Download The Importance of Being Earnest

2013 | EYE ON THE MARKET SPECIAL PUBLICATION
T HE IM P O RTAN CE O F BEING EA R NEST
IMPLICATIONS OF SAVING, INVESTING AND FUTURE
POLICY CHANGES ON TODAY'S WEALTHY INVESTOR
MARY CALLAHAN ERDOES
Chief Executive Officer
J.P. Morgan Asset Management
How do you summarize a year that was in many respects indefinable? On one
How do you plan for the unknown? In many respects, that’s the challenge we are all facing as
hand, the European sovereign debt crisis, contracting housing markets and high
we move
toward retirement.
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To help guide you in the coming year, our Chief Investment Officer Michael
economic, investment and retirement experts have left no stone unturned in identifying how
Cembalest has spent the past several months working with our investment
bestleadership
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reach for families who recognize the “importance of being earnest” with careful planning and
Mostinvestment
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the right
Families around the world are increasingly being expected to control their own financial
destiny. But that doesn’t mean you have to do it alone. We hope this study provides you with
new ideas and insights, and we look forward to helping you achieve a secure retirement.
As always, we thank you for your continued trust and confidence in us.
Most sincerely,
MI CHAEL CEMBALE S T
Chairman of Market and Investment Strategy
J.P. Morgan Asset Management
Michael Cembalest is Chairman of Market and Investment Strategy for J.P. Morgan Asset Management, a global leader
in investment management and private banking with $2.0 trillion of client assets worldwide. He is responsible for leading
the strategic market and investment insights across the firm’s Institutional, Funds and Private Banking businesses.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment Committee and a member of
the Investment Committee for the J.P. Morgan Retirement Plan for the firm’s 260,000 employees.
Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private Bank, a role he held for eight
years. He was previously head of a fixed income division of Investment Management, with responsibility for high
grade, high yield, emerging markets and municipal bonds.
Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging Markets Fixed Income at
J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in 1987 as a member of the firm’s Corporate Finance division.
Mr. Cembalest earned an M.A. from the Columbia School of International and Public Affairs in 1986 and a B.A. from
Tufts University in 1984.
JA NINE R AC A NELLI
Global Head of Advice Lab
J.P. Morgan Asset Management
Janine Racanelli is Global Head of J.P. Morgan Private Bank’s Advice Lab and Wealth Advisory practice.
Ms. Racanelli’s expertise encompasses U.S. and cross-border tax, wealth transfer and charitable-giving
strategies. In 2005, she assumed responsibility for Advice Lab, the Private Bank’s think tank, staffed with a
multidisciplinary team of experts responsible for developing innovative strategies in the areas of taxation,
executive compensation, philanthropy, analytical techniques and global ownership structures.
Ms. Racanelli is an attorney admitted to practice law in New York and before the U.S. Tax Court. Before joining
J.P. Morgan in 1993, she practiced law at Paul, Weiss, Rifkind, Wharton and Garrison, specializing in tax, estate
planning and administration and representation of fiduciaries.
Ms. Racanelli is a frequent author and speaker on investment and wealth planning topics. She has been
featured in national publications such as Barron’s, BusinessWeek, The Wall Street Journal and Forbes, and has
appeared on CNBC’s Power Lunch. Ms. Racanelli is the co-author of Stocker and Rikoon on Drawing Wills and
Trusts, published by the Practicing Law Institute, and an adjunct professor of law at Fordham University School
of Law. She serves on the Memorial Sloan-Kettering Cancer Center Trust and Estate Advisory Committee,
the New York-Presbyterian Hospital Planned Giving Advisory Council and the Metropolitan Museum of Art
Professional Advisory Council.
Ms. Racanelli received her B.A. from St. John’s University and her J.D. from St. John’s University of Law.
AN T H O N Y WO O D S
Advice Lab
J.P. Morgan Asset Management
Anthony E. Woods is an Executive Director in the Advice Lab group at J.P. Morgan Private Bank. Since joining
the Private Bank 12 years ago, Mr. Woods has been responsible for analyzing legislative developments and their
implications for wealth and estate planning.
During this time, Mr. Woods has published articles in Trusts & Estates on legislative developments and estate tax
decoupling. He has also co-authored several ALI-ABA papers on new developments in international estate planning.
A graduate of Kalamazoo College, Mr. Woods also has an M.A. and Ph.D. in History from Michigan State University.
SUMMARY
Many Americans live for two to three decades after they retire.
Without adequate planning, even some wealthy families may not be
able to sustain the standard of living they had become accustomed to
during their working years. This paper examines retirement dynamics
for wealthy families whose retirement assets range from $5–$10 million
in 2012 dollars.1 We focus on the availability and use of qualified retirement plans, the balance between savings and spending, and the level
of portfolio risk. Given the long-term outlook for the Federal debt and
the search for a “grand bargain,” future retirees may need to increase
precautionary savings given the policy options under discussion, many of
which may impact them substantially. Some of our observations:
• Know what your savings rate is, including all your pre-tax contributions
to savings plans. Ideally, it should be north of 20%.
• Monitor investment risk in the assets you put aside for retirement.
Underinvesting and overspending are a potentially toxic combination.
• You should generally maximize all available forms of pre-tax savings
that allow for tax-free compounding.
• Policy risks facing wealthy families and longer lifespans increase the
amount of assets families are likely to need in retirement.
There are of course very wealthy families whose assets will almost certainly outlive them, and whose investment focus is often on structuring assets
with an eye toward the next generation and/or their philanthropic interests. This paper is not geared to such families. Instead, for purposes of this
analysis, we assume a wealthy family that retires with $5–$10 million in assets (in 2012 dollars), and analyze the prospects for their wealth sustaining
them to the end of retirement, rather than surviving them.
