Squeezing More Return Out of Your Retirement Account

Today’s guest post is by @FinEngr, fellow Yakezie member and author of Engineer Your Finances. He applies a background in engineering to personal finance. FinEngr gives readers a different perspective on money with the belief that everyone has the ability to reach their financial goals through education and continual refinement.

If you’ve been keeping up with Sweating the Big Stuff, you’ll know Daniel’s been hard at work funding his Roth IRA. He’s done a great job of adjusting his lifestyle to accommodate his aggressive investing goals, which leads in nicely to the topic at hand.

Most people understand the concept of compound interest and the benefits of starting sooner rather than later, but did you know you can squeeze EVEN MORE out of your investments by starting EVEN EARLIER?

That doesn’t make sense? How can someone so young start any earlier?

FRONT-LOADING

Plenty of friends ring in the New Year by starting on their resolutions or recovering from hangovers, but my big excitement is fully-funding my Roth IRA. While this may seem a bit much, it’s a preplanned event much like what was discussed in the defense is a calculated defense.

I recently had this conversation with a financial adviser whom I respect, partially because he’s an ex-engineer, but primarily because he doesn’t mind taking time out of his day to help young investors. I’m not even under his employer’s plan anymore, and we still trade emails now and then. Too bad there aren’t more like this in the industry.

He agreed, noting that it should give your contributions a (generalized) 4% bump over time. That’s pretty considerable. Especially since it involves no special investment knowledge.

Of course, it makes perfect sense applying the principles of compounding. Consider investments paying monthly or quarterly dividends. If you’re reinvesting those dividends, then the shares received are calculated based on the shares already owned. The earlier you have that money invested, the more shares you’ll receive. And the cycle continues each month, quarter, or year.

Although you’re not spreading your investments throughout the year, single years seem almost negligible when you’re considering decades, or half-centuries in Daniel’s case, of investing. There are plenty of (decent) articles out there refuting the idea. Actually, Warren Buffett has even been known to remark on the pitfalls of dollar-cost averaging.

There’s no set strategy either. Maybe it’s too nerve-wracking or simply unfeasible to get everything in all at once. Instead, maybe you shoot to get everything in before the first declaration date or semi-annual dividend.

Just to illustrate the benefits of front-loading, I went over to Dinkytown and plugged in some different scenarios into their Future Value Calculator. To prove the point, the only variable I changed was whether there were periodic deposits or a single lump sum.

I’m not sure why, but I spend the time making these different graphs and then scrap them anyway. At any rate, here are the parameters used:

Case A = $5,000 initial deposit
Case B = $416.67 monthly deposit ($5,000 yearly deposit / 12 months)

Scenario 1 = Compounded Monthly, 1.25% Yield, 1 Year
Scenario 2 = Compounded Quarterly, 3.5% Yield, 5 Years
Scenario 3 = Compounded Annually, 7% Yield, 10 Years

Drum-roll please… And the FV results were:

Scenario 1, Case A = $5,063
Scenario 1, Case B = $5,034
Difference of $29

Scenario 2, Case A = $33,741
Scenario 2, Case B = $27,357
Difference of $6,383

Scenario 3, Case A = $83,754
Scenario 3, Case B = $71,675
Difference of $12,079

These were my own concoctions so I urge anyone to go over and plug in their own numbers. What you will find is that any value, over time, should return more through front-loading than periodic deposits. Now, I believe that the adviser noted (generalized) because you need to factor in the positive AND NEGATIVE fluctuations of investments.

If the better return isn’t enough to entice you, let me offer a few other benefits in closing.

Being One-Year Ahead

Like I mentioned, the contribution is a planned event. The year prior is spent saving for that January deposit. As a side effect, holding yourself to this standard will help develop more savings discipline.

Other Opportunities

Checking anything off your financial to-do list allows you to explore other investments. Or spend more time with friends and family. Or whatever else it is that you enjoy. Point is, It’s just one little thing off your back that you won’t have to worry about.

Alright readers, now it’s your turn. What do you think of the idea? A worthwhile effort or too many holes in my assumptions? Do you think that training for this goal, whether it be your IRAs or 401ks, will better prepare you for other saving goals?

21 Responses to Squeezing More Return Out of Your Retirement Account

  1. MyFinancialObjectives says:

    I think that frontloading is a great idea, and something I am currently doing with my 401k. There a point in time I am trying to reach I refer to as the “Tipping Point”, where the interest accrued from my balance creates more wealth than my total contributions for the year. From this point on, the growth factor really takes off and you will see some serious gains. Again, I think that this is a great idea! Nice article!

    • Daniel says:

      @MyFinancialObjectives, I’m also trying to do that. I was investing through a 401k but decided that the Roth IRA was the way to go. So far this year, I’ve already maxed out my 2009 contributions and the sooner I can contribute the 2010 max the better. I just hope the market goes up over the next year or it won’t be worth it!

    • FinEngr says:

      @MyFinancialObjectives,

      Whether it consciously or not, talk to any grandparent and you’ll find that was a big part of the strategy. Keep filling up the bucket until it starts overflowing, then enjoy the fruits of your labor and take an interest shower ;)

  2. MyFinancialObjectives says:

    Me too! I would love it if the rest of the year saw the same returns we have had for the past 10 days or so. It’s been a nice little ride!

  3. I’m convinced dollar cost averaging is just a marketing ploy by the mutual fund/investments companies to make people feel good about putting money away slowly since that’s all they can probably do. A lot of people don’t have the money up front to dump in a lump sum so people say “great, dollar cost averaging” as if you had a choice.

