Some Thoughts on Leverage and Retirement

James writes in:

Do you have any opinions on people leveraging their retirement savings in their 20s and early 30s? You use your retirement savings to buy lots of stocks and other investments on margin, moving all of the risk to the early part of your career. Read a book about it and wanted to know what you think.

I’m not sure which book James read, but there’s a decent chance that it’s Lifecycle Investing by Ian Ayres and Barry Nalebuff, which was a hugely popular investment book several years ago and more or less recommends this exact strategy.

Basically, the authors recommend that young investors – those in their 20s, mostly – leverage their retirement investing when they’re young. Leverage simply means that you’re borrowing money in order to be able to invest more right now, with the idea that you’ll pay back that money in a few years and keep the extra returns.

As a simple example, imagine that you’re 22 years old. You’re putting away $5,000 a year into retirement, which is great, but you want to really kickstart things. So, you borrow $100,000 from someone willing to lend you money (perhaps your brokerage, perhaps a bank, whatever) and you put all of that into aggressive investments, intending to pay it back in ten years.

In that situation, you have a greater than 50% chance of making money on that move and a small chance of making a lot of money, but you have a very significant chance of losing money on that move (because you’re not making enough on the investment to cover the money you borrowed). However, if you are able to do well here, you get a huge jump start on your savings for the future.

If, for example, the loan has a 5% annual interest rate and you earn 10% a year on that money, you could pay the loan back after 10 years and still have $96,000 in savings. On the other hand, if you borrow money at 5% and the stock market only earns you 2% per year, you will owe almost $50,000 at the end of that loan (even after selling off all of your investments) and have nothing to show for it other than that debt.

What you’re doing here is moving a lot of the risk of your retirement savings to the earliest years of your savings. Those first ten years are loaded with risk, but if it turns out well, your retirement savings are very well in hand. If it doesn’t turn out well, you may have a hole to dig out of, but you’re still just in your 30s and have plenty of time to save in a more stable fashion.

On paper, this all seems like a reasonable plan, but there’s a big problem with it: the real world consequences of the downside of this are more impactful than the real world consequences of the upside of this, as compared to simply saving as much as you can and putting it into index funds or target retirement funds within your retirement account.

It simply comes down to some realizations about life.

In terms of your annual living expenses, there’s a certain “happiness point” that, depending on how you calculate it and where you’re at in American, means a significant drop in happiness if you’re below that annual income level and very little difference in happiness if you’re above that income level. Once you have enough money coming in to secure your basic needs and have enough left over for a little bit of travel and a few hobbies, additional money does not add significantly to your personal happiness. This has been an area of significant study in economics and this landmark paper by Daniel Kahneman and Angus Deaton sums it up and even identifies the approximate number – about $75,000 a year in 2010 dollars, varying widely depending on where exactly you live in the United States (much less in some areas, more in others).

The thing is, if you have a decent job and follow a more traditional route to retirement, meaning you put adequate money into a 401(k) or 403(b) or some similar plan, you’ll very likely get to somewhere near that number in retirement, especially when you add in Social Security and other benefits. Of course, “adequate money” means you’re putting in 10% of your pay per year starting in your 20s and that you’re reasonably aggressively invested up until you start getting close to retirement (just putting everything in a Target Retirement Fund matching your retirement year is probably adequate). You are very, very likely to reach that “happiness point” by following this basic plan.

On the other hand, if you use leverage and debt to invest for retirement early on, moving the risk to your earliest career years, one of two things will happen. Either you’ll do well with it and make it easier to save for retirement and potentially early retirement, or you’ll do poorly with it and find yourself in the hole for retirement savings in your early 30s, actually owing money.

The upside? You have some extra cash in retirement or you get to retire several years earlier. You probably wind up a bit past that “happiness point,” which basically means you don’t feel any noticeable difference in your personal happiness level.

The downside? You start your 30s with a big debt on your lap and nothing saved for retirement. You’ll have a harder time even getting to that “happiness point” as you have to both pay off your debt and likely “catch up” on retirement.

The upside is a little more likely than the downside, but the downside is so awful that, in my judgment, it’s not worth the risk for most people. The small amount you gain (some extra money beyond the “happiness point” or a few extra years of retirement) don’t add up to enough to counterbalance the risk of being in extra debt with no savings at age 30.

My advice? Put as much money as you can afford into your retirement accounts as early as you can. If your workplace offers a 401(k) or similar plan – especially if they offer matching – start contributing immediately. Choose a Target Retirement fund if one is available; if not, put the money into something aggressive and low cost, like a Total Stock Market Index. Then, just let it ride until you’re about ten years from retirement, at which point you should start giving it some more focused attention.

The key thing to remember is this: once you get above a certain fairly low financial threshold, you don’t gain happiness. Your best bet for happiness now and happiness in retirement is to aim for that threshold now while also working toward getting there in retirement. That means putting away a small portion of your money now, at a slow pace, and letting it build with aggressive investing so that it can be enough to help you reach that happiness point in retirement. That doesn’t mean taking on enough risk that you add a significant chance of a large amount of debt now and a total depletion of your retirement savings just so you can overshoot that happiness point by a little bit or retire a couple of years earlier.

A bird in the hand isn’t worth two in the bush when it comes to retirement. Invest aggressively, but don’t leverage your retirement, because the downside just isn’t worth the upside. Just keep plugging away. Keep the risk within your investments, not outside of it.

Good luck!

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