1
In addition to this document, we have also prepared similar analyses of retirement dynamics for affluent and median income families. Please
contact your J.P. Morgan coverage team if you would like to receive them.
J.P. MORGA N | 3
THE WE A LT H Y FAM ILY:
ON T HE I MP ORTAN CE OF BEING E ARNEST
Retirement income is the byproduct of factors over which families have no control
(market returns, policy regarding taxation, savings and entitlements), some control
(longevity, employment) and total control (consumption vs. savings, and portfolio
risk). A framework based on history is a good place to start, as it allows us to
understand the scope of what’s possible. Let’s examine the Browns when they retire
in 2013 at age 62 (see sidebar for background).
THE BROWNS:
• Have one working spouse that since 1975
consistently earns 12x the median income
(in 2012, 12x MI = $670,000)
• Buy a home once they save enough for a
down payment and which they own free
and clear by retirement
How much post-retirement cash flow do the Browns need? For wealthy families like the
Browns, we assume they need 80% of what they lived on before retirement. Here’s how
it works: in 2012, they earn $670,000, put $22,500 in a 401(k) plan, pay their taxes, invest
$72,000 out of after-tax income and live on what is left, which is ~$410,000. Using the
80% target, the Browns would be able to live off of ~$330,000 beginning in 2013.
We grow this target each year by inflation so that their post-retirement income maintains
its purchasing power.
• Max out pre-tax 401(k) contributions and
benefit from a 3% employer match
• Put aside another 15% of after-tax income
in a savings account, for a total lifetime
savings rate of 26% (4% above our rough
estimate of “average” for their income
demographic; see Appendix 1 for more
details)
Exhibit 1 looks at the Browns’ financial assets. They accumulate $7 million by retirement,
which they gradually deplete. Exhibit 2 shows how they finance their cash flow target:
they run down after-tax savings first and do not draw from their 401(k) (to retain pre-tax
compounding benefits) until the minimum 401(k) mandatory distributions begin. Note
that the Browns need to come up with enough cash to meet their income target, and
taxes payable on 401(k) distributions.
• Invest in a balanced portfolio of 65%
equities at age 25, declining to 45% by age
62 (remainder in fixed income)
• Intend to spend $330,000 in 2013 when
they retire, adjusted upward for inflation
each year
By making consistent pre-tax contributions to savings and sticking to a balanced portfolio
approach, the Browns are able to live out their retirement to age 90 with their cash flow
target intact, and with a substantial sum left for the next generation. Life’s emergencies and
unexpected hardships can get in the way, but this outcome is well within the realm of the
possible. Note that the Browns’ savings rate is around 26%, which is 4% above our rough
estimate for their income demographic. Appendix 1 contains a description of what savings
rates mean, how they are computed, and what “average” is for a wealthy family. The Browns
demonstrate the importance of being earnest about saving and investing: families that
don’t do this as aggressively face greater challenges in retirement, as we’ll explain.
EXHIBIT 1: Baseline case: high lifetime savings rate and
balanced investing gets the Browns through retirement
EXHIBIT 2: Baseline case: how the Browns meet their
cash flow needs in retirement
Value of financial assets
$700,000
$8,000,000
$7,000,000
$500,000
$6,000,000
Baseline
$5,000,000
$300,000
$3,000,000
$200,000
$2,000,000
$100,000
$1,000,000
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
4
Income target
$400,000
$4,000,000
$0
1972
Withdrawal from after-tax savings
Mandatory 401(k) distribution
Social Security benefits
$600,000
Retirement
| THE IMP ORTA N C E O F B E ING E A RNE ST
$0
2013
2017
2021
2025
2029
2033
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
2037
Spending conservation in retirement
Many retirement studies suggest only a modest decline in post-retirement spending
needs relative to pre-retirement patterns. The reason: most median income retirees
have greater inelastic spending needs that cannot be easily cut. For wealthier families
in the Browns’ demographic, we assume greater conservation potential such that
post-retirement cash flow needs can fall to 80% of pre-retirement levels. Sources of
spending conservation often include a decline in graduate and post-graduate assistance
for children now in the workforce; charitable contributions; mortgage costs; work-related
apparel, transportation, entertainment and food expenses; and an eventual end to the
need for financial assistance to aging parents.
The concept of post-retirement spending is a critical one in retirement dynamics.
Even if the Browns are diligent about saving and investing, should they set a spending
target equal to 100% of pre-retirement spending, their assets would be depleted much
more quickly, requiring the family to monetize some of the value of their home
(Exhibit 3). Of course, a family would not maintain such a high spending rate, and
would cut back at some point before exhausting their assets; the point is that without
any plans to reduce spending, a lot more saving would need to take place beforehand.
A family intending to spend 100% of pre-retirement cash flow would need a lifetime
savings rate of 31% rather than 26% to recapture the cushion of the baseline case.
EXHIBIT 3: Maintaining pre-retirement spending levels in
retirement is often unsustainable
Value of financial assets
$8,000,000
Baseline 80%
spend target
$7,000,000
$6,000,000
$5,000,000
$4,000,000
$3,000,000
Baseline 100%
spend target
$2,000,000
$1,000,000
$0
1972
Home sale
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
A note on the family home. In some cases we analyze, after the family’s financial assets
are exhausted, the family is assumed to sell their home and live off the proceeds for as
long as they last. For some families, that decision might take place earlier in retirement
as a means of boosting savings (when, for example, the family downsizes into a less
expensive home). Such a step would allow tax-advantaged savings balances such as their
401(k) to accrue for a longer period of time before being withdrawn. Another means of
accessing home equity would be to borrow against the appreciated value in the house,
which, for some families, is substantial after a couple of decades of home price appreciation.
