the importance of being earnest: a review of the affluent case

The Importance of Being Earnest:A review of the affluent case

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Retirement

Portfolio risk

Market returns

Policy regarding taxation, savings &

entitlements

Longevity

Employment: earnings and

duration

Consumption vs. savings

OUT OF YOUR CONTROL

SOMECONTROL

TOTAL CONTROL

The retirement equation

The Browns: Let’s look at some factors under their control

The Browns

Have one working spouse that since 1972 consistently earns 6x the median income (in 2012, 6x MI = $340,000)

Buy a home once they save enough for a down payment, and which they own free and clear by retirement

Make annual pre-tax 401(k) contributions equal to 6% of wages, which an employer matches up to a 3% rate (subject to prevailing caps)

Put aside another 4.5% of after-tax income in a savings account, for a total lifetime savings rate of 22% (2%–3% over averages for their income demographic)

Invest in a balanced portfolio of 65% equities at age 25, declining to 45% by age 65 (remainder in fixed income)

Are subject to an effective Federal tax rate (incl. payroll taxes) of 20%, and a 3% state tax

Intend to spend 80% of their pre-retirement after-tax, after-savings cash flow in retirement

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The above example is hypothetical and is shown for illustrative purposes only.

Sources of spending conservation often seen in affluent families:

Mortgage, paid off

Opportunity to downsize real estate needs

Gifts/tuition for children no longer needed, now in workforce

Work-related apparel, transportation, entertainment and food expenses

Gas, insurance and maintenance expenses on a second car

Home improvements

Charitable contributions

Costs of supporting aging parents eventually fade

How do affluent families cut 20% from their pre-retirement spending?

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Baseline case

Source: TPC, BEA, NAR, BLS, J.P. Morgan Asset Management, Census, Bloomberg.Shown for illustrative purposes only.

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Where they get their cash flow from

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People that want to or have to retire early, or live much longer than expected?

People that save a lot, but not in the most efficient vehicles, either by choice or due to lack of access?

People that invest too conservatively?

People that spend too much money?

People that want to spend more than 80% of pre-retirement income after they retire?

Future policy risks regarding entitlements and taxation?

What are the benefits and disadvantages of Roth 401(k) plans, annuities, non-qualified deferred compensation plans, Sep IRAs and non-deductible IRAs?

That all looks fine, but what about…

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Early retirement can be costly, even for diligent savers


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Comparing different means of saving


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If you manage your own future, you cannot under-invest…


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…or over-spend


For the big spender, it’s hard to invest out of an under-saving hole

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A comment on savings consistency – The impact of periodic savings lapses

For purposes of highlighting the impact of savings lapses, the baseline case in this chart does not include an initial home purchase. This has the impact of increasing pre-retirement financial assets, from which the impact of savings lapses can be more readily examined. Shown for illustrative purposes only.

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So far, we have examined factors under the Browns’ control. Now let’s consider the ones that aren’t

Retirement

Portfolio risk

Market returns

Policy regarding taxation, savings &

entitlements

Longevity

Employment: earnings and

duration

Consumption vs. savings

OUT OF YOUR CONTROL

SOMECONTROL

TOTAL CONTROL

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Example: Equity market returns

Source: Robert J. Shiller data set, J.P. Morgan Asset Management.Shown for illustrative purposes only.

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And another: The national debate about the debt and the deficit

Source: CBO, OMB, J.P. Morgan Asset Management.Shown for illustrative purposes only.

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Potentially adverse changes that could affect the Browns of the future

Potential outcome in the future:

Social Security: Changing indexation results in payments lagging behind overall inflation by 0.4% per year. Benefits are means-tested, and the eligibility age for full benefits is raised from 66 to 69

Medicare: An affluent family must purchase supplemental Medicare insurance at a cost of 2% of pre-retirement income

Taxation: Tax rates on all brackets revert to higher pre-2001 levels. In addition, Pease limitations on itemized deductions are increased (3% exclusion raised to 4%, $300k threshold lowered to $250k)

Restrictions on the use of pretax savings plans: Limits are applied to 401(k) contributions as per the Bowles-Simpson proposals (the “20/20” rule), over-riding existing caps

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The Browns of the future: Baseline case, subject to policy and market risks


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Assessing the relative impact of policy, market and behavioral changes to retirement assets

Bowles-Simpson limits applied to pre-tax 401(k) contributions

Cost of supplemental Medicare insurance premium equal to 2% of pre-retirement income

Social Security means-testing and eligibility delayed by one year

Tax rates revert back to higher pre-2001 levels

Savings rate lowered by 3%

Shift of 5% from equities to fixed income

Annualized equity market returns are 1% lower

Impact of:


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Some conclusions for affluent families

The importance of being earnest

Know what your savings rate is, including pre-tax contributions to savings plans. It should be > 15%

