Appreciating Assets Part 2: Other Investments

The following is a guest post from Marotta Wealth Management.

Your top-level asset allocation determines both the ultimate return you will receive and the volatility you will experience. Your investments should be working for you, appreciating more than inflation to become an engine of growth that pays you money and provides some measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of growth.

Stocks average 6.5% over inflation. Bonds average 3% over inflation. Thus after 25 years, $100,000 invested in stocks will have a buying power of $483,000. And $100,000 invested in bonds will have a buying power of $209,000.

Many other assets fare worse than these two categories. Understanding the average appreciation of these assets can help you model retirement projections and decide to invest or not.

Commercial real estate barely appreciates at the rate of inflation. Actually, it depreciates against inflation by about 1% a year. Fortunately, it should produce enough income to overcome this depreciation and produce a real return of about 4.9% over inflation. We invest in Real Estate Investment Trusts (REITs) that are publicly priced and traded as equities on the stock exchanges.

Handling a private commercial real estate requires more work. If private commercial real estate isn't generating a lot more income than it costs to maintain it--including depreciation--it isn't pulling its weight. Only if it can produce significant income and grow at a real return of 4.9% over inflation will a $100,000 investment in real estate grow to $331,000 after 25 years.

Similar equations can be used for residential real estate. On average it produces slightly less income, giving a real return of 4.1% and growing to have a buying power of $273,000. Obviously all real estate is subject to the increasing desirability of the area where it is located. Some excellent school districts have experienced appreciation significantly greater than inflation. But many rural communities have barely kept up.

A few years ago real estate was the darling that appreciated at over 1% a month. Now in parts of Michigan, Florida and California, those same homes are going for 20 cents on the dollar in foreclosure sales.

Remember that the house you are living in is an expense, not an investment. An investment pays you money. Although the principal portion of your mortgage payment is forced savings that will nearly keep up with inflation, it doesn't grow and work for you. Because you are occupying the house, you forgo the rental income that would provide the real return above inflation.

Gold is even worse than real estate. There is never any possible income from gold, so it just holds its value. And gold can be extremely volatile, losing 69% of its value in a 21-year decline from $850 an ounce in 1980 to $260 an ounce in 2001.

At least gold holds its value. Cash loses its buying power by the rate of inflation. After 25 years, although you might still have $100,000 in cash, it will only have the buying power of about $32,000. An inflation rate of 4.5% is devastating over the long term.

Fixed annuities act like cash. They lose their buying power quickly over time. Even if you could get an immediate annuity paying 7% at age 65, it would still be a bad deal. Seven percent sounds good only because you fail to take into account the immediate loss of 100% of your principal. If you die any time during the first 14 years, your return would be zero. You would only have received your own money back.

Assuming you live an average lifespan, your return would be 3.06%, not even keeping up with inflation. And even if you and your spouse both lived to be 100, your annual return would only reach 6.35% or a 1.85% real return, which is worse than an all-bond portfolio.

Immediate annuities initially seem like sufficient spending money, but that's only because they are front-loaded with buying power. If you want to maintain a certain standard of living, you should save some of the initial payout to supplement purchasing power at the end.

Even if you could purchase a $100,000 fixed annuity paying 7%, or $7,000 a year, you should only spend half of that amount. You would need to save the other half to supplement your spending later when you need more money to keep the same lifestyle.

Social Security is a little like a fixed annuity. Because it is indexed to the government's official inflation numbers, it doesn't keep up with real inflation. As a result, Social Security has a real return of about -2%

At this rate, over 25 years your Social Security payments will drop to about 60% of their initial purchasing power. Consequently, at the full retirement age of 66, we recommend only spending 84% of your Social Security income on your standard of living. Save the other 16% and invest it in equities to supplement your lifestyle later when the buying power of your Social Security payment dwindles because of inflation.

No one should count on Social Security. Had the money we've paid into Social Security been saved and invested in almost anything, every senior would be retiring as a multimillionaire. Until our Social Security system is privatized--like the one in Chile--it is not an investment you own. It is completely subject to the political risk of the next stroke of the pen. Inevitably Social Security benefits will be means tested so that people with more than a certain amount of assets, say a half million dollars, will no longer receive benefits.

We pencil Social Security payments into retirement equations tentatively and then see where we are without considering them. The younger the client, the less chance of collecting even the smallest fraction of what was contributed.

Many other expensive items should not be considered an investment. Just because it costs a lot doesn't mean it is an investment. For example, art is not an investment. Neither is furniture or a new roof. Neither is installing solar or geothermal. It may save you money, but that doesn't make it an investment. If it saves you money, you should be able to reduce your standard of living accordingly and put more money into your real investments. If that is the case, I would call putting more money into your real investments the "savings" and not consider the energy efficiency an investment.

If you can't put more money into your savings, then your purchase simply allowed you to increase your spending someplace else and was neither an investment nor did it save you any money. This principle should be applied toward anything that salespeople are apt to call an "investment," such as energy-efficient cars or time-share rental property.

Just calling something an investment doesn't make it so. Investments should appreciate at a rate that grows faster than inflation and gains purchasing power. And spending your money on non-investments can jeopardize a plan to reach your goals of financial freedom. Investments should work for you, paying you money that you can spend or reinvest elsewhere.

Comments

[jim]

"Because it is indexed to the government's official inflation numbers, it doesn't keep up with real inflation."

That seems like unsubstantiated opinion.

"Had the money we've paid into Social Security been saved and invested in almost anything, every senior would be retiring as a multimillionaire."

That is false. Even if you contributed the maximum amount and added the employer share and got 10% annual growth over a 68 year period you wouldn't hit $2M.
Most seniors contributed far less and get worse returns in private investments.

