during the last several months. Let’s examine the investment environment we’ve recently enjoyed.

There is almost always geopolitical current events that are capable of scaring investment markets. While this generation will always have concern about ISIS, North Korea, Iran, Afghanistan, and terrorism, we haven’t recently experienced the kind of negative political event that has immediately sent the stock market into a tailspin. Even stories regarding missile strikes in Gaza have been few and far between. The most relevant international political event of late is the United States’ increased cooperation with Raul Castro and Cuba -- a positive event.

Global economic situations also have the ability to increase volatility in the stock market. Yet, we haven’t recently been bombarded with headlines about excessive debt in Argentina or other countries on the doorstep of financial collapse. Actually, international markets are the big investment story thus far in 2015, with Europe, Asia, and emerging markets outperforming U.S. stocks.

Social tragedies also have the ability to move the markets. I believe the most dominant story regarding social issues of late has been the horrific stories of potential racism and excessive police violence. Of course, these events are shocking and unfortunate, but they aren’t usually the type of stories that impact investment markets. Fortunately, I’m not aware of any school shootings, mass suicides, or broad violent attacks on U.S. soil that have caused a national mourning in 2015. 

Further, there have been relatively few natural disasters such as hurricanes, earthquakes, or tornados that have significantly set back a geographic area or the nation as a whole. In fact, the Weather Channel announced that the tornado count is 59 percent below average year-to-date. There were some large snow storms in the North-East earlier this year, but they had a nominal impact on the direction of the stock market.

Even the U.S. economy hasn’t produced any data that has been particularly frightening to investors. It was all the way back in October that the Federal Reserve announced the ending of its quantitative easing (QE) program, which caused some to wonder if the economy would start to dry up (it hasn’t…). The concern about potentially higher interest rates has been present for so long that it is now old news, and people seem less and less convinced that higher interest rates would significantly stall the economy. Meanwhile, the unemployment rate continues to decline.

Lastly, the stock market itself has hardly provided reason for heartburn. The total return of the S&P 500 has been positive every year since 2008. The index hasn’t even had a temporary pullback of more than -7.27% (9/18/14 – 10/16/14) since 2011, even though the market historically goes through a -10% correction approximately once per year, on average. In fact, the biggest investment concern of 2014 was that small cap and international stocks didn’t make as much as large cap stocks, causing most diversified portfolios to under-perform the larger market indexes such as the S&P 500 and Dow Jones Industrial Average. If your largest investing disappointment is that every part of your diversified portfolio didn’t perform as well as the best performing asset category in the market, you should really focus less on your portfolio and more on enjoying life as a whole.

When we examine the factors that typically lead to volatility in the market, we’ve had a relatively tame past couple of months. My purpose in pointing out this fact is not to imply that the market is in a prime position to continue to do well nor on the verge of dropping drastically when the next sign of uncertainty appears. I simply hope to remind investors that the stock market is not always such a smooth ride.

The most counter-productive action an investor can take is to liquidate their positions after the market drops. I believe the best way to avoid this mistake is to constantly remind yourself that you are investing for long-term results and that short-term (and potentially drastic) volatility is certain to occur. Reminding yourself of this fact now, before the volatility arrives, is likely to increase the probability that you will be able to stick to your long-term investment strategy during both the good and bad periods of market performance.

As Carl Richards points out in his new book The One-Page Financial Plan, no skydiver would try to figure out how a parachute works after jumping out of a plane. Sooner or later, an unfortunate event that will negatively impact the stock market is certain to occur. At that time, remember that just as it always has, the world will continue to turn. Further, remember that the longer you allow the world to turn, the more positive your investment results are likely to be. Don’t let this unusually quiet investment period make you more susceptible to short-term instability once it returns.

Monday, April 20, 2015

Living and Dying on Averages

Never forget the six-foot tall man who drowned crossing the stream that was five feet deep, on average.

We want to abide by averages because they make our lives simple and manageable. A couple on a date night assumes a movie will be an average of two hours long so they know when to schedule dinner with friends. The entrepreneur wants to think in terms of making an average profit of $100,000 per year so he has a guideline regarding the standard of living he can enjoy. The 65-year old retiree wants to assume he will live to the average age of 84.3 so he knows at what pace he can enjoy his nest egg.

