Retirement

Should Target Date Funds Be Standardized?

by Flexo on November 4, 2009

The Security and Exchange Commission (SEC) is setting up a new division to oversee new financial products, and this group is starting with target date funds. These are mutual funds usually taking the form of baskets of other mutual funds, designed to target a certain year of retirement. As the year approaches, the fund automatically changes asset allocation, usually between stocks and bonds, to become less risky.

I’ve pointed out some of my concerns with target date funds here before. Mainly, they could be too conservative and it’s easy to hide fees. Mary Schapiro, the head of the SEC, pointed to the exchanges from stocks to bonds. The cost of the sales and purchases is buried in the daily price of the target date fund, and there is currently no good way for customers to understand how much they are being charged for the re-balancing of the portfolio they could do on their own.

Schapiro also noted that there is no standard across companies. A target date fund designed for those who plan to retire in 2050 with one fund manager may have a different allocation between stocks and bonds than a 2050 target date fund with another fund manager.

Here is a comparison of the asset allocations for the funds designed for those retiring in 2050 from Vanguard, Fidelity, and T. Rowe Price.

	Vanguard	Fidelity	T. Rowe Price
Domestic Stocks	72.0%	69.5%	67.2%
Foreign Stocks	18.0%	20.0%	22.9%
Bonds	10.0%	10.4%	7.2%
Other	0.0%	0.1%	2.7%

The variation seems small but could have an significant effect on returns by retirement in 2050. If target retirement funds were standardized across companies, customers could accurately and easily compare returns between fund managers, understand the level of risk, and have the opportunity to make better investment decisions.

I am not convinced there is a need for this. Any fund’s composition is described in detail in the prospectus and in on a multitude of financial data websites like Yahoo Finance and Google Finance. What isn’t clear are the true fees. We do know that Vanguard’s fee for their 2050 fund is 0.19%, Fidelity’s is 0.82%, and T. Rowe Price’s is 0.79%, but that only tells part of the story. Whenever there is turnover — stocks are sold and other stocks, bonds, or other investments are purchases — fees are generated but wrapped tightly into the daily price of the fund so it is barely noticeable.

Asset re-allocation is the purpose of target date funds. Even if the underlying funds, those in the basket, are low-turnover index funds, the managers may be rearranging the index funds in the basket often. For those disciplined to handle the responsibility of occasional re-balancing themselves, and it’s not that difficult, I suggest avoiding target date funds.

Target date funds have lots of fans because it’s a form of automation, and automation in finances is usually a good thing. There is a danger of automation leading to complacency and a false sense of security. If you choose target date funds, familiarize yourself with the details and evaluate whether the pre-packaged re-allocation system is worth the thousands of dollars or more you could be losing in hidden fees and with a risk profile that doesn’t match your income needs and tolerance.

Would you like to see target date funds standardizes so a “2050 Fund” from one company matches a “2050 Fund” from another company? or should companies be left to determine what strategy is best for their customers?

Photo credit: viZZZual.com
‘Target Date’ Funds Get Senate Scrutiny, Daisy Maxey, Wall Street Journal, October 30, 2009
SEC to look at retirement investing risks, Marketplace, November 3, 2009

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How is Your 401(k) Retirement Account Performing?

by Flexo on October 7, 2009

I’ve been investing in a 401(k) retirement account since I joined the ranks of the corporate employed seven years ago. I started with a small percentage of my income, just enough to take advantage of the full company match. As my income increased, I diverted a larger percentage to the 401(k) with the hopes of retiring with a sizable nest egg decades later. I’m at the point now where I am contributing the full amount allowed by law.

This plan has worked well for a while. But like most people in similar situations, my 401(k) suffered damage over the past year or two. I figured that over the course of my career, I’d hit a recession at some point, and I suppose I am lucky that I am not forced to retire and begin drawing income right now, with the account value depleted.

Here is a graph that depicts my 401(k) account value since January 2004.

The cost basis, or the amount I invested, is represented by the line and the market value of the account is represented by the bars. Ignore the bump in the cost basis at the end of 2004. That should be a smooth curve. From 2005 through most of 2007, my account was performing quite well. Soon after that, the value fell below my cost basis. I was losing money on paper.

I continued to invest in my 401(k) every other week. Even with increased investments, my account has not caught up to my cost basis. The Employee Benefit Research Institute and the Investment Company Institute recently released a report that shows that many investors have been able to bring their 401(k) account balances above the level recorded at the beginning of 2008. I fall into this group, but at the beginning of 2008 my account value was higher than my cost basis. As of today, the total value of my 401(k) is below my cost basis.

In other words, if I had been putting the portion of my paycheck that I had been investing in my 401(k) into a bank account — or even kept cash under my mattress — I would have fared better. So far. The good news is that while I was investing throughout the past few years, I was, I hope, purchasing funds at relative bargain prices. If stock market performance returns to average over a long period of time, I should be in luck; those bargains will pay off.

