Working Teens and Roth IRAs

Summary: If you have a teenager with a job, opening a Roth IRA for them is really good idea from both a learning and a financial perspective.

roth

Our daughter is 17 and has had a part-time job for a little over a year. She makes minimum wage and probably works about 8 hours a week on average during the school year, and a bit more during breaks if we are in town. (Ironically, this summer she’s interning at a summer camp, which means she’s working full-time but making less.) While I think it’s safe to say that not many 17-year-olds are thinking much about retirement, ours is (well, at least she is when I make her :-).

As a result, as soon as she received her first paycheck, she opened a Roth IRA via Vanguard (since she’s not yet 18, it’s a custodial account, but will become completely hers once she turns 18). Why in the world would we do that? Simple, because it’s a fantastic opportunity for her to learn about finances and planning ahead, and also because it’s an incredibly smart move financially for her to do this now.

If you aren’t familiar with Roth IRAs, they allow you to put money (earned income up to $5500 per year for those under 50) in post-tax (so you don’t get an immediate tax deduction like regular IRAs or 401ks). That money then grows tax-free (like a regular IRA or 401k) but then, and this is key, upon withdrawal is also tax free. That means for my daughter, and most teens working part-time like her, this money is never, ever taxed because she doesn’t make enough in a year right now to owe state or federal taxes.

In 2016 she earned a total of $1651 and contributed the same amount to her Roth IRA. In 2017 so far she has earned $2133 and contributed that to her Roth IRA. With some investment gains, her current balance is about $4000. She’s invested in a low-cost Vanguard Index ETF because since she started with $0 she didn’t meet the $3000 minimum for the index mutual fund, and the ETF allows you to buy individual shares at whatever the current cost is. We’ll wait until she surpasses $10,000 so that she qualifies for the low-cost admiral fund and then probably move it over into the mutual fund version (same expense ratio as the ETF, but a little less hassle on our part to invest).

So why is this an “incredibly smart move financially”? In a word (okay, two words): compound interest. If she continues to work about the same amount between now and August 2018 (she graduates in May 2018 and will probably be going to college in the fall), she will have invested somewhere around $7,500 in her Roth IRA. Including the investment gains she’s had so far and assuming a bit of a gain in the next year, let’s call it $8,000 at the point she starts college.

Now she’s likely to work part-time in college, and eventually she will begin full-time work, at which point she will most likely add a 401k to her retirement savings plan and she may or may not continue to contribute to a Roth IRA depending on the circumstances. For the moment, let’s assume she never contributed another dollar to her Roth IRA for the rest of her life, let’s explore what happens.

Well, predictions are just that, predictions, but we can do some decent estimates based on historical results. The stock market has typically returned over 10% a year on average for a long time (and small-cap value, what our daughter is invested in, is even a bit higher), but most folks think that at least in the short term (the next 10 years or so), those returns will be muted a bit. So for demonstration purposes, we’ll use 8% returns (feel free to substitute in a lower or higher amount if you want). So if she has $8,000 invested in her Roth IRA at age 18, doesn’t invest another dollar for the the rest of her life, and “retires” (whatever that will mean at that point) at age 68, how much money will she have? Over $375,000.

That’s fantastic, considering it’s totally tax free and it came simply from the part-time jobs she worked while in high school. But it also overstates it a bit, as those are not today’s dollars, but 2068 dollars, which means you have to take into account inflation. We’ll assume inflation of 3%. Historically inflation has averaged 3.5%, but it’s been lower lately, and governments try harder now to manage that rate, so lots of folks think it will be lower going forward (that’s also part of the reason that the expectation is that stocks will earn lower than 10% going forward as well). So, in reality, what we’re calculating here is a 5% real return after inflation (8% nominal return minus 3% inflation). That amounts to over $91,000 in today’s dollars. That may not sound quite as impressive, but keep in mind that’s assuming no additional investments after she graduates from high school, and that money is completely tax free. (That’s also likely more than a lot of the adults reading this post currently have saved in their retirement account.)

