Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 4: Maximizing Your Annual Return?

This is the fourth in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training. In the last post, I demonstrated how reaching a goal of a $9,000,000 retirement fund is achievable in 35 years if you invest $40,000 per year and get an annual rate of return of 7.5%. On the surface, this sounds so simple, but in reality, many physicians never get this rate of return due to the pitfalls that get in the way. In this post, I’ll outline some of the common pitfalls.

Physicians are in one of the highest paid professions on the planet and so they have a lot of money to invest. But we usually know a lot less about investment than other professionals in business or law. Consequently, there are a lot of people who would like to get paid to steer us toward our retirement goal. Although you are going to need some advice, it is up to you to be sure that you are not being taken advantage of. Here is where we often go wrong:

  1. Expense ratios. Lower is better. If you are investing in a mutual fund, for example, there will be a certain percentage of the total fund balance that you pay each year to the investment company for them to manage that mutual fund. This is called an expense ratio. These can vary from as little as a tenth of a percent to as much as 2%. Let’s assume that you have $100,000 to invest and you anticipate an 8% annual rate of return and you’re going to leave the money in for 20 years before you use it. Now let’s look at two mutual funds: Fund A has an expense ratio of 0.21% and fund B has an expense ratio of 1.15%. The cost to manage fund A over the next 20 years will be $19,000. The cost to manage fund B over the next 20 years will be $96,000. In other words, when you get ready to take the money out of this account in retirement, you’ll have $77,000 less if you paid the higher expense ratio.
  2. Index v managed fund returnMutual fund category. Index funds are better than managed funds. With an index fund, the investment company buys stocks based on the proportion of various companies in some index, for example, the S&P 500. It is all done by computer and the investment company does not have to hire a lot of expensive analysts and stock-pickers to choose the stocks that are in that fund. With a managed fund, there are analysts, managers, and stock pickers that try to outwit other investment companies’ analysts, managers, and stock pickers in order to get a higher annual rate of return. As a general rule, index funds have lower expense ratios than managed mutual funds and so right away, you’ll have more money in your retirement account when you retire if you invest in index funds. On the surface, you might think that the managed funds would perform better than the index funds because they are backed up by all of this human brainpower to choose better stocks to put in the fund. However, as it turns out, humans are pretty fallible in the stock market just like they are in other professions. Although there will always be some winning funds that outperform everyone else, you won’t know for sure now which funds will be winners. Over time, index funds outperform managed funds as a whole..
  3. Commissions. No load is better than a front load. Some mutual funds will require a “front load fee” which is essentially a commission that you pay when you first put money into that fund. This reduces the amount of your investment and over time, this results in a reduction in your total retirement fund amount. Let’s go back to the example of $100,000 invested for 20 years with an 8% annual return. If a mutual fund has a 1.5% front load fee, the ending value of that investment will be $485, 290. If the mutual fund does not have a front load fee, the ending value will be $492,680. That is a $7,390 difference that you ended up paying over the course of that investment.
  4. Value of $1 invested in 1965Stocks versus bonds. In the long run, stocks perform better than bonds. In the short run stocks are more volatile than bonds. In the 50 years since 1965, the average annualized rate of return in stocks has been 9.91% whereas the average annualized rate of return of bonds has been 6.58%. In other words, $1 invested in stocks in 1965 was worth $112 by 2014 whereas $1 invested in bonds in 1965 was worth $24 by 2014. The problem is that the value of stocks can vary wildly from year to year whereas the value of bonds varies relatively little from year to year. Therefore, if you have a long investment horizon, stocks are a better investment but if you have a short investment horizon, bonds are safer. But remember, when you retire, you are not going to be taking all of the money out of your retirement fund the day you retire; some of that money is going to need to stay invested until you die 15, 20, or 30 years later. Therefore, it is best to have a mixture of stocks and bonds in your retirement fund with a higher percentage of stocks when you are younger (say 80-90% when you are age 30) and a lower percentage of stocks when you are older (say 50% when you are age 65). An important caveat to this is that if, in addition to your retirement fund, you also have a pension or an annuity and can expect a fixed income from that pension or annuity for the rest of your life in retirement, then you can afford to have a greater percentage of your other retirement portfolio in stocks since that pension or annuity will give you some insulation from the inevitable year-to-year volatility in stock prices.
  5. Stock turnover. Less is better. If you are purchasing stocks in individual companies for your retirement fund, then every time you buy and sell a stock, you are going to have to pay a stock broker a fee. If you are buying and selling frequently, then those fees add up and you can end up with less money in your retirement fund than if you bought a stock and held it. This has to be tempered with not holding onto loser stocks forever but you have to be judicious. Beware of the financial advisor who periodically sends out sell and buy advisories for the stocks that you own; although it is possible that he (or she) is some kind of stock market oracle with a unique ability to see into the future of stock prices, it is also possible that he needs to make a boat payment on his new yacht.

