Is Savings Rate More Important Than Returns?

On Monday I spoke at a pretty large gathering of 401k investors at a company whose plan we manage. During that seminar there was one question that brought me back to a point I've made once or twice before but that is crucial to understanding the importance of portfolio returns.

The importance of saving money comes up here often and although I don't bring it up often enough, for many people the manner in which they save will be more important than investment results (here the assumption is that investment results are not super human or freakishly bad).

This can matter on several different levels, you figure out for yourself whether it pertains to you or not. One way this is relevant is for people just starting out. I'll use the example of a Health Savings Account because if you have one, you've probably not had it very long. A few years ago when they first became available I believe the maximum contribution was $5000, now it is $6150. In year one if you deposited the full $5000 and had a very good year how much would you have made on the $5000? I think a real good year (not super human) might be $1000 which is obviously 20%.

At the start of the second year if you put in another $5000 the account goes from $6000 to $11,000 which is an increase of 83%--obviously not an investment gain but after the second deposit the account is much larger than the investment result and I would say the discipline to make that second deposit is more important than the investment result. If the investment result in the second year was again 20% or $2200 I would say that would still be less important than the third deposit which by now might able to be $6150 (this has been the max for three years now I believe). You can carry this out as far as you want and decide at what point you think the return is more important than the deposit but it would probably be after quite a few years as getting 20% repeatedly would drift into super human.

Someone who is 50-60 years old probably has something specific in mind about when they want to retire or what their retirement will look like (or at least an aspiration of what it will look like). If this is you, how much money do you have right now? How many more years of accumulation to you plan to have? How much per year can you save while you are still accumulating?

If you planning on 12 more years of accumulation and can put away $20,000 per year (this presumes you are at your peak earnings which we know is not the case for everyone) then we are talking about $240,000. In this example where does $240,000 stand? For some 50 year olds it will be a lot of money and for some it will be very little. If we take a middling number and say the total nest egg today is $200,000 with a 65% equity allocation and over the next 12 years that $130,000 doubles (not a super human result) and the fixed income portion goes up 40% then the $200,000 becomes $358,000. Add in the $240,000 saved and the portfolio is up to $598,000.

I realize the math is overly simple but this is not a blueprint, just an example. It is probably a push as to whether the savings is more important in this example but it is at least equally important as the withdrawal rate from $598,000 is much larger than $358,000 whether we are talking about the 4% rule or something else. I would also note from this example though that $200,000 was accumulated up to whatever age we are talking which was a period of decades compared to turning up the savings and socking away $240,000 in what the end user hopes is his last 12 years of accumulating.

A final point on this regard is that if the last ten years has taught you that you don't have a tolerance for normal stock market volatility then you might only have 40-50% in equities (maybe less?) which means less overall long term price appreciation which places a greater emphasis on savings or as I've worded it before if you want less stock market exposure, no problem, just plan on saving more money.

As a follow up to yesterday's post about dividends a reader at Seeking Alpha left the following comment;

"Even a portfolio with a market equaling yield of 2-ish percent would only need modest gains to meet a reasonable withdrawal rate."

Does this mean that you sell some of the portfolio?

Once the selling starts, when does it stop?

Doesn't selling off assets increase the risk that the client might "outlive their money"?

My reply;

There are countless studies from different sources that draw the same conclusion about a 4% withdrawal rate having a 90-95% success rate (that is not outliving your money).

From where I sit a combination of price appreciation, stock dividends and bond interest over a long period of time works if the account holder can stick to 4%. There will of course be down years but the number crunching behind the 4% rule takes that into account. There is no guarantee but the numbers can work.

The picture is from the green sand beach on the Big Island. The sand is actually green, kind of pea soup colored.