Even with the recent home price collapse factored in, the Browns’ house tripled in value
since 1979 (rising at 3.5% per year).
J.P. MORGA N | 5
What if the Browns didn't use a 401(k) plan, but were
still diligent about saving?
Most wealthy families are aware of the benefits of 401(k) plans with employer matching:
the ability to compound investments on a tax-free basis, and then withdraw them in
retirement when they are generally taxed at lower marginal tax rates. However, to get
a sense of the magnitude of such benefits, let’s reevaluate the baseline case when the
family only saves with after-tax money, but has the same savings discipline. Exhibit 4 shows
how the Browns would come close to running out of financial assets late in retirement.
The bottom line: even though their 401(k) contributions are capped, the benefits of taxadvantaged savings plans for families like the Browns are meaningful in the context of
their overall wealth.2
EXHIBIT 4: Measuring the benefits of pre-tax savings and
tax-free compounding
Value of financial assets
$8,000,000
Baseline
$7,000,000
$6,000,000
$5,000,000
$4,000,000
$3,000,000
Same savings
behavior,
no pre-tax savings
$2,000,000
$1,000,000
$0
1972
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
Many self-employed individuals have greater control over employer contributions to tax-advantaged retirement accounts (SEP IRA, Solo 401(k), etc).
As a result, they can effectively save more in these plans than non-self-employed individuals, who are subject to IRS limits on employee
contributions, and who benefit from traditionally smaller employer contributions. However, the benefits for the self-employed of maximizing
contributions need to be weighed against a plan’s administrative complexity, and the cost of contribution requirements that might have to be
extended to other employees (if any). Even in the case where the net benefit is positive, the key conclusions reached above for the Brown family
would not be significantly different. In other words, a slightly higher level of tax-advantaged investing cannot offset the cost of much higher
spending, underinvesting or substantial government policy changes.
2
6
| T HE IMP ORTA N C E O F B EING E A RNE ST
Are there other tax-advantaged savings accounts
worth considering?
There’s another 401(k) option that can increase the benefit of tax-free compounding:
Roth 401(k) plans. Roth 401(k) plans are like traditional 401(k) plans, but involve
the contribution of after-tax dollars to an account that compounds tax free, and
which is not subject to taxation upon withdrawal. The largest benefits of Roth
401(k) plans generally accrue to families that anticipate much higher tax rates in
retirement, and families whose intended contributions are higher than prevailing
401(k) caps. On the latter point, since traditional and Roth 401(k) contribution
limits are the same, the Roth version effectively allows greater value to compound,
as it is funded with after-tax dollars. Exhibit 5 shows the benefit of a Roth 401(k)
plan in our baseline case, when the family is constrained by IRS contribution limits.
In the chart, we assume that the current tax code is the same in the future. If future tax
rates were considerably lower than today’s, much or all of the benefits of Roth
401(k) plans could be eliminated.3
EXHIBIT 5: The benefits of Roth 401(k) plans, assuming an
unchanged tax code
Value of financial assets
$8,000,000
Roth 401(k)
$7,000,000
$6,000,000
$5,000,000
Baseline
$4,000,000
$3,000,000
$2,000,000
$1,000,000
$0
1972
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
Our Advice Lab teams routinely review with clients the break-even tax rates that would make Roth 401(k) plans preferable to traditional versions,
subject to a set of assumptions regarding their investment horizon, investment choices, etc. In the chart, we assume a Roth 401(k) option was
available for the duration of the analysis with the same contribution limits as a traditional 401(k), even though the Roth 401(k) has only been
available since 2006.
3
J.P. MORGA N | 7
Are there other tax-advantaged savings accounts
worth considering? (Continued)
Some families can add pre-tax dollars to savings plans that are not subject to any IRS
contribution limits, if they have access to non-qualified deferred compensation plans
through their employer. Additional pre-tax compounding is beneficial to family wealth
dynamics, but families should be conscious of the credit risks associated with non-qualified
plans and monitor their concentrations accordingly.
Some analysts assess the risk of non-qualified deferred compensation plans by looking at
the magnitude of compositional changes in the Dow or S&P over 20- and 30-year periods.
However, these index changes occur not just as a result of bankruptcy, but also due to
mergers, acquisitions and spin-offs. As a result, the default risk on investment-grade and
high yield bonds is a better way to understand the credit risk associated with non-qualified
deferred compensation plans. Historically, such default risks have been highly cyclical,
and reflect the swings in the business cycle. In Appendix 2, we include a chart on high
yield default rates since 1981; they trough at 2% during the peaks of the cycle, and rise to
10%-12% during recessions. The incidence of investment-grade defaults are much lower,
as shown in a separate chart in Appendix 2.
Families accumulating large amounts of after-tax savings can also try to increase
investment and tax efficiency by investing in a non-deductible IRA. The benefits vs.
ordinary after-tax savings accounts: the IRA would compound on a pre-tax basis.
However, some income that would have been taxed as capital gains is taxed as ordinary
income (net of original basis) upon withdrawal. The net benefit depends on the time
horizon (the longer, the better), and the nature of the investment in the IRA (the less
tax-efficient, the better). Investments that generate a lot of ordinary income (fixed
income, many hedge funds, etc.) are good choices for non-deductible IRAs, annuities and
other savings plans funded with after-tax dollars.