    • FinEngr says:

      @Evolution Of Wealth,
      Definitely the case when sales charges, loads, and other transaction fees are a factor.

      Hadn’t thought about the second part, but makes sense. Collecting expense fees on a few HUNDRED smaller accounts can equate to the same as few larger accounts.

  4. RJ Weiss says:

    This is actually my strategy. Never thought of calculating out the advantage so thank you!

    Also, I still consider this a form of DCA. Since I’m investing at the same time every year, no matter what the market is at.

    • Daniel says:

      @RJ Weiss, That’s funny, I was thinking about the same thing last night. Over a short period of time, it’s more of a lump sum investment. But over a long period of time, it is dollar-cost averaging, with the advantage being the 4% of added returns by doing it at the beginning of the year (or course it’s only an advantage if the market goes up!)

    • FinEngr says:

      @RJ Weiss,
      Awesome – hope the calculations work out in your advantage! You’re right, it is still DCA, just over a longer period of time. I exactly started drafting that very notion, but only alluded to in the paragraph about “spreading” your investments.

      If you’re investing “for the long haul” (however that applies to you), the difference between investing monthly vs. yearly should be relatively neglible. If you’re trading more frequently, then you shouldn’t really be using DCA and instead looking for price points e.g. as W.Buffett commented on.

  5. We are currently trying to fund our 2010 Roth IRA ASAP so we can then concentrate on opening another one and saving for both of them in 2011. Sadly, I think it will be at least 2012 before we’ll be able to fully fund both Roth IRAs in January. Saving for next year’s while funding the current year is a little difficult, but after one year of hard, the rest will be simple. :-)

    • FinEngr says:

      @Budgeting in the Fun Stuff,
      Congrats and keep on plugging away! I’ll be adding Jan 1st, 2012 to my calender so I can check in…

      To offer some outside inspiration, I’ve been relating many things to running recently. Saving for the current and next year can seem tiresome (esp. for 2 accts!), but its similar to maintaining your speed towards the end of a race. The more tired you get, the harder it is to maintain, or even push, that pace. Here’s where that internal fire comes in, and the question becomes “how much do you want this”.

      If you can push yourself (to financial exhaustion), by embracing whatever unconventional strategies will help you reach your goal, realize that eventually it will come to an end and that result will be extremely rewarding. Plus, once you push yourself to the brink all subsequent years will seem trivial and much easier.

      Best of Luck!

  6. Thank you for breaking this into examples. This makes perfect sense. The first year, the rate of return doesn’t seem very large. However, by the third year it has made quite the difference. Now, I just have to open a Roth IRA (I keep telling myself to do this ;) !)

    • FinEngr says:

      @Little House,
      AAAAAAAAAAAAAAAAAAAAAAAAAHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHH!!!!!!!!!!!!! Little House. If you get a house before you open an account, I will be VERY :(

      Yes, the results can vary depending on what timeframe you assume / interest amount / accural rate / etc. If you’ve ever played an instrument, I like my examples to crescendo to a grand finale! :) It’s more exciting to build something up from a little whisper to a loud roar, and makes it harder to counter-argue.

  7. FinEngr says:

    Dearest Daniel,

    Thanks so much for the opportunity to guest post. Glad to see that the strategy hasn’t been ill-received, there’s those already implementing it, and others who are interested in it.

    The comments have been great so far and I hope they continue on that track!

    • Daniel says:

      @FinEngr, You’re always welcome, and I think that as long as the markets rise, front-loading is a perfect plan. If every year was like this one, this strategy would bring lots of sweet rewards.

      You can tell a good post by the comments, and it looks like there’s been a lot of very interesting discussion. Thanks again for your post, I think it was fantastic.

  8. Excellent explanation and you are making me feel much better about the fact that I have already funded my Roth for the year!

    Frankly I just hate the hassle of having to do monthly contributions and while I use some automation, I am a little old to feel comfortable with it.

    Great point in the comments about is still being DCA!

    • FinEngr says:

      @LeanLifeCoach,

      Making you feel good about saving early?

      Following your mantra, it makes sense to “eliminate the muda” of automated, monthly contributions – one fell swoop & done!

  9. Hmmmm, doesn’t it all equal out in the end? Whether you front load now, or front load later, it’s all the same over a long enough period of time?

    What if you front load in January, and the markets take a dive in Feb, March, April.. then what?

    • FinEngr says:

      @Financial Samurai,

      Theoretically, no. Reality, very possible. Different ways to address the comment…

      Reversing the argument, what impact does the intra-year peaks and troughs have over a long enough period of time? It will make a difference short-term, but as long as the denominator (total # of years) is large enough, it should average out.

      Don’t necessarily have to make any purchases immediately. Simply depositing the money at the beginning and letting it sit while you decide what to do will still grow in cash reserves/money market.

      The end result is highly dependent on many factors, but I think the key component to recognize is the distributions. If you’re compounding quarterly or bi-annually maybe the single-block strategy doesn’t make as much sense compared to monthly payouts.

      There’s a lot of “luck” involved as someone once noted. Going back to the original question, predicting the reality is near impossible but to argue against the principle would be to argue against compounding.

      • Mark @ SpotlightInvesting says:

        @FinEngr, good answer!

        Over a sufficiently long period of time all things tend towards their mean, and I guess that is the point – you want the comforts of time to increase the probability that your asset allocation performs as expected…

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