Is Thomas Stanley's Wealth Index (WX) a valid indicator?

In his recent book, Stop Acting Rich, Thomas Stanley (author of The Millionaire Next Door), describes his "wealth index," a measure that he says gives people a good indication of whether they are on the right track to financial independence.

The formula is:  Invested assets should be greater than or equal to 10% times your age times your income.

So, according to the index, if you are 50 years old, you should have 5 times your income in invested assets.

Is this a valid formula?

In my experience, this formula is a reasonably good "first look" for people under the age of 50.

For example, a 40 year old making $100,000 per year with $400,000 invested is probably doing pretty well, assuming he accumulated that amount via a frugal lifestyle, and continues to save and invest.

Like most rules of thumb, though, it is too simplistic and doesn't capture the myriad variables associated with financial planning.

Is he married?  How many kids does he have and is his wealth going to be used to send them to college?  Does he have any income sources during retirement?  How long does he plan to work?

Additionally, the formula tends to fall apart for most people over age 50 (the formula is linear but the mathematics of retirement investing are not).

Example:  according to the formula, a 65 year old making $100k should have $650k invested.  If he retires at that age, he can reasonably expect to safely draw 4%, or $26k from his portfolio in the first year.... way short of the $100k he's used to earning.  Social Security, pension, and other income sources might make up the difference but as in the case of the younger person, it depends greatly on a number of variables that are specific to each person.

In Dr. Stanley's defense, the point of the WX indicator is to segregate large samples of people into different categories to further study the behavioral traits that characterize certain groups.  It is not intended to replace an individualized financial plan.

Bottom line:  The WX indicator is a fast, easy way to see if you are falling short of a prudent savings path.  It should only be used as a negative indicator-- if you fall short, you are likely NOT on the right track, but if you exceed the threshold, it doesn't necessarily mean that you are on the road to financial independence.

Social Security "do over" provision officially coming to an end

SSA revises withdrawal policy

It's official. On Wednesday the Social Security Administration published final rules, effective immediately, that limit the time period for beneficiaries to withdraw an application for retirement benefits to within 12 months of the first month of entitlement and to one withdrawal per lifetime. In addition, beneficiaries entitled to retirement benefits may voluntarily suspend benefits only for the months beginning after the month in which the request is made.

The agency said it is changing its withdrawal policy because recent media articles have promoted the use of the current policy as a means for retired beneficiaries to acquire an "interest-free loan." However, this "free loan" costs the Social Security Trust Fund the use of money during the period the beneficiary is receiving benefits with the intent of later withdrawing the application and the interest earned on these funds. The processing of these withdrawal applications is also a poor use of the agency's limited administrative resources in a time of fiscal austerity—resources that could be better used to serve the millions of Americans who need Social Security's services.

Although the new rules are effective immediately, the agency is providing for a 60-day public comment period. The agency will consider any relevant comments received and publish another final rule to respond to comments and to make any appropriate changes to the rule.

See the Federal Register for a complete discussion of the rule change.

Thank you to Elaine Floyd, CFP® for highlighting this new change.

 

Social Security "do over" may be going away

A little-known provision of Social Security that allows retirees to "pay back" their benefits in exchange for a higher, delayed benefit may not be an option much longer.

The SSA is scrutinizing the loophole and may act within a few months to drastically limit its use.

Read the Kiplinger article "Social Security Payback Option May Disappear."

Time diversification: Does time decrease the riskiness of stocks?

Investing in stocks is risky.  But does equity risk decrease as your timeframe increases?

Yes.  or No.  Depending on how you define risk.

"In the end, the time diversification debate can be restated as a debate over opposing views of risk. Supporters of the time diversification perspective perceive risk as the chance that an equity portfolio will underperform a low-risk portfoli

The historic record suggests that such risk declines with time. Critics of time diversification perceive risk as variations in the final wealth value of a portfolio and uncertainty about the returns investors will experience during specific time periods.

The historic record suggests that the range of such outcomes, from best to worse, widens with time."

Read the entire Vanguard article, Equity risk and time:  A survey of U.S. investors.

The bottom line is that investors need to view equity risk in light of both of the above definitions.  An appropriately balanced portfolio that includes stocks, bonds, and cash is the most sensible way to protect against both market volatility (or "sequence risk"), and inflation.

 

At least it's not 1966 (as far as we know)

1966 was an infamous year in investment history.


For any retirement period duration from ten to fourty-four years commencing that year, 1966 produced the dubious distinction of the worst possible retirement year in recorded market history (going back to 1926).
 
Worse even than any year prior to, or during, the great depression.
 
The combination of brutally high inflation throughout the entire decade of the 1970's and early 1980's and an abysmal bear market during 1973 and 1974 (with a subsequent excruciatingly slow recovery) produced the ultimate portfolio stress test.
 
Two takeaways, one fairly obvious, and one more subtle:
 
1)  If you want a historical "worst case" scenario to stress test a portfolio, start with 1966.  Sure, the future could hold something worse, but if your portfolio can sustain you to a ripe old age under the worst that history has served up (so far anyway), you're probably in a pretty good place.
 
2)  Think back to the environment on the eve of 1966.  The country had begun to heal from losing President Kennedy to an assassin's bullet.  The Cuban Missile Crisis had been averted and the backyard bomb shelter building craze had come to an end. 
 
The United States' ground participation in the Vietnam war had begun only nine months earlier and had not yet turned into the quagmire it would eventually become (public opinion hit its high point in support of the war in March of 1966).
 
The stock market was coming off of three consecutive double-digit gain years.
 
Inflation had run under 2% for the prior eight years.  Interest rates had been at historical lows for nearly a decade.
 
