Retirement Planning: DCA matters - right?

There is a school of thought circulating that dollar cost averaging is not smart investing. For those of you unfamiliar with the term, it is how your 401(k) plan works and why it works so well. You essentially make a contribution determination - usually a percentage of income which is taken before taxes ore levied - and each paycheck, you buy share of whatever investment you have chosen in your retirement account.

The concept is basically simple enough for most every investor to understand, even embrace. One, the investment is steady and in many cases affordable and painless. Because of its automatic nature, you need only check your statement every quarter to make sure the money went into the account and went where it was supposed to go.

DCA also benefits the average retirement investor with some control over the numerous errors that plague most investors. By doling out money evenly, your investments are bought based on affordability and not on the decision of the herd. Herd decision making relies on following the rest ofthe investors as they sell or buy and experience with this sort of mentality suggests that they usually buy when the markets are on the way up and sell as they descend.

DCA does something unique. It allows the investor to buy less as the herd buys more and to buy more as the herd sells. Imagine a share of a mutual fund costing a dollar. You allocate one dollar of your paycheck and you buy one share. But the market goes up and the share now costs $2. DCA restricts your enthusiasm at joining the herd and allows you to only buy one-half a share. the shares you already own have increased in value so you aren't missing the upswing. You just aren't throwing more money at something that may be over valued.

Now imagine the opposite happening. The share falls in value to 50 cents. Your dollar buys two shares and while it is true, your other shares have lost value in the process, the investment thinking here is that over the long-term, there will be more upsides than downsides. This means that you will be buying the same share at a discount.

Are there any downsides to this investment strategy? Some think so. One gentleman I was discussing this with suggested that folks using a 401(k) plan should never forget that this is investing. I couldn't agree with him more on that point. He went on to say that even the most passive investing requires some diligence and dollar cost averaging takes that diligence away. That is a downside but not an insurmountable one.

He thought that all of the money in a given year should be sent to the most conservative fund available in the employee's 401(k) and then redistributed to funds that are doing better. While this may work for some people, few of us know how mutual funds operate, whether the markets are favorable or not and often we find out after the markets have made the decision for us, and lastly, our 401(k) do supply the rapid response some of this thinking implies.

It does require a skill level and command of all of the emotions and biases that plague even seasoned investors. It obligates us to be better educated - but for most of us, we need time to get to that point. It is always my hope that we do attempt to become better acquainted with the way our money is being invested. But in the mean time, the concept of dollar cost averaging serves far too many of the average investors too well to be discarded.

Taxes and Retirement Planning

As the late George Carlin once said, “the poor are only there to keep the middle class going to work each day.” And so it goes, we are off to work each day, hoping beyond hope to scrap by without having your life’s work stripped away by health insurance costs, lack of creditworthiness and kids and/or parents who are becoming increasingly dependent on your incomes.

And the one hidden menace, lurking in the background is taxes. Sure, I focus a great deal on the influences of the economy at large, the subtle impact of inflation and the political landscape of money, but taxes, the thing that no one likes to admit keeps the public engine running in communities across the country, are about to increase. But will you notice?


On the Local Level
Revenue for state and local governments ebb and flow with the state of the economy. When property values jumped dramatically, taxes tied to the assessed value of those home filled the coffers and made new project planning easier. But as those values decrease, those revenues will still be needed to keep the communities running even if its residents feel as though those taxes would be better kept on their own side of the balance sheet.

Some states are making swaps, using one revenue source to pay for another that may not be doing as well. A good example of these kinds of swaps is cigarette and alcohol taxes increasing as property taxes are frozen (usually at 1-3% of assessed value), capped or cut.

Expect sales taxes, if your state has them, to increase over the next several years. This does help tourist rich cities to capitalize on outside sources of revenue but for the most part, it slows the economic growth by taking spending money from the consumer.

Look for an increase in amnesty programs, events designed to get delinquent taxpayers back into the system using the lure of payment without penalties of late fees.

On the Federal Level

This is the big unknown question. Senator Barrack Obama has made I clear he believe that the families with household incomes exceeding $250,000 should be paying what he refers to as “their fair share”. Investors expect that this group, the ones most likely to support the capital gains tax of 15%, to pay more for the sale of stocks if he is elected. (The prevailing belief is that even if Obama is elected and increases this tax on the wealthiest of families, it would be capped at 28%.)

Senator John McCain on the other hand, is offering much of the same program that has been successful, but only if you ask the right people. Mr. Obama’s plan would force many folks who have not diversified, specifically those with illiquid assets, to do so before the new president takes office.

If Obama gets his way, states and local municipalities would see a huge influx in revenue from tax-exempt municipal bonds. This can be tricky territory though. Some munis trigger the alternative minimum tax (AMT) because they pay interest.

The Effect on your Retirement Plan

Unless you are among the highest wage earners, your approach to retirement planning should be focused not so much on how much is in the nest egg but how much income, less taxes and inflation, will allow you to be comfortable. That number is generally different for each of us and unfortunately is based on a perfect situation (usually calculated without considering taxes and inflation).

Most of us can expect to take home – after retirement – a paycheck that is 30% lighter than we estimate (3% for inflation – modest and hopeful guess, 15 – 20% income taxes on earnings from deferred income sources like pensions and retirement accounts, and 10% on property and local taxes).

That means you will need to save an additional 30% above what you are currently putting away for your future or, lower your expectations on how much you will need.

We can count on one thing: Your elected officials feel your pain but can do little about it. Taxes will not go down no matter whom takes the helm in Washington or at the local level. The best you can do is plan for the worst.

Retirement Planning at 60-years-old

Now is the time to ask the serious questions.

