A Summer Grab Bag

The secrets to sound retirement planning? Invest as much as you can as early as you can, and reduce volatility to produce better outcomes.

W. Scott Simon


In the dog days of some summers past, I have assembled a number of disparate topics in one column. They don’t merit treatment on their own, but they still seem to be worthy of a good mention.

Contribute as Much as You Can as Soon as You Can–and Never Break That Discipline

The famous conviction, “The battle of Waterloo was won on the playing fields of Eton,” may (or may not) have been uttered by the Duke of Wellington to explain his victory over Napoleon Bonaparte.

Akin to this seemingly remote cause and the enormous affect that it produced (at least perhaps in the Duke’s mind): The start dates and participants’ contribution rates to retirement plans are the biggest determinants of the terminal wealth they amass by retirement.

Let’s isolate two mathematical issues at work here. The first is the simple arithmetic difference between given contribution rates of, say, 3% and 6%. Of course someone contributing 6% over the same period as someone contributing 3% will end up ahead. Further, both contribution rates will be subject to some exponential rate of growth that will (presumably!) generate compounding of wealth over time that favors the investor who contributed more.

The key here is to get plan participants to understand that they should maximize their contribution rate from the first day they enroll in a retirement plan. Some won’t contribute anything, because they think the amount that they can afford to contribute is inconsequential. But any amount is better than none, if for no other reason than to get such participants to begin psychologically to commit to a regular routine of contributions, however small the amount.

It’s often difficult to get participants to realize the link between what appears to be a paltry percentage contribution rate and a large terminal dollar wealth that can result from long-term compounding. That’s frustrating enough but, in my view, what’s even worse is that many plan participants fail to maximize their contribution rate from the get-go so that they can maximize the compounding rate at which their wealth will grow over time.

A compounding rate will be whatever it will be and so it will take care of itself. But a participant’s contribution rate is within his or her power to control. Many participants can contribute, say, 6% instead of 3%, but they won’t take the time to examine their monthly budget to reassure themselves that they can do so. As a result, far too many participants end up contributing at a lower rate to their plan account than they otherwise could, resulting unnecessarily in lower compounded terminal wealth at retirement. This is especially a problem when participants and their employer together should be contributing 15% to 20% of compensation to participant plan accounts.

At one of the plans that our registered investment advisory firm manages, we have two plan participants who are both in their early 60s and still working. One began plan contributions at age 34 and the other at age 37, so neither has even 30 years of contributions. No doubt over that time period, there were variations in the quality of plan investment options as well as the costs that they imposed on plan participants. In neither case could the participants say what their contributions rates were over time.

Be that as it may, one participant has amassed $1.4 million in his plan account and the other $1.7 million. Note that one participant was pushing 40, and the other wasn’t too far behind when they began contributing to their plans. These were not 20-somethings, so even those midcareer accumulators who have never been invested in a retirement plan can take hope that it’s possible to build a substantial nest egg for a comfortable retirement. You just need to get started.

It’s safe to say that these two plan participants contributed as much as they could as soon as they could and never broke that discipline. That should be the guide for all plan participants, whether they can contribute, say, 3% or 10% each pay period. In either case, a seemingly remote cause–a relatively inconsequential percentage contribution–can, in many cases, generate an enormous effect: amassing dollar outcomes. But it is critically important to first maximize the contribution rate because that’s the basis for all that follows.

The idea of “enormity,” of course, is relative to a higher earner winding up with $1.4 million or $1.7 million, or a lower earner winding up with, say, $300,000. In many cases, though, the amount amassed by the lower earner is a source of greater pride and accomplishment–especially if the lower earner had never been able to save much of anything before–than that of the higher earner. That’s why I always tell participants to contribute to their plan account as much as they can, just short of when it begins to hurt, as soon as they can and never break that discipline.

Reducing Portfolio Volatility is Critical

According to Nobel laureate Harry Markowitz, the father of modern portfolio theory, investment returns are random variables subject to inherent uncertainty. They are therefore unknowable in advance of their occurrence. So it’s preferable for investors to focus on portfolio costs and risk–which they can control–and not worry so much about portfolio return, which they cannot control. Apart from reduction of costs, reducing a portfolio’s volatility reduces its (diversifiable) risk.

An example illustrates the importance of reducing volatility. A $100 investment makes a 50% return after a year, climbing in value to $150. If 50% of that $150 is lost in the second year, the ending value is $75 ($150 less $75). Even though the simple average return was 0% (50%-50%), the actual loss is $25 ($100-$75) by the end of the second year. Reducing the range of gains and losses from ±50% to ±25%, results in a value of $93.75, or a loss of $6.25. Reducing the range further to ±12.5% results in a value of $98.44, or a loss of $1.56. Note that each time the volatility range is reduced by one half (±50% to ±25% to ±12.5%), the resultant loss is 4 times smaller ($25 to $6.25 to $1.56).

From this we see that losses can have a bigger impact on a portfolio than gains, and large losses have a proportionally bigger impact. These dry mathematical facts square quite nicely with section 404(a)(1)(C) of the Employee Retirement Income Security Act of 1974, in which a fiduciary shall discharge its duties “by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.”

Apart from the preceding perspective of (lower) mathematics, this issue can be restated from a (perhaps higher) mental/emotional perspective: Losses have a bigger impact on an investor’s brain (often producing bad investment decision-making) than gains, and large losses have a proportionally bigger impact on an investor’s brain (often producing even worse investment decision-making). So the best way to reduce portfolio losses is to reduce portfolio volatility, and the best way to do that is to broadly and deeply diversify portfolios as much as possible.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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