In the Part 1 of this post we looked at the scary statistics from the US Census Bureau of the number of Americans that retire each year and the bleak future that confront them despite the government support available. You can read the first part here to be able to follow.
In the US, the following plans are available to the worker at his active stage of employment:
- IRAs and its variants
- 401K Plans
- SIMPLE IRA Plans (Savings Incentive Match Plans for Employees )
- Payroll Deduction IRAs
Please visit http://www.irs.gov/Retirement-Plans for details.
One thing that is common amongst all these schemes is that you only add to the pool as long as you are still working, and the size of your retirement account depends on how long (or how early you started investing) and how much your contribution is. When you stop working and retire, the growth of the fund stops by your level of contribution, and from this time on, it begins its downwards journey.
Usually an investment officer analyses the market and invests these monies in some funds that yield interests which are capitalized until the retirement date of the contributor after which it is switched into another fund to provide annuity income subject to certain conditions. We will not discuss withdrawal rates and how much is needed for retirement. These are all subject to several factors.
Some of the funds (actually most them) are indexed to annual inflation rate. The challenge before the investment officer is that he must carefully analyze and choose the investment vehicle, first for security and then returns. In considering returns, he must be careful to at least ensure that the returns on the investment are above inflation rate with a good margin/buffer. This buffer is needed to justify the costs associated with managing the funds, salaries, administration costs etc.
With the global economy still stuttering and government keeping interest rates low, getting decent rates from conventional banking products are often a challenge as banks only make money when the interest rate differential between deposits and lending rates are significant.
Coming back to inflation and its impact on fixed income securities holders, as long as inflation rate is positive, you will not get the full benefits or interest income promised at the time of investment.
Let’s take an instance. According to US data report, the inflation rate for September 2015 is 0.2%. This figure is probably the best in recent years and you might not know the impact of this on savings and consumer prices until you look at the long term.
Since retirement planning and investment are always for long terms, if you saved $100 in your account and you plan to retire in 2015; by 2015 it would have lost its value by 38.4%. In other words, it will only be worth $61.60!!
Although this is very simplistic, it shows how much value our portfolio loses value with inflation. Now, assuming the investment officer invested the funds in an index yielding same 0.2% and compounded annually-which is the beauty of long term savings), it will have appreciated by $38.39 and now worth $138.38 in nominal value!.
Very good returns over 15 years, right? Well, I think so too. However, how does this compare with real estate in real terms within the same time horizon? A house bought in year 2000 for $100,000; on annualized basis, in an average market, what is the comparative value added?
Let’s discuss this in our Part 3