It seems as if the topic of 401(k) investing is surfacing quite often. The young are starting to establish a plan with their employer and the "old" are beginning to worry if their 401(k) is working in the best way possible for them. Truth is, a lot of individuals don't get the most out of their plan. Either, they are too afraid to invest in equities so they let the funds accumulate in the money market account available within the plan or are way too aggressive by investing in one segment of the market.
Ironically, people spend hours upon hours researching their next car (depreciating asset) or the new, coolest computer. What if that same time was spent educating yourself about your 401(k)? You could use your knowledge to not only make your investments work better for you, but to educate the trustees responsible for servicing the plan to get a better one - now we're talking!
You worked hard for that money, you earned every single cent of it. How come I see 401(k)s that are half of what they were ten years ago, or just simply haven't moved? It has nothing to do with the market, the market certainly provided healthy returns over the past 10 years.
Simply put, people just aren't educated about investing, especially within their 401(k). The beauty of it is, the warehouse worker can become more educated than the CEO, creating a better investment experience for him/herself just because the warehouse worker did a little bit of homework. This research, in most cases, can be a difference of millions of dollars. Yes, millions, for a little bit of time and know-how! My plan is to give EVERYONE several easy steps that they can utilize within their 401(k)...for FREE! Put that in your back pocket. Here we go.
1. Participate. Your company is without a doubt giving you a great deal! If you don't participate, you don't reap the benefits. You should contribute as much as you can afford, especially if your employer matches - it's free money. Also, you can usually set it up so that automatic deductions are taken out of your paycheck and put into your 401(k). You don't even have to think about.
2. Invest the funds appropriately. Here is where we see the biggest mistakes made. You want to find the lowest cost funds. Academic studies show that the funds with the best performance have the lowest expense ratios - duh! Do not invest in a fund that has an expense ratio over 1%. Try and find funds that have expense ratios in the .08% to .6% range. Once you have found low-cost funds, you should begin to put the puzzle together. You want to find these asset class (what markets they are invested in):
US Large-Cap, US Large-Cap Value, US Small-Cap, US Small-Cap Value
International Large-Cap, International Large-Cap Value, International Small-Cap, International Small-Cap Value, and Emerging Markets.
Just make a check-list and cross them off as you find each one.
If you can find funds with "index fund" within the name, perfect, these are your best bet! Ideally, your plan will most likely not have all of the aforementioned funds (poor plan). To do something about this see Step #8.
3. Determine your allocation. Simply said, how much will you allocate to equities and bonds. Equities will earn you a greater return, but with more risk. Bonds, the opposite. To determine your allocation here is a quick rule-of-thumb: Take your age, subtract the number from 110, the number you get is about the percentage you need to invest in all of your equity funds. Obviously, a much younger investor (21), could handle putting all of their funds in equities. Like I said, this a quick rule-of-thumb.
An example: You are 40 years old. You subtract 40 from 110, equaling 70. Roughly 70% of your overall funds should be invested in equities. Now, half of that 70%, 35%, we will split up equally among your 4 US funds mentioned in Step #2. The other 35% will be split up equally, five-ways into your International and Emerging Markets funds. Obviously, the other 30% of the overall plan will be put into the bond fund. You are almost off to the races!
4. Rebalance your funds once a year. Generally speaking, since you have your percentage or allocation figured out via our quick rule-of-thumb, this number should be your target every year. In our previous example, our target should be to maintain a mix of 70/30 (Equities/Bonds). The individual funds you invest in will move, up or down. Each year, rebalance the funds so that your allocations are appropriate, both your equity/bond allocation, and your allocations within the equity funds. This quick exercise will keep your assets aligned and on the way to your goals. Plus, some plans even allow you to select an auto-rebalancer. Even better, you don't have to check it, unless of course you get older, in which case your equity allocation will go down.
5. Don't invest your plan assets in the company you work for. This step is fairly obvious, but I have seen people's fortunes get wiped out for making this mistake (Citigroup, Enron, etc.). No matter how big, tough, and great your company is, do not invest in your own company. This is called double exposure or career risk - you wouldn't stand on top of a hole you are digging right?