This entire scenario assumes, of course, that the teen can afford to invest this money. Many teens have to work to help support their family day-to-day, so this unfortunately isn’t an option for them. Ours doesn’t have to help support the family, so this is another advantage of us being financially secure – we can not only help our daughter learn about saving, investing, financial planning and retirement planning, but we can give her a head-start on her savings and investing. If your family is in a similar position, I highly recommend you consider this option and, if you choose to work with me, this is something we will investigate.

photo credit

Focus On: LPS Retirement Plans (401k/403b/457 Plans)

Summary: Choose the PERA 401k plan and invest as much as you can.

lpsretirement

The idea of retirement is a fairly new one. It wasn’t until early in the 20th century that the concept of retiring from work and “living a life of leisure” was even a concept. Many employers started offering pension plans and then Social Security came along in 1937. Then in 1978, the idea of a tax-deferred savings plan (401k) was created, although it’s original intent was not the way we’ve ended up using it.

Social Security was really designed to be part of a “3-legged stool” concept of retirement, that retirees would draw from their company pension, from social security and from their personal savings. As pension plans have gone out of favor and 401ks have taken their place (particularly in the private sector), it has really become a two-legged stool (which is somewhat problematic). For public school employees in Colorado, PERA is a social security replacement plan, so basically covers those two legs, leaving the personal savings leg for you to figure out on your own. That’s where employer-offered tax-deferred savings plans come in.

All PERA employers offer the PERA 401k plan to their employees, and some employers also offer access to the PERA 457 and the newly created PERA Roth 401k/457 plans. Many school districts also offer additional, non-PERA options for tax-deferred accounts. This post will focus on what’s offered in Littleton Public Schools, but you should check with your employer to see what options they offer.

LPS allows you to choose between PERA and TIAA for retirement savings vehicles, offering the PERA 401k, 457, Roth 401k and Roth 457 plans, and the TIAA 403b, 457, Roth 403b and Roth 457 plans. There are subtle differences between 401k, 403b and 457 plans that can be important but, for the purposes of this discussion, we’ll treat them as roughly the same, with the important exception that you have separate contribution limits for 401k/403b and 457 plans which gives you the ability to save more if you have the cash flow to do that.

This post is not intended to be an in-depth explanation of 401k/403b/457 plans (or their Roth versions), but let me try to briefly describe them (if you decide to work with me we can dive deeper if need be). The idea behind 401k/403b/457 plans is to save money in a tax-deferred account, which means that you are not taxed on your income that you place into those accounts now, nor are you taxed on the earnings in those accounts as they accumulate, but you are only taxed when you make withdrawals which will hopefully be when you are retired. The traditional thinking is that most folks will be in a lower tax bracket when they are retired, so not only do you reap the benefits of saving “extra” all those years by not paying taxes up front, but when you do pay taxes upon withdrawal you will pay a smaller amount.

More recently Roth 401k/403b/457 plans have been created (along with Roth IRAs, which don’t flow through your employer) that take a different approach. For these plans you do pay taxes on any income you invest, but the earnings grow tax free and all withdrawals in retirement are tax free as well. In other words, pay the tax up front, never have to worry about taxes on this money again. For folks who think their tax bracket might actually be higher in retirement, this is a better option.

The obvious conundrum is how do you know for sure whether your tax bracket will be higher or lower in retirement? You don’t, which is why many folks choose to put money into both types of accounts to hedge their bets and give themselves more flexibility in retirement by giving them the option to withdraw from whichever account makes the most sense based on their current tax situation. (There are also some really nice benefits of a Roth if you are trying to leave an inheritance.)

Many employees, especially younger ones, kind of throw up their hands at all this. Retirement seems like a long way off, the choices can be complicated, and of course choosing not to spend money right now can be difficult for some folks. But the beauty and power of investing is compound interest, and it’s most effective the more time you give your money to grow, so the sooner you start, the better (and easier) it is to generate the retirement savings you want.

Many folks thinking about 401k/403b/457 plans also don’t take into account the effect on the tax-deferral on their current income. They think about putting say $100 a month into a 401k, but then worry they can’t do without that $100 a month. But they’re missing that their actual paycheck won’t go down by $100, but more like $70 (if you are in the 25% federal bracket, plus 4.65% for Colorado taxes). The government is basically saying, “invest $70 and we’ll give you $30” (always remembering that eventually they are going to tax you on that when you withdraw it). If you choose the Roth options, you don’t get that tax break up front, so your paycheck will decrease by $100 (but the potential for tax-free growth over time is tremendous).