In the following sections, we analyze changes in the Browns’ savings and investment
behavior relative to the baseline case, all assuming retirement at age 62, a traditional
401(k) plan, and without any benefit from non-qualified deferred compensation plans.
8
| T HE IMP ORTA N C E OF B EING E A RNE ST
Challenges for retirees: very conservative long-term
investing and too much spending
What if the Browns maximized the use of their 401(k), but invested more conservatively?
Assume an equity allocation of 50% at age 25, declining to 35% by retirement. Their
assets do not accumulate as rapidly, and unless future fixed income returns match the
past, their assets will decline more rapidly (Exhibit 6). We think it’s unlikely: the trailing
35-year real return on 5-year Treasuries at the end of 2012, for example, was the highest
since 1926.
The big spender is an even bigger problem: what if the Browns were balanced investors,
but their lifetime savings rate were lower? First we need to figure out what a wealthy
big spender would look like. In the baseline case, the Browns had a lifetime savings rate
in the neighborhood of 26%. So, let’s assume a big spender with a savings rate of 21%
instead. In this case, the Browns accumulate $2 million less by retirement, run down
savings much faster, and need to access their home equity (Exhibit 7). The takeaway
here: if your retirement relies mostly on your own asset growth (rather than on
Social Security or defined benefit pension payments), it is suboptimal to either
underinvest or overspend. Of course, combining overly conservative investing and
excessive spending would simply compound their retirement problem.
R E S I S T I N G T E M P TAT I O N
Saving is a constant battle against the
temptation to overspend. Perhaps more
than any other country, the United States
effectively encourages its citizens to spend,
which may explain why consumption is so
high relative to GDP (71%). Examples of
pro-spending policies include:
• Lower sales, VAT, excise and import duties
on a wide range of goods and services,
including fuel, food, wine, electronics,
accountants and lawyers
• Favorable tax treatment of housing
(mortgage interest deduction, capital
gains exemption on sale of residence),
which results in lower population
densities, greater suburban sprawl and
increased household spending on home
improvements, transportation, etc.
• Lack of single-payer healthcare leads to
greater healthcare consumption (U.S.
private sector healthcare expenditures are
more than twice every other OECD country)
EXHIBIT 6: The more conservative investor
EXHIBIT 7: The big spender
Value of financial assets
Value of financial assets
$8,000,000
$8,000,000
Baseline
$7,000,000
Baseline
$7,000,000
$6,000,000
$6,000,000
$5,000,000
$5,000,000
$4,000,000
$4,000,000
$3,000,000
$3,000,000
$2,000,000
More conservative
investor
$1,000,000
$0
1972
1982
1992
2002
2012
2022
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
2032
$2,000,000
Big spender
$1,000,000
$0
1972
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
J.P. MORGA N | 9
Challenges for retirees: very conservative long-term
investing and too much spending (Continued)
Can the overspending Browns invest their way out of an undersaving hole? It would be
difficult, if not impossible. Exhibit 8 shows the relationship between savings rates and
required equity returns, where the required equity return is the real compound annual
equity return needed for the big spender to regain the equity cushion of the baseline
case. For example, a family with a 20% savings rate would need a real equity return
of 9.2% over several decades to compensate for undersaving vs. the baseline. That is
substantially above the real returns of the S&P over almost any timeframe. That’s why
we consistently stress the importance of saving first, and get into discussions about
investments later.
EXHIBIT 8: Extraordinary equity returns needed to
compensate for undersaving
Real annual equity return over one’s entire lifetime
16%
For a big spender, equity
returns required to regain
$3.5 million final value
cushion of baseline case
14%
12%
10%
(9.2%, 20.2%)
8%
6%
11%
13%
15%
17%
19%
21%
Savings rate
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
10
| T HE IMP ORTA N C E OF B EING E A RNE ST
23%
25%
What about wealthy retirees of the future?
A historical framework is helpful since it allows us to contemplate how the future might be
different. We can superimpose some new assumptions over historical ones, while leaving
others unchanged. First, let’s address market returns. As shown in Exhibit 9, returns on
U.S. equities from 1977 to 2012 were favorable. Even after incorporating the lost decade of
the 2000s, with its two 40%+ equity declines, the annualized return on the S&P 500 over
this period was approximately 7% above inflation. One catalyst for these high returns was
the decline in interest rates that began in 1982, which has obviously run its course. The
lower end of the range of post-war, long-term real equity returns is closer to 5%; over long
periods, this 2% difference adds up to a lot. In the baseline case, the Browns retire with
$7 million based on actual equity returns that were 7% over inflation. Had equity returns
been 5% over inflation instead, they would have retired with $1 million less.
Positive returns on government and corporate bonds over the past 30 years also benefited
from the great disinflation and are not repeatable (even after the Federal Reserve’s “War
on Savers” shown in Appendix 2 eventually comes to an end). The real returns on 5-year
Treasury bonds were 3.5% from 1975 to 2012, a result we do not anticipate in the future.
As a result, a look at future retirees should incorporate the risk (although not the certainty)
of modestly lower long-run real returns on stocks and bonds.
EXHIBIT 9: Long-term return on the S&P 500, highlighting
the post-war channel of real returns
35-year annualized return
15%
Nominal return
13%
11%
9%
7%
5%
3%
1905
Real return
1915
1925
1935
1945
1955
1965
1975
1985
1995 2005
Source: Robert J. Shiller data set, JPMAM.
J.P. MORGA N | 11
What about wealthy retirees of the future?
