Sunday, October 9

Week 14 - Retirement on a Shoestring: The Roth IRA

Situation: Many people spend their careers working at jobs that offer slim retirement benefits. Consider this: a year of retirement will cost you about as much as a year of private college. Unlike a child’s college expenses, retirement doesn’t end after 4 years! Many people are now in a situation with big problems looming on the retirement horizon. Those with little money set aside for retirement have only 4 ways to supplement Social Security income (excluding extortion):
   1) convert home equity to a reverse mortgage,
   2) raid their “Rainy Day Fund”,
   3) remain employed for more years,
   4) set up a Roth IRA.

Goal: Explain to a 50 yr old how to start a retirement plan based around a Roth IRA.

Okay, you’ve reached the age of 50 with little by way of retirement savings, and you know you need a sound retirement plan. One thing that Congress got right was to provide middle income workers with a special kind of IRA, called a Roth IRA. With standard IRAs, you receive an annual tax deduction for monies invested but as those monies are spent in retirement you will pay taxes as with ordinary income. A Roth IRA, however, uses monies that are already taxed so that the monies spent in retirement are tax-free. From an accountant’s point of view, a Roth IRA is a bonanza! It shows the lengths to which Congress will go to entice people to save for retirement. 

We want a benchmark to use for the IRA recommendations we’ll be making and have picked the Vanguard Wellesley Fund (VWINX), a bond-centric no-load balanced fund that channels our Goldilocks Allocation to some degree. VWINX had been perking along for several decades without much attention but now investors are taking notice. The reason is that during the recession it posted one of the best records among balanced funds. VWINX has done rather well: investing $200 a month since 2/1/97 would have yielded $57,497 by 10/7/11 for a total return of 5.67%/yr (pretty sweet). This compares favorably to the same investment in the S&P 500 Index, SPY, which would have yielded $40,349 for a total return of 1.69%/yr (not so sweet). The top-performing balanced fund during the recession (MDLOX, the Blackrock Global Allocation Fund that we highlighted in Week 13) yielded $61,233 for a total return of 6.31%/yr (also rocking the house). During that 14.7 year period, inflation averaged 2.5%/yr according to the BLS

After age 50, you can pay $6,000/yr into a Roth IRA. We set up a $3,000 allocation to stocks and picked a model portfolio of 3 “low beta” DRIPs. These were chosen because they carry no investment costs if purchased through Computershare. [Please note: the same purchases could be made using Sharebuilder at an accumulated expense of $144/yr, which cuts 0.5%/yr off your total return.] We selected XOM ($75/mo), BDX ($75/mo), and NEE ($100/mo). Over 14.7 yrs (ending 10/7/11), the $75/mo invested in XOM ($13,275) returned $24,592 for a total return of 7%/yr; the $75/mo invested in BDX ($13,275) returned $25,286 for a total return of 7.28%/yr; and the $100/mo invested in NEE ($17,700) returned $34,860 for a total return of 7.61%/yr. All together, $250/mo was invested in 3 DRIPs ($44,250) and returned $84,738 for a total return of 7.33%/yr. This beats SPY by more than 5.6% a yr. It also beats inflation by more than 4.8%/yr. Other DRIP combinations can be selected and may show even better results.

For the bond side of our demonstration Roth IRA ($3,000), we’ll track $250/mo invested in the diversified T. Rowe Price investment-grade fund, PRCIX. For the 14.7 years ending 10/7/11, that monthly investment would have totaled $44250 and yielded $69,984 for a total return of 5.38%/yr. It is a no-load fund, so we have now constructed a no-load Roth IRA fund balanced 50:50 between stocks and bonds. Our fund is composed of 4 assets and carries no investment costs: XOM, BDX, NEE, and PRCIX. Our benchmark balanced fund (VWINX) is also a no-load fund. In addition, we’ll show what would happen if you invested $6000/yr in MDLOX (Blackrock Global Allocation A), which is also a balanced fund but carries a front-end load of 5.25%. That is, you’d be paying $26.25 in fees with each month’s $500 investment. [While there are other share classes that have a lower initial cost, this is compensated by a higher expense ratio. For long-term investors, the A class shares (MDLOX) are the most economical.] Our model balanced fund composed of 3 stocks and one bond fund yielded $154,633 over 14.7 years on a total investment of $88,500, for a total return of 6.42%/yr. This compares well to the 6.31% total return for MDLOX and 5.67% for VWINX. So our key point is that even the best-performing managed stock fund can be bested by regular purchase and dividend reinvestment using DRIPs in combination with a diversified bond fund, without paying any upfront fees or commissions.

In next week’s blog, we’ll provide a spreadsheet of our proposed Roth IRA and also outline a proposed “Rainy Day Fund”. We’ll include appropriate benchmarks and update the spreadsheet periodically, and model additional DRIP choices from the Master List. In an upcoming edition of “The Incubator”, we’ll discuss the process for incorporating DRIPs into a Roth IRA plan.

Bottom Line: If you’re earning less than $100,000/yr and don’t have a pension plan or 401(k) plan through your employer, it’s time to start a Roth IRA. Don’t delay - the pain only increases!!

<click here to continue to Week 15>

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