Category — Retirement

The end of December is rapidly approaching, especially with Christmas coming up this weekend. Luckily though you have until April 15th of 2009 to contribute to an IRA or Roth IRA. Also remember that the limit has been increased to $5000, so if you can swing it that’s more money that you can save and grow tax free.   

They say you’re only young once. Most often that is said as a reason to spend money, but keep in mind that the sooner you start investing the longer the magic of compounding can work. You’re only young once.

If you want to read more about compound interest, check out my post on understanding compound interest.

With stocks down 40-50% this year, many in the financial press are saying that this is a good opportunity to purchase at a discount. They point to evidence that stocks have always gone up in the long run, and that you should continue to invest.

Financial experts have also said that real estate always goes up, and that there has never been a national downturn in real estate in history. But we are now witnessing a new era in real estate that the financial experts never expected. So is it possible that the experts are wrong about “stocks for the long run?”

There are two very big cases against stocks in the coming years. First are interest rates which are at historic lows. As interest rates go up returns on stocks will likely fall. The other factor, and I think this is a big one, is the aging population.

Over the past 20 years the stock market has been the de-facto vehicle for retirement funding. This was great for stocks as people contributed to their 401(k)s and IRAs, driving up valuations. But soon the first wave of baby boomers will begin to retire, selling their stock funds for living expenses, and the cycle will begin to work in reverse creating downward pressure on prices.

I’m not sure how this will affect stocks as a whole, or it will even affect them at all. I am not saying that you should pull all of your money out of stocks now and use only CD’s. I am saying I don’t agree with the idea of investing 100% of your money in stocks because you’re young and have x# of years until retirement.

Here is a portfolio recommendation from David Swensen, the former investment manager of the Yale endowment portfolio. The author of the post also recommends ETF’s to gain exposure to those asset classes. Notice that there is only a 30% exposure to domestic stocks, and only a 50% exposure to stocks overall. The rest of the portfolio is in bonds and REITs.

While REITs are definitely no less risky than stocks, they do offer another way to diversify, and give you exposure to the real estate market if it turns around. Investing in bonds offers less risky returns for your portfolio.

This post is in no way a recommendation on how to balance your portfolio, it’s simply me organizing my thoughts on asset allocation and the “stocks for the long run” hypothesis. If anyone has any thoughts on the matter I would love to hear them in the comments.

After watching a preview for the movie I.O.U.S.A. and reading the book Fewer I am really beginning to think the problems facing the United States are much more serious than anyone previously thought.

According to the projections in I.O.U.S.A. the government will need to double taxes to cover budget deficits caused by overspending, social security, and medicare/medicaid. On top of that, according to Ben Wattenberg, the author of Fewer, the population of the United States is shrinking due to a birthrate below the replacement rate. With a lower tax base, maybe the tax increase projections made by the I.O.U.S.A. team are actually optimistic.

How does this affect you? The biggest change I see coming is increasing tax rates, which may influence what type of retirement account you choose. Typically a worker will choose an IRA for a tax break now so they can pay taxes later, when they are in a lower income tax bracket. On the other hand, a Roth IRA is popular for someone who wants to pay taxes now so their retirement income is tax-free. I’m thinking right now that a Roth IRA might be the better deal, at least for now while taxes are relatively low, and especially as a supplement to a tax advantages 401(k) if you have one.

As far as asset allocation goes, I think global assets are more important than ever to own, although that’s still a tough call due to the high positive correlation between U.S. and global stock markets. I think domestic stocks are not going to achieve the returns they have returned historically, and domestic bonds are also going to be challenged by a difficult interest rate environment. Commodities like gold and silver may be a good choice for diversification.

Overall I think that diversification is going to be more important now than ever. Your exposure to any one asset class, including domestic stock, foreign stock, domestic or foreign bonds, commodities, or real estate (through REITs) should remain balanced compared to anything else.

Speaking of exposure and balance, when was the last time you checked your portfolio to see how it was doing? Have you analyzed what you did right and what you could improve? If you haven’t done it lately, now is the time to check.

Like a lot of people, the recent downturns in the market have really gotten me to rethink how I have my money invested. In Getting Ahead When The Market Isn’t the Wall Street Journal discusses what the recent downturns in the market mean for the average investor.