Are you considering what your after-work sources of income will be? Can you live on them now? Take your Social Security payments, any pensions you might receive, and any other source of income from savings or retirement plans, add them together and create a household budget around them. Does this support your idea of retirement?

Can you afford taxes, insurance and upkeep on your home? Is it too big? Will it need major repairs to last until you are eighty, or ninety? Do you still have a mortgage? Have you created equity? Do you have debt?

It is the classic observation that George Foreman made: “The question isn't at what age I want to retire, it's at what income.”

There is an excellent chance that you will still be working when you celebrate your sixtieth birthday. The ability to remain viable and contribute something to the workplace should be worn as a badge of honor. Unless you are working for the wrong reasons.

If you are working because you failed to save enough for the retirement you envisioned, then now is the time to lower those expectations just a little bit. Many of us harbor outsized visions of what we want retirement to be. By age sixty, we will either be disappointed or overjoyed.

Perhaps you have been blessed when better than average health. If so, working beyond what many consider normal retirement age is creating wealth that will make your post-work years more comfortable.

But far too many adults are entering this time of life with less-than-perfect health and worse, the inability to pay for health insurance to cover it – if they have insurance at all.

Debt, and not just mortgage debt, has become a problem among this age group, weighing on their mental well-being and forcing many to work because they have to rather than because they want to.

It is possible that you have more than you think. If you have lived in the same house and built up a good deal of equity – the difference between what you owe and what the house is worth, this might be a solution to your problem. You could downsize, selling the property, satisfying your debts and even creating a small, but much needed nest egg to help with your retirement years.

If you do, you should consider places where the amenities meet your needs. Do you want to be close to your family? For many people thinking about retirement, this is a serious consideration. They want to be near their families, help with their grandchildren and even be closer to their own children.

If you intend to move, ask yourself if there a viable and mixed population present? Recent studies have proven that communities that cater exclusively to seniors do not fulfill many of the social needs of people entering retirement. They like the neighborhoods they live in to have a good mix of people already living there. Businesses often look for the same types of neighborhoods and in doing so, increase the livability of the area.

If you are considering working until you are seventy, you can delay taking your Social Security withdrawals until later. Any retirement savings in 401(k) plans or IRAs will need to begin distributing funds by age 70 ½. Until then, you can continue to make contributions.

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Retirement Planning and Optimally Saving

This is the popular notion:

“A long time ago, New England was known for its thrifty Yankees.
But that was before the baby boomers came along. These days, many New Englanders in their 30s and 40s, and indeed their counterparts all over America, have a different style: they are spending heavily and have sunk knee-deep in debt. . . A recent study sponsored by Merrill Lynch & Co. showed that the average middle-aged American had about $2,600 in net financial assets. Another survey by the financial-services giant showed that boomers earning $100,000 will need $653,000 in today’s dollars by age 65 to retire in comfort—but were saving only 31 percent of the amount needed. In other words, the saving rate will have to triple. Experts say the failure to build a nest egg will come to haunt the baby boomers, forcing them to drastically lower standards of living in their later years or to work for longer, perhaps into their 70s. (Wall Street Journal, Wysocki 1995, A1)”

And here is the contrarians view:

John Karl Scholz (University of Wisconsin–Madison and National Bureau of Economic Research) Ananth Seshadri (University of Wisconsin–Madison) Surachai Khitatrakun (Urban Institute) suggest, in a paper titled “Are Americans Saving ‘Optimally’ for Retirement?" the following:

“We solve each household’s optimal saving decisions using a life cycle model that incorporates uncertain lifetimes, uninsurable earnings and medical expenses, progressive taxation, government transfers, and pension and social security benefits. With optimal decision rules, we compare, household-by-household, wealth predictions from the life cycle model using a nationally representative sample. We find, making use of household-specific earnings histories that the model accounts for more than 80 percent of the 1992 cross-sectional variation in wealth. Fewer than 20 percent of households have less wealth than their optimal targets, and the wealth deficit of those who are under-saving is generally small.”



So who is right? And as I ask in the book, “How could you save too little?” The authors use a stochastic (from the Greek for guess) life cycle model that, it should come as no surprise is what the insurance industry uses when they do actuarial estimates. But that is another book.

The authors look at “precautionary savings and buffer stock behavior” as well as “end-of-life uncertainty and medical shocks”, what they call “the evolution of average effective federal income tax rates over the period spanned by our data” and “realistic expectations about earnings; about social security benefits, which depend on lifetime earnings; and about pension benefits, which depend on earnings in the final year of work.”



Using that info they then began “calculating optimal life cycle consumption profiles.” They were also concerned with “he timing of earnings shocks can cause optimal wealth, which can “vary substantially, even for households with identical preferences, demographic characteristics, and lifetime income.”

And based on that, they wrote, “We find that over 80 percent of households have accumulated more wealth than their optimal targets.”

To make this claim, they offer the following as way of quantifying that statement. “Households typically maintain living standards in retirement by drawing on their own (private) savings, employer-provided pensions, and social security wealth.” Private savings is described as “housing assets less liabilities, business assets less liabilities, checking and saving accounts, stocks, bonds, mutual funds, retirement accounts including defined-contribution pensions, certificates of deposit, the cash value of whole life insurance, and other assets, less credit card debt and other liabilities. It excludes defined-benefit pension wealth, social security wealth, and future earnings.”


In short, and you can read the entire paper here, we fail to calculate what we have in assets, our ability to accumulate wealth over the course of our working careers, and our changing life style habits which could allow us to downsize quite effortlessly, giving us access to accumulated wealth equity in our homes.

Key is to this savings is keeping debt manageable and low as you enter the waning years of your working career.