Simple Steps to Making 401Ks Better


Clingdome2My broker feels that 401Ks – the retirement plans that have largely replaced pensions – are a terrible idea and that most people would be better off in a traditional pension.  The main issue with pensions is that they can become a burden on a company since the company may need to add more money from time-to-time, depending on how the markets do.  When companies fail, they can also end up dumping their pension plan on the US Government, which will both cost the taxpayer money and can result in substantial reductions in the payouts the retiree receives.  Another issue is that companies tend to promise a lot in the pension plan when workers start to demand higher salaries and benefits since it is easier to promise to pay money later than it is to actually come up with the cash today.

The issue with 401Ks isn’t the plan itself.  It is the poor level of financial literacy that most people have.  This is surprising, given how important money is to most people (and by money, I mean shelter, food, and clothing, not gold rings and trips to the Riviera).  If people would spend a little bit of time reading and learning (The Smallivy Book of Investing is still on sale), they would find that managing their 401Ks is really not that difficult.

Given that they probably won’t, there are a few things that could be done that would make it a little harder for people to mess up their 401K.  These are:

1.  Make enrollment at the maximum company match opt-out.  Many people fail to enroll at all since they must opt-in to the 401K plan, or they don’t contribute up to the full company match, leaving money on the table.  This could be changed where employees are automatically enrolled at the amount needed to capture the full company match.  If they choose to not participate or reduce their contributions, they would need to go in and opt out.  Given that most people are slow to act, this would cause most people to do the right thing financially and put money away.  Actually, it would be even better if you were enrolled at 10% of your pay regardless of the company match since you need to be putting at least that amount a way to have a secure retirement at your current level of lifestyle.

2.  Make a target date retirement plan the default.  Given the choice, I’d choose my own funds rather than use a target date retirement fund.  For many people, however, a target date retirement fund is better than what they tend to choose.  Many plans drop people into a money market as a default, and many people then just leave it there.  This guarantees that they will lose a lot of their money to inflation and will lead to a dismal retirement unless they sacrifice like crazy and put a lot of money away.  For those who don’t want to mess with it, a target date fund would provide at least the returns that a traditional pension would.

3.  Eliminate the ability to withdraw funds before retirement.  One of the worst things about a 401K is that you can withdraw funds before retirement.  Often this comes with a 10% penalty plus a large tax bill, such that you lose 50% of your money by taking it out early, yet people continue to take the money out on a whim or when they change jobs.  You wouldn’t be able to go to your pension plan manager and say you want to take your money out before you reached retirement age.  You shouldn’t be able to do so in your 401k either.

These three simple changes would totally transform the landscape when it comes to retirement security in the United States.  Are any Congressmen reading?  I’d be happy to discuss them.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Good and Bad of Adding Fiduciary Duty


Lost Cave1I was talking to my broker the other day about the changes that are coming for individual retirement accounts.  The biggest change is that brokers and others who manage or advise people on individual retirement accounts will need to take on a fiduciary duty.  This means that they will be required to work in the best interest of the client,rather than their own best interest or the best interest of the firm.  Currently, they are required to recommend “suitable” investments, but not necessarily the lowest priced investments.

In many ways this is a good thing since it will help to prevent the common practice of selling things like annuities and proprietary funds that perform poorly relative to other investments but pay the salesman and their firm a big sales commission.  Unfortunately, there are many who take advantage of the lack of knowledge of their clients to make money for themselves.  We don’t need people with the stereotypical used-car salesmen approach selling financial instruments.

The downside is that there will be a lot more paperwork, particularly if you do have knowledge of what you’re doing and want to go against the conventional wisdom.  For example, I see no reason to own bonds at my stage of life (although I do own some REITs) since I have more than 20 years until retirement.  I know that stocks will return several percentage points more than bonds over that period and I don’t want to give up that additional return.  I take the chance in any given year of seeing 40-50% of my portfolio value evaporate because of this position, but I also feel that stocks will recover from any such drops before I need the money because I have 20 years.  As I get closer to retirement, as long as I have at least 2-3 times what I really need to make it through retirement, I’ll probably stay heavily invested in stocks since I’ll be able to take a 50% drop without it really affecting me. I’ll have excess funds, so if I lose some money I can still eat.

The conventional wisdom for someone my age would be to have about 35% invested in bonds by this point.  This would help shelter me from market downturns since bonds usually fall less than stocks since the interest they pay helps prop their prices up.  The issue with this strategy is that it doesn’t take the effect of time in reducing risk into account.  It uses diversification – spreading out investments into more than one type of asset – to reduce risk, but holding the investments for a couple of decades also reduces the risk.  Having 35% of my portfolio invested in bonds would mean that I would get about a 6-8% return on that money instead of the 12-15% I can get in stocks over the same period of time.  That can add up to be a lot of money.  The new laws, however, will certainly require me to sign a lot of documents saying that I understand the risks of doing so.  Perhaps in the future I won’t even have the choice.

