Funding our future: being rich takes a lot more money than you think - so you'd better start saving

Being rich takes a lot more money than you think -- so you'd better start saving . . .

THE investment markets have been nothing short of spectacular in recent years. Both stocks and bonds have earned far more than history teaches us to expect. As a result, people are pouring ever more money into longer-term mutual funds, creating a virtuous circle that has helped keep the markets buoyant.

Still, most of us will probably wind up disappointed in our investments. Why? Because most of us have no idea just how much invested capital it will take to support ourselves through long retirements -- even if Social Security remains in place -- nor any idea how hard it will be to amass such a sum.

Let's say you were lucky enough to retire with $1 million in 1960 -- the equivalent of some $5 million today -- and invested this money entirely in the stock market. Judging from the average returns so widely published, your million dollars would have grown to nearly $29 million in the years since then. If you invested entirely in bonds -- say, five-year Treasuries -- your capital would have mounted to $12 million by year-end 1994. Even in stolid, conservative Treasury bills, it would have multiplied to $8 million.

But all these numbers are before taxes. Considering federal levies only, and minimum investment costs, your final total invested in stocks after 35 years would have been roughly $15 million -- about half the theoretical total before taxes. Not that the tax rate has averaged 50 per cent since 1960, but in withdrawing money each year to pay taxes on your investment earnings, you lost not only the withdrawn money itself, but all the future earnings on that money that would otherwise have accrued, and the earnings on the earnings, compounded over many years.

Invested in bonds, your million would have grown to $5.5 million rather than $12 million after taxes (or if we substitute tax-exempt municipals for Treasuries); in T-bills, to $3.5 million rather than $8 million.

These numbers are still nothing to sneeze at -- until you remember that a dollar bought five times as much in 1960 as it does today. And so $3.5 million today represents $700,000 in 1960 purchasing power (bottom row of table above). In other words, after all these years, your 1960 T-bill investment would be behind the 8 ball in real terms. Bonds did somewhat better: in tax-exempt municipals, you'd have ended about where you started, with $1.1 million in "real" -- that is, inflation-adjusted -- purchasing power. Only stocks managed to grow substantially after taxes and inflation, with the $1 million nearly tripling in real value. But Jackie Mason used to say he had enough money to last the rest of his life, as long as he didn't spend a dime. So far in this analysis, you haven't spent a dime. Which renders the above figures moot if you're saving to fill a retirement-income gap. Assume you spent all your dividends and interest payments over the past 35 years -- not an unrealistic length for a modern retirement. If your portfolio was bond-heavy -- say, 80 per cent in municipal bonds and 20 per cent in stocks (left column, table below) -- your capital's real value declined after all the years of taxes, spending, and inflation, from $1 million to about $300,000. Not much of a cushion against emergency, and probably a disappointing legacy.

As you see in the third column of that table, an all-stock portfolio withstood the ravages of the three big hurdles well. Indeed, it managed to increase by a third in real value over the years, while also (perhaps to your surprise) throwing off more cumulative income than the 20/80 mix. But there was also a problem. To be completely invested in stocks since 1960, you had to remain in the market through some very frightening times. You had to withstand the loss of nearly half your money during the decline of 1973 - 74, not to mention the losing years of 1962, 1966, 1969, 1977, 1981, 1990, and the 30 per cent decline of late 1987.

Could you have stayed in the market? The sad fact is, we humans feel the pain of loss far more powerfully than the pleasure of gain. In recent years we've experienced only the latter where the stock market is concerned, and so we've lost our fear of stocks. But after the 1973 - 74 decline, most people avoided the market for years to come, thereby missing exceptional gains like the 70 per cent of 1975 - 76 -- the very recoveries that have accounted for most of the high long-term return we read about.

To balance risk-and-reward considerations, many investors compromise with a 60/40 mix, mostly in stocks but with a large bond component to tone down volatility. We put this portfolio to the test in the middle column of the table below. As you see, it threw off more cumulative dividends and interest than either the all-stock or the bond-heavy portfolio, while the money still at work maintained two-thirds of its value in real terms. This is a very acceptable outcome to most investors, in my experience. But even in this case, some real wealth and purchasing power were lost, demonstrating just how hard it is to maintain spending, pay taxes, and still build capital through the markets.