In the next post, I’ll show how the tax implications of different investment options affect your final net retirement fund value.

August 22, 2016

Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 3: How Much Money Do You Need To Save For Retirement?

This is the third in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training. In the last post, I made the argument that a physician making $250,000 per year now will need about $9,000,000 in retirement savings 30 years from now in order to maintain the same standard of living that he or she has now. In this post, I’m going to outline the path for getting to that $9,000,000 number.

A $9,000,000 retirement fund is not that difficult for a physician to achieve, as long as the physician starts saving early in their career, saves regularly and invests wisely. And it is all due to the wonder of compound interest.

Let’s again start with an example of a new physician making $250,000 a year currently. Assume that the hospital or group practice employing that physician has a retirement plan that automatically puts away 10% into a retirement plan. That is $25,000 per year right away. Now let’s assume that the physician also puts away an additional $15,000 per year in a 403(b) plan each year. That is a total of $40,000 per year in retirement savings each year. In other words, 16% of your annual income is going into saving for retirement. Let’s further assume that the physician is 30 years old and plans to retire in 35 years at age 65.

Because retirement is a long way away, you can tolerate a lot greater year-to-year volatility in the value of the retirement fund than you could if you were 5-10 years away from retirement. This means that your retirement fund should be primarily invested in stocks as opposed to bonds at age 30. Historically, over the past 90 years, the stock market has averaged a 10% return per year. However, this is an average and there is a lot of year-to-year variability and even decade-to-decade variability so a more realistic return is lower, for example, 7.5%.

At the optimistic 10% average annual rate of return, the $40,000 invested in a retirement fund today will be $1,306,000 in 35 years. At the more realistic 7.5% annual rate of return, that $40,000 will become $548,000 in 35 years. But you will not just be investing into your retirement fund this year, you’ll be investing every year up until retirement.

So, let’s assume that you invest $40,000 per year every year for the next 35 years. At a 10% annual return, the value of your retirement fund will be $14,000,000. At the more realistic 7.5% annual rate of return, the value of your retirement fund will be $7,360,000.

But the reality is that you are unlikely to just put $40,000 into retirement every year for the next 35 years. As inflation gradually increases your salary over time, the amount that you put into your retirement plans will also increase over time, even if your retirement contributions stay as a fixed percentage of your total salary. Therefore, if you keep up with your current investment contributions of 16% of your annual income, you will easily exceed the $9,000,000 retirement fund goal in 35 years.

The good news is that reaching your projected retirement fund balance is achievable. The bad news is that many physicians fall prey to the 2 biggest obstacles in achieving their goal: bad advice and bad judgment. In the next post, I’ll outline some of the common ways that physicians’ annual rate of return gets eroded, leaving them with less money in their retirement account than they had planned on.