The reason these laws were enacted, however, was that most people aren’t financially literate (and generally proud of it, for some reason), and the people taking care of their money for them were lining their own pockets.  Generally, this was not by offering them investments that were too risky, but investments that we’re risky enough, such that they lost a lot of the return they would have gotten if they had invested properly, but have high fees.  These are things like annuities, which almost no one under age 65 or maybe 70 should have.

So in summary, because most people don’t even get the preliminary education in investing and money management that they could get through reading a couple of books (The SmallIvy Book of Investing, Book 1 on sale now!) or reading blogs like this one, they need to rely on “experts.” Many of these “experts” have little financial education other than on how to sell the high-fee annuities and funds their firm is pushing.  Because of this, we’re going to see a lot more controls on the people who manage money and sell financial instruments.  Unfortunately, people are ignorant enough about finances and some advisors are unscrupulous enough that this is needed.  I’m just hoping that the rest of us who do know what we’re doing will be able to still make the choices we feel are right for our situation.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Start an IRA Today (If Not Sooner)


Clingdome2How would you like to retire a millionaire?  Well, if you’re a teen working a summer job and you put $1000 away into an IRA (Individual Retirement Account) today, you have a shot at reaching that goal even if you do nothing else.  That’s if you earn a 15% return between now and about 50 years later when you’re ready to retire.  If you earn only 12%, you’ll only end up with about $300,000, but still that’s not bad for a $1000 investment.

Now I know that $1,000 is a lot of money when you’re working for $7.25 per hour, especially after taxes are taken out and you factor in expenses like gas to get to work, so you really only earn about $6.00 per hour.  Still, that 170 hours worth of income you give up now could help set you up for retirement.  And it doesn’t even need to be your $1000.  As long as you earn at least $1000 from working, your parents or a nice uncle could give you another $1,000 to invest while you spend the $1,000 you earned.  Maybe you can work out a deal with your parents where they match your contribution, so you actually only need to contribute the earnings from about 80 hours ($500) yourself.

So what is an IRA?

An IRA is an account included in the tax code where contributions are allowed to grow either tax deferred – where you take the money out and then pay taxes, or tax-free – where you pay no taxes.  This means that your money will be able to compound without taxes being taken out all of the time as you go.  The more money you have to earn interest on, the faster your money grows.  If you use a traditional IRA, you don’t pay taxes on the money you contribute, which means Uncle Sam will be putting something like $100 of the $10000 you are investing in for you.  Whatever money you pull out when you retire, however, will be taxed at that point, so your Uncle Sam will take back about $200,000 of your $1 M.  If you do a Roth IRA, you’ll need to pay all of the taxes now, meaning you’ll need to come up with the full $1,000, but when you pull it out the money is all yours.

How do I setup an IRA?

The easiest way with $1,000 is to go to Vanguard, open an IRA (it takes about 15 minutes online), and buy into their Vanguard Target Retirement 2060 Fund.  I choose this fund because it has only a $1,000 minimum investment and because it has mainly stocks, which is what you want for the next 40 years or so.  You then just have your parents send in a check for you or transfer money from a bank account and you’re an investor.  Simple.

What do I do then?

Well, you don’t need to do anything, really, at least for while.  Once you reach the account minimums for Vanguard’s other funds, which currently are at $3,000, you should switch to the Vanguard Total Stock Market Index Fund because that will increase your returns over time since you’ll then get rid of the bonds that are in the 2060 fund and be invested in all stocks.  It will take you until about 2039 to reach that point, however, if you only invest the original $1,000.  (Compounding starts slowly and then accelerates at the end.)

I would rather you become a regular investor, sending in $50 whenever you can through college.  Once you’re working a regular job, see if you can contribute the maximum ($5,500 per year, plus another $5,500 into a spouse’s IRA if you get married).  Also get into the 401k plan at work if there is one.  While $1 M may seem like a lot today, the truth is you’ll need like $10M or $20 M by the time you’re ready to retire since $1 M won’t buy what it does today.  If you invest regularly through your twenties, however, you’ll have it easily.  In fact, if you do a good job of sending in money between 16 and 35, you really won’t need to contribute at all after you reach about 40 since you’ll already be set.

The other thing to do is something not to do:  Do not touch the money for any reason until retirement.  If you take the money out early, you’ll pay extra fines and taxes.  Plus, you’ll be undermining yourself.  Right when you were going to start earning really money from your investments, you’ll take it out.  If you try to start over in your forties or fifties, it will be much more difficult.

What if I wait?

I know, money is tight and you’re busy doing other things.  If you wait until you’re 25 to start investing, however, that $1,000 will only make you $300,000 ($100,000 at a 12% rate-of-return).  Wait until your 40, and it will only net you $33,000.  That means you’ll need to work a lot harder and sacrifice a lot more to retire comfortably.  The other choice would be to retire uncomfortably and be scrounging for food and heat.

So see if you can set aside $1,000 and a half hour to start an account.  Maybe take one extra hours or spend some time with friends doing things that don’t cost money.  Your future self will thank you.

Got an investing question? Please send it to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.