What is the state of your 401(k)?

401(k) investors: Hit hard in ‘08, doing better now, Jeanne Sahadi, CNNMoney.com, October 6, 2009

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Is It Possible to Save Too Much Money?

by Flexo on October 2, 2009

in Saving

For most humans, life is much shorter than we would like, and for many of us saving even ten percent of our income will never result in a state of wealth within our lifetime. There are too many forces working against this endeavor: a lack of sufficient opportunity, inflation, and unplanned events to name a few. In addition, most people, at least in the United States, save much less than ten percent. It’s no wonder spending other people’s money and going into debt is so alluring for many.

Even if wealth eventually arises through conscious, compounded saving, by the time we reach a level of net worth that qualifies us to fall into the category we have set as a goal for ourselves, we are too old to enjoy what we have set aside. Putting aside the noble, selfless acts of passing our assets to charitable causes and descendants, the point of accumulating money is not to have a large bank account; the purpose of saving is to do something with the money.

When we save, we are putting aside our desire to do something now for the chance of doing something more later. Those nurturing a superfrugal mindset argue you should always choose the latter. The problem with the future is it never arrives regardless of how long you wait. Even though there is always a place or time or dollar amount where you can draw the line and begin living your life, that line may never come.

I will freely admit that I am not particularly adept at focusing singularly on the future. I likely fall somewhere along the spectrum of forward-thinkers. While I am not overly concerned about the present and I do not need immediate satisfaction, I do have my doubts about the future. I am saving money for retirement, including putting money into accounts that can’t be touched without penalty until several decades pass, but there is a possibility I may not live long enough to reach that goal. I am sacrificing a part of my life — not only the selfish activities in which I’d like to participate but the good, charitable things I could be doing with that money now — for the chance of doing more later.

If I don’t have the opportunity to do more later later, I would have made many needless sacrifices.

There are no certainties, so how can anyone truly offer advice about how much someone should save for the future? Life is short, and it’s important to make the most of it while you have a chance. No one knows what tomorrow will bring, so we guess and we offer suggestions. Save ten percent of your income (a weak but popular rule of thumb), or save as much as possible, but don’t completely sacrifice your life now for your future.

With your finances in control or on the path to being in control, ensure you are making the most of the short time you have on this planet. The slow road to accumulating money is the road that most people will take, so enjoy the scenery. The future may never come, so don’t deny yourself all joys of experiencing life now, however you define these joys, in deference. If your approach is causing you to miss out on aspects of life that you find important and will later regret, you may be saving too much money.

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Three Detailed Income Strategies for Retirement

by Flexo on September 26, 2009

Earlier this week, I reviewed common financial rules of thumb and offered a quick evaluation of how each rule would likely perform if accepted by an individual as the final word. One of these was the rule that convinces retirees they will be financially secure if they withdraw 4% of their nest egg for income one year and continue withdrawing the same amount adjusted for inflation each year.

Walter Updegrave has a much more detailed strategy for retirees who would like to make their money last from age 65 to 95 and beyond. He offers three alternatives that one can follow depending on their assets and their needs in retirement.

Three strategies for retirees

The first strategy is for retirees who have enough income from Social Security and pensions to cover basic expenses and who are confident in their ability to manage their portfolio.

For those in this situation the 4% withdrawal rule has a chance of succeeding — having your money last 30 years — 77% of the time. If you need more income than 4% would provide, you’re risking not having enough to last that long. For example, someone retiring today with a $1 million nest egg could withdraw $40,000 that first year. But if you’re 33 years old like me, you better plan on having much more than $1 million when you retire; thanks to inflation, an income of $40,000 thirty years from now will probably not be sufficient.

In order to maintain a 4% withdrawal rate, according to the article, is to maintain a portfolio of 50% stocks and 50% bonds. And by the way, a bad year in the stock market could wipe you out.

The second strategy offered by Walter Updegrave is for retirees who need more income for basic expenses than is provided by Social Security and pensions or who do not want to subject their portfolio to as much risk as required in the first strategy.

Take part of your nest egg and purchase a lifetime immediate annuity. This will provide you with steady paychecks for the rest of your life. According to the article, recent annuities pay out 8%, so you would only need $500,000 to make that $40,000 income mentioned earlier. These are most beneficial for people who live longer because money is pooled with other investors. Those who die earlier help fund the incomes of those who survive in retirement longer. The problem with annuities is your money is often locked inside them, and you can’t get it if you need it without paying steep penalties.

Walter Updegrave also offers a third strategy for retirees who need more income than Social Security and pensions provide but want access to more of their money. In addition to a portfolio of stocks and bonds, and an immediate lifetime annuity, add a variable annuity with a guaranteed lifetime withdrawal benefit to the mix.