(Continued)
Second, there is the issue of the U.S. fiscal situation and how future policy
decisions may impact wealthy families. As shown in Exhibit 10, entitlement
spending has been steadily crowding out other forms of government spending
(e.g., infrastructure, energy R&D, worker retraining, etc.), and a national debate
has begun about the most sensible policy options. Some argue that tax rates
should keep rising so that no expenditures have to be cut; others argue for reductions
in entitlements; and still others argue for neither, suggesting that the U.S. run
larger fiscal deficits given the market’s complacency about them. One thing is for
sure: there is little discretionary spending left to cut. As shown in Exhibit 11, by
2017, the first phase of the Budget Control Act will reduce non-defense discretionary
spending well below the lowest level of the last 40 years. If the sequester is not
amended, non-defense discretionary spending will decline even more. Recent data
show that the budget deficit is falling markedly from year to year, and should hit
around 3% in 2015. However, the overall level of debt is expected to stabilize at
around 75% of GDP, according to the Congressional Budget Office, and is likely to
exert constant pressure on policymakers to shrink it.
EXHIBIT 11: Non-defense discretionary spending: already
low after BCA kicks in
EXHIBIT 10: Government spending by category
Percent of GDP, historical and CBO baseline case 2013-2023
25%
Gov’t receipts
20%
15%
5.5%
Other mandatory
spending
5.0%
Social Security,
Medicare, Medicaid
10%
Assuming spending caps from the Budget
Control Act but without the sequester
5%
0%
1972
1977
1982
1987
1992
1997
2002 2007
2012
Source: CBO, OMB, JPMAM.
12
| T HE IMP ORTA N C E OF B E ING E A RNE ST
2017
2022
Percent of GDP
Interest
4.5%
4.0%
Discretionary
3.5%
Defense
3.0%
Assuming spending caps from the Budget
Control Act but without the sequester
2.5%
2.0%
1962
1973
Source: CBO, OMB.
1984
1995
2006
2017
While we don't know where the fiscal debate will end up, potential outcomes could
negatively affect wealthy retirees:
ISSUE
POTENTIAL OUTCOME IN THE FUTURE
Social Security. Congress might change indexation formulas
(designed to reduce cost-of-living adjustments), means-test
Social Security payments and raise the eligibility age for full
benefits.
Changing indexation results in payments lagging behind overall inflation
by 0.4% per year. Benefits are means-tested as per methodology
explained in Appendix 3, and the eligibility age for full benefits is raised
from 66 to 69.
Medicare. All families qualify for Medicare as long as they fulfill the
“years worked” eligibility requirement. Pressures emanating from the
fiscal policy debate may result in changes which effectively increase
medical expenses for wealthy families.4 Possible examples include
higher co-pays or more limited coverage for certain procedures and/or
requirements to purchase supplemental insurance for treatments
deemed outside basic coverage.
A wealthy family must purchase supplemental Medicare insurance
at an annual cost of 2% of pre-retirement income. Exhibit 13 shows
the increase in medical spending by age group as a percent of
after-tax income.
Taxation. Future retirees may be subject to higher effective tax
rates during their working lives and in retirement. The tax code is
already quite progressive (see Exhibit 12), but so-called “grand
bargain” compromises may further increase effective tax rates for
wealthy families by raising statutory tax rates and/or by limiting
deductions.
Tax rates on all brackets revert to higher pre-2001 levels. In addition,
Pease limitations on itemized deductions are increased (3% exclusion
raised to 4%, $300,000 threshold lowered to $250,000).
Restrictions on the use of pre-tax savings plans, such as those
proposed in Bowles-Simpson and in the President’s budget, overriding
current caps now in place. Some proposals curtail contributions as
a percent of income, while others restrict further contributions
once assets accumulated reach a given threshold.
Limits are applied to 401(k) contributions as per the Bowles-Simpson
proposals (the “20/20” rule), overriding existing caps.
EXHIBIT 12: The progressivity of retiree tax rates
EXHIBIT 13: Retirees spend much more of their incomes on healthcare
Effective federal income and payroll tax rate, percent
Avg. healthcare expenditure, percent of avg. after-tax income
35%
12%
30%
10%
25%
8%
20%
6%
15%
4%
10%
2%
5%
0%
0%
0
200
Source: IRS, JPMAM.
4
400
600
Gross income, thousands
800
1,000
25-34
35-44
45-54
55-64
65+
Age of reference person
Source: BLS, JPMAM.
Some estimates of retiree medical expense needs are higher than the ones we use in our analysis. An Employee Benefit Research Institute paper in
2006 estimated that a 55-year-old couple, planning to retire at age 65, would need to accumulate more than $400,000 during the next 10 years to
afford supplemental health costs, beyond what Medicare already covers, through age 90.
J.P. MORGA N | 13
The Browns of the future
Let’s return to the baseline case (balanced investing and consistent high levels of pre-tax
saving), and assume that all of the future policy changes shown in the table on the
previous page come to pass. Let’s also assume that real equity returns are 5% above
inflation (the lower end of the range shown in Exhibit 9), and that fixed income returns
are closer to 2% over inflation instead of the historical 3.5%. The chart below (Exhibit
14) shows the results of how the Browns of the future would differ from the Browns of
the past. Applying all of these changes alters the trajectory of the Browns’ nest egg:
they deplete their financial assets, live on the proceeds raised from accessing their
home equity, and run out of assets before the end of their presumed retirement. This
is what happens in the future baseline case, when they are diligent savers and
balanced investors; in other future cases (e.g., conservative investing and too much
spending), the Browns run out of financial and property assets even sooner.