So, with that overview, if you are an LPS employee, should you choose PERA or TIAA? Well, again, that depends on your individual circumstances and I’d be happy to discuss those with you, but for most people PERA is the better choice because of lower fees.

PERA offers a choice of several funds or a self-directed brokerage account if you want more control. For most folks, the funds are the better choice. In 2011 PERA chose to go with a “white-label” approach to investments. Research has shown that many folks make poor investment choices when given too many choices so, instead, a “white-label” approach has you choose among asset allocation choices instead of picking individual funds.

whitelabel

I’ll write more in future posts, but there are basically three things you can control when saving for retirement:

  1. How much you save.
  2. What asset allocation you choose.
  3. How much in fees you pay.

By going with a white-label approach and trying to keep fees low, PERA has tried to simplify the second and third choices for you. For each of their asset classes, PERA has typically gone with a combination of a passive (index) approach and an active (managed) approach. This combination gives you lower fees than a fully active approach, but higher fees than a strictly indexed approach. PERA thinks that they can achieve higher returns than the index this way. I’m a big fan of index funds, so I’m not totally convinced of this approach but, so far in their short lifespan (since 2011), they have mostly achieved this to  a small extent.

perafees

PERA does also give you a self-directed brokerage option (for an additional fee), which allows you almost unlimited choices in investments. For most folks, the additional complication of choices and fees make this sub-optimal, but it’s there if you want it.

selfdirected

TIAA is more like the self-directed brokerage option, which is one of the reasons the fees tend to be a bit higher (although still not bad compared to many other companies, 0.42% plus the underlying fund fees). Here’s a comparison of fees for a large-cap investment in the PERA white-label fund, the PERA self-directed brokerage option invested in a large-cap index fund (they require you to keep $500 in PERAdvantage funds), and the TIAA option invested in the same index fund. (You can view comparisons for other asset classes here.)

401kfees

If you look carefully, you’ll notice that the cheapest option is the PERA self-directed brokerage option (as soon as you pass about $20,000 in your account), with the PERAdvantage funds coming in second, and TIAA coming in last. Since the middle and third columns are essentially the same choice in terms of what you’re investing in, there’s no reason to choose the higher fee TIAA option over the PERA option. If you are investing a lot, you can save in fees by going the self-directed brokerage option, but this is where PERA would argue that they think they will outperform the index and make up those fee differences. The differences are small enough between the first two columns that, for most folks, it’s probably best to stick with the PERAdvantage options.

In future posts I’ll write more regarding possible asset allocations (which fund(s) should you choose), contribution limits (and the fact that you get separate limits for 401k/403b vs. 457, allowing you to save much more if you can), and the power of compounding. But, for now, this gives you an idea of where to start. The key thing is to start now and put as much as you can into one or more of these vehicles so that your “stool” will be sturdy enough to support you in retirement.

Why You Should Go Solar

Summary: Going solar, either rooftop or via a community solar farm, is not only the right thing to do for the environment and to combat climate change, but it will save you money.

Let me be clear up front, I’m passionate about sustainability, particularly the use of sustainable energy, and I believe climate change is a very serious threat. I think everyone should be concerned, not just for themselves, but for their children as well, so I of course think you should go solar. But, even if I didn’t believe all of those things, you should still consider going solar for financial reasons.

We put solar panels on our roof at the end of 2009. That’s only 8 years ago, but there’s been tremendous change in the solar energy industry since then. In 2009 solar panels were much more expensive than they are now (and the continue to get less expensive), and they weren’t as efficient as they are now (and still getting incrementally better each year). On the flip side, the incentives (at least in Colorado) were much better then than now.

roof

We purchased a 5.04 kW system from Standard Renewable Energy (SRE) and they installed it. (They’ve since been bought by GridPoint and no longer do solar installations, at least in Colorado.) The total cost was listed as $38,307, but then there was an “instant rebate” from SRE of $10,080, which took what I would consider the real cost down to $28,227. But we didn’t even have to pay that as, at the time, the combined utility and state rebate for that size installation was $17,020, which means our out-of-pocket cost (the check we had to write) was $11,207.