In short, there was nothing that might have indicated that 1966 would commence such a bad retirement investment climate.  To the contrary, things looked pretty good.

 

Roth IRA conversion myth #2: "Tax is always paid at the margin"

Continuing the Roth IRA conversion theme (see previous post Roth IRA conversion myth #1), I'll elaborate on a very common misconception about taxes paid on IRA funds.

When you convert a traditional IRA to a Roth, you pay tax on the conversion at your marginal rate.  So a married taxpayer with taxable income of $100,000 would pay 25% on the conversion
(and if the conversion is large enough, some of it could be taxed at an even higher rate if the conversion pushes him into a higher bracket).

It's potentially a different story, however, if you don't convert.

Traditional IRA distributions may or may not be taxed at the margin.  In many cases, a taxpayer might pay significantly less than their marginal rate when they withdraw funds from their IRA.

Example:

Jim and Marge Gfarbnick’s sole source of income is their IRA withdrawal of $68,000 per year. If we ignore deductions and exemptions for the sake of simplicity, their marginal tax bracket is 25%. However, their actual tax liability is $9,375, or 13.8% (because of the progressive nature of the income tax system, some of the withdrawal is taxed at 0%, some at 10%, some at 15%, and only a small amount at 25%). In this case, they pay tax on their IRA withdrawals at a rate almost 50% below their marginal bracket.

Taking this example further, if they converted their IRA to a Roth just prior to retirement at their peak career earnings, then retired and began withdrawing funds from their Roth IRA to meet their expenses, it's likely they made a bad choice since their marginal rate probably dropped at retirement, not to mention their average rate (the rate at which they would pay tax on IRA withdrawals) was lower than both their pre-retirement and retirement marginal rates (and the timeframe was likely too short for the tax-free compounding of the Roth to offset the rate differential).

Takeaway:  your tax situation at conversion and withdrawal are an important driver in the conversion decision but the analysis goes way beyond just your marginal rates.

The cost of entitlement

The latest round of health care reform has produced a pair of bills which promise to not only fix the healthcare woes in this country, but to dramatically reduce the deficit at the same time
(the new plan could reduce the deficit by $138 billion over the first 10 years -- $20 billion more than the Senate bill, according to the CBO forecast).

Excuse me for being cynical, but I've heard this song and dance before:

"In 1967, the House Ways and Means Committee predicted that the new Medicare program, launched the previous year, would cost about $12 billion in 1990. Actual Medicare spending in 1990 was $110 billion—off by nearly a factor of 10."

So why were these cost estimates so far off?  The cost of entitlement.

The estimates failed to recognize or account for the behavioral change that occurs in people when they are promised a no-cost benefit.

"Roosevelt described Social Security as a modest offer to 'give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.'

Look what has happened since then. About 35 percent of Americans rely on Social Security for 90 percent or more of their retirement income. ... And Social Security is only one example. Over the years, the federal government has created a number of social insurance programs -- including the Medicare plans for doctors' visits and prescription drugs -- that provide significant taxpayer subsidies to even middle- and upper-income Americans.

We started these programs as a safety net for our hard-luck fellow citizens, and of course that safety net must remain strong. My point is that programs designed to help the needy should not become enshrined as benefits to which all are entitled. Too many of us who can afford to contribute more to our own well-being are jumping into the safety net instead. That approach is not affordable or sustainable. More important, it's not the American way."

--David Walker, Former GAO chief from his book, Comeback America.

Roth IRA conversion myth #1: "same tax bracket now and retirement, it's a wash"

Many articles on the subject of Roth v. Traditional IRA boil it down to nothing more than an issue of current v. future tax bracket.

The myth goes that if your tax bracket at retirement is expected to be lower than it is now, don't convert to a Roth, while if your tax bracket is expected to be higher at retirement, do convert to a Roth.

And, if your tax bracket ultimately stays the same, the conversion decision is moot since you'll end up paying the same in tax either way.

The uncertainty of your future tax situation not withstanding, the "wash" only occurs if you pay the tax due from the IRA you are converting,
in which case, the whole decision is reduced to a bet on future tax rates and on your future tax situation, both of which are highly unpredictable
(not to mention, you will pay a penalty in addition to the tax if your conversion and IRA withdrawal occur before age 59 1/2).

If, however, you pay the tax due on conversion from after-tax money, you are essentially converting the future growth on the amount of tax paid from "taxable every year" to "never taxable again" (assuming you meet the holding requirements of the Roth IRA).

Or to put it another way, the amount of tax paid at conversion is a "bonus allowable Roth contribution."

Example:

$100,000 traditional IRA, $25,000 after-tax account, 25% tax bracket now and forever, 7.2% annual investment growth.

If you convert, your $100,000 IRA becomes a Roth and your $25,000 after-tax account goes away.  After 30 years, you have a Roth IRA worth $800,000 (in after-tax terms).

If you don't convert, your $100,000 IRA is worth $600,000 (after-tax), while your taxable account is worth $200,000 assuming a 0% tax rate over 30 years.

It's only a "wash" if you manage to avoid taxes altogether on the original $25,000 after-tax account.  In this example, at a 25% tax rate, the initial $25,000 grows to only $121,104.

Takeaways:

1)  If you can't pay the conversion tax from a taxable account (ie, funds you've already paid tax on, not from the converted IRA itself), don't convert.
2)  Even if you can pay the tax from after-tax $, it still may not be in your best financial interest to do so.  There are other factors involved which may outweigh the benefit illustrated above (future blog post).

This post and all others on the blog are for informational purposes only and should not be considered individual investment or financial planning advice.
Consult your financial planner or tax advisor before making the Roth IRA conversion decision.