The main points in the article:

• U.S. Stock Markets have lost an entire decade of returns (WOW!). The S&P 500’s annual returns over the past 10 years are negative
• Dollar-cost averaging is still the way to go for steady performance and emotionless investing according to most financial planners
• Most 401(k) plan investors don’t have the desire to actively manage their investment portfolios (a topic we will look at when I review the book Nudge later in the week)
• If you are frustrated by the huge downswing in the market, it’s time to rethink your asset allocation to something less risky. This usually means a higher allocation to bonds and cash and less money in stocks

My thoughts:

I read a book a few years ago called Unexpected Returns by Ed Easterling that says the stock market goes through periods of extended uptrends and downtrends which the author called secular bull markets and secular bear markets respectively. We are currently in a secular bear market, which the author argues we will be in for some time. It’s a book that I plan on revisiting and reviewing soon, but it’s worth checking out if you’re interested in market cycles.

That takes us to asset allocation. In a period where you are expecting stocks to downtrend, such as in a secular bear market, it’s wise to put a larger percentage of your assets in cash and bonds, as the Wall Street Journal suggests. This is tough to do when common ‘wisdom’ tells young people like myself to put a majority of our assets in stocks. If you’re closer to retirement it’s a good idea to keep a larger percentage of your assets in less-risky classes anyway since you will generally have less time to recoup any losses. Imagine if you were planning on retiring next year and had 100% of your assets in stocks. You would have lost about 30-40% of your total assets, and your retirement standard of living would be way down, assuming you could retire at all after losses like that.

I do think dollar cost averaging and market index funds are still the way to go for most investors who want a hands off approach. I think 90% of your returns are going to come from good asset allocation strategies. If you don’t have the stomach to watch your portfolio fall 40% in one month, you had better increase your bond allocation.

Did anyone else reading this lose a large amount of money in the market in October? What are your plans for the future of your portfolio?

This is part 3 of the retirement planning series.

Part 1 covered the basics of retirement planning.

Part 2 gave you a basic idea on what to invest in.

Part 3 will help you learn what you need to do to maintain your accounts until retirement. Depending on when you open your accounts, that could be a very long time. The good news is that once your accounts are open, maintaining them can be very easy.

Rebalancing

After reading part 2 you should have an ideal investment mix that you would like to use. Over time it is natural for one asset class to outperform another. At that point you need to decide if you will increase the allocation to the highest returning class, let everything stay as it is, or if you will rebalance your funds so that the allocations are back inline with your original plan.

How often you rebalance is up to you. I feel that a six month time frame is long enough that you can let your winners ride, yet not so long that your portfolio no longer resembles what you had envisioned.

Generally I think that it is a wise decision to rebalance your funds to your original plan. Why should you rebalance? In stock markets there is often a reversion to the mean, so putting more money in underperforming assets may allow you to buy shares when prices are low, and sell when the prices are higher at your next rebalance. On the other hand, the market may be different enough from when you originally started that you decide to change the amount going to each fund.

Another thing to consider is the mix of risky assets you own in your portfolio as a function of your age. The younger you are the more you should allocate to risky investments. As you get closer to retirement age remember to move more money into less risky assets like CDs. You wouldn’t want a major stock market downturn to wreak havoc on your retirement portfolio.

Consolidating

Over-time you may find that your retirement accounts become spread out among multiple companies, especially 401(k) accounts. Whenever you change jobs you will likely open a new 401(k) while your former account remains open. This presents two problems. First, a large number of accounts is obviously more difficult to track than a single account. Second, the more accounts you have the more likely it is that you will stray from you investment mix.

To keep your money together it is necessary for you to rollover your accounts from your old ones into the current one that you want to maintain. Unfortunately there is no one single process that every fund company uses for dispersing money. Some companies may remit funds directly to your new account, while others may require you to receive the money and then transfer it into your new account.

Moving funds between two accounts can be a little tricky. You do not want the funds to be sent to you in your name, or you may be hit with hefty fees and taxes. I recommend talking to your HR department at work, or a customer service rep of your new fund company to find out what is needed to transfer funds from an old account into your new one.

That’s It!

Simple right? Managing your own money doesn’t need to be difficult. In fact, the more simple your plan the more likely you are to stick with it for the long run. A few hours of maintenance once or twice a year will keep your accounts earning for you while you’re out doing whatever you want.

This is Part 2 of the Retirement Planning series. In Part 1 we covered what a retirement account is and some of the basic account types available.

One of the more confusing things about retirement accounts is choosing where your money will go. After reading this post you should have a better idea of what you’re looking at when you are picking investments for your account.

Side note: this post is mostly in regards to mutual fund investments. If you are investing in individual company stocks with your IRA then you probably have a different approach to investing, and may find this article less useful.

