Automatic drafts: Why doctors should use them
When managing investments, many doctors spend a substantial amount of time focused on specific stocks, bonds, and mutual funds within their portfolios.
By John K. McGill, JD, CPA, MBA, and K. Warren Poe Jr. CFP®
When managing investments, many doctors spend a substantial amount of time focused on specific stocks, bonds, and mutual funds within their portfolios. As a result, they often fail to pay attention to other issues such as fees, taxes, and funding techniques. While asset allocation is certainly important, these other items have a dramatic effect on the long-term performance of their accounts and should not be overlooked. One of the easiest ways doctors can improve their overall investment returns and increase their chances of reaching their annual savings goals is to establish automatic drafts.
Many doctors wait until the following year to fund the employer portion of their retirement plans. For the average doctor, a 401(k) profit sharing and safe harbor contribution is approximately $50,000 per year, and a typical defined benefit contribution is approximately $120,000. Instead of waiting until the end of the year, doctors should fund approximately 80% to 90% of these contributions throughout the year.
The plan is intentionally underfunded at year-end to allow for any fluctuations in staff demographics and compensation. The best way to fund the plan throughout the year is to set up automatic drafts, or electronic fund transfers, between the practice's checking account and the investment custodian.
While there are many benefits to setting up monthly drafts, one is the ability to dollar cost average the contributions into the investments throughout the year, rather than waiting and funding the majority of the plan at the end of the year. Dollar cost averaging creates investment discipline by forcing doctors to invest the same amount each month, regardless if the stock market is going up or down. By doing this, a doctor will buy more shares when the market is down and fewer shares when the market is up. As a result, emotional decision-making in the process is eliminated.
Last year provided a great example of using a dollar cost averaging strategy, when the S&P 500 increased over 32%. Assuming a $50,000 profit sharing/safe harbor contribution, a recommended draft would be $3,750 per month. A retirement plan with a monthly draft of $3,750 into a balanced portfolio would have approximately $4,000 more in the account at the end of the year versus making a contribution of $50,000 at the end of the year.
This example used the Vanguard Balanced Index fund to represent the doctor's 60% stock and 40% bond portfolio, and the fund returned 18.1% in 2013. One contribution per month of $3,750 (total of $45,000) would have been worth $49,123 at the end of the year. The difference of $4,123 represents an internal rate of return of 9.16%. This is considerably higher than the historically low interest rates that doctors earn in their checking accounts. Many doctors have their 401(k) plans invested even more aggressively. As a result, a more aggressive portfolio would have yielded an even higher return. With defined benefit plans that have annual contributions two to three times higher than 401(k) plans, the benefit is even greater.
Dollar cost averaging will most likely improve the performance of the investment account. Additionally, the automatic drafts help improve a practice's cash flow, and doctors who use monthly drafts are significantly more likely to reach annual savings goals compared to those who wait to fund their retirement plans at once. It is much easier to budget $3,750 per month than to accumulate the cash by saving throughout the year and writing a large check in January to fully fund the plan. More often than not, doctors who wait to fund their retirement plans are unable to maximize contributions to the plan.
Given the benefits, it is surprising that less than one third of doctors use monthly drafts as a part of their saving strategies. While the examples above relate to retirement plans, the same concepts apply to any type of investment/savings account. With emotions out of the way once an automatic draft is in place, doctors rarely notice the money absent from their accounts, since it has become part of their monthly budgets, and they are on track to accomplish their financial goals.
John McGill provides tax and business planning and publishes The McGill Advisory through John K. McGill & Company, Inc. Warren Poe provides investment advice through McGill Advisors, Inc. (RIA). Both firms are affiliates of The McGill & Hill Group, LLC, a one-stop resource for tax and business planning, transition, legal, retirement plan, CPA, and investment management services. Visit www.mcgillhillgroup.com.
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