I will open by giving you a Frontline video to watch. Check it out when you have time (it’s a bit longer than 45 minutes). The video is located here.
So that probably pissed you off a bit. 401Ks are the typical retirement vehicles that regular folks have access to, and they use mutual funds that pay kickbacks to the management companies, and you suffer the consequences. Sucks to be you.
Now, let’s actually look at the numbers
Bogle said that a two percent return would lose something like two thirds of its value over fifty years, which is outrageous. And that’s true, but I think we should look at the numbers a bit more closely to really understand the magnitude of the issue. How many people, after all, can you name who enter the workforce and stick with the same employer for 50 years?
Here’s the summary shot from the video:
I don’t want to minimize this, because the concept is huge. The problem is that in order to find this sort of gap you need to drag it out to fifty years, which is hugely unlikely. They gave this away a few seconds earlier in the story:
Most of the increase there happens in the last few years, as you’d expect. This isn’t as bad if you assume thirty years – that same scenario (7% annual market return, 2% fees versus no fees) “only” takes 31.78% of your return over thirty years. That’s still almost one third of your return, and you’re still providing all the capital and taking all the risk, but it’s not nearly as bad as they make it out to be.
Looking at the numbers a bit differently
Here’s another take on it. In the first column you find a way to make 7% annually with no fees, in the second you’re paying a 1% fee to an index fund as Bogle suggests, and in the third column we’re plotting the 401K numbers assumed above (2% fees, same market return.)
That’s an impressive difference. In the 1% index fund case you’re still losing 17.66 percent over three decades, which is a whole lot better than losing 32%. But the “bad deal” 401K outperforms the no-fee market rate investment by 36.4%, and it outperforms Bogle’s recommended strategy by 65.7%. It does so because most 401K plans have an employer match. Frontline did its viewers a huge disservice by ignoring this.
Basically 401Ks have an employer match component. If your employer will match up to 100% of 3% of your salary and you invest 3% of your salary, then they instantly double it in your retirement account. You donate $200, and they put in their $200, so you’re effectively putting in $400.
This is why it is so important to max out your 401K contribution up to the employer match. Sure, you can outperform the mutual fund options you’ve got available if you invest in indexes (or individual stocks, which we’ll get to later). But it’s hard to get over that instant doubling up-front.
What you should have taken home from that video
It was all in the front. People aren’t comfortable unless they have 10-15 times their annual living expenses in savings. I assume a 4% draw-down on investments is pretty close to safe, so I’m using a 25 times multiplier, but the point remains. Retirement planning needs to start early. Years lost at the beginning can’t be easily made up for later. If you’re young, then start now. Sorry to be emphatic there, but it’s true. This is compound growth – look again at the screenshot above for the difference 2% makes 40 years in. It’s huge, and it’s huge enough that small retirement savings at 20 can make a monstrous difference in outcome. Here’s more information from a more legitimate source.
So I should use a 401K for retirement?
Yes, up to the employer match because it’s free money, and turning down free money isn’t wise in most of these cases.
But we’re magicians, right? It’s hard to enchant to make the entire US Equities market beat whatever return it’s getting overall, but there are a number of strategies that can work for stock picking. That’ll come way down the line, though.
First we dig through all the boring stuff so you understand the rational and non-magical approach to all this crap. And then we figure out how to mix in magic to give us our edge.