Asset Allocation

At the broadest level, a mutual fund will cover one of the major asset classes: stocks, bonds, commodities, and real estate. Each asset class has it’s own risk and return characteristics that you should keep in mind when investing. The general rule of thumb is that riskier investments have higher returns, and that the longer your investment horizon the riskier your investments should be. The thinking behind this is that a longer time horizon gives you a larger chance to realize the higher returns.

Bonds are generally considered to be the least risky investment, but also the lowest returning. Stocks have historically had higher returns than bonds, but have higher swings up and down. Commodities, such as gold or crude oil, have the most risk, but can also exhibit large price swings. Real estate can be anywhere on the scale due to its unique characteristics. Most 401(k)s will have many stock fund options, a few bond options, and a money market (cash) fund. Commodity and Real Estate funds will be available for IRA accounts through a company like Vanguard or Fidelity.

When choosing investments for your retirement account you should consider the time until you retire. A person in their 20’s may decide that they want to have only risky investments with no low risk investments, with the hope to maximize their return potential. Someone closer to retirement may want to have more money in cash, bonds, and dividend paying stock funds, and less in risky investments so they don’t risk money they will need in a short timeframe.

Asset Allocation At Another Level

Once you’ve decided on the appropriate percentage of your account to allocate to stocks, bonds, and other investments, it’s time to break the allocation down further.

Company stocks are categorized into market capitalization groups. Capitalization is a fancy word for the size of the company. This means that based on size, a company’s stock will fall into micro cap, small cap, mid cap, or large cap. Market cap is calculated as the share price times the number of shares outstanding. To capture a broad range of stocks you should choose a fund from each of these groups to include in your stock portion.

In addition to capitalization, stock funds can be broken up into domestic and foreign. Foreign stock funds will have names like Euro-Pacific or Emerging Market. For now I think it’s important to diversify into foreign companies, especially considering the slide of the U.S. dollar.

Bond funds often have many types available as well. The most common types include total bond funds, high-yield bonds (called junk bonds by most), and government bonds. Again, each type of fund will have it’s pros and cons. High-yield bonds will have higher yields (obviously), but they will exhibit higher price swings similar to stocks. Government bonds will usually have lower rates, but should have less risk since their cash flows are backed by government agencies. A total bond fund will cover a range of all bond types.

Expense Ratios

While you can’t control the returns of your investments, you can do your best to minimize losses. The two biggest return robbers are taxes and expenses. Since retirement accounts are non-taxable, you have already eliminated the first issue. The second, expenses, is a little tougher to control for.

An expense ratio is the amount of money that the fund charges to manage your money. If the ratio is 1% then the fund will keep 1% of your money every year. It doesn’t sound like much, but over the long term any amount will hurt your returns due to the effects of compound interest.

Typically index funds will have the lowest expense ratios. Actively managed accounts run by a portfolio manager will have much higher expense ratios. It’s up to you to determine whether you think the expense is worth it. I personally try to stay with index funds as much as possible, due to both expenses and my belief that most managers cannot beat the market consistently (a topic for another post).

What About Lifecycle Funds?

One of the newest products of the mutual fund industry is the lifecycle fund. These types of funds give you an easy way to diversify, especially if you only have one account and all of your money is in that one lifecycle fund. A lifecycle fund will typically invest your money in a mix of stocks, bonds, and cash, depending on what year you specify for your retirement. As the retirement date approaches the ratio of cash and bond investments increases, and the amount of money in stocks goes down.

Sounds great, right? The downside to these funds is they generally have higher expense ratios than if you simply invested in a stock and bond fund yourself and handled the rebalancing yourself every year. The lifecycle fund options in my wife’s 401(k) had expense ratios around 1%, fairly high considering the index fund options all had ratios under 0.5%.

How Should I Pick Funds?

The absolute worst way you could choose funds is to pick the ones with the highest historical returns. Instead you should consider the advice above. A typical 401(k) plan or IRA mutual fund list will have funds that fall in the categories we just talked about. Start by thinking about your investment timeline and choosing the appropriate risk level. Decide what percentage you would like to devote to equities, what percentage to bonds, and what percentage to devote to cash. If they are available, also decide if you will contribute to a commodities or real estate fund.

Once you’ve determined a percentage to devote to stocks, decide what percentage will be domestic, and what percentage will be foreign. Choose ONE fund for each of the asset classes. For example choose one small cap fund, one mid cap fund, and one large cap fund. As I said before, if index funds are available I recommend choosing them. But you may decide another fund offers better prospects.

Do the same thing for your bond allocation. Determine an amount to put into high-yield, government, or any other bond funds that are available. Try to mix it up between high risk and low risk, just like you did with the stock funds.