But it gets even better, because that doesn’t take into account the federal rebate, which turned out to be an $8,693 tax credit on our 2009 taxes, so we effectively paid $2,514. At the time SRE showed the break-even point to be between 3 and 4 years, but we estimated it at more like 5 (they had built in 10% electricity rate increases each year). We didn’t track it exactly, but we estimate the break even point was at about 4.5 years, which means that since mid-2014, our electricity has been close to free (not completely free, as we still pay a grid-access charge).

So what’s our “return on investment” on solar? Well, that’s a bit hard to tell, as the solar panels are still operating great and effectively generating income for us, and we don’t know how long that will continue or what electric rates will do. We spent $2514 at the end of 2009 and, so far, have “made” probably more than $4,000 in saved electricity bills. That’s currently around a 6% compounded yearly return (with no associated tax liability).

Plus keep in mind with all of the solar options I discuss in this post, these returns are tax-free, unlike the equivalent equity or bond investment so, depending on your tax bracket, that could significantly close the difference in returns between going solar and investing the money in the markets.

As part of the agreement with the utility company, solar systems are generally sized to generate approximately the same amount of electricity you use in a year, plus or minus a bit. (You can choose to install a smaller system and generate less, but they don’t like you to overshoot the mark.) Ours was sized at about 98% of our usage, although over the subsequent years we have actually used a bit less electricity (we installed new windows and replaced some appliances), so each year we typically have received a small rebate check from Xcel at the end of the year for the excess we’ve generated.

That was true until the beginning of this year, when we started again using more than we generated. This is because at the end of December we bought a used 2013 Chevy Volt, which is a plug-in hybrid. Much more on this in a future post, but basically because we are charging it each night, our electricity use has gone up and now surpasses what we generate. (To keep that “cost” in perspective, however, we still haven’t had to put gas in the car, having driven it more than 3,800 miles and only used 3.2 gallons of gas so far.)

Being the sustainability guy that I am, I of course wanted to figure out a way to make that new energy clean energy as well. We still had some room on our roof (perhaps not the ideal orientation, but still okay), but it turns out that most solar companies don’t want to add on to an existing system (I’m sure for liability/insurance reasons) and, since our system is still working great, we certainly didn’t want to tear it off the roof and put a whole new system on.

So we began looking at alternatives and ended up purchasing 4 panels at a community solar farm operated by Clean Energy Collective. Community solar farms are big arrays of solar panels, typically installed in big open fields, that generate electricity and feed it back into the grid. Individuals or businesses can then buy a portion of the array and get credit for the electricity generated to offset their own usage. It’s often called “roofless solar” and, in many ways, it’s better than solar on your roof. Solar farms are generally more efficient (they can align the panels perfectly) and cost effective (cheaper to install on the ground than on a roof, as well as economies of scale). I still prefer putting solar panels on roofs, as then I know for sure it’s new energy generation and it provided at the source, not simply purchasing already existing solar farm panels and feeding into the grid, although by purchasing those you are using up existing farms and therefore they are likely to build additional ones. But, because we couldn’t easily add any more to our roof, this was a great solution for us.

cec

The cost of this, of course, varies, but let me share the specifics in our case to give you an idea. Because we only needed to generate the additional amount of electricity we were using by charging the Volt, we only “purchased” 4 panels (which is the minimum) at the solar farm (located in Arapahoe County). We are effectively leasing the panels for 19 years (for initial customers it was 20, but because this farm has been in use for a little while, I guess we only have 19 years left). The cost for those panels was $3,050 out of pocket (ironically, more than our entire solar system after rebates in 2009).

Those 4 panels will generate 1.22kW. The way we get “paid” is that we get a credit on our utility bill from Xcel each month, currently 7.6 cents per kWh (that rises and falls with whatever the current rates are), as well as an 8 cent per kWh renewable energy credit (REC) that gets paid quarterly. The estimated yearly savings for 4 panels comes out to about $322. CEC then estimates that electricity rates will rise 4.8% per year. This is more realistic than the 10% SRE used back in 2009, but still perhaps a bit too high (unless a carbon tax is eventually passed, in which case it might be much too low). Using those assumptions they calculate a 9.5 year break-even point and a total return of “187%” after 19 years. Assuming no increase in electric rates, the return is about 4% per year compounded. Given that electricity rates will likely rise some, I’m going to guess it will turn out to be about 4.5% per year compounded.

