Tuesday, March 3, 2015

Straightening deck chairs during the "retirement crisis"

Here's Eduardo Porter:

On average, a typical working family in the anteroom of retirement — headed by somebody 55 to 64 years old — has only about $104,000 in retirement savings, according to the Federal Reserve’s Survey of Consumer Finances. . . . 
The standard prescription is that Americans should put more money aside in investments. The recommendation, however, glosses over a critical driver of unpreparedness: Wall Street is bleeding savers dry. 
“Everybody’s big focus is that we have to save more,” said John C. Bogle, founder and former chief executive of Vanguard, the investment management colossus. “A greater part of the problem is the failure of investors to earn their fair share of market returns.”

So people are approaching retirement with $104,000, and "a greater part of the problem is the failure of investors to earn their fair share of market returns." What are we talking about? Bogle and Porter suggest that the real problem is about active vs. passive management.

I'm not kidding. That's what the article is about (despite its title).

This is what I'm talking about when I say that the early retirement people have shown that the emperor has no clothes. Do Porter and Bogle really want us to believe that the main reason people are trying to retire on $100 grand is that they haven't made sufficient use of passive funds?

Really? Really?!

I'm as big a fan of passive management as anybody, but this is totally absurd. This sort of logic is straightening the deck chairs on the Titanic. What would the average nest egg be if everyone had chosen the right fee structure and asset allocation? Whatever it is, it's not going to get anyone very far in retirement, particularly if they're accustomed to spending money at the kind of rates that lead to having such a small stash at that age. Porter and Bogle even reveal the real problem with their own example:

Assuming an annual market return of 7 percent, he says, a 30-year-old worker who made $30,000 a year and received a 3 percent annual raise could retire at age 70 with $927,000 in the pot by saving 10 percent of her wages every year in a passive index fund. (Such a nest egg, at the standard withdrawal rate of 4 percent, would generate an inflation-adjusted $37,000 a year more or less indefinitely.) If she put it in a typical actively managed fund, she would end up with only $561,000.

But even $561,000 would be a massive improvement on the status quo, and we're talking about someone who started at $30,000/year. Where's the example where active management reduces a $927,000 nest egg to $104,000?

By all means, don't throw your money away on active management, and don't waste your time trying to pick stocks. That stuff matters at the margin. But that particular margin is insignificant compared to the problem of low savings rates. And the early retirement people have shown that almost everyone could easily hit a higher savings rate. The journalists who tell people that the problem is the banks, or the government, or stagnating incomes, or anything other than savings rates are doing people a huge disservice (see MMM on this topic).

I understand the urge to do something about Wall Street misleading savers. I understand the role that journalists can play in showing people that they're getting duped; I even understand why some people want the President of the United States to do something about this. But if Porter's readers are relying on changes in banking or policy to save their retirement, they are totally screwed.


UPDATE: First, check out the comment by "ed" in my comments section. Second, Noah Smith responds:

Ryan is wrong to say that this makes Bogle and Porter's argument invalid. Actually, Bogle and Porter have a good argument.

Noah then proceeds to explain how switching from active to passive management is basically a free lunch, allowing people to have higher total lifetime consumption without having to save an extra dime. I agree! But Noah isn't reading me--or Porter--very carefully.

I'm not saying that switching from active to passive management isn't worthwhile. Do it! I'm a huge fan of Bogle, and all of my retirement savings is in Vanguard passive funds. I'm also not saying that people should want to have larger nest eggs. Rather, I'm responding to Bogle and Porter's actual argument. Porter's piece isn't just telling people to switch from active to passive. Porter and Bogle are selling passive management as the solution to huge shortfalls in retirement saving. Let's see what they actually say:

That’s not nearly enough [meaning, the average nest egg of $104,000 isn't "enough"]. And the situation will only grow worse. . . . 
The Center for Retirement Research at Boston College estimates that more than half of all American households will not have enough retirement income to maintain the living standards they were accustomed to before retirement [this seems to be Porter's definition of "enough"]. . . . 
The standard prescription is that Americans should put more money aside in investments. The recommendation, however, glosses over a critical driver of unpreparedness: Wall Street is bleeding savers dry.

The context suggests that "prescription" here refers to the remedy for massive shortfalls in retirement savings. Noah is annoyed because it looks like I'm telling people that they should want to save more, when maybe they're actually happy with their current rate of savings. But I'm not doing that. Porter is starting with the assumption that nest eggs are far too small. I'm taking his premise as given and simply pointing out the obvious: if people want to "have enough retirement income to maintain the living standards they were accustomed to before retirement," switching from active to passive isn't going to do it for them. Porter isn't just saying that passive management is a good idea; he's portraying it as an alternative to saving more if people want to have his definition of "enough" retirement money.

It's a pretty simple point. I'm not moralizing about whether people should have a huge nest egg. I'm just saying that if they want a huge nest egg--which Porter and Bogle are clearly taking as given--then the only prescription that can get them there (compared with the current average) is more cowbell, I mean saving. If you're happy being poor in retirement, by all means don't change your savings habits--and keep your stuff in passive since it's basically a free lunch compared to active. But if you want a lot of retirement money, you need to save more. That's a much higher priority than getting the fee structure or asset allocation just right.

Noah's other argument is that telling people to save more is assuming we know better than they do what they want. If they don't want to save more, stop moralizing! It's ok to tell them to switch from active to passive because they may have been making that choice based on limited information or behavioral blinders. That's fine. Again, I'm taking preferences as given--Porter is the one assuming that people want larger nest eggs, and I'm just pointing out the unpleasant fact that if we think $104k is several hundred thousand dollars too little, reducing fees isn't going to suddenly give us enough.

Moreover, we can just as easily justify the save-more moralizing in terms of limited information: Maybe people are making their current savings decisions because they actually think they are on track for a big nest egg. Maybe part of the reason for this misconception is that people like Porter keep writing articles telling everyone that it's not their fault their nest egg is tiny--if only they'd used Vanguard they'd be sitting on a million bucks! Showing up for retirement with $100k in the bank then complaining that fees kept you from having your pre-retirement living standard in retirement is like losing a basketball game by 60 points then blaming the loss on the referee because he called one too many fouls on you. The ref should make accurate calls, but you just needed to make more shots.

I'm also responding to a broader sentiment suggesting that it's impossible for the middle class to have enough money for the retirement they want. It's all doom and gloom about how the middle class is totally screwed by forces beyond their control. But Bogle's own numbers in the Porter article reveal that even people on low income can accumulate a large amount of savings in time for retirement by putting away just 10 percent of their income. Maybe Noah is right and people are happy with tiny nest eggs. Or maybe Porter and Bogle are right that people want more. I don't care who is right: either way, the doom and gloom stories are misguided.

The bottom line is that it's hugely misleading for Porter and Bogle to start from the assumption that people want enough retirement savings to preserve their pre-retirement standard of living, then to suggest that the main thing standing between having $104k and having the appropriate amount for the goal is active management. That's what they're suggesting (Bogle: "A greater part of the problem is the failure of investors to earn their fair share of market returns"), and that's what annoyed me about the article. Bogle isn't doing his job as an investment guru, and Porter isn't doing his job as a journalist.

9 comments:

  1. I agree, and the problems with the piece are even worse than you say. You can see that by playing with a retirement calculator like the one here:

    http://www.bankrate.com/calculators/retirement/401-k-retirement-calculator.aspx

    It appears they are assuming active management brings a performance drag of over 2% per year. That seems way too high. There may be some funds that are that bad, but it's not really a matter of active vs. passive, there are some index funds that have high fees as well. Check out this steaming pile of crap from JPMorgan:

    https://www.jpmorganfunds.com/cm/Satellite?UserFriendlyURL=fundoverview&pagename=jpmfVanityWrapper&cusip=4812C1546

    Even worse, the 7% real rate of return is way too high! (Or maybe they are doing a nominal calculation, but I don't know why you'd want to do that for this kind of problem.) The current CAPE yield is under 4%, and in the past that has been a decent guide to long term returns, if you adjust for valuation changes. Plus if you do a target date fund or some such bonds/stocks mix, you probably don't even get that.

    So lets assume that generously you get a 4% real return, $30K salary with 3% real income growth (which is maybe too low at first but too high later), and 10% savings rate. According to the calculator, you can retire at 70 with $473K. If fees caused a 1% drag so that real return falls to 3%, you'd end up with ionly $387K.

    To get back up to $473 with the fees, you'd have to save 12.25% of income instead of 10%.

