Review of Paper: “Investment Performance, Inflation, and Taxes: Redefining History’s Bear Markets”

In a paper in the summer 2013 edition of The Journal of Retirement, Matthew Kenigsberg discusses the importance of inflation and taxes in evaluating rates of return on retirement savings (he will present the paper at the monthly Savings and Retirement Foundation lunch on October 25). Kenigsberg’s thesis is that financial analysts need to look at pretax nominal returns, taxes, and inflation; rather than total returns alone.

The paper presents a number of informative graphs which look at rates of return over the past eighty years. Kenigsberg calculates a ten-year rolling average for pre- and post-tax rates of returns for the years 1935 through 2011.

The first series of graphs calculate returns based on a 60/40 stocks to bonds portfolio. The data shows that investors realized negative post-tax real rates of returns in 1948 (i.e. 1939-1948 average). Yields returned to positive levels until the 1970s. Between the ten-year averages of 1964-1973 and 1974-1983 real post-tax returns were negative. The recent recession resulted in negative returns in 2008 (1999-2008 rolling average).

Kenigsberg then calculated the same rates of returns based on 40/60 stocks to bonds portfolio. He found the returns were slightly better than the less conservative 60/40 portfolio—though the year-to-year movements were similar.

In a final analysis he compares the nominal balances of hypothetical retirees—who followed a 40/60 investment strategy—for two different time periods: 1940-1971 and 1980-2011. In the former period, an individual who invested in a Roth IRA experienced far higher ending balances relative to someone who invested in a traditional IRA. In fact, a person investing in a traditional IRA would exhaust their balance over the time period. The reason for this was the high inflation and marginal tax rates quickly depleted balances. For the period of 1980-2011 the opposite was true—a traditional IRA experienced higher growth in balances relative to a Roth IRA. The reason was this three decade period saw much lower inflation and marginal tax rates.

Kenigsberg concludes:

If the most important goal is avoiding a complete depletion of assets, then the analysis suggests using the Real Return 40/60 and a Roth IRA would be much less detrimental in a scenario like 1980-2011 than not using them would be in a scenario like 1940-1971. In other words, historically, the cost of hedging against a spike in taxes and inflation when that spike doesn’t occur was much less than the cost of not hedging against a spike when it does.

I think there is two things one can take away from the paper. One is the importance of inflation and tax rates when calculating what one needs for retirement. The second is the need for consistent economic policy by government officials. If the Federal Reserve would maintain an announced inflation target and Congress keep marginal tax rates constant; then savers could make sound investment strategies to maximize their retirement savings.

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