Is that a great return on investment? Well, no, not compared to investing it in equities (but, again, keep in mind there’s no tax liability, so that boosts the return up some). If I was just trying to maximize my return, this would be a bad idea, investing $3,050 into an index fund would likely generate more return. But since I can generate clean energy, help combat climate change, and still earn a return that’s better than a money market account and probably pretty equivalent to what bonds would return, I think that’s a pretty good trade-off (as well as diversifies my investments a bit).

Now, if you don’t already have solar on your roof, you should definitely first investigate the cost and return on investment for that (more on that below). But, if you don’t own a house, or if you can’t or simply don’t want to put solar panels on your roof, then this is a great option. If you are interested, I’d recommend contacting Pete Stein at CEC (pete.stein@easycleanenergy.com or 720-623-0618), he was very thorough and helpful.

Full disclosure: If you mention my name and end up purchasing from CEC, I will receive a $200 referral fee. If you feel icky about that, don’t mention my name :-). But keep in mind that if you do, you also will receive a $200 check after completion of your purchase and $100 will be donated to charity, which is why I decided to go ahead and include it in this post.

Since we already had solar on our roof, I couldn’t get a quote for what it would cost to install solar now. Luckily, I have a friend who just installed solar in my neck of the woods in Colorado and he was willing to share his information. As I mentioned previously, much has changed in the solar industry since we installed in 2009. In addition to the changes in cost and efficiency, you now have many more choices of installers and many of them now offer solar leasing in addition to up-front purchasing.

My friend ended up going with Ion Solar and, so far at least, he’s been very happy with them. Let’s take a look at some of the details for his install. They installed a 4.85kW system, so roughly equivalent to the system on our roof. Their total system cost was $18,896, less the federal rebate of $5,669, for a net system cost of $13,227. There are no longer the huge state/utility rebates like when we installed ours, instead you now get a minimal REC from Xcel for the energy generated. (From the information shared with me, I can’t tell how much this is or exactly where it figures in the calculations, but I know it’s often less than 1 cent per kWh).

ion

My friend chose to finance the system, which is basically a solar lease. The amount financed is the full amount of $18,896 at 4.99%, and they’ll make payments of $79 per month for the first 16 months, then $91 a month thereafter for the remainder of the 20 years of the lease (this assumes that the $5,669 tax credit is then applied to the loan when it’s received). In their calculations Ion assumes a 4% yearly increase in electricity rates and, based on this information, after 25 years they will end up $20,667 ahead.

How does that work? Well, each month the (average) amount they save on their electric bill is more than their loan payment, so they come out ahead. Ion even does a calculation where if you apply that savings to the loan payments, the loan is paid off in 15 years and the 25 year accumulated savings is then $22,743.

So what’s the return on investment? Well, since there’s no money put down up front, it’s complicated. But for the sake of argument, let’s assume they had decided to purchase the system for the net cost after federal rebate of $13,227. Ion estimates that over 25 years (factoring in the estimated 4% yearly increase in electricity rates) they will save $42,280, which is about 4.8% per year compounded (again, tax-free). Again, compared to investing in equities, that’s not a great return. But given the good that you’re doing, along with diversifying your investments and earning a bond-like return, I think it’s more than worth it.

So what should you do? If you own a house, I’d suggest getting bids from several vendors for installed solar and compare, and perhaps also contact Pete at CEC to compare roofless solar as well. There are lots of vendors to choose from, but I would certainly include Tesla Energy (formerly Solar City), because I anticipate with their new Gigafactory 2 coming online shortly their prices will be very competitive. (In addition, if you happen to need a new roof sometime in the future, look into their new solar roof option. It’s more expensive because it’s tile, but when you factor in the electricity savings, it ends up being cheaper than an asphalt roof, plus it has an infinite warranty on the tiles themselves – you’ll never have to replace the roof again.) If you don’t own your own home, or for whatever reason don’t want to install solar panels on your roof, then definitely contact Pete at CEC and get all the details.

Any of these options will give you a decent, but not great, return on investment, as well as contribute to a better world. In future posts I will talk more about the used Chevy Volt we recently purchased, electric cars in general, and why your next car should be electric, as well as about the opportunity to invest in solar directly.

