November Q&A: Real World WynnSights

I’m testing out a new wrinkle. I frequently get with questions from folks through Quora and social media channels about their specific real-world financial concerns… both near and long-term. I thought it might be beneficial to share some of those here through a monthly Q&A blog.

Names and personal information is excluded to protect privacy. Caveat: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Q: As a 20-something, I’m trying to estimate the potential future growth of my investments. What is your opinion of how much the average annual return of the S&P 500 might be over the next 40 years?

A: First, some background: The S&P 500 Index is a group of companies whose stocks mirror the overall performance of large-cap stocks and is considered by many to be a leading economic indicator for both the stock market and the economy. The 500 or so companies chosen by the S&P 500 Index Committee are selected by market capitalization, liquidity, and industry. The average annual return (1957 through 2019) has been approximately 8%. This total nominal return per annum includes dividends but does not adjust for inflation. According to measuringworth.com inflation calculations, the annualized US inflation rate for that period was 3.62%.

To answer the question: I don’t have a clue what the next 40 years will bring. And while that 8% average number over the last 62 or so years may sound pretty darn attractive in light of today’s interest rates, timing is everything. For example, if you are fortunate enough to buy during market lows and wise enough to patiently hang with your investment (or sell at market highs), you will obviously earn larger yields than those who buy during market highs… particularly if they then sell during dips. In 2019, the S&P 500 yield was 31.1%. In 2018, it was -4.41%.

Okay, my answer is elusive, but my point is simply this: Attempting to time the stock market is ill-advised, even though timing always plays a significant role in an investor’s ultimate returns. For young folks (for that matter, any folks) who want to avoid the missed opportunities of not being invested during the good times, avoid active trading, build a portfolio around a low-cost S&P 500 index fund on a “dollar-cost averaging” basis… and then exercise patience! patience! patience! with your investing. I call it daring to be average. Studies show that year-in, year-out, this approach will outperform most managed mutual fund portfolios.

Q: I had to temporarily liquidate 20% of my long-term investments in a Roth account when the market was 5% lower. Now, I’d like to get back in the market without a loss. I don’t believe in market timing, but in light of the current market’s strength, I feel like I should wait. What do you think?

A: Not to be a wise acre, but apparently you didn’t follow someone’s good advice about creating an emergency Rainy Day Fund, the absence of which put at risk your long-term retirement portfolio (often at the worst of times, or so it seems). Now, about the cash you’re stuck with. First, I would create that missing Rainy Day Fund to avoid going through this “liquidation experience” again. And second, don’t fear a strong market like the one we currently enjoy, despite the pandemic. Consider getting back in, but perhaps on a measured basis called dollar-cost averaging (versus “all-in”). This way, you avoid that market timing bugaboo (which by waiting, you’re practicing) while at the same time, you avoid “missed” potential market opportunities associated with not having a market presence. How many times have many of us missed big moves up by thinking the market is already overpriced? Perhaps it is overpriced… but then, perhaps it isn’t.

Q: Today’s stock market gains have exceeded my expectations. I do enjoy them, but I’m not comfortable with dollar cost averaging at these higher prices. And my 80% stock / 20% cash portfolio probably needs rebalancing. Do you think this market is getting too HOT compared to the current state of our pandemic-ravaged economy?

A: Well, these gains exceed my expectations, too… and like you, I am enjoying them… and like you, I’m uncomfortable with dollar-cost average at these high prices… but let’s reflect on history for a moment. How many times have you decided not to invest in a market because you felt it was too high in light of “the current state of the economy”? I’m betting more than a time or two. For that reason, I continue to reinvest surplus dividends and capital gains on a monthly basis (yup, that’s a form of dollar-cost averaging) and if the market decides to do a near-term correction, I’ll patiently set through it like I did the last one – fretting but investing all the while – because that’s how I approach investing. By the way, depending on your current age, you may need to rebalance, but do think twice before letting a strong market interrupt your investment patterns.

Q: My boyfriend starts drawing Social Security this month, at age 62. He is also starting a part-time job with benefits. Can he still contribute to a 401(k)?... hopefully, enough to get the employer match (the part-time job pays about $18,000, so we plan to watch what he earns closely).

A: There’s no short answer to this one. As I’m sure he knows, when your friend starts receiving Social Security (SS) benefits at age 62, the benefit amount will be lower than if he had waited until full retirement age. He can, of course, get SS retirement benefits and work at the same time, but there is a limit to how much he can earn without impacting those SS benefits. If he is younger than full retirement age for the entire year and earns more than the yearly earnings limit, SSA will reduce his benefit amount. SSA will deduct $1 from his benefit payments for every $2 he earns above the annual limit (for 2020, that limit is $18,240). In the year he reaches full retirement age, SSA will deduct $1 in benefits for every $3 he earns above a different limit (in 2020, this limit is $48,600). When he reaches full retirement age, beginning with the month he reaches full retirement age, his earnings will no longer reduce his benefits, regardless of how much he earns.

Now, to address your question. Yes, your friend can contribute to a 401(k) plan and receive employer matches… if available. Disbursements from the 401(k) will ultimately not affect the amount of SS retirement benefits he receives each month. However, he may be required to pay taxes on some or all of his benefits if his annual income exceeds a certain threshold—and 401(k) distributions could cause that to happen. In short, SS retirement benefits do not changebased on other retirement income because SS income is calculated based on his lifetime earnings and the age at which he elected to start taking SS benefits. But be mindful that 401(k) distributions might increase his total annual income such that his SS income will be subject to taxes… but only federal and perhaps state taxes. And why is that? Contributions to his 401(k) will have been made with compensation on which he has already paid SS taxes despite the fact that those contributions were made with pre-tax dollars. The 401(k) pre-tax contribution tax shelter feature only applies to federal and state income tax, not Social Security taxes.

The Conundrum: 401(k) income does not affect the amount of an individual’s SS benefits. However, when, at age 72, that individual must take 401(k) RMDs, the boost in a “combined” annual income can result in taxation… or increased taxation. Nothing is simple.