Retirement Planning Types of Retirement

Retirement Planning

Types of Retirement Accounts

There are a number of different types of retirement accounts, with different tax characteristics, so it is important to understand what each of them is. The first type is the IRA, or Individual Retirement Arrangement. This is a tax-deferred plan. The traditional IRA can be set up with any number of different financial institutions. Under the IRA, gains from the investments are not taxed when they are realized within the plan. Instead, they are taxed when withdrawn in retirement as income (IRS.gov, 2013). Other features of a traditional IRA are that you may open one even if you have another type of retirement plan. In most cases, contributions to a traditional IRA are tax deductible.

A Roth IRA is similar, but with some differentiating features. Contributions to Roth IRAs are not tax deductible (IRS.gov, 2013, 2). The difference is that on withdrawal, the money in the Roth IRA is also not taxed, including income earned on that account. The difference is that the Roth IRA is tax-exempt savings rather than tax-deferred (Wolpe, 2013).

While the IRAs are individual plans, a 401K plan is sponsored by an employer. Under this type of plan, part of a paycheck is deferred to the plan on a pre-tax basis. Taxes on the money are only paid when the money is withdrawn in retirement (WSJ, 2013). The benefit of deferred taxation, as with a traditional IRA as well, is the assumption that the tax rate in retirement will be lower than the tax rate during one's working years.

The Portfolio

The goal of the portfolio is to have $1.1 million future value at the age of 72. We do not know the current age of the person in question. The present day value of the portfolio is $488,000. There are four types of securities that are to be included in the portfolio. These are bonds, large cap stocks, small cap stocks, and foreign stocks. We do not know the expected or historic returns of these different instruments. We do not know the risk tolerance of the account holder, but we will assume this is a young person with moderate risk tolerance and a 50-year investment horizon. We do not know the amount of money available to start the plan today and we do not know how much this person expects to put into the plan.

We do not know if this person has an employer that offers a 401K plan or what the amount of such a plan might be. Most employers do offer a 401K, but without this knowledge it will be assumed that there is no 401K. This leaves us with a choice of a traditional IRA and a Roth IRA. The traditional IRA is a tax-deferred plan, which has the benefit of lowering the tax burden of the client through the course of the client's working life. The Roth IRA is tax exempt, so contributions to that plan are paid out with net dollars. The more desirable plan at present is the traditional IRA, since we will assume that the client needs to minimize the tax burden during the working years, either to help finance daily living (or a house) or because the client has a good job and therefore a high marginal tax rate.

Asset Allocation

For this client, asset allocation can be relatively aggressive with respect to risk. Even with a moderate risk aversion, the client is young and has a very long investment horizon. If the money is in a traditional IRA, the client is unlikely to withdraw these funds prior to retirement, so is therefore unlikely to be forced to take a loss on any security that happens to be underwater in the short-run. There is, at this point, no need for there to be any bonds. It is also worth considering that interest rates are very low right now, so even long-term corporates are not paying much. To get a reasonable return on a corporate these days, one must sacrifice investment quality, at which point it makes more sense to purchase a higher-quality equity.

With respect to asset classes among equities, diversification is the most important objective. With that in mind, all three categories should be represented. Historically, the large caps are the most reliable of the three asset classes, with the lowest risk. These are companies with large markets and they operate in the U.S. so there is little information asymmetry with respect to these stocks. Since the other two classes are higher-risk, they should carry with them a premium. It is worth remembering, however, that most U.S. large caps have a lot of exposure to foreign markets. Rather than investing in a Chinese company you know nothing about to get access to China's growth, you would do just as well to invest in Starbucks or Wal-Mart, both of whom have tied much of their growth plans in the next few years on China. It is also worth noting that it is easier to invest in foreign stocks that have ADRs in the U.S., or in mutual funds, as this reduces the information asymmetry.

Given that reality of globalization in U.S. large caps, and the information asymmetry, not to mention foreign exchange rate exposure, the focus of the portfolio should be on U.S. stocks. Thus, a recommended allocation should be 50% large cap, 30% small cap and 20% foreign stocks. This is an aggressive asset allocation, but working with a fifty-year time horizon an aggressive allocation can be made. The risk is high for an all-equity plan, but the time horizon has historically been large enough that an average growth rate will be achieved. It would require the United States to enter a sustained period of economic catastrophe for this portfolio not to experience growth. It is worth remembering that during such a period interest rates on debt will be rock bottom as well, offering little or no gain in nominal terms, much less real.

This asset allocation delivers high growth potential. If we assume 7% as an average annual return for this portfolio, the initial investment only needs to be $20,560, with no subsequent investments. If an initial investment of $2,000 is assumed, with additional deposits into the account of 5% more per year, then the portfolio only needs to earn 4.8%, which is well within the range of what an equity portfolio can expect to earn. This is, of course, a nominal return. The portfolio needs to accommodate around 2% inflation per year for a real return. Thus, if the portfolio proposed earns 7% nominal, that is 5% real, which is enough to just break the $1,100,000 mark in future dollars.