Variable annuities are flexible but they are also expensive. Rather than 8% like the lifetime immediate annuity above, a 65 year old is likely to receive a 5% return. It is not rare for these accounts to charge a fee of 3% of your account balance each year. The author suggests that the optimal mix between these products and investments would be 25% of your portfolio in variable annuities, 25% in immediate annuities, and the remaining 50% in the diversified portfolio of stocks and bonds.

The problem with annuities

The sale of annuities, particularly variables annuities, is riddled with problems. These are very popular products for salespeople because they make a lot of money for the companies that sell them. It’s not rare for salespeople to misrepresent the product. Often customers are not given the full information regarding withdrawal penalties.

Here’s an example of an 86-year-old man who was pressured into buying a product he did not understand and would never benefit from. Dateline investigated annuities salespeople and found more deception in the industry. Ben Stein, however, credits variable annuities for making his parents rich, though it might be important to note that a Ben Stein’s long-time working partner is Phil DeMuth, a registered investment adviser (salesperson) who benefits financially when more people are convinced that annuities are good products.

How to make your money last, Walter Updegrave, Money Magazine, September 23, 2009

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Roth IRA Conversion

by Flexo on August 21, 2009

The option to convert a Traditional IRA to a Roth IRA has been around for a while. Here are the differences between a Traditional IRA and a Roth IRA for those new to these retirement accounts. As long as your modified adjusted gross income (MAGI) is under $100,000 you have qualified for this conversion. Contributions to the Traditional IRA is tax-deductible, which means that your tax bill is calculated after ignoring the amount you deposit into the IRA. You will pay those taxes after you retire and begin withdrawing these funds. If you have a higher tax rate now than you will in retirement, the Traditional IRA is a good choice.

On the other hand, the Roth IRA is not tax-deductible, so the deposits into this type of IRA are not exempted from your total income calculation for tax purposes. In effect, you use “after-tax money” to invest in a Roth IRA. This is a great choice for people who believe their tax rate now will be lower than it will be in retirement once they begin taking distributions.

There are two other benefits to the Roth IRA that often go unnoticed. The Roth IRA does not require distributions after age 70 1/2 like the Traditional IRA, offering more flexibility in retirement. The Roth IRA is better for estate planning; choosing a Roth IRA rather than a Traditional IRA for funds passed onto your heirs will allow them to avoid tax bills.

These benefits come with a drawback: if your MAGI is above $105,000 ($166,000 for those who are married filing jointly) your maximum allowed contribution begins to reduce and will completely phase out at $120,000 ($176,000 for married filing jointly). But there is now a law that will help you get around this for a short time.

In 2010, the $100,000 maximum for Roth IRA conversions will temporarily disappear. If you believe the Roth IRA is a better option for you but you have been prevented from investing in this type of account due to income limitations, now is your chance to make the change. Here is why this will be allowed: When you convert from a Traditional IRA you owe taxes on the amount of the conversion, and the government would really like that income.

If you must pay those taxes using funds from your IRA, the conversion might not be a good idea, but if you have cash saved for the tax bill you will be better off.

You can also convert accounts known as SEP IRAs and SIMPLE IRAs.

Here are some quality resources regarding Roth IRA conversions.

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4 Important Tips for Graduates Beginning a First Real Full-Time Job

by Flexo on June 29, 2009

in Career and Work

The summer following graduation is an interesting time for recently-former students. The newly-commenced young men and women, those not opting to pursue an additional number of years in an institution of higher learning, spend their time amongst activities such as attending backyard barbecues in celebration of their achievements, traveling to distant lands with newfound free time, and possibly beginning the first real job on their career path.

Not every job is the same, but for the most part there are a number of things in common.

You need to make a positive impression on people you are meeting for the first time.
How you perform on your first job sets the stage for your work ethic.
If you stay in the same career throughout your life, your initial salary will be your most important negotiation.

Here are more specific tips for making the most of your first job.

1. Look the part. As much as it is superficial and stupid, people will judge you by your appearance. You need to dress and carry yourself in a manner that is expected and accepted by the people who work in your field. What is acceptable varies. If you work in banking in New York City, it’s almost guaranteed you will be expected to show up in a suit every day. If you work in the graphic arts, more liberal clothing might be acceptable. Find out what your manager or supervisor wears and emulate.

If you have not been accumulating attire during college, you may find the need to buy a variety of clothing at the last minute. This is one reason it may make sense to accept a controllable level of debt. Attire is a start-up cost associated with accepting a first job, and if you are required to dress well, your salary should cover these costs before long.

2. Negotiate. Graduates may be experiencing a “sellers’ market” while starting new careers this summer. With stories of the difficulty of finding a great job in the right field, it may be tempting to jump at the first offer. It is true that times like this call for adjusted expectations, but the dance of negotiation is an important and expected part of every job offer.