EXHIBIT 14: Even diligent saving and balanced investing may
be trumped by policy changes and lower market returns
Value of financial assets
$8,000,000
Original
baseline
$7,000,000
Policy
changes
$6,000,000
$5,000,000
$4,000,000
$3,000,000
$2,000,000
Lower
market
returns
Future
baseline
$1,000,000
$0
1972
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
To be clear, all of these adverse policy, bond market and equity market changes
might not happen at the same time, and some may not happen at all. So as a final
step, we wanted to take a closer look at the individual impact of policy, market and
behavioral changes. The next chart (Exhibit 15) takes a closer look at their respective
impacts on retirement. We start with our baseline high saver, who is then subject to
policy changes (the four blue wedges), lower equity and bond market returns (the
green wedges), and eventually his/her own excessive spending and conservative investing
decisions (orange wedges). The interaction between these variables is case dependent;
the chart gives a general sense of their respective magnitude when starting with a high
saver. If we had analyzed a low saver, the impact of Bowles-Simpson pre-tax 401(k)
contribution limits, higher tax rates and lower equity market returns would be smaller,
since the family has fewer savings balances to either curtail, tax or accrue.
14
| T HE IMP ORTA N C E OF B EING E A RNE ST
972
EXHIBIT 15: Assessing the respective impact of policy, market and behavioral changes to retirement assets
Value of financial assets, millions USD
$8.0
Social Security means-testing and eligibility delayed
$7.0
Social
means-testing and eligibility delayed
by Security
one year
by one year
$6.0
Cost of supplemental Medicare insurance premium
equal
toof2%
of pre-retirement
equal
to 2%
pre-retirement
income income
$5.0
Bowles-Simpson
limits applied
pre-tax 401(k)
Bowles-Simpson
limitstoapplied
to pre-tax 401(k)
contributions
$4.0
Tax rates revert back to higher pre-2001 levels
$3.0
Real equity market returns are 1% lower
$2.0
Real bond market returns are 1% lower
Cost of supplemental Medicare insurance premium
contributions
Tax rates revert back to higher pre-2001 levels
Real equity market returns are 1% lower
Real
bond
returns
are 1% lower
Shift
of 5%
frommarket
equities to
fixed income
$1.0
Savings rate lowered by 3%
Shift of 5% from equities to fixed income
$0
1972
1982
1992
2002
2012
2022
2032
Savings rate lowered by 3%
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg. Assuming lifetime earnings of 12x median income, retirement at
1982 age 62, lifespan
1992 to age 2002
2012
2022
2032
90 and post-retirement cash flow equal to 80% of pre-retirement income.
A few comments on the chart:
• Changes in savings rates (e.g., changes in the balance between spending and saving) generally
have the largest impact on retirement assets.
• For high savers, equity market returns are an important variable; the chart above shows
the impact of long-run annualized returns being 1% lower. Of course, if they were to exceed
the historical averages shown in Exhibit 9, retirement portfolios would be able to withstand
considerably more stress.
• Legislation in 2012 already raised the highest two statutory income tax rates back to
pre-2001 (pre-EGTRRA) levels, and our model reflects this change. However, a wholesale
change back to the pre-EGTRRA tax code would also lower the brackets at which these rates
apply, in addition to raising tax rates at lower bracket levels.
• The impact from the assumed Social Security changes is split roughly evenly between the
assumption of means-tested benefits and the increase to the eligibility age for full benefits.
• The imposition of Bowles-Simpson caps on pre-tax 401(k) contributions in our baseline case
reduces annual contributions by 33% in 2012 when compared to the impact of existing limits.
• The presumed imposition of a supplemental Medicare insurance cost would reflect a
substantial shift in policy from the current system, which provides access for all retirees
having fulfilled minimum payroll tax requirements. Our proposal implies that Congress elects
to redistribute entitlements through means in addition to the payroll tax and the Medicare
surtax. This would likely reflect an environment in which entitlement spending becomes
unsustainably large relative to overall government spending.
J.P. MORGA N | 15
The benefits of working (a little) longer
All the cases above assume a retirement age of 62. If we were to assume a
retirement age for the Browns of 65 instead, there would be several benefits: more
earned income that contributes to lifetime savings balances; three more years of
an employer 401(k) match; and three more years to compound savings balances
before having to draw down on them. Exhibits 16 and 17 highlight a couple of
important points. First, the revised baseline with an age 65 retirement reaches an
enviable equilibrium: the Browns generate enough income from their higher
savings balances to fund their retirement spending goals, such that the balances
remain roughly constant throughout retirement. Second, under the combined
adverse market and public policy case of the future, the family’s assets last through
to the end of retirement.
Not every family has the ability to work those extra years, however.5 As a result,
it makes more sense to plan for an earlier retirement and enjoy a windfall if it
doesn’t happen.
EXHIBIT 16: Deferring retirement to age 65: how the
baselines differ
EXHIBIT 17: Deferring retirement to age 65 helps offset
the impact of future potential policy and market changes
Value of financial assets
Value of financial assets
$12,000,000
$12,000,000
$10,000,000
$10,000,000
Revised baseline:
Retire at age 65 in 2012
$8,000,000
Revised baseline:
Retire at age 65 in 2012
$8,000,000
$6,000,000
Baseline:
Retire at age 62
in 2012
$4,000,000
$2,000,000
$6,000,000
$4,000,000
Lower
market returns
$2,000,000
$0
1972
$0
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
5
Policy changes
1972
1982
1992
2002
2012
2022
2032
Source: TPC, BEA, NAR, BLS, JPMAM, Census, Bloomberg.
On the issue of “having to” retire, a 2004 study from the Boston College Center for Retirement Research estimated that as many as 37% of retirees
did so since they “had to,” rather than wanted to. Reasons included both health and business cycle issues.