You’re done!

If you follow these steps you should be able to create a diversified portfolio that covers a broad spectrum of investments. You should also have a better understanding of what is going on with your portfolio when you see month to month fluctuations. I realize this is an incredibly broad topic to cover, enough that an entire book has been written about it. But this should be enough for you to look at the funds available to you and determine what class they fall into. Next week will be part 3 of the retirement series, so keep on the lookout!

This post is part 1 of a series on retirement accounts, and a continuation of the financial basics series. The idea of becoming free from money is based on having enough passive income that you never have to worry about working for money again. For most people that is retirement. And one of the most powerful financial tools available for investors is the retirement account.

Why a retirement account?

In the past a company provided for their employees with a pension. You worked for the company for x number of years, and they would provide a fixed payment for you to live off of for the rest of your days. These are called defined benefit plans, since you will receive a predefined amount of money when you retire.

Then somewhere along the line employers made the switch to defined contribution plans. With this type of plan (typically a 401(k)) a company could shift the burden of funding a retirement to the employee. This is obviously a huge benefit to the company, but not so much for the employee, who now needs to plan to save enough, invest it wisely, and plan how long they will be living after they retirement (obviously not an easy thing to know!)

The big benefit of having an individually owned retirement account versus a company funded one is that you can take it with you between jobs. The old days of being chained to a job for a certain number of years so that you can collect your retirement are over if you are not receiving a pension. So now you can actively pursue jobs you want, and roll your accounts when you leave.

What types of accounts are available?

There are many different types of retirement accounts available, but the most common are the 401(k), the IRA, and the Roth IRA. There are a few other types of accounts available as well, but they generally all have a few things in common. First is that they are considered long-term accounts, and will impose steep penalties if you take money out of the account before you reach retirement age (typically 59 1/2 or older). Second is that they will allow your money to grow tax free every year. This is different from regular accounts that require you to pay annual taxes on interest, dividends, and capital gains.

The 401(k) is generally offered by a company to its employees, oftentimes with a match of some sort, either as a percentage of pay or a flat dollar amount. The money that goes in is pretax, but you will have to pay taxes upon withdraw of the money. As of 2008, the annual cap is $15,500, not including the match from your employer. So if your annual income is $50,000, you could contribute 31% of your income a year, regardless of what your company matches you.

The IRA is very similar to the 401(k) in function. The money you contribute goes in tax free, reducing your taxable income, and is taxed when you take the money out at retirement. The amount you can contribute is capped at $4,000 a year ($5,000 if you are 50 or older). IRAs can be opened with many different financial institutions depending on where you would like to invest. Stock market investors can open IRA accounts with brokerage firms and buy individual stocks and bonds. Mutual fund investors can choose a company like Vanguard or Fidelity. Even banks usually offer retirement accounts, although sometimes the selection of investment choices can be slim.

Similar to the IRA is the Roth IRA. The major difference between the two is that money that goes into a Roth IRA is after-tax, but the money you withdraw during your retirement years are tax free (since the money was already taxed before it went in). This annual limit is the same for each, and generally the same financial institutions offer both IRAs and Roth IRAs.

Which one should I pick?

If the company you work for offers any matching amount for contributing to a 401(k), then investing at least that amount should be a no brainer. Not putting money in is saying no to free money, and no matter how strapped for cash you might be there’s no reason to say no to free money, right? Add to that the tax savings and this is an easy place to start.

If your company doesn’t offer a match, or you’ve contributed enough to max out your company’s matching amount, an IRA (either a traditional or a Roth) might make more sense than investing in the 401(k). When a company sets up a 401(k) it generally has to choose a small number of funds for you to invest in. These may not always be the best funds, either due to poor management, lousy expense ratios, or they might just not be the types of funds you want to invest in. As I mentioned earlier, many financial institutions offer IRA or Roth IRA accounts. I personally invest with Vanguard and have been happy with them.

The decision to use a traditional IRA or Roth IRA is based on whether you think you will fall into a lower tax bracket when you retire or not. You could have both, but the $4,000 annual limit is cumulative between accounts - you cannot put $4k in an IRA and another $4k in a Roth IRA. If you are making a ton of money now, and could use a tax break, a regular IRA might be a good idea. Otherwise a Roth IRA may be a good idea.

Until next time . . .

So that wraps up part 1 of retirement basics. Hopefully this was helpful, and if you have any questions please leave a comment. Next week I will cover the basics of asset allocation and how to pick funds for your retirement accounts. See you then!