How Do You Measure Investment Risk?

risk

There are a lot of sophisticated measures in the investment business: P/E Ratios, Cash Flow Analysis, EBITDA, etc. The list goes on and on (and on). The one I find most interesting, however, is how most people measure risk. The generally agreed upon method is to measure volatility, which is how much the price of a particular asset (stock, bond, whatever) goes up and down, often in conjunction with looking at expected return of the particular asset. To simplify it a bit, the more the price of something changes, the riskier it is.

I find that fascinating and mostly wrong. If you are a long-term investor armed with self-control, measuring risk by measuring volatility is not very useful. This analogy is a bit of a stretch, but I’ll use temperature as an example. If a particular day starts at 60 degrees Fahrenheit and goes up to 80 then back down to 60, that would be considered “worse weather” than a day that starts at 100 degrees and stays there (or 40 degrees and stays there).

Now, if you are an investor who is actively trading, constantly moving in and out of different positions, volatility is important. Likewise, if you are an investor that is going to need to take money out of a particular investment in the near future, volatility could be important. But I prefer a different measure of risk: how likely are you to meet your goals?

To me, this is really the only measure of risk that matters. Will your investment portfolio/strategy achieve the goals you have set for it? If you are a long-term investor (and if you end up working with me you will be :-), you don’t care all that much about the daily ups and downs of your investment, as long as at the “end” your investment is up a sufficient amount that allows you to achieve your goal. Which means that if you construct your portfolio correctly, there is really only one sub-component of that risk that matters: you.

More specifically, do you have the self-control, the discipline, to follow your investment plan? When bad things happen (like the Great Recession in 2008, or the dot-com bubble in the early 2000’s, and the value of your investments drop, sometimes by a lot), will you be able to stay the course and not bail on your plans? One of the main reasons to hire a real financial planner (or even avail yourself of my services), is that they hopefully will help you to stick to the plan. While there are no guarantees, based on the entire history and theory of financial markets, if you invest for the long-term and don’t sabotage yourself by abandoning your investment plan at the worst possible times, you are (almost) guaranteed to be successful.

In fact, there is plenty of research that most investors earn less (often far less) than the mutual funds and other investments they invest in earn. How can that be? They buy high and sell low. They typically buy into a mutual fund (or stock, or whatever) after if has performed really well for a while (missing out on most of the gain), then lose heart and sell when it inevitably goes down. It’s the investor’s behavior that causes them to under-perform, and hence the riskiest part of investing isn’t typically what you choose to invest in, it’s you.

So what’s the secret?

  1. Spend less than you make.
  2. Regularly invest the difference in low-cost index funds.
  3. Don’t sell (unless you’ve achieved your long-term goal).

I’ll write several more posts exploring different aspects of this, but it pretty much is that simple. That’s one of the most frustrating aspects when I hear others talk about their finances. Either they are too afraid of “investing” because they are worried about losing their money (or somebody taking advantage of them), or they are constantly moving from investment to investment to try to outperform the market (generally with poor results, as that study indicated).

As I mentioned in one of the FAQs, about 90% of what you need to do is really pretty straightforward, and not all that hard to do, if you simply know a little bit and have that self-discipline. I’d be happy to get you started on that path.

Photo credit: Foter.com

PERA: It’s Even Better Than You Think

pera

Most Colorado (public school) educators know that Colorado PERA is a “good” retirement program, especially compared to Social Security, but often they don’t know just how good it is. Fully exploring this topic is beyond the scope of this blog post, but let me briefly hit some of the highlights.

As part of SB 14-214, the the state of Colorado commissioned three independent studies of Colorado PERA, two of which are particularly relevant to this discussion. The Milliman Retirement Benefits Study, released in January of 2015, looked at how Colorado PERA’s benefits fit into the larger picture of total compensation, and was designed to evaluate the value of PERA compared to other retirement packages offered by other states and by private companies. The executive summary states,

The state’s total retirement compensation package is equivalent to 15.7% of pay (15.4% defined benefit and 0.3% retiree health), relative to the market median of 14.7% (combined sources: defined contribution, defined benefit, social security, and retiree health)

Basically, this says that as part of a total compensation package, Colorado PERA is just above the median benefit paid by states and private companies.

The second study, the Gabriel, Roeder, Smith & Company Plan Design Study is a bit more in-depth and relevant to this discussion. The purpose of this study was to compare Colorado PERA’s plan design and, specifically, the costs and effectiveness of PERA, as compared to other retirement plans offered in the public and private sectors (including the one that affects the most people, Social Security). Again, from the executive summary,

This study found that the current PERA Hybrid Plan is more efficient and uses dollars more effectively than the other types of plans in use today.

