Grading Your 401k

Sixty five million Americans now invest for retirement through 401(k)s and similar plans. Defined contribution plans have become the centerpiece of many American’s retirement savings. How can you determine if your plan makes the grade? Here are some of the components to look at when judging your company’s 401k.

Fees

Low fees and expenses are important to getting the most benefit from your 401k. Unfortunately it is often hard to determine how much you are paying in investment, administrative, legal, record keeping, and accounting expenses. Now the various fees are not secrets, but are typically hidden in the fine print of multiple documents available in multiple places, so it's very hard for individual investors to figure out what has been subtracted from their individual accounts.

Fortunately, under a proposed Labor Department regulation, scheduled to go into effect January 1 of 2009, your employer may be required to tell you these fees, and disclose in dollar terms each quarter how much you are being charges for these various fees.

What levels of expenses are appropriate for your plan? It depends on the size of your plan. But for all but the smallest plans (plans with less than $500,000 in total assets) total expenses of 1% to 1.5% is reasonable. The total expenses include investment management, record keeping and accounting, legal, and administrative expenses.

If your plan charges more you should question those in charge of the plan. The company sponsoring the plan has a fiduciary duty to plan participants and they may be just as much in the dark as you about the fees being charged.

Matching

Matching is a key feature of 401(k)s participation rates increase when an employer matches a participant's contribution in one form or another. Most large employers realize that and many small companies have matching programs under the ‘safe harbor’ rules, that allow highly compensated employees and business owners to maximize their 401k deferrals.

No restrictions on sales of employer stock

In the wake of such high profile corporate bankruptcies such as Enron and more recently Bear Stearns the importance of not having too much of your retirement money invested in employer stock is evident. The best plans, at least of those that use employer stock funds, have no barriers to immediate diversification.

Automatic Enrollment

The best 401(k) plans automatically enroll workers into qualified default investment option and automatically increase their contributions over time. With auto enrollment more employees end up saving for retirement, and they start saving earlier, making their chance of reaching their retirement goals higher.

Investment Options

The best plans offer enough investment options to allow you to build a well diversified portfolio. They often include large cap, mid cap, small cap, and international stock funds, as well as bond funds and money market or guaranteed income options. Many of the best plans now offer target date or risk based portfolios to simplify your selections. The best plans also offer automatic rebalancing of your investments at regular intervals.

Education

Employee communications and education is an important piece of keeping you informed of the changes that could affect your retirement plans. The best plans offer ongoing investment education and financial planning information.

Pricing

Some of the best 401(k) plans tend to invest in funds that have what's called institutional pricing. Most mutual funds come in many classes, with some classes having higher fees than others. Plans that use funds with institutional pricing typically have the lowest fees, but in any event your plan should be using the share class with the lowest expenses available to the plan based on the plan size.

Taking The Mystery Out Of Retirement

Uncle Sam offers a useful retirement planning and financial education tool "Taking the Mystery Out of Retirement Planning". The Department of Labor offers the sixty two page booklet as a free download from their web site, or as a free printed booklet by calling 1-866-444-3272.

The online worksheets walk you through the budgeting process and calculate future needs adjusted for inflation. Finally, the program will calculate the monthly saving you'll need to maintain your lifestyle. Although the calculator is designed for those 50 and over it is a helpful exercise for all who have questions about their retirement needs.

Kitchen Table Planning - How Much Will You Need

If you were planning a vacation you would start with a desired destination, select the dates you can go, determine your budget, and then tweak your plans to fit your budget. It is the same with financial planning. You have to determine where you want to go (how much income or how big a nest egg you need), set a target date for getting there, determine how much you need to save and invest, and then tweak your plan for the realities of your situation.

If you are planning for a down payment on a home you will have to amass a lump sum that you will be spending all at once. So calculating your need is pretty straight forward. If you want to buy a $300,000 house, you will need to save at least a 10% down payment, or $30,000.

If you are planning to send a child to college you can look up the cost of tuition, books, and living expenses at the schools web site. But unless your child is starting school this year you will have to estimate what future expenses might be, or you will surely come up short due to likely increases in costs between now and the time your student enrolls.

So how do you plan for such price increases? Well, if you do a little snooping around you will learn that college costs have been increasing at about twice the level of general inflation. Armed with that and the number of years until your student enters college, you can make an educated estimate of how much you will need in the future to pay for this expense, by using one of the 'secret' formulas of financial planning.

It is called the Future Value formula. It is, like the name implies, a formