A note arrived from a long time Invest-Notes reader claiming bragging rights for having an IRA that did much better than the S&P 500 in 2016. His plan, he explained, was to begin spending more time “managing” his investments since he had “cracked the code” on “beating the markets.” When pressed to explain his methodology for calculating the return earned on his IRA he replied simply, “I took the account value on January 1 of this year and subtracted the account value from the previous January 1.”
There is much to laude in this this narrative. Making regular contributions to retirement accounts and monitoring the performance of these accounts are things we should all be doing. None the less, my spidey-senses were tingling and I pressed for a bit more detail. Did he make the maximum contribution in 2016 ($6,500 for those of us over a certain age)? Yes, and he was just sorry not to have made the contribution earlier in the year. Had dividends been included in the calculations? They had not, but this just proved that the returns were even better than originally calculated. How much trading occurred during 2016 in this account? Clearly not enough considering how well those few trades played out.
According to the Employee Benefit Research Institute the average IRA balance for someone around 55 years old is about $100,000. A late start in saving for the future meant this particular account was below average. But just how much money is needed for retirement? There is a simple calculation in the terrific new book, Right Away and All At Once by Greg Brennenman, that everyone should know about. Calculate what your annual income after you leave the workforce will need to be to maintain your current lifestyle. And don’t kid yourself, there’s not going to be any big decrease in your spending level.
Assume a 5% annual return on your savings – again, don’t kid yourself – and the calculation is straight forward. So if you want to have $160,000 in annual income, you need $3.2 million dollars in your IRA (or whatever savings vehicles you have). You can use whatever number you want, this is just the example in the book. Which also provides the wise counsel, “It is not lost on me that the average household income in the United States is less than $160,000 per year; we all tend to want more than we have. Happiness always seems to be right around the corner.”
It turns out that when calculating the returns on his IRA, this investor included the $6,500 contribution as a return on investments, which it was not. Meaning around 7% of the calculated returns came from his annual contribution. In fact, the S&P earned north of 11% last year and in this case, the actual return on his IRA investments mildly underperformed the S&P. Yet this story does have a happy ending.
First, more things are going right than wrong. His annual IRA contribution for 2017 has already been made and the decision to begin doing more trading in the account has been shelved. Additionally, an effort will be made to set aside some additional savings towards retirement. Second, a healthy dose of reality is good. We all want to be above average, which is a tough goal to reach statistically. The whole point of investment vehicles like indexed exchange traded funds is that average is not a bad thing for most investors. We also tend to overlook account fees and transaction costs, which have an outsized effect on smaller investment accounts.
Finally, and perhaps most importantly, this investor didn’t blame the messenger. We had a constructive conversation and he plans to continue as an Invest-Notes reader. My thanks go to all of you readers for making these kinds of interactions possible.