Not every job has this flexibility. For example, if you start as a teacher in New York City, your salary and benefits are determined by the union contract and you have no room for negotiation. If your first job is with a cash-strapped non-profit organization, you may face resistance. But the first salary offer you receive is almost always lower than the company’s true ability to pay.

The best suggestion is to be prepared to support your desire for a higher salary by researching your peers’ compensation and by explaining well the skills you can bring to the table above other candidates. As you may not have much experience in your field when you start your first job, you may not have a list of accomplishments, so be creative while being honest.

Here are tips for dealing with a low salary offer. Remember to look at the total compensation, not just the salary. You may have more wiggle room if you ask for more vacation days or for quicker establishment of your retirement benefits.

3. Enroll in your company’s retirement plan. When I started at the company where I currently work, I qualified for the company’s 401(k) on the day I began. Although a portion of my company’s matching contributions wouldn’t vest (become officially mine) until I had been working there for three years, my first paycheck included a deduction for my 401(k) and a matching contribution from the company. While enrollment is often automatic, some companies don’t start helping you put aside money for retirement until you tell them how much you want taken out of your paycheck.

Young adults with their first job often do not think about retirement, an event likely to be more than forty years in the future. Not enrolling in a 401(k) with matching contributions is the same as throwing away money. I understand that people who are just establishing themselves at work and in life have expenses, and retirement savings cuts into income. But putting aside two or four percent of your income — or up to the maximum matched by your employer — should not be a stretch.

4. Open an IRA. Your 401(k) contributions are taken right from your paycheck, so you might not even notice your money is being transferred to your future self. It may be more painful to your wallet to open an IRA, but if there is no pain, there is no gain. So open an IRA at a low-cost brokerage like Vanguard. When I started my IRA, I didn’t have the $3,000 minimum, so I jumped right in with TIAA Cref. I suggest saving money periodically in a special bank account until you have the $3,000 necessary to open an account at Vanguard because I have encountered some problems with TIAA-Cref.

If you already have a 401(k), open a Roth IRA. These two types of accounts have different tax treatment, and it’s good to diversify. If your company does not offer a 401(k) or its non-profit cousin the 403(b), split your money between a Traditional and Roth IRAs, if you can, to get the same tax diversification.

Your career and the skills and tools you use to thrive in that career are your biggest assets, even though you won’t see them measured on any balance sheet. Protect, refine, and showcase your self and your skills when you can. If your career is important to you, go above and beyond the call of duty.

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Let’s Stop Envying Millionaires

by Flexo on June 8, 2009

in Wealth and Affluence

It is a shame that people are still fascinated with the idea of being a millionaire. According to an online etymology dictionary, the word “millionaire” was first seen in print in 1826, a year when having a net worth of one million dollars was an amazing accomplishment. An inflation calculator puts this into perspective; $1,000,000 in 1826 has the same buying power as $19,359,086.05 in 2009. There is nothing wrong about aspiring to become a millionaire as long as you realize that over time, the cachet of this status decreases and the number of millionaires increases.

Financial authors still look to millionaires as examples for the rest of us. Books like The Millionaire Next Door by Thomas Stanley and William Danko point out that most millionaires have self-made wealth, are business owners, and have a mostly frugal attitude towards spending.

A net worth of one million dollars in 2009, even if this does not include money tied up in the value of a primary home, will not provide financial independence for most people in United States. Assuming the one million dollars is invested in the stock market, and assuming financial planners’ recommendation of a safe withdrawal rate of 4% for maintaining value, a retiree or retired couple would be living on $40,000 each year. Considering families in this economy may be wary of investing their total nest eggs in the stock market, 1% or 2% may be a safer withdrawal rate.

One million dollars is not going to provide enough income each year for full retirement unless investment income is augmented by income from working, which defeats the purpose of traditional retirement, drastically reducing expenses to the point where retirees might need to redefine their planned retirement adventures, or moving to a country with a lower cost of living. For these reasons, my Number is well north of the one million figure. Note that I don’t call any certain number a goal, a real goal is not a number but the purpose behind acquiring wealth.

Rather than looking at the habits of millionaires, many of which are helpful but commonplace, I’d like to see more books focusing on the habits of those who have amassed wealth in the eight or nine digits. A quick look at the list of the world’s top billionaires (see Wikipedia) shows that like millionaires, the richest people in the world built their wealth by being atop the world’s largest corporations, and in Warren Buffet’s case, great investment prowess.

I prefer to focus on those who have achieved my Number, somewhere above “millionaire status” but below the stratospheric net worth enjoyed by the richest in the world.

Photo credit: TEDizen

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How Much of Your Portfolio Should Be in Stocks When You Enter Retirement?

by Flexo on May 27, 2009