August 20, 2016

Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 2: Retirement Fund Options

This is the second in a series of posts about physician retirement planning that I created as part of a presentation that I am giving to fellows in training at the upcoming American College of Chest Physicians annual meeting. In this post, I am going to define some of the common retirement options that physicians may have available to them.

For many physicians, the decision you make on the first month of your job will dramatically affect your retirement decades later because some these retirement planning decisions are permanent. After going through medical school, residency, and maybe a fellowship, physicians are not trained in how to invest for retirement and when they finally sign a contract for their first job out of training, they don’t understand the nuances of the retirement options that they are about to choose from. This blog post is a primer on the different choices that you have. In future posts, I’ll go into some of the unique pros and cons of several of these different options that physicians face.

  1. Pension plans. In these plans, the employer, employee, or both put pre-income tax money into a pension fund and when the employee retires, he or she can draw down on the fund, paying income tax as the money is withdrawn. There are two general types of pensions:
    1. Defined benefit pension plans. In these plans, the employee and employer contribute a percentage of the employee’s income into the pension plan every year that the employee is working. The employer usually controls how the money is invested. Then, when an employee retires, they get a fixed annual income (the “benefit”) every year for life. The amount of the benefit is usually based on the amount of the employee’s final salary before retirement plus years of service to the employer.
    2. Defined contribution pension plans. In these plans, the employee and employer contribute a percentage of the employee’s income into the pension plan every year that the employee is working but the employee controls how the money is invested. Unlike a defined benefit plan, when the employee retires, they can determine how to withdraw money from their pension account but when that money is gone, they no longer have any benefits.
  2. Annuity plans. These are really an insurance plan for retirement income. In these plans, a person purchases an annuity and then when they retire, the annuity pays them a certain amount every year. In this sense, it is sort of like buying into a defined benefit pension plan. Some people who have a defined contribution pension plan with their employer will take the money out of their account at retirement and purchase an annuity to ensure that they always have some annual income for as long as they live. An advantage is that it gives the person a fixed annual income for life after retirement. A disadvantage is that annuities can have a lot of overhead expenses.
  3. Social Security. In reality, this is just a big defined benefit pension plan. It was originally created as a safety net to address the high poverty rate among older Americans by providing them with a minimum basic income. It is funded from payroll taxes. But the amount of income a retired person gets from Social Security is fairly low and barely enough to live on. For physicians, social security will only be a very small part of their retirement income. And for physicians who are employed through state governments that have state-affiliated pension plans (for example state teachers retirement systems), the Social Security annual benefits are reduced and in some cases, non-existent (since the government pension takes the place of Social Security).
  4. 401(k) plans. These are deferred compensation plans used by companies. They are a way for employees to carve off a chunk of their take-home income to save for when they retire. When you contribute to a 401(k), your taxable income for that year drops by however much you contribute to the 401(k). So, for example, if you make $200,000 and contribute $15,000 to a 401(k), then you only have to pay state and federal income tax on $185,000 that year. The 401(k) money can then be invested and grows but you pay no taxes on it until you retire. When you take the money out in retirement, you pay regular income taxes on it. So, for example, that $15,000 you invested today may be worth $250,000 when you retire due to interest, dividends, growth in stock prices, etc. If you take money out of your 401(k) before age 59 ½, then you have to pay a penalty for early withdrawal. Some companies will have a policy of matching some or all of your 401(k) contributions so if you put $10,000 in your 401(k), the company will contribute an additional $10,000 but if you don’t contribute to your 401(k), the company contributes nothing. The maximum you can contribute to a 401(k) in 2016 is $18,000 per year if you are under age 50 years old and $24,000 if you are over 50 years old. You can decide how much you want to put away into a 401(k) each year from as little as $100 or so to as much as the $18,000 (or $24,000) limit. You may have to pay local income tax on the money you put into your 401(k) even though you don’t have to pay state or federal income tax on it.
