Last week we discussed the ‘illusion of control,’ which can manifest as a state of financial nirvana in which we fancy ourselves the master of our financial outcomes.
The opposite feeling – knowing that we must rely on markets which are beyond our ability to predict or control – sounds far less pleasant. One might imagine a dinghy helplessly riding monumental waves, Perfect Storm-style.
Courtesy of Franklin Parker, who grew up on a Texas cattle ranch and is now CIO of Dallas-based RIA Bright Wealth Management, we now have a more pleasantly pastoral illustration:
You can get quite a lot done with a tractor…You can also get a lot done with a horse. Horses have different advantages, like getting to those hard-to-reach places on your land… But horses are bigger and stronger than we are and unlike tractors, they have a mind of their own. If you wake up to a horse who has decided she isn’t going to work today, there really isn’t much you can do about it!One of the biggest mistakes I see investors make — especially professional investors — is to treat financial markets like tractors. They expect to wake up every day to a reliable and consistent tool that helps them achieve their financial goals…But in my experience, financial markets are much more like horses.
It’s a compelling metaphor, and one we’d like to see him take further. On this financial farm, is an annuity like a combine harvester? Is whole life insurance a grain silo? What’s the equivalent of a manure spreader?
Still, Franklin does get some good horsepower out of the analogy, going on to write:
To be fair to my professional colleagues, economic theory presents financial markets as though they are tractors. By reducing the world to equations, it is easy to be trapped into thinking that markets are the equation — x goes in, y reliably comes out. Equations may help us better understand the relationships between variables, but they get us no closer to controlling the mind of the market. At best, all of our economic equations are a bridle to a powerful horse — useful and helpful, but not the final word.
As a corollary, it’s interesting to note that while horseback riding is a reasonably common hobby, few will ride a tractor for fun.
I’d argue that part of the reason investing can be enjoyable, for amateurs and professionals alike, is due to the untamable variance that is endemic to any market-riding strategy. The fact that the market cannot reliably be bested is precisely what makes investing so challenging and so fascinating. It makes the creation and execution of strategies akin to the slow cracking of an unbreakable code.
Code-breaking isn’t for everyone, but what really makes the blood pump is that every attempt at a solution causes us to gain or lose money. And as Tommy Angelo writes in his poker-guide-cum-philosophy-treatise Elements of Poker:
The ticker tapes of life go by, and we just love to watch. It almost doesn’t matter if we get richer or poorer, heavier or lighter. When our stats change, we feel something, and that’s what we’re hooked on, that fluctuated feeling. We want to get fluct up.
That horsey unpredictability is itself a draw – even if it terrifies us. That doesn’t mean it won’t prove very inconvenient when we really need to get a job done.
Roth revisited
We don’t usually get political here at RIA Reads. But we have to make an exception to say that like many Americans, we found Tuesday’s political debate incredibly jarring, dispiriting and concerning.
I mean, not one mention of how Biden’s tax plan would impact the attractiveness of Roth IRAs vis-a-vis 401(k)s?
We’re essentially kidding, although it is notable how challenging it would be to pick a candidate based on bread-and-butter policy issues in 2020.
And indeed, this policy-deemphasizing environment may be partially culpable for the lack of clarity we have about challenger Joe Biden’s granular positions.
When it comes to the specific issue of retirement savings, the Biden-Harris campaign’s website does share three proposals.
One proposal is to allow unpaid caregivers to contribute to retirement accounts even if they are not earning income. Another aims to increase access to retirement plans by giving small businesses tax incentives to set them up, and by giving workers without an available plan access to a so-called ‘automatic 401(k).’
The proposal likely most relevant to advisors, however, is around ‘equalizing the tax benefits of defined contribution plans’:
The current tax benefits for retirement savings are based on the concept of deferral… This system provides upper-income families with a much stronger tax break for saving and a limited benefit for middle-class and other workers with lower earnings. The Biden Plan will equalize benefits across the income scale, so that low- and middle-income workers will also get a tax break when they put money away for retirement.
In a previous RIA Reads, we discussed why a Biden win plus a Democratic sweep of the Senate could lead wealthy individuals to convert traditional IRAs to Roth IRAs toward the end of 2020.
But going forward, it could get much more complicated – as Morningstar’s Aron Szapiro explains in a recent post aptly called ‘Biden’s 401(k) Plan Is Vague, but Worth Paying Attention to.’
The problem Biden is trying to solve is that tax-privileged retirement accounts are inherently regressive, for the simple reason that the taxes which are being deferred are themselves progressive.
So what will it mean for Biden to ‘equalize benefits’? Szapiro does his best to guess:
This would probably lead to about a 26% credit on every dollar any worker saved for retirement. (That estimate assumes Biden’s plan would not change the total amount of the tax incentive to save in a retirement plan, just the way the tax benefit is distributed.)
As a result, the benefit for those with a marginal tax rate above 26% would decrease, while Americans who pay lower rates (because they make less) would get a bigger break. Workers earning less than $40k, for instance, would stand to see their tax benefit double.
Szapiro goes on to consider whether such a policy would increase the relative attractiveness of Roth contributions for the wealthy individuals who would see a decreased benefit from 401(k) contributions:
That may well be true to some extent, but these higher-earning people would also have to assume that their effective tax rate in retirement would be less than 26% to make this worthwhile. Unlike the marginal tax rate, which is the highest rate a taxpayer pays, the effective tax rate is the weighted average of the various rates of taxes one pays on all their income in a given year. No one knows what the future holds for tax rates, but a 26% benefit today would still be attractive.
Another wrinkle is that the wealthiest earners can’t contribute to a Roth IRA straightaway. For 2020, couples married filing jointly cannot contribute anything if their modified adjusted gross income is above $206k; since joint incomes below $326,600 are taxed at 24% or less, most who are eligible to contribute to Roth IRAs will actually be helped by the proposal.
Of course, they could choose to make backdoor Roth contributions, which one expert said would become more popular if Biden’s plan went into effect.
Another possibility is that the plan would help the lesser-known Roth 401(k) to steal a bit more of the spotlight. Unlike the Roth IRA, the Roth 401(k) does not have an income limit, making it appropriate for the higher-income households currently paying steeper tax rates.
Not every employer offers a Roth 401(k), but interestingly enough, these plans are reportedly most popular for the manufacturing sector – a group which did come up in Tuesday night’s debate.
Perhaps the manufacturers are simply ahead of the curve.
This article originally appeared on CityWire.