However, when we rely too heavily on averages, our planning can go awry. If the movie runs longer than two hours, the couple will be late for their dinner date. If the entrepreneur has a slow year and earns less than $100,000, he may end up taking out short term debt to pay his bills. If the retiree lives past age 84.3, he may outlive his money.

The use of averages is essential in financial planning. A range of assumptions is required in the development of a financial plan – how long will you live, how much will you spend each year, what rate of return will your investments achieve, what tax rate will you pay, what will the rate of inflation be, etc. Without these assumptions, retirement projections can’t be constructed. Further, the best method for making these assumptions is to use averages – an average life expectancy, an historical average rate of return, an historical average inflation rate, etc.

So how do we prevent the use of averages from destroying us? By allowing enough time and repetitions for the law of averages to come into effect. Just because a basketball player shoots free throw shots at a 90% success rate doesn’t mean he will necessarily make the next free throw shot he takes. It does, however, mean that if he shoots 100 free throws he is likely to make 90 of them.

A financial plan may assume you achieve an average annual rate of return of 7% per year. Of course, this doesn’t mean it is impossible that your portfolio will actually lose 10% over the next 12 months. It is critical to remember that the financial plan assumes you achieve a 7% return over the entirety of your retirement, which may be 30 years. Consequently, if a loss of 10% occurs in the first year of retirement, your portfolio still has another 29 years to achieve returns that average out to 7% per year. Thus, a 10% loss is far from catastrophic to your retirement projections.

In fact, the primary way a 10% loss could become catastrophic to your portfolio is if it motivated you to make changes to your investments that would prevent the law of averages from applying. If an investor sold their portfolio after suffering the 10% loss, it would essentially guarantee that the anticipated average rate of return won’t be achieved, and consequently, the financial plan would be likely to fail.

For this reason, while it is true that over an extended period of time the market has averaged an annual return of 10%, we should always remember that there is a significant chance of the market taking a loss during any given year (or three-year) period, and it is possible that the market could endure a decade without any significant gains (similar to the 2000’s). Still, if the financial plan requires an average investment return over an extended period of time such as a 30-year retirement, even these setbacks are far from certain to dislodge your secure retirement as long as time is granted for the average to work itself out.

As famed writer and investor Howard Marks said, “We can’t live by the averages. We can’t say ‘well, I’m happy to survive, on average.’ We gotta survive on the bad days. If you’re a decision maker, you have to survive long enough for the correctness of your decision to become evident. You can’t count on it happening right away.” The use of averages has a purpose in financial planning, and in other aspects of life. We simply need to be confident that the figures we use for our averages are achievable over time, and allow time the opportunity to prove us right.

Tuesday, March 24, 2015

How To Make Your Family Line Rich

Have you heard the story behind the invention of chess?

The inventor brought the chess board to the emperor of China, and the emperor was so impressed he said he would grant the inventor one wish. The inventor had the simple wish of receiving one grain of rice for the first square on the chess board, two grains for the second square, four grains for the third square, eight grains for the fourth square, and so forth. Sounding like a fair and modest proposal, the emperor agreed. However, it turns out that filling the last 10 squares on the chess board would have required 35 quintillion grains of rice – more than enough to bury the entire planet. Unamused, the emperor had the inventor beheaded.

Who knows whether the story is true, but the point is that with compounding, grains seem small at first, modest in the middle, then suddenly overwhelming. In the investment world, what enables compounding? Time.

Let’s review the rule of 72. The rule of 72 states we can divide the number 72 by the rate of return we achieve, and the resulting number will tell you how many years it will take your money to double. For instance, if we obtain a 9% rate of return, it will take eight years (72 / 9) for our investment to double in value.

So what rate of return can we expect when we invest in the market? From 1920 thru 2014, the S&P 500 (a typical measure of the stock market) has returned an average annualized rate of return of 10.31%.* Coincidentally, 72 divided by 10.31 equals 6.9835. Thus, if we had invested in the S&P 500 in 1920, our money would have doubled every 7 years.