  5. 403(b) plans. These are very similar to 401(k) plans except they are used by not-for-profit companies. Like the 401(k), you contribute to the 403(b) pre-tax and then pay regular income tax on the withdrawals you make after you retire. The maximum contribution is also $18,000 per year (or $24,000 if you are older than 50 years old) for 2016 and there is a penalty for withdrawal before age 59 ½.
  6. 457 plans. These are also similar to 401(k) plans except that they are for state and municipal employees. They have the same contribution limits. The one important difference with a 457 plan is that there is no penalty for withdrawal before 59 ½ years of age.
  7. 401(a) plans. These are retirement plans that are set up by the employer and usually have a fixed percentage of the employee’s salary going into the 401(a) plan. These plans are tax-deferred so that the employee does not pay state or federal income tax when contributing to the 401(a) but do pay income tax when withdrawing money from the plan after retirement. 401(a) plans are for non-profit organizations, government organizations, and teachers.
  8. 415(m) plans. These are retirement plans for public employers (colleges, universities, etc.) that allow for additional pre-income tax money to be put into a tax-deferred account after an employee has exceeded the contribution limits set by the IRS for other retirement plans (such as a 403(b). The 415(m) plans do not get lot of press because they don’t really apply to the vast majority of employees, only the highest paid employees. However, at a university, physicians are often the among the highest paid employees so these plans may be available.
  9. Traditional IRA. This is money that you put away for retirement. Unlike the 401(k), 403(b), and 457 plans that usually have a limited number of mutual funds or other investment options, you have total control over what you invest your IRA money in. If you are single and make less than $61,000 a year ($98,000 if you are married filing jointly), then you can make the entire IRA contribution pre-tax and then pay regular income taxes when you withdraw money in retirement. If you make more than $71,000 a year ($118,000 if you are married filing jointly), then you can still contribute to an IRA but you have to pay income tax on the money first (i.e., use post-income tax dollars); when you take the money out in retirement, you pay regular income tax on however much the IRA appreciated over the amount that you initially put into the IRA. Most physicians have an annual income that is too high to allow pre-tax traditional IRA contributions but they can still contribute to a traditional IRA with post-tax dollars. The most you can put into a traditional IRA in 2016 is $5,500 per year ($6,500 if you are over age 50).
  10. Roth IRA. Like a traditional IRA, this is money that you have total investment control over. Unlike a traditional IRA, you don’t have to pay any income tax on it when you take withdrawals in retirement. Also unlike a traditional IRA, anyone who puts money into a Roth IRA has to use post-income tax dollars. There are limits of who can contribute directly to a Roth IRA: the income limit to do this in 2016 is $117,000 if you are single and $194,000 if you are married filing jointly. However, current tax law allows a person who would not normally qualify to put money in a Roth to open a traditional IRA using post-income tax money and then immediately “convert” it to a Roth. This is sometimes called a “backdoor” Roth.
  11. Self-employment plans (SEPs or SEP-IRAs). This is a retirement plan for self-employed persons. Physicians frequently have the bulk of their clinical income from either a hospital or group practice that they work for but may also have some income that they make on the side, for example, money from giving talks or from outside consulting. The SEP is an option for investing part of that self-employment income for retirement. Each year, the physician puts away a part of his or her pre-tax income into the SEP. The SEP money grows untaxed, similar to a 401(k), and then when the physician retires, they take money out of the SEP and pay income tax on the withdrawals. The maximum amount a person can contribute to an SEP in 2016 is 25% of their compensation for that year up to a maximum contribution of $53,000.
  12. Regular investments. These can take a lot of different forms, such as stocks, bonds, and mutual funds. The money you invest is all post-income tax. You may get annual interest or dividend income from these investments and you may sell them for a profit in the future. Interest income is taxed at your regular income tax rate. Dividend income and the profit from selling one of these investments at a higher price than you originally paid for it is taxed at the capital gains tax rate, which is generally lower than the income tax rate.