    So that's what we're talking about, an extra 2.25% of income saved. You are right, it saving rates that are the problem, not the drag from fees.

    (I should say that despite all this, John Bogle is still one of my heroes.)

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    1. Wow, yes I didn't bother to run the numbers. Pretty extreme assumptions.

      And I agree--huge fan of Bogle as well.

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    2. I don't see why you would consider 4% real too high a hurdle - even August 1929 to August 1969 was a 5.922% dividend reinvested, inflation adjusted return on the S&P 500 - and that's for a lump sum. A 0.06% management fee wouldn't hurt that too much (but, yes, 2.27% would be pretty bad).

      Consider that you'd also have invested through some poor valuation years - high valuations would do the most damage to today's 20-somethings if 3# years from now valuations were low, and had stayed high the rest of the time.

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  2. There's another element coming in here too -- whether the retiree or their spouse, having amassed a half million by careful lifelong investment, needs medical or nursing home treatment. Medicare doesn't cover long term care. Such needs will wipe out that savings in less than two years*, leaving no inheritance and leaving any real estate subject to sale towards Medicare Extended Care expenses, once the surviving spouse passes away. The careful savings cannot be gifted to children or others within six years of entering Extended Care, or it will be clawed back from them. That savings must be spent down before Extended Care can even be applied for. (What income the surviving spouse will use to maintain the household I am sure I don't know.)

    For all practical purposes, the savings of a large number of retired Americans consists of government programs, NOT whatever cash they have squirrelled away. If they are financially savvy, their best bet for ensuring an inheritance to increase generational wealth has to lie outside of formally tracked financial vehicles.

    Noni

    * example, my mother, whose nursing home fees were about $1,500 a week until Extended Care cut in. Think ahead!

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  3. What Ed said.

    Returns, savings and raises are all rates which are highly sensitive. Note too that raises are assumed at 3% (valorous, since incomes at that wage level have generally not tracked inflation). And speaking of inflation: we assume *increases* with inflation, but the final result is in nominal terms and not real terms. An honest examination would state the result in nominal terms and note that 37K/year adjusted for inflation would be quite small *or* would do the calculation with real returns. In any event 7% is way too high for a prudent portfolio with some fixed income and a reasonable equity premium given the current high PE.

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  4. How in the world are low income (or middle) supposed to save their way out of this problem when real incomes have been stagnant for over a decade? This is a social problem, solutions requires more social insurance and support, not fantasy of individuals saving their way out of the problem. And adding long-term care and health issue just makes it worse.

    --Rick McGahey

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    1. I'm sympathetic to that argument, but it's only real gross income that's stagnant. When you redo the math for disposable income you'll see that it's been stagnant for 6 years (not 1980 or 1965 or so, depending on your deflator).

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    2. Rick--constant real incomes over time does not justify increasing the doom and gloom. If it's true that real incomes have been flat, then it shouldn't be harder to save for retirement now than it was a decade ago.

      In any case, go look at the early retirement people's numbers. Jumping off the hedonic treadmill makes retirement savings possible at almost any American income (the lowest of rich is better off than 80% of the world).

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  5. I like your argument against the "doom and gloom" bringers, but I think the fees make a bigger difference than most realize, gloom aside.

    First, against the Bogle arguments - 0.06% on the Vanguard fund (it's 005% now) - that wasn't available back in 1980, when our current investors started, and it's not available to all Vanguard investors. Admiral shares have a minimum, otherwise they are .17%.

    Now, for the Bogle arguments - if his 2.27% effective fee is close to correct, that's a massive giveaway. I did the math on Noah's blog, but doing it with the S&P 500, the 0.06% fund would leave our heroes with $195,420.04 if they started in February 1980 and invested in some theoretical S&P 500 fund. So, increase your investment by almost double, or just pick a cheaper fund.

    As for 'how much to save'? I walked through it in his comments as well - my guesstimate is roughly $270,000 for a 60 year old headed household retiring in 6 years and making $54,000 today. That's factoring in an 8% savings rate and whatever Virginia's state taxes look like (figured VA was neutral).

    If we use these reasonable guesses, that gets our household to more than 2/3 funded from a bit more than 1/3 - and hey, maybe they pay off their house soon and are just fine expense-wise, who knows.

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