16
| T HE IMP ORTA N C E OF B E ING E A RNE ST
SOME CONCLUSIONS FOR
W E A LT H Y FA M I L I E S
• Know what your savings rate is, including all your pre-tax contributions to savings
plans. Ideally, it should be north of 20% for wealthy families like the Browns.
−− Wealthy families generally spend 2.5x more in retirement than they initially
contribute to savings
• Monitor investment risk in the assets you put aside for retirement. Underinvesting
and overspending are a potentially toxic combination.
−− Our overly conservative investor would need to spend 10% less in retirement
or save 2% more every year to match the baseline case
• Be aware that deferring retirement by 2 to 3 years can substantially improve the
trajectory of retirement assets, and allows for less savings in advance, and/or
more post-retirement spending.
−− Accelerating retirement by 2 years requires either a lifetime savings rate that’s
2% higher, or a 10%-15% further reduction in spending in retirement
• You should generally maximize all available forms of pre-tax savings that allow
for tax-free compounding.
• The prior four decades of equity and bond market returns benefited from the
Volcker disinflation, a phenomenon that is unlikely to repeat itself. As a result,
long-term real returns over inflation may be modestly lower than in the past.
−− For every 1% decline in lifetime savings rates, real equity returns need to rise
by roughly 0.5% (it is hard to invest your way out of a hole)
• Congress has focused much of the deficit reduction burden on wealthy families
earning more than $250,000 in adjusted gross income. In the future, they may
continue to do so, through policies that increase effective tax rates, and limit
pre-tax contributions to savings. Congress may also means-test the largest
component of retiree spending (medical).
• Lifespans are gradually increasing, thus increasing the amount of assets families
need in retirement.
−− Every additional year you work adds financial assets sufficient to support an
additional 3-4 years in retirement
In other words, being earnest about investing and saving, and frequently reassessing
the viability of a retirement plan, is more important than ever.
J.P. MORGA N | 17
Appendix 1: Savings rates, and what's ªnormalº for wealthy families
One of the most widely used concepts in economics is a “savings rate.” It’s meant to capture how much a family (or country) saves out of their potential ability to do so, with
the remainder going to consumption, taxes and interest on debt. It sounds simple, but there are some important details that affect how it’s computed, particularly for wealthy
families.
First, put aside the notion of a “5% savings rate” as being relevant to wealthy families. A 5% personal savings rate may be average for the U.S. as a whole, as reported by the
Bureau of Economic Analysis. However, the aggregate personal savings rate is heavily skewed by lower income quintiles with very low savings rates (close to zero for the
bottom quintile). Research economists at the Federal Reserve, Dartmouth and Columbia wrote a paper in 2004 (Dynan, Skinner and Zeldes) that performed one of the most
detailed analyses to-date on how savings rates break down by income quintile. They used various methods to estimate savings rates, with the longest-running dataset being
the Panel Study of Income Dynamics (PSID) from the University of Michigan. The chart below shows the paper’s estimates of “active savings” rates by income quintile, with
active savings rates referring to how much families save out of current earned and unearned income each year. For the top quintile, active savings rates derived from the
PSID are around 14%. There isn’t enough detailed information in the PSID to break down the results further, but savings rates for the top 1% of the income distribution would
probably be considerably higher, based on our estimates using the Survey of Consumer Finances (which does have data for top 5% and 1% income categories).
Savings rate estimates by income percentile
Savings rate based on change in net
worth inclusive of capital gains (Federal
Reserve Survey of Consumer Finances)
Median savings rate on current income, percent
60%
50%
“Active” savings rate
(Panel Study of Income Dynamics)
40%
30%
JPMAM estimate of “active” savings rate
(consistent with Dynan, Skinner and
Zeldes, measure from University of Michigan
Panel Study of Income Dynamics)
20%
10%
0%
Low 20% 20%–40% 40%–60% 60%–80% High 20%
Top 5%
Top 1%
Income percentile
However, active savings rates used by Dynan include certain categories that are normally considered consumption by the BEA, such as mortgage payments, home capital
improvements, life insurance payments and spending on vehicles. A BEA definition would probably be a bit lower, which is why our estimate of a normal savings rate for a
family with income in the top 1% is closer to 22% than 28%.
As a reminder, the BEA version of the savings rate takes the following form:
[A+C] / [B+C], where A = amount saved out of after-tax income (in other words, all of the contributions made into investment accounts during the year out of current
after-tax income); B = after-tax income; and C = portfolio dividend and interest income earned on savings, and current period pre-tax employee and employer contributions
to 401(k) plans and IRAs.
These are all admittedly very rough estimates of average behavior, and ones that cannot be refined further until/unless the BEA or some other governmental agency were to
compute more detailed savings rates by income group, and did so using a transparent, consistent and estimable methodology. We believe our estimates are sensible based on
research we have seen, and based on our experiences with wealthy families. Regardless of the methods involved, one thing is clear: the oft-quoted 5% personal savings rate
has almost nothing to do with the consumption and savings dynamics of wealthy families.
Appendix 2: Charts on fixed income returns, equity allocations, high yield default rates and
U.S. budget deficit and debt levels
The War on Savers returns
Inflation-adjusted T-bill return, 3-year % change at annual rate
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012
Source: U.S. Treasury, BLS, JPMAM.
U.S. HY bonds
Global HY bonds
10%
8%
6%
4%
2%
0%
1981
U.S. leveraged loans
1985
1989
1993
1997
2001
2005
Source: J.P. Morgan Securities LLC, Standard & Poor’s.