If you are wise, you’ll have retirement investments in more than just one of these and preferably, in more than half of these. In future posts in this series, I’ll tell you which options I think make the most sense for physicians.

August 18, 2016

Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 1: How Much Money Will You Need In Retirement?

I was asked to give a presentation on financial planning to fellows attending this fall’s annual meeting of the American College of Chest Physicians. In preparation for that presentation, I am preparing several posts about retirement planning for physicians. This is the first of these posts. As a disclaimer, I am not a financial planner but after more than 30 years of being a physician with 15 of those years spent as the treasurer of our Department of Internal Medicine, I have seen physicians make a lot of good choices and bad choices so I have a few thoughts on the subject.

The question everyone asks when planning retirement income is: “How much money will I need?”. The answer is… a lot. Before you can even begin to try to answer the question, you have to consider a number of variables including:

  1. How long will you live in retirement? Somehow, this one always gets me queasy whenever I have to consider it. Currently, the average life expectancy for an American who is 30 years old is age 77 for a man and age 81 for a woman. Since you are a physician, you can probably add a couple of years to that since you are likely a non-smoker and have reasonably healthy eating and exercise habits. So, if you are looking at retiring at age 65, then you’re going to need 15-20 years of income saved up. And if you’re planning on living to 100 like me, then you’re going to need to support yourself for 35 years.
  2. What is the inflation rate? The consumer price index goes up each year with an average inflation rate for the past 100 years of 3.1% per year. But remember, that is an average. The year I started medical school, the inflation rate was 13.5% and a couple of years of that rate will dramatically erode your retirement account. For the sake of simplicity, let’s assume the consumer price index goes up the same amount in the next 30 years when you get ready to retire as it has in the past 30 years when I was a resident. If that is the case, then an annual income of $250,000 this year will be equal in purchasing power to an annual income of $549,813 in 30 years.
  3. Will your fixed expenses change? Hopefully, you’ll have the house paid off, the kids out of the house and their college paid off. Once you retire, you won’t have to be setting aside a big chunk of your annual income for retirement savings since you’ll be drawing off of those savings. But things happen and it is possible that you’ll have different fixed expenses in 30 years. But for simplicity sake, subtract out your current mortgage payments, retirement contributions, and kid’s college savings contributions from your current income to determine what percentage of your current income is used for your activities of daily living in order to determine what you will need to maintain that level of daily living in retirement.
  4. What portion of your retirement income will be subject to income tax? As you will see in a later post, there are taxable and non-taxable retirement savings options for you but most of your retirement income is likely to be subject to income taxes, just like your current income is.

So, for the purposes of example, let’s assume you are a physician making $250,000 a year currently. And let’s further assume that you are spending $30,000 a year on your mortgage, you are putting $40,000 a year away for retirement, and you are saving $10,00 a year for your children’s college savings and all of those expenses are going to go away when you retire with your house paid off and your children graduated from college. That means that your effective current income is $170,000 per year. If the consumer price index goes up at the same pace as it has for the past 30 years, then in order to have the same lifestyle in 30 years as you do now, you’ll need to have $374,000 per year. The good news is that your annual income will likely be also going up each year for the next 30 years and presumably the amount that you are contributing into your retirement fund will also so it won’t be quite as much of a sudden shock to your finances.

There are a lot of formulas for estimating how much of your retirement account you should plan to take out each year. A commonly quoted number range is 3-5% of your total retirement portfolio.  Let’s go with 4% as your initial withdrawal rate and you estimate that you will live for 30 years in retirement. In order to have $374,000 per year, starting 30 years from now, you’ll need to have about $9,000,000 in your retirement account in order to fund yourself entirely out of your retirement savings.

If you are a physician and you and your spouse are making a lot more than $250,000 per year, then your retirement target may be closer to $15,000,000 or $20,000,000. These are really scary numbers but as I’m going to show you in the next several posts in this series, it is actually pretty do-able as long as you start saving early and you save smartly.


August 16, 2016