What would happen if on the day your child, grandchild, or great grandchild was born, you invested $1 in the S&P 500 but kept it a secret. Assuming the infant lived to age 84, the dollar would be worth:

$2 at age 7
$4 at age 14
$8 at age 21
$16 at age 28
$32 at age 35
$64 at age 42 (still not a big deal, right?)
$128 at age 49
$256 at age 56
$512 at age 63
$1,024 at age 70
$2,048 at age 77
$4,096 at age 84

Over one life span, $1 grew into $4,096. Impressive! Now let’s add three zeros to all figures mentioned. In this scenario we invest $1,000, and after 84 years of the child’s life, you would have $4,096,000 in the investment account. Of course, I suppose you could invest $10,000 rather than $1,000…

The key, of course, is time. The child will have many urges to withdraw and spend the accumulated amount throughout his life. For this reason, the chances of success for this project likely increase if you can find a way to not tell the child for as long as possible.

How fun would this be? Imagine 84 years down the road, long after you are gone, the young heirs in  your family line – who may have very ordinary finances at the time – suddenly get such a massive infusion of assets that they could then use to maintain the family’s stability for generations to come. All due to an amazing, mysterious great, great grandparent with the incredible financial foresight to take advantage of compounding. Now, imagine you stipulate that the heirs can have access to the funds only if they take a fourth of the resulting investment account and repeat the process!

Think of compound interest as a bunch of tiny personal employees that work extremely hard for you both day and night, and mate like crazy!

Tuesday, March 10, 2015

Is the Stock Market Rigged?

I recently had dinner with a friend who abruptly asked “is the stock market rigged?” As I attempted to fully understand his question and address his concern, he ultimately said “if someone makes money by conducting a trade he wins, and if someone wins, doesn’t someone have to lose?” This viewpoint was preventing my friend from investing in his employer’s 401k plan or an individual retirement account.

While I can see the logic in my friend’s viewpoint, I don’t think it is accurate. Many people are reluctant to invest because they don’t want to be on the losing side of an investment, opposite a more experienced and skilled investor. This hesitancy likely stems from the fact that investing in the market requires the purchase of an intangible asset. However, I believe the same reasons that make purchasing a more tangible asset like a home worthwhile also apply to investing in the market.

When an individual purchases a home, he does so for a reason – he needs a place to live. For most people, the need to put a roof over his head is more of a driving force to buy the home than because he believes the current price is lower than the home’s actual value. The person only sells when his needs are no longer matched by the home – perhaps because the individual has retired and wants to move to a warmer climate or have a yard that doesn’t require much maintenance. When he sells, assuming enough time has passed since the house was purchased, the individual hopes to sell the home for more than he paid for it.

Assuming the individual does sell the house for more than he paid for it, does that make him the winner and the new purchaser of the home a loser? Of course not. The new purchaser is buying the home to fill a need, just as the original purchaser did. Similarly, assuming the new purchaser owns the home for a long enough period, chances are pretty good that he too, one day, will sell the home for a profit.

When we examine the purpose of investing in the market, it is very similar to why we purchase a home. First, we invest in the market because we have a need – to not outlive our assets. Again, for most people, the need to save for retirement is the primary reason we invest, not because we believe the market is particularly undervalued. Similarly, we only sell our investment when it no longer matches our needs – perhaps because we need to convert the asset to a more liquid and tangible asset (cash to buy a car), or because the investment has become more risky than we are willing to tolerate later in life. Just as the home provides a benefit (a place to live) while it is owned and is later sold at a higher price after enough time elapses, our investment in the market provides a benefit (dividends) while it is owned and is later likely sold for a higher price after the passage of time.

Again, just because the selling market investor sold the asset for more than he paid for it doesn’t make the purchasing investor a loser. The purchasing investor will benefit from the same dividends the first investor collected, and if he holds the investment long enough, will also likely sell at a profit when the investment no longer meets his needs. When the market continues to increase in value after the first investor sells, it doesn’t make the seller a loser. He is still a winner in that he made a profit from investing in the market and was later able to exchange the intangible investment for a more tangible asset like a new car, an exotic vacation, or simply the ability to not outlive his money.

There is, however, a factor that can potentially cause a winner/loser scenario with both the purchase of a home and an investment in the market – time. After buying a home, we are much less certain that the home’s value will have increased after only a month as compared to ten years. The impact of time is the same when investing in the stock market. We can be far from certain that the market will increase in value after only a day, month, or even a year. However, you’d be hard pressed to find a ten-year period when a diversified investment portfolio didn’t increase in value to some degree. Consequently, while both buying a home or investing in the stock market to make a quick profit is far from certain, history tells us that doing either to fill a need and with a long-term investment horizon is likely to yield a win-win situation.