18
70%
65%
60%
55%
50%
45%
40%
35%
30%
1972
Baseline
More conservative investor
1976
1980
1984
1988
1992 1996 2000
2004
2008
2012
Cumulative default rates of outstanding investment-grade
bonds over the next 5, 10 and 20 years, Percent
Issuer-weighted, last 12 months
12%
Percent
Source: JPMAM.
Non-investment grade default cycle
14%
Allocation to equities within 401(k) over time
| T HE IMP ORTA N C E OF B E ING E A RNE ST
2009
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
1970 1974
20-year
10-year
5-year
1978
1982
1986 1990 1994
1998 2002 2006 2010
Source: Moody’s, J.P. Morgan Securities LLC. USD-denominated.
Appendix 3: Notes on the assumptions and calculations in our retirement model
SCENARIO ANALYSIS:
• Analyses are based on historical median income levels, home prices, caps on 401(k) and IRA contributions, equity, Treasury bonds and T-bill returns, tax rates by
income quintile, and Social Security benefits accumulation formulas. In the scenario analyzing the future, we use the same historical data, modified by policy
options discussed above (e.g., lower caps on pre-tax savings plans, higher tax rates and lower market returns).
AGES AND EARNINGS:
• The family is assumed to begin their savings journey at age 25 with no accumulated financial assets.
• The family does not have any sources of earned income during retirement. While most Americans over age 65 no longer work, significant subsets do. BLS data
show that 30%, 18% and 7% of those aged 65–69, 70–74 and 75+ were employed in 2012.
• The model estimates a family’s financial assets until age 90. We picked this age since it is roughly five years beyond the life expectancy for wealthy individuals
that reach the age of 70.
SOCIAL SECURITY PAYMENTS:
• We computed Social Security benefits using actual historical indexing factors and income growth, and added benefits paid at a rate of 50% to non-working
spouses.
• The recipients take Social Security payments when they are eligible for full payments at age 66. A substantial amount of Americans take accelerated Social
Security (eligibility begins at 62), but such payments are paid at a discount.
• Means-testing of Social Security, when applied in our model, takes two forms. First, current law taxes a maximum of 85% of Social Security benefits. Meanstesting would probably subject 100% of Social Security benefits to taxation. Second, Social Security means-testing would probably curtail benefits for higher
income individuals. Currently, there are caps on income subject to Social Security and on benefits received. In our model, when means-testing takes place, the
cap on taxes is effectively raised higher than the cap for monthly benefits, creating a net loss for high income recipients.
CASH FLOW MANAGEMENT AND HOME OWNERSHIP:
• Families are assumed to avoid making discretionary 401(k) distributions whenever possible, drawing down on after-tax savings accounts first to meet their
spending needs. Mandatory 401(k) distributions are assumed to take place starting at age 71; both mandatory and discretionary 401(k) distributions are taxed
when received.
• The family is assumed to make “catch-up contributions” to their 401(k) plan. Such contributions allow individuals who are age 50 or over to make additional
contributions above the normal limit.
• When the sum of mandatory distributions, Social Security benefits and home sale proceeds are greater than the targeted cash flow for that year, the difference is
deposited into the family’s savings account.
• The down payment required for the home is 20%; by retirement, the home is assumed to be owned free and clear with no debt. In all scenarios included in this
paper, the family purchases a home that is worth ten times the median home price. They are assumed to postpone employee and employer 401(k) contributions
until they have saved enough for the down payment, using both foregone contributions and other after-tax savings as down payment proceeds. If the family
cannot afford the full down payment by year 10, they are assumed to purchase a home at the implied prorated value. During retirement, if both savings accounts
and 401(k) balances have been depleted, the home is sold at prevailing prices. We do not assume any future increase in the current $500K residence exclusion
for capital gains tax purposes.
RETURNS AND INFLATION:
• Annual equity, bonds/T-bill, inflation and home price appreciation estimates for the post-retirement period: 7%, 4%, 2% and 2%, respectively. For tax purposes,
80% of equity gains in after-tax savings accounts are assumed to be realized each year.
TAXATION:
• The model applies the prevailing tax code to retirement cash flows, incorporating base and personal exemptions, itemized deductions and applicable limits,
Medicare surtaxes on unearned income, AMT considerations, etc. Tax brackets are indexed to inflation.
• Pease limitations were first introduced as part of the Omnibus Budget Reconciliation Act of 1990. They were designed to limit itemized deductions (i.e., mortgage
interest, state and local taxes, charitable contributions) for high income earners. These limitations were scaled back in 2001 as part of the Economic Growth and
Tax Relief Reconciliation Act. They were then restored in 2013 in order to raise revenue once again. They limit certain itemized deductions by the lesser of (a) 3%
of the amount by which adjusted gross income exceeds a given threshold ($300,000 in 2013) and (b) 80% of itemized deductions.
Sources
• “Do The Rich Save More?,” Dynan, Skinner and Zeldes, Journal of Political Economy, 2004.
• “Are You Sure You’re Saving Enough for Retirement?,” J. Skinner, Journal of Economic Perspectives, Summer 2007.
BEA = Bureau of Economic Analysis; BLS = Bureau of Labor Statistics; COBRA = Consolidated Omnibus Budget Reconciliation Act; CBO = Congressional Budget Office;
COLA = Cost of living adjustments; EGTRRA = Economic Growth and Tax Relief Reconciliation Act of 2001; IRA = Individual Retirement Account; NAR = National
Association of Realtors; OMB = Office of Management and Budget; TPC = Tax Policy Center; JPMAM = J.P. Morgan Asset Management
J.P. MORGA N | 19
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