6. Do not borrow against your 401(k) savings. Some plans allow individuals to borrow against their funds for certain situations. This is not a good idea.
For an example, if for any reason you cease to be an employee at your company, the entire balance of the loan becomes due and payable immediately. If you don’t pay, you will have to pay taxes (plus a 10 percent penalty if you are under 59 ½ years old) on the loan balance. This means that if you are laid off, you will suddenly have to pay back this loan – just at the time you may be the least able to afford it. This among other reasons, show that it is unwise to borrow against your savings.
7. Know thy plan. Reading your plan documents doesn't sound like fun, especially when Monday Night Football or the Victoria Secret Fashion Show is on. But again, your education will earn you a substantial amount of money over the long haul. Get to know what you can and can't do within the plan. Who is in charge? What are the fees? Knowledge is power here! If you can't figure out what a term means, ask H.R. at your company.
8. Educate the trustees of the plan. Again, it is your money. If the investment options I mentioned are not available, your plan is not good enough. Try and persuade the plan trustees to include low-cost index funds in the plan. Keep in mind, the trustees usually have their assets in the plan as well, so what helps you, helps them. You are a tribe. Refer the trustee to our website or blog so they can become educated. Remember, from reading your plan documents you will know who is in charge and responsible. The trustees usually hold a fiduciary standard to the plan. So, if you point out that the current plan is sub-par and they can get better, and they don't get a better plan - Uh oh...somebody may be in trouble, just saying.
9. If you do leave your employer, get your moolah. Tax laws will hurt you if you aren't familiar with what happens when you leave your workplace. Bottom line: Once you leave your job get your money within 60 days, roll it over into a Rollover IRA (a professional advisor can help you here). Two things: You will have better investment options within a Rollover IRA and if you don't roll it over and instead, decide to go shopping with the money, you will be taxed by the IRS 20%, and possibly a 10% penalty. All at your current tax rate - not fun!
Example: If you have $60,000 in your IRA when you leave your job and ask for the money in cash, the employer pays $12,000 to the IRS and gives you a check for $48,000. You can invest that $48,000 into a Rollover IRA, without tax consequences. But unless you also invest another $12,000, the IRS will tax you (and possibly also penalize you 10 percent) on the $12,000 that you had withheld. It doesn’t seem right or fair, but that’s the law.
10. Upon retirement, create a plan. You have made it this far, you need a plan to maintain your standard of living after work. A professional will be able to help you in this area. The professional can transfer the funds to a better investment solution for you. Take this part seriously. Find a fee-only, independent advisor. Someone who will take fiduciary responsibility for your money. The advisor should only be paid by you, no one else. Are they going to sell you a product or choose the best solution for you? Make sure to ask them these questions. Again, important decisions will translate into millions earned or lost. The last thing you want to happen is to realize you do not have enough to support your lifestyle and end up having to go back to work. Talk about a loser.
That's it! Any person can follow the 10 steps. They are easy and simple. If you put in the time to read this article, you will be successful at maintaining a disciplined approach. Do not try and time the market within your plan. Stick to your guns (funds) and rebalance - that's it. This a portion of your life where you have complete control, whether it is taking the time to read your plan documents or persuading your CFO for change, the decision is a vital and a beneficial one. Please help others and pass this article along. In 10 to 30 years people will thank you for enriching their lives, both financially and emotionally.
Showing posts with label Retirement. Show all posts
Showing posts with label Retirement. Show all posts
Tuesday, December 7, 2010
Monday, November 8, 2010
Portfolio Endurance
The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life — and through different economic and market conditions.
Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.
Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.
Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.
Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:
· Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
· Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.
Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.
Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.
Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.
Exhibit 1: Basic Tradeoffs in Portfolio Survival
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.
Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.
Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.
Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:
· Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
· Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.
Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.
Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.
Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.
Exhibit 1: Basic Tradeoffs in Portfolio Survival
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
Wednesday, May 5, 2010
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