I thought this post was too good to put at the end of the guest post queue, and given the nature of the topic, it’s more valuable information early in the year.
I’ve written about front-loading before, but have not done the rigorous analysis to see the numerical value of the benefit of maxing out your available retirement accounts early in the year. Mike has.
Thank you, Mike!
Do you front-load your retirement accounts? I know PoF does. I’ve considered it since it should provide a boost to my investments given the general trend of a rising market. This boost could really add up over a lifetime of investing. Vanguard performed a study that compared lump sum investing to dollar cost averaging. SPOILER: Lump sum investing wins. This article is about the yearly version of that decision.
I wanted to know the effect of front-loading retirement accounts and if I should be taking aggressive measures to make it happen.
Retirement Account Front-Loading Options
My 401k plan allows up to 25% of each paycheck to be directed to a 401k. In order to get all $18,500 (2018 limits) deposited in January, I would need a gross salary of $74,000 per month, or $888,000 per year. I’m not quite there yet. Any front-loading strategy would be spread out over much of the year.
The other factor is that my company match is based on each pay period. If I don’t contribute, I don’t get a match for the period. My maximum match is 3% to my 6% contribution. I would be giving up a guaranteed 50% return on that money.
I could try to be extra smart and contribute the maximum amount early in the year that would still allow me to contribute enough to get the match for the remainder of the year. But then any front-loading effect is even less powerful and I don’t think it’s worth the effort. Especially since I have to make a conservative guess on my raise to make sure I could contribute 6% (the max for my match) for the rest of the year.
There’s nothing that stops me from maxing out IRAs early in the year. Except that we don’t cash flow $11,000 a month in extra investment deposits.
But, maybe drastic measures are warranted if the benefit is large enough.
Front-Loading With Steady Growth
There are a few ways to look at the front loading “bonus” or monthly “penalty”. I’ll assume the market goes up at a steady 10% for the year, including monthly compounding, and $1,200 total invested. The year-end total return for front-loading is 10.5% ($1,325.66). This is 4.6% higher than the monthly contributions year-end total of $1,267.03.
Alternately, you can think of it as a penalty for not front loading. You get 95.6% (4.4% penalty) total return of a front-loading strategy.
Finally, you could calculate the annual return required for a monthly strategy to match a front-loading strategy (same principle invested). For a 10% steady yearly return, it’s 18.3%. 8.3% higher! This means the market would need to rise at a steady 18.3% with monthly contributions to match a front-loaded strategy with 10% growth.
ENOUGH WITH THE NUMBERS!
OK. It’s basically worth half of what the steady growth rate is. Of course, if the market rises early and then flattens, front loading has more of an advantage. If the market drops early and then rises, front-loading may have no advantage. In the worst case scenario, which happens roughly 30% of the time, the market is down for the year and front loading amplifies the loss.
Financing Front Loading
You could finance your front loading to get the front-loading bonus. Is it worth it?
If you have 0% financing, the net balance (investment – loan) is the same as the front-loading strategy. If you have financing equal to the growth rate, the net balance is equal to monthly contributions. Any financing rate between the two captures a little bit of the front-loading bonus. There is a complication though.
You don’t realize the net balance until you sell the investment. If this strategy is for a retirement account, you pay the interest now and get the benefit much later. If it’s in a taxable account, you have to pay taxes on the gains that are supposed to offset the financing interest.
Even with the complications, I’ve considered doing this. Except, the interest is a guaranteed expense and the front-loading benefit is not a guaranteed return. Also, that’s a lot of hassle. If I was churning cards anyway for travel hacking and had a 0% promotional rate, I might do that. Maybe.
One of our credit cards sends us 0% balance transfer checks since it’s not the card we typically use. They’re trying to get our business. This could be an option, except that there is a 3% fee on the check. Assuming an 8% return, 4.4% front loading benefit, and 3%, cost of financing this scheme, we could come out 1.4% per year ahead.
That’s savings account level returns combined with market level risk. One percent is still huge over the course of a lifetime if the trend holds though. But that assumes steady growth. 2017 would have been a good year for that strategy (12% higher return with front loading!). Hindsight makes us all genius investors of the past.
I want to determine how often front loading has a benefit, and what the benefit is using real returns over a longer time period.
Back Testing That Front-Loading Strategy
I’ll use a simplified version of the PoF asset allocation for this analysis and an all US stock run for a long term look. I assume $1,200 per year in the front loading scenarios or $100 per month for monthly contributions. The dollar amount doesn’t matter since I’m comparing overall performance and the percentage difference in these strategies.
- Vanguard 500 Index Fund Investor Shares (VFINX) (60%)
- Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) (10%)
- Vanguard International Growth Fund Investor Shares (VWIGX) (22.5%)
- Vanguard REIT Index Fund Investor Shares (VGSIX) (7.5%)
I used Portfolio Visualizer to test the strategies The information for these particular funds goes back to the start of 1997, which gives me a 21 year time period to test this portfolio.
This is what 2017 looks like:
Wow! That’s a big difference.
This next chart shows the difference in return for each year: (total return front loaded) / $1,200 – (total return monthly) / $1,200
1997 was the best year for front loading with a nearly 13% improvement over monthly contributions. Unsurprisingly, 2008 was the worst at -10.3%.
Here’s the result for investing over the full 21 year period:
3% better! Not bad. Well, wait. That’s 3% on the total return, not annual.
Math must be done. It turns out the strategy is worth 0.13% additional annual return.
Surely, this must be wrong. Let’s check the total US stock market. I ran it from 1972 through 2017 and here are the results:
4.9% better on the total return. Math again to the rescue to determine that the annual benefit is 0.1%. It’s so close to the first example. Math can be so satisfying.
Why Front Loading Investments & Monthly Contributions Even Out
Even with a large front loading bonus, like in 1997 or 2017, that percentage change applies to the contributions that year, not the entire portfolio. The next year, both strategies change by the next year’s return. The total percentage difference remains the same, but the annualized return is reduced as the timeline grows longer.
This explains why the effect is small compared to the effect of a high expense ratio or management fee. The fee applies to the entire amount under management, not just the contributions for the year.For example, in 2017 front loading was worth 12.1% increase over monthly contributions. That ratio for the money invested in 2017 remains the same going forward. After a 20 year investment period that chunk of money is still a 12.1% difference, but when you spread it over 20 years, the annualized return is 0.57%.
What To Do?
You should not worry about not being able to front-load your investments. You should worry about being honest with yourself and if you can front load, then do it. There is a slight investment return benefit as well as a behavioral benefit.
Don’t try to get fancy and finance this strategy or give up any 401k match. You will lose money unless you happen to do it in a year that the market rises rapidly.
You could save up throughout the year in your personal escrow account and put a front load strategy into effect the next year. But that would actually be back-loading since you wouldn’t be putting the money in as soon as you were able.
Ultimately, the question isn’t usually “Should I front load or not?” Most people invest the money as they perceive they are able. The important thing is to invest as much as you can, as early as you can. Make as much as you can be AS MUCH AS YOU CAN by growing income and controlling expenses.
Don’t you feel better knowing you knew the answer all along?
Notes to run this experiment yourself
- You have to start with an initial amount, which is the January contribution. You also have to manually subtract one contribution amount from the final balance since portfolio visualizer assumes contributions occur at the end of the time periods.
- Turn off inflation adjustment.
Thanks again to Mike from Married & Harried for this in-depth analysis. Are you a front-loader? Which accounts do you fill up first?