Of Retirement & Dwarves

A few weeks ago I came across this interesting website on Get Rich Slowly. The website offers a tool for calculating your cross-over point: the point at which the income from from your investments exceeds the amount of money you spend on a monthly basis. Theoretically, from that point forward you are financially independent and would no longer be required to work to maintain your living standard.

I found the notion intriguing and played around with the numbers a little bit. Here is what I came up with: assuming we spend 80% of what we make (which is pretty close to the mark), achieve a return on our invested capital of 8% per year, inflation averages at a rate of 3% per year and we gain a pay increase of 4% per year, my wife and I will be achieving our cross over point in... wait for it... 12 years. Financial freedom, here we come! Or, maybe not so fast.

Here's the rub. While the crossover theory is sound in principle, it fails to take into account a number of parameters:

1. Inflation - say we were to get to our cross-over point and then stop working. At that point our income from investment would equal our expenses and we would no longer be adding to our savings, nor would we, in theory, be diminishing them. However, inflation is a nasty beast. Just because we stop saving and investing, doesn't mean that prices will remain fixed. In fact to the two eternal truths (death and taxes) we should probably add a third: inflation. With time inflation would erode the purchasing power of our investment income, and back to work we go (with very few hi-hoes).

2. Market Fluctuations - while our portfolio can reasonably be expected to return 8% annually over the long term, there are no guarantees that we will not be hitting any short term bear markets. Assume we stop working at our crossover point, and the very next year the market tanks and goes does 20%. If at that point we continue to draw down our investment income at the previous rate, the value of our portfolio will erode very quickly. Once again if you listen carefully, you can hear seven dwarves singing a much too cheerful song in the background.

3. Additional Expenses - if indeed we reach our crossover point in 12 years and choose to retire, we will be many years away from qualifying for medicare. Right now our medical insurance costs are largely covered by our employers, but if we need to pay for medical insurance ourselves, that crossover point is probably a little bit farther into the future. Will someone shut-up those darn dwarves already?

4. Asset Allocation - while we are young, both working and have no immediate need of our retirement assets, we can reasonably expect our investments to yield something like 8% a year on average. However, as the time comes for drawing down on those assets to support our living expenses, a more conservative investment strategy will probably be required, and the more conservative your investment the lower the average return you can expect. Once again, our crossover point just got a bit farther away.

So, is there no hope? On the contrary, there's big hope. As we close in on the cross-over point, we will have amassed a substantial asset base, and this asset base will be compounding at a pretty impressive rate. We may not be able to wave our bosses good-bye quite yet, but we will be well on our way and with just a few more years of hard work we will be able to kiss the corporate life good-bye.

Interestingly, I actually enjoy my work and as of today I am not in a rush to leave it behind me. Still, it would be nice to know that the option is there, if I choose to use it.

For a detailed discussion of the cross-over concept, be sure to visit The Simple Dollar.

IPO Investors, Beware!

For the past several months, a close friend of mine has been salivating about the upcoming IPO of VMware (NYSE: VMW). He thought that it would be a great investment opportunity. He even tried, unsucessfully, to get some shares at the IPO. VMware finally went public earlier this month in a wildly successful offering. Turns out that my friend was right. The IPO was an excellent investment opportunity. My friend invested at $55 a share, so as of Friday evening his investment certainly paid off (the stock closed at $71.30).

However, not all IPOs have a happy ending. In fact, a number of academic studies have shown that for the first 3 to 5 years after an IPO, shares of newly public companies tend to underperform the general market. See for example this article, and this excerpt. This is such a well known phenomenon that I first heard about it when I took my very first finance class in business school.

My friend did very well for himself, but I am not clamouring for a share of that pie. In fact, I am going to stick to my tried and true indexing strategy and not try to outperform the general market. While my friend seems to have beat the odds so far, on average he is playing a game that is stacked against him. Remember, some people also win money at the slot machines, at the roulette table or by playing their state lottery, but that doesn't mean that playing those games is a prudent investment strategy.

Thanks for the offer, but I'll take my equity investments slow, steady and well diversified.

Celebratory Post!

This is a quick celebratory post acknowledging the fact that this evening, for the first time, the number of RSS subscribers to Money and Such has exceeded 100!