When the study was presented to the State of Colorado’s Legislative Audit Committee, GRS officials told members,

Colorado’s largest public employee pension system is the most efficient and effective a state could have.

Those are important pieces of background to know, especially when the legislature is in session and various bills are offered regarding PERA. But I want to point out some specific features of Colorado PERA that are particularly relevant to you from an investment and financial planning perspective.

Colorado PERA represents over 500,000 members which provides some significant advantages to you in terms of economies of scale and in terms of investment returns. Because PERA is so large, it is able to both invest at low cost and to invest in areas that are not available to you as an individual investor. Because they are a large, institutional investor, they are able to negotiate investment fees that are lower than what you can typically achieve on your own. They can also invest in areas such as real estate and private equity that are not available to you as an individual investor. Both of these help PERA achieve higher returns (at the same level of risk) than most individual investors.

Perhaps even more importantly, however, is the fact that PERA is the ultimate long-term investor. As an individual, you have a “life-cycle” to your investments. Typically as you get older and then eventually when you are retired, conventional wisdom indicates that you should get more conservative with your investments because you don’t have time to “recover” from a market downturn. But because PERA pools money from over 500,000 members, and because they are essentially investing in perpetuity, in many ways PERA can invest like each one of those investors is an unchanging 35-year old.

While PERA does have to deal with cash flow issues in order to pay benefits, and they certainly have to manage risk and particularly be concerned with sequence-of-returns risk, overall they can truly invest for the long term. Which means that even as you get older, PERA doesn’t have to adjust its investments based on your age, they continue to invest as if you were 35. This allows them to stay fully invested for the long-term at an appropriate level of risk that will generate good long-term returns.

In addition, once you do retire and start drawing your PERA benefits, those benefits are guaranteed for life, including a 2% annual increase to help cover inflation. (Note: that 2% applies to those hired before 2007, and can temporarily decrease following calendar years that PERA investments lose money, which does happen, but not that frequently. For those hired after 2007, it could also be 2%, but it’s a bit more complicated.) Let’s use a specific example to put that into perspective.

The median PERA retiree earns about $35,000 per year in benefits. There’s a rule-of-thumb in financial planning circles called the 4% rule which says that, based on historical results, people can typically withdraw 4% of their investment balance each year to live on and still expect their money to last until they die. While not perfect, the 4% rule is pretty robust, which means that the $35,000 per year in our example equates to about $875,000 in savings. Many career educators will likely qualify for a much higher benefit, maybe $55,000 a year or more, which equates to $1.375 million in savings.

Now, this is a very rough equivalency, as an investment balance using the 4% withdrawal rule has a decent chance of actually growing over time, which means you could leave a healthy inheritance, while your pension income ends when you die (or when your beneficiary dies if you take Option 2 or 3). But I think it still gives you a rough idea of the incredible value of your PERA pension. It really does allow teachers to become millionaires by the time they retire (and multi-millionaires if you invest your own savings wisely).

There’s one other important aspect of this that I think many Colorado educators may not notice. Because this pension income is guaranteed, in many ways you can think of your PERA pension as the fixed income (bonds) portion of your portfolio. This means you can invest your other retirement savings (401k/403b/457 – I’ll write a post soon on retirement savings plans) more aggressively than folks who don’t have a pension plan like PERA, which can ultimately generate a lot of increased wealth and therefore financial security. (I will write a post soon on investment “risk” and how “aggressive” investments are not necessarily more risky for the long-term investor.)

This is one of the main reasons why I think it’s unfortunate that many Colorado educators don’t really start thinking about PERA until they are close to retirement. In reality, the fact that you have PERA as your retirement plan should affect your financial planning from the first day you begin PERA-covered employment. (This is also one of the reasons I decided to start Fisch Financial – after talking with colleagues over the years about PERA, I realized how little many of them have thought about how PERA should affect their financial planning.)

So, how good is PERA? It’s great in-and-of-itself, but it also allows you to be more successful with the rest of your investments as well. Please consider incorporating the affordances that your PERA benefit allows you in the rest of your financial planning.