Monitor investment risk in assets put aside for your retirement. Under-investing and over-spending is a potentially toxic combination

Accelerating retirement by even 2–3 years can substantially change the trajectory of your retirement assets, and requires adjustments in advance to your savings, or after the fact to your spending

401(k) plans can be more effective than IRAs due to higher limits and employer matching on the former

The prior four decades of equity returns benefitted from the Volcker disinflation, a phenomenon that is unlikely to repeat itself. As a result, real returns over inflation may be modestly lower than in the past

Congress has focused much of the deficit reduction burden on affluent families earning more than $250,000 in adjusted gross income. In the future, they may continue to do so, through policies which increase effective tax rates, and limit pre-tax contributions to savings. They may also means-test the largest component of retiree spending (medical)

Lifespans are gradually increasing, increasing the amount of assets families need in retirement

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Some rules of thumb: Many people underestimate the importance of their investment and saving decisions

Breakeven calculations on working, spending, investing and saving

Our overly conservative investor would need to spend 15–20% less in retirement than in the baseline case, or increase the lifetime savings by 5–7% to maintain the same wealth cushion

Accelerating retirement by 2 years requires either a lifetime savings rate that’s 2% higher, or a 15% further reduction in spending in retirement

For every 1% decline in lifetime savings rates, real equity returns need to rise by roughly 0.5%

Every additional year you work adds financial assets sufficient to support an additional 5 years in retirement

Moving from a high-tax to a low-tax state allows for post-retirement spending to rise by 4%–5%

Families would have to work for 2 more years to offset the impact of all our adverse policy changes

By the time the Browns retire, 70% of their financial assets will come from their investment decisions, rather than from their initial contributions to savings

Ratio of retirement spending to lifetime savings contributions, in 2012 dollars: 3.0x

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Saving is a constant battle against the temptation to over-spend

Perhaps more than any other country, the United States effectively encourages its citizens to spend, which may be why consumption is so high relative to GDP (71%). Examples of pro-spending policies include:

Lower sales, VAT, excise and import duties on a wide range of goods and services, including fuel, food, wine, electronics, accountants and lawyers

Favorable tax treatment of housing (mortgage interest deduction, capital gains exemption on sale of residence), which results in lower population densities, greater suburban sprawl and increased household spending on home improvements, transportation, etc.

Lack of single-payer health care which leads to greater healthcare consumption (U.S. private sector healthcare expenditures are more than twice every other OECD country)

The private sector finances most post-graduate education expenditures, unlike other OECD countries

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Appendix

Additional options to invest with pre-tax and after-tax dollars

Option Comment

Roth 401(k) Roth 401(k) plans are like traditional 401(k) plans, but involve contribution of after-tax dollars to an account that compounds tax free, and which is not subject to taxation upon withdrawal. Largest benefits generally accrue to families that anticipate higher tax rates in retirement, and families whose intended contributions are higher than prevailing 401(k) caps. Since traditional and Roth 401(k) contribution limits are the same, the latter allows greater value to compound since it is funded after-tax.

Non-qualified deferred compensation plans

Contribute pre-tax dollars into a tax-deferred account without being subject to IRS contribution limits; withdrawals are taxed at ordinary rates. The pre-tax compounding is beneficial to wealth dynamics, but families should be conscious of unsecured credit risks and monitor concentrations accordingly.

Non-deductible IRAs

Benefits vs. after-tax savings: the IRA compounds on a pre-tax basis. However, some income that would have been taxed as capital gains is taxed as ordinary income upon withdrawal. The net benefit depends on the time horizon (the longer the better), and the nature of the investment in the IRA (the less tax-efficient, the better).

Annuities Same as non-deductible IRAs, but typically with higher fees

Sep IRA, Solo 401(k)

For self-employed individuals, who can effectively save more in these plans than non-self-employed individuals subject to IRS limits on employee contributions, and who benefit from traditionally smaller employer contributions. However, the potential tax savings need to be weighed against a plan’s administrative complexity, and the cost of contribution requirements that might have to be extended to other employees.

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What it takes to spend 100% of pre-retirement income in retirement


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Viable retirement cash flow targets under baseline case: Before and after potential policy and market shifts

Shown for illustrative purposes only.

Using historical data

Using the policy and equity market assumptions for the future discussed on pages 14 and 16

Taxes

Source: IRS, J.P. Morgan Asset Management.Shown for illustrative purposes only.

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Equities

Source: J.P. Morgan Asset Management. Shown for illustrative purposes only.

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Important information

Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable. These views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results.

This material is distributed with the understanding that J.P. Morgan is not rendering accounting, legal or tax advice. You should consult with your independent advisors concerning such matters.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. Note that J.P. Morgan is not a licensed insurance provider.

JPMorgan Distribution Services, Inc., member FINRA/SIPC.

© 2013 JPMorgan Chase & Co.

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