I would like to take the opportunity to thank my regular readers (as well as all the newbies) for putting up with my shenanigans and for coming back again and again to read my articles. Writing Money and Such for the past several months has turned into a fun part of my daily routine, and I have you to thank for it.

Here's to the future.

While We Are Holding You Hostage...

It was only a couple of days ago when I wrote about American Express' dim-witted security policy with respect to their credit cards. Yesterday I received my replacement AmEx card in the mail and got another dose of lousy customer service from that company.

As with any other credit card, when the AmEx card arrives via mail it requires activation over the phone. When I called to activate my card I was asked to enter my card number at which point I got something similar to the following message: "Thank you for choosing American Express, while your card is being activated let us tell you about the following great offer..." This was followed by an approximately one minute inane commercial for the company's credit protection services. The thing that really gets my goat is that I know that this is an unnecessary delay - the actual activation of the card takes a second or two, if that. It is a simple database query. The use of the phrase "while your card is being activated" is contrived, and should be replaced by something like "While we are holding you hostage..."

I find this method of delivering a marketing message to be rude and obnoxious. I felt like AmEx was holding me hostage to their marketing message. Would my card be activated if I simply hung up the phone? After I made the call, I remembered that I ran into similar practices with Citibank when I activated my card with them. However, if I remember correctly, when I turned down Citibank's terrible offer (by pressing the appropriate key on my phone), I got something like "Are you sure that you want to decline this offer", followed by another 20 seconds of marketing drivel. At least AmEx did not sink to that low.

I don't care if those companies are advertising free money, whatever it is that they are selling, I am not buying. Companies must be made to understand that if they treat their customers like their property, try to force feed us their marketing messages or simply give us lousy service, we will retaliate against them by using our economic power.

In the course of the simple transaction of transitioning me from an expired card to a new one, AmEx has managed to turn me from a very happy long time customer, into an unhappy customer who writes blog entries about their unsatisfactory level of service. I am not sure that this is the outcome that they were going for.

Dislike Your 401K? Join the Club

My first unscientific blog poll closed last week, and here are the results. The simple question I asked my readers was: "Are you happy with your company's 401K?" Of the (measly) 21 votes I received 57% said "yes", while 43% answered "no".

The number of people happy with their 401K plans surprised me. I was expecting a distinct majority of people that would vote against their employers' plans, especially among more engaged investors, a group which is probably over represented in the readership of this blog. Nevertheless, the poll results clearly show that a large minority of workers are unhappy with their employers' plans. Why is that?

As a member of my company's 401K committee, let me take a few educated guesses:

1. Limited Options - many people are unhappy with the type or selection of investment options made available to them in their employer's 401K plan. Whenever the topic of our retirement plan comes up in a discussion with my colleagues, the number one request I get is: "can you add XYZ fund?"

The truth is that employers are unable to accommodate all employee requests in this area. There is a substantial management cost associated with administering the plans, and these costs increase as the number of investment options in the plan goes up. If we were to add every investment option people are asking for, there would be hundreds of different funds in our plan.

In addition, we must also consider those employees that are less comfortable with investing. We find that when such employees are faced with too many choices they either make bad financial decisions, or decide to avoid the issue altogether by not contributing to the plan.

So how do we solve the problem? We offer people a self directed 401K option. You want more options, you got them.

2. Lack of Transparency - OK. Maybe this is just my own pet peeve, but it truly annoys me that even as a member of my company's 401K committee I cannot get a full grasp on the costs our plan participants are incurring. Sadly, the financial institutions that sell and administer these plans go out of their way to make things difficult to understand, and complex to follow. They figure that if you knew the true costs you are paying you may be less inclined to trust your money to them.

So how do we solve the problem? My company is trying to improve the situation by taking the long road towards switching 401K providers - so far, it has taken us eight months (and counting...)

3. Matching - many companies offer only token matching of employee contributions. I have previously worked for a company that did not offer any matching whatsoever. I would not repeat that mistake again today. The nice thing about the match (in addition to the fact that it is free money) is that it goes on top of the employee's $15,500 annual contribution cap. By the way, as far as I am concerned, this is not fair towards those employees whose companies do not offer a match. Why should the government care who is the entity putting the money into the account?

I have previously stated that as far as I am concerned, the 401K system is flawed and should be replaced. I stand by that statement.

Are you unhappy with your company's 401K plan? If so, why?