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The Problem with Market Timing Research

I recently took a continuing education class about retirement planning. The instructor was super enthusiastic about a recent piece of research that showed that, based on historical data, retirees’ ability to safely spend from their portfolios would be improved if they followed a set of rules in which they dramatically adjust their asset allocation each year based on current interest rates and price-to-earnings ratios.

Personally, while I find such research interesting, I don’t think I’d be able to trust it if it were my own money on the line.

My qualms can be best explained by an analogy I heard several years ago (though I don’t remember where).

Imagine that we want to test whether eating various types of mushrooms improves health outcomes among people with pancreatic cancer. So we find 50 people with pancreatic cancer who are willing to participate in a study, and we find 50 different species of mushrooms. Each person in the study gets one type of mushroom, and they eat that mushroom everyday for lunch. Person 1 eats Mushroom A everyday, Person 2 eats Mushroom B everyday, and so on.

As it turns out, Person 17’s cancer quickly goes into remission, while he’s eating Mushroom Q every single day.

What does that tell us? Not a lot, really. Mushroom Q might be useful as a treatment. Or perhaps Person 17 was just a lucky individual, and it has nothing to do with mushrooms.

Fortunately for the sake of our research, mushrooms (at least the ones we’re testing) are harmless and not especially expensive. In addition, there are lots of people with pancreatic cancer. So we could do a study in which many people with pancreatic cancer are given Mushroom Q (while others are given a placebo), and we see what happens. In just a handful of years, we’d have a decent idea of whether this mushroom really has any effect or not.

Unfortunately, for two reasons, this type of research isn’t really possible for market timing strategies.

Problem #1

With investing, somebody can look at historical data and come up with a strategy that would have worked wonderfully in the past. This is like the first part of our mushroom research in which we test a bunch of different mushrooms. But we can’t go out and do a large number of simultaneous tests of the new strategy. For example, if we want to test how a certain market timing strategy affects likelihood of portfolio depletion over a 30-year retirement, we have to wait 30 years to get any new independent data points.

And by then:

  1. Your own personal opportunity to benefit from such rule has likely expired, and
  2. There’s a decent chance that markets have changed in some way that invalidates the conclusion anyway. (When successful market-beating strategies become commonly known, they usually stop working as the market adjusts.)

Problem #2

Part of what makes our hypothetical mushroom trials feasible is that all of the people involved can still get whatever medical care is currently considered to be the best for fighting their cancer (e.g., radiation, chemo, surgery, etc.). That is, the patients don’t have to bet their lives on mushrooms being more effective than chemo/radiation/surgery.

With investing, current conventional wisdom says that using a “strategic asset allocation” strategy is the best approach (i.e., an allocation that varies with your life circumstances but not with market indicators). You cannot simultaneously use that type of strategy and a “tactical asset allocation” strategy in which you vary your allocation based on your chosen indicator(s). It’s one or the other.

In other words, to the extent that you want to try out the new approach, you have to abandon the conventional wisdom approach. There’s no “chemo, plus eat some mushrooms” option here.

Is It a Good Idea to Front-load 401(k) Contributions?

A reader writes in, asking:

“On dollar cost averaging, if you can frontload your entire max 401(k) contribution to the first half of the year, is there a reason not to? It seems like you’d give it more time to do its compound interest thing, and in general the market trend is up over time.”

In many cases, yes, it makes great sense to max out your 401(k) contributions as early in the year as possible, in order to get the money invested as early as possible. (Ditto with IRA contributions, for the same reason.)

In some cases, however, doing so can cause you to miss out on part of the employer matching contribution — if your employer offers one. It all depends on how the plan actually calculates the matching contribution each pay period.

For example, consider three different hypothetical 401(k) plans, each of which could be described as having a “dollar for dollar match, up to 4% of compensation.”

With Plan A, the employer matches every dollar you’ve put in, until you hit 4% of your annual compensation. So by front-loading, you get your maximum match, and you get it early in the year. Great!