[Funny about Money]

Interesting remarks on SS. First, I have to agree with Jim: it is not true that if you invested SS you would end up a multimillionaire. Out of curiosity, one day I ran the numbers. Figuring a 4% drawdown of the results, I personally would actually collect more from SS than I would had a lifetime of FICA contributions been invested.

Additionally, not "every senior" works throughout adulthood. Some of us work as wives and mothers. That labor is not valued, either in the marketplace (except by those who want to sell us something) or through financial recognition of our occupation at retirement. A woman who spends a substantial part of her adult life caring for a husband, home, and children, working sporadically around that full-time occupation, would retire with far less than a million bucks if the equivalent of her FICA were invested.

We've all seen what happened to our private investments in a serious downturn. Despite a layoff, I still can't draw money from my IRA (which is considerably heftier than the average American's), because I need to wait until those investments recover from the crash, when I lost $180,000. Meanwhile, my Social Security benefits did not drop or disappear as a result of the economic collapse. That benefit now provides more than half my net income as I try to cobble together a living in unemployment.

So as you can imagine, I'm getting a little tired of hearing all the badmouthing of Social Security. And I'm pretty sure I wouldn't like to see my retirement savings modeled on the plan of country that was a dictatorship until 1988.

[tlm]

"At least gold holds its value"

Not so fast. Gold is subject to speculative bubbles and other nasty stuff. It's not a steady inflation tracker. Pity the man who bought gold in 1980. He needed 25 years just to break even. See:

http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx

[Tyler]

Very good post.

Jim and inflation: It's certianly not an "unsubstantiated opinion". The Federal Gov't in a briliant move changed how the offical inflation numbers were calculated. Had they not made said changes, inflation would have been higher and payments tied to inflation would thus be larger. Although there is plenty of opinion, it is certianly substantiated.

And at the current rates of SS (someone who is starting to pay in today), one would have around a million dollars that could be transfered to younger generations or spent on a nice boat all at once. Id love to opt out of SS for that very reason. Then again, its unlikely that I will ever see a dime I have put into the mess.

[StL Pastor]

It is definitely true that the Government recalculated inflation at the beginning of Clinton's term. Whether this was a legitimate move (e.g., which measure is the most accurate reflection of real inflation) is an open question, a matter of both fact and opinion.

Obviously, the calculation as to whether SS is worth it depends on one's income and how your savings do. But an annuity paying 30,000$ per year that increases with inflation does not come cheap, which is basically what S.S. is (well over half a million). It is also important not to forget that SS is calculated on your highest 7 quarters of income, which is a nice bonus when compared to what you actually put in to the system.

I'm certainly glad that since 1940 those over 65 went from being the most impoverished group of people in the country to the least impoverished group.

[StackingCash]

"Stocks average 6.5% over inflation. Bonds average 3% over inflation. Thus after 25 years, $100,000 invested in stocks will have a buying power of $483,000. And $100,000 invested in bonds will have a buying power of $209,000."

Another financial myth perpetrated by the financial community. I like how they just whip up numbers like they are an absolute truth.

I believe bullets and guns are more valuable than gold.

Social security better be there when I retire since I'm contributing. If not, I believe there will be a bloody revolution.

I'm not an extremist but I'm not a dreamer either. I think I'm a realist.

[Stephan]

StackingCash im with you, if its not there anymore when i retire, i will be serisouly pissed off since i will have paid into it for 40 years. I do think there should be a means test, a rising in the retirement age, as well as a strict rule that FICA payments should go towards these payments and not wherever the government wants them to go. That has been the problem, and i dont understand why it hasnt been fixed. any ideas?

Preferred Financial Services

[Tyler]

Good to hear you'll be pissed if SS doesnt pay out... I'm pissed its cloudy today.

Means tested? Great. So I pay the max every year of my life, and I get nothing. But at least it will all be "fair" in the minds of the majority. Looking out into the future, this unfortunate desire for "fair" is a very likely solution. Yet another great reason I'd love to opt out of the mess. I should probably pay more for my cheese burger, car, etc too. Let's means test everyone to equality.

[jim]

Yes inflation calculation process was changed in the 1990's. That is a fact. But that fact doesn't mean the new figures are wrong. The idea that the govt. current inflation index calculations are woefully inaccurate is what I consider to be just unsubstantiated opinion.

[JimL]

Those that have positive comments on social security are looking at the program from a historical point of view. Unfortunately, the system is going broke and changes will need to be made. Either higher taxes, benefit cuts or changing the eligibility age (or combination thereof) will need to be made.

Social Security is not a good deal/program if is non sustainable.

Opinions will continue to go more negative as the problems increase.

[J]

What kind of math is being used for the first post? For a $25,000 investment growing at 10% for 40 years, 25000*1.1^40=1,131,481.38 which is a capital amount much less than contributing the maximum amount to social security for a cap of $110,000 is $16500 year (7.5% of your income times two for the amount your employer contributes).

Granted a 10% return on stocks is unrealistically high unless your name is Warren Buffett, but using that assumption for a 40 year period and saving $2400 a year, which is what the government takes from a person making only $15,000 a year, millionaire status is still achieved.

[StL Pastor]

Social Security is sustainable-the changes required are not ridiculous-small benefit cuts, an increase in the retirement age, and higher taxes are all possibilities. The real budget problems in the US comes from health care spending, because it is getting so much more expensive every year.

[Squirrelers]

I appreciate the article's take on social security. The younger someone is, the more I think its a good idea to factor out SS when planning for retirement. As a 39 year old, I'm considering it a bonus if its there when I retire. I realize we pay into it, but I think its wise to look at it as a "tax", and instead focus on money you can save TODAY. Cash is king, and as the saying goes, possesion is 9/10ths of the law!