Saturday, March 9, 2013

The Keys to Successful Pension Funding and Individual 401(k) Retirement Investing Can Be Summed Up in Three Words.... RULE OF 72


The key to investing successfully is a surprisingly simple and low cost approach using the "rule of 72." Once we understand and adopt the rule of 72 in our own individual planning and investing (works for companies and the government too), we're on the road to a comfortable financial future.

Let's think of it in three stages: (1) getting ourself in position to be successful; ((2) spending some minimal time upfront on task learning the basics of investing; and (3) then developing over time the habit of improvement so we'll know all we need to know as we move toward oldster status.

The combination of getting an early start, saving and investing regularly, and developing a habit of learning more about long term investing will assure that we make no dumb mistakes along the way.


Let's start our discussion with a simple question: Over time how much will an incremental 2% average annual return on investment be worth when the individual retires?

And here's the simple answer: When investing for the long run, an incremental 2% per year means a whole lot. And 4% extra? Well, that can represent an astronomical amount.

But as or more important that that is this: We need to start early and save a substantial amount from each paycheck. And that savings needs to be invested in a low cost fund such as the S&P 500 Index fund available from Fidelity, Vanguard or others with similar offerings. Then stay the course as we take the time to learn the basics of investing.

The "MAGICAL" Rule of 72 Explained

The secret is to understand and use the rule of 72 to our benefit over a long period of time. The rule of 72 is a straightforward example of compounding. Through the 'magic' of compounding, money initially invested doubles EACH TIME (1) the average annual percentage rate of return multiplied by (2) the number of years invested approximates the number 72. {NOTE: For example, 8% x 9 years, ~10% x 7 years, 2% x 36 years and so forth --- will all result in a 100% gain on the initial sum.}

But We Have To Let The Rule of 72 Work Its 'Magic' For Us

But here's the problem. In general, a lousy investment job by almost all investors (including individuals, many companies and government entities alike) has been done over the years. This criticism especially applies to government pension plans and individual 401(k) investors.

So let's spend a few minutes educating ourselves. Now that we're 'in position to learn,' spending some 'time on task' will enable us to acquire the basic knowledge necessary to form the 'habit of improvement' which in turn will result in adequately funding and investing for our retirement years.

Corporate pensions feel low-rate squeeze is a good place to begin:

"Most retirees feel the pinch of the Federal Reserve’s policies in the income-oriented parts of their portfolios, as low interest rates make it tough to derive a satisfying yield from bonds and annuities. But cellar-dwelling rates can put pressure on other pillars of investors’ retirement planning, too—by wreaking havoc with the pension accounting at big publicly traded companies.
Wanted: About $350 billion more.

. . . in the CFO Journal, Vipal Monga . . . cites a report from J.P. Morgan Asset Management estimating that America’s private-sector companies had a $347 billion gap in 2012 between what they’ve promised their pensioners and what they have on hand to pay them; that deficit is just below 2011’s all-time high. Put another way, the companies have only $81 for every $100 they’ve promised. Many pension analysts consider an 80% funding level to be the bare minimum for a healthy pension system; by way of comparison, about two-thirds of the country’s state-government pension systems fail to clear that bar.

Low interest rates are one major factor in the shortfall. A company’s pension liabilities are determined in part by a “discount rate” based on the rate of return of a hypothetical portfolio of highly rated corporate bonds – and when that rate falls, companies have to put aside more money to shore up their pension plans. The costs can be huge: Boeing, for example, has said that every 0.25-percentage-point drop in the discount rate adds $3.1 billion to its projected pension obligations – and its discount rate has fallen almost 2.5 points since 2007.

As Monga points out, some of these pension shortfalls could disappear just as quickly if interest rates rise, but with the Fed having committed to keeping rates low through 2015, that hardly seems imminent. Though Monga doesn’t delve into the wider implications, the broader impact of these deficits provides plenty of cause for concern for retirement savers and investors."

Summing Up

The moral of the story is simple. Government plans are woefully underfunded, and the individual 401(k) investor is woefully underfunded as well.

Accordingly, achieving an average annual return of an 'extra' 2% on investments over time will mean a whole lot to both the government entity and the individual 401(k) investor, too. And 4% extra would mean exponentially more than a whole lot.

With today's low interest rates, it's virtually impossible for companies, governments and individuals to earn 8% annually on their investments unless they fundamentally change their investing methodology for the future.

That's just a fact.

It's also a big reason why I recommend a low cost passively managed all stock portfolio for individuals, companies and governments.

And it makes no difference whether these investments are made with respect to pensions or 401(k) plans.

The essence of appropriate retirement funding is to set aside enough money, and then invest that money wisely over time, in order that there will be sufficient funds on hand when an individual's retirement years commence.

And that's true whether the funds are invested to provide benefits for thousands of employees in a government or company plan or just one single employee --- ourself.

So with the assumption that low interest rates are here to stay, at least for the foreseeable future, it's definitely time to pull the plug on investing in bonds and it's time to invest and stay 100% invested in blue chip stocks.

That's my take.

Afterword ... A Lesson in the Rule of 72 and Its 'Magic'

Consider the following examples.

An all stock portfolio earning 8% annually will double every 9 years. One that earns 10% will double approximately every 7 years.

A portfolio with 50% bonds and 50% stocks earning 4% and 8%, respectively, will on average earn 6% and take 12 years to double.

It's as simple as 1-2-3.

(1) In 36 years, the all stock portfolio which begins with an initial investment of $1 will turn into $16 at 8% and $32 at 10%. 

(2) On the other hand, the 50/50 blended portfolio which begins with that same $1 and earns 6% will grow to only $8 in 36 years.

(3) Accordingly, in the case of the 50/50 portfolio, the investor would have to set aside $2 at the outset to reach $16 and $4 to reach $32 in 36 years.

It's just the rule of 72 at work, and the longer it's working, the higher the ending amount. And the greater the average annual return, the higher the ending amount, too.

More time and higher average annual returns are a winning combination for all investors.

I'm only reporting the 'news' and in the end only you can decide what to do about it.

But the rule of 72 has performed its 'magic' for me.

Thanks. Bob.

1 comment:

  1. Many say Rule # 72 contradicts to many basic conditions for pension planing. I don't think it is but many say it loudly!!