With Plan B, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you have contributed an equal amount already in the year. So by front-loading you get your own money invested as soon as possible, and you still get the maximum match, but it doesn’t speed up the rate at which you get the matching contribution (i.e., you still only get 4% per pay period). Still, front-loading is probably a good idea, if you can do it.

With Plan C, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you contributed an equal amount in that pay period. In this case, if you front-load your contribution, you actually end up missing out on part of the match. For example, if you max out the 401(k) in the first quarter of the year, you would not get any matching contribution in the final three quarters, because you didn’t contribute anything in those pay periods. In other words, you’d miss out on 3/4 of your total possible maximum match.

So, in short, it’s important to have a discussion with the plan administrator about how exactly the matching contribution is calculated (if there is one). Or, if you really want to be sure, get a hold of the plan document and read for yourself how the matching contribution is calculated.

Social Security Earnings Test with Spousal Benefits

A reader writes in, asking:

“Does the SS earnings test apply to spousal benefits? If so, how exactly does that work?”

For those unfamiliar with the Social Security earnings test, the general idea is that if you claim Social Security benefits prior to full retirement age and you work while you’re entitled to those benefits, the earnings test can result in all or part of your benefits being withheld if your earnings exceed a certain threshold.

Then, when you reach full retirement age, your benefit is adjusted upward to account for months in which you received no benefit or a reduced benefit due to the earnings test. For example, if you claimed 36 months early but the earnings test resulted in benefits being withheld for 24 of those months, when you reach full retirement age your monthly benefit will be adjusted to what it would have been if you had only claimed 12 months early rather than 36.

Whose Benefits Can Be Withheld?

One question I see frequently is whether Spouse A’s earnings can affect Spouse B’s benefits. And the answer is, yes, sometimes. Specifically, as a result of the earnings test, your earnings prior to full retirement age can result in withholding of:

  • Your retirement benefit,
  • Your benefit as a spouse or widow/widower,
  • Anybody else’s benefit based on your work record (e.g., your spouse’s benefit as your spouse or your child’s benefit as your child).*

Your earnings cannot, however, result in withholding of anybody else’s own retirement benefit.

Whose Age Matters?

For application of the earnings test, it is only the age of the person with the earnings that matters.

Example 1: Arthur is 64, and his wife Betty is 68. Arthur has filed for retirement benefits, and Betty has filed for a spousal benefit based on Arthur’s work record. Arthur is still working. The earnings test can still reduce Betty’s benefit as a spouse even though she has reached her full retirement age. The key point is that Arthur is the one with earnings, and he hasn’t reached his full retirement age.

Example 2:  Connie is 68, and her husband Daryl is 64. Daryl is receiving a spousal benefit based on Connie’s work record. Daryl is still working. His earnings can reduce his benefit as her spouse, even though she has reached full retirement age. Again, the key point is that Daryl is the one with the earnings, and he is the one who hasn’t yet reached full retirement age.

In either of the above examples, if the younger spouse was not working and it was the older spouse (the one beyond full retirement age) who was working, the earnings test would have no effect.

Benefit Adjustments at Full Retirement Age

When you reach full retirement age**, your own benefit (whether it’s a retirement benefit, benefit as a spouse, or benefit as a widow/widower) gets adjusted as necessary to account for months in which the earnings test resulted in your benefits being withheld. Nobody else’s benefit gets adjusted at that time.

So, in our Example #1 above, when Arthur reaches FRA, his benefit will be adjusted, but Betty’s will not be.

Example 3: Edward is 62, and his wife Francesca is 64. Francesca is receiving spousal benefits on Edward’s work record. Edward is still working. When Francesca reaches full retirement age, her benefit as a spouse gets adjusted upward based on the number of months in which the earnings test resulted in a reduced benefit or no benefit. It does not, however, get adjusted again when Edward reaches full retirement age, even if the earnings test results in additional months of withholding from her spousal benefit in the interim.

*Exception: Your ex-spouse’s benefit on your work record will not be reduced as a result of your excess earnings if you have been divorced for at least 2 years.

**People claiming widow/widower benefits also have a benefit adjustment calculation that occurs at age 62, in addition to the one that occurs at full retirement age.

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