- Traditional financial strategies, which prioritize accumulation of wealth in a conventional retirement plan, as soon as people enter the workforce are not working for many households.
- The alternative financial strategy outlined here involving — aggressive elimination of student debt, greater use of 15-year mortgages, the use of Roth retirement accounts instead of conventional accounts, and additional investments outside of retirement accounts — will reduce financial stress and lead to a more secure retirement than the traditional financial plan.
Many households are struggling with historic levels of debt.
Average student debt for college graduates in 2019 was 26 percent higher in 2019 than 2009. Around half of bachelor’s degree recipients in 1992-1993 borrowed to finance their education, compared to around 65 percent today.
Increasingly, young and middle-aged adults are tapping 401(k) funds prior to retirement to meet current needs. A CNBC article reveals that nearly 60 percent of young workers have taken funds out of their 401(k) plan. A study by the Employment Benefit Research Institute (EBRI) reveals that 40 percent of terminated participants elect to prematurely takeout 15 percent of plan assets. A poll of the Boston Research Group found 22 percent of people leaving their job cashed out their 401(k) plan intending to spend the funds.
Statistics presented in a recent Business Economics article show that people who tap 401(k) plans prior to retirement were more likely to have taken out consumer loans, were more likely to have a poor credit rating and were more likely to be underwater on their mortgage than people who did not tap their 410(k) plans prior to retirement.
A CNBC portrayal of the financial status of millennials nearing the age of 40 found many members of the age cohort highly leveraged struggling to pay down student debt, using innovative ways to obtain a down payment on a home and barely able to meet monthly mortgage payments.
A 2019 Congressional Research Service Report found that the percent of elderly with debt rose from 38% in 1989 to 61% in 2021. The Urban Institute reported that the percent of people 65 and over with a mortgage rose from 21% in 1989 to 41% in 2019. A 2017 report by the Consumer Finance Protection Board found that the number of seniors with student debt increased from 700,000 to 2.8 million over the decade.
The standard financial plan, proposed by most financial advisors, emphasizing large contributions to traditional 401(k) plans instead of aggressive reduction of consumer and mortgage debt often fails to provide a secure financial outcome. Future outcomes will be worse, barring a change in strategy in financial strategy, because people are starting their careers with higher debt burdens.
The aggressive pursuit of long-term investments in stocks and bonds instead of rapid reduction in debt is especially problematic in the current market environment where stock valuations are stretched, and interest rates are at historic lows. The purchase of expensive securities inevitably leads to subpar returns when valuations return to more normal levels.
The alternative financial strategy proposed here differs from the traditional financial strategy in four important respects.
First, the alternative approach prioritizes the establishment of a solid credit rating, the creation of an emergency fund and the rapid reduction of student debt for individuals leaving school and entering the workforce. The achievement of these goals usually requires new entrants to the workforce delay or reduce 401(k) contributions for a number of years when starting their careers.
Second, the alternative financial strategy places a high priority on the growth of house equity and the elimination of all mortgage debt prior to retirement.
Many households with less than stellar credit purchase a home with a subprime mortgage. Subprime mortgages tend to have high interest rates, adjustable rates with short adjustment periods, a balloon payment, and restrictions on prepayments. The alternative financial strategy opposes the purchase of a home with an unfavorable interest rate or subprime features.
Most households currently use a 30-year fixed rate mortgage. The alternative financial strategy recommends the use of 15-year mortgages, either through the original home purchase or through a refinancing, to reduce lifetime mortgage payments and to accelerate growth in house equity.
Many financial advisors currently recommend additional catch-up payments to 401(k) plans for workers nearing retirement even when the worker will retain a mortgage in retirement. The alternative financial strategy prioritizes mortgage payoffs over additional 401(k) contributions.
Third, the alternative financial strategy utilizes Roth retirement accounts instead of conventional retirement accounts.
The decision to use Roth rather than conventional retirement accounts can increase tax burdens in working years; however, there are multiple other ways for working-age households to reduce current tax obligations. In particular, contributions to health saving accounts linked to high-deductible health plans reduce current-year tax obligations, reduce insurance premiums and like retirement accounts increase income during retirement.
The use of Roth rather than conventional retirement accounts directly reduces tax obligations in retirement, reduces the marginal tax rate for people with other sources of income and indirectly reduces tax on Social Security benefits for some households.
The use of Roth rather than conventional retirement accounts reduces the amount of money a person must park in stocks inside a retirement account because the investor no longer needs to save for taxes on disbursements. The lower taxes from use of Roth accounts reduces financial exposure to market downturns.
Retirement account fees will be lower on Roth accounts because the total annual fee is a percent of total invested assets, which is lower because tax on Roth accounts is paid prior to contributions.
The use of Roth rather than conventional retirement accounts will substantially reduce tax on inherited IRAs. This savings is larger today because of recent changes in tax rules governing inherited IRAs.
Fourth, the alternative financial strategy makes greater use of investments outside of retirement accounts including investments in stocks and investments in inflation linked bonds.
Retirement accounts are an effective way to defer taxes until retirement. However, the existence of assets outside a retirement account reduces tax obligations during retirement years.
Disbursements from conventional retirement accounts are taxed as ordinary income while taxes on capital gains and dividends are currently taxed at preferential rates. (The tax preferences for capital gains and dividends may be reduced by the Biden tax plan.)
The availability of funds outside a retirement account are especially important when retirement accounts have high annual fees and interest rates are low. The effective interest on some bonds held in retirement accounts is negative when the retirement account has a high annual fee.
There are no fees associated with the purchase bonds directly from the U.S. Treasury. These bonds have relatively low market risk. The purchase of Treasury bonds with specific maturity dates is an effective way to hedge against market down turns impacting consumption during retirement.
The traditional approach to retirement often centers on the question – How much money should be placed in a 401(k) plan in order for you to retire? There are even calculators that create estimates of the amount people need to place in a 401(k) to retire with adequate income.
The actual amount of wealth you need to place in your retirement account is indeterminate. The amount you need to save depends on several factors including whether the retirement account is Roth or conventional, retirement account fees, amount of debt, whether you plan to downsize, the quality of your health insurance and the tax status of assets outside your retirement account.
The alternative financial strategy outlined in this introductory memo recognizes that financial security cannot be summarized by the dollar value of a 401(k) plan. A person with large net worth dominated by large equity holdings in a conventional 401(k) plan is faced with large future tax obligations and is perpetually exposed to a market downturn, especially if she has a monthly mortgage bill to meet. The person could be better off with a lower 401(k) balance if she had paid off her mortgage, put money in a Roth rather than a conventional retirement account, and purchased some inflation-indexed bonds.
Several features of the alternative plan presented here will reduce the amount that you must contribute to a retirement plan and the amount you pay over your lifetime in retirement plan fees. Fees charge by retirement accounts are not a trivial matter. This report by the Center for American Progress reveals a median-wage worker might pay $138,000 in retirement fees over her lifetime.
The traditional goal of financial planners is the construction of a portfolio that will allow retirees to initially distribute 4 percent of the 401(k) balance and maintain that distribution level though out retirement. The 4 percent rule often fails to provide a sustainable level of consumption in retirement with the largest failures occurring when portfolios are closely tied to the market and the market takes a downturn early in retirement.
Some financial advisors advocate a more flexible distribution rule that mandates reductions in distributions during market downturns. It seems as though a strategy calling for sharp reductions in distributions during retirement is an admission that the financial strategy planning for retirement was a failure. An alternative financial strategy which includes alternative investment including, I-Bonds, E-Bonds and perhaps annuities, will lead to more stable consumption patterns in retirement. The alternative financial strategy would include a more stable and sustainable rule determining monthly distributions of funds.
The upcoming blog posts presented here and a larger formal paper will describe the potential benefits of the alternative financial strategy in greater detail. A detailed discussion on how to best rapidly reduce student debt and the potential advantages of the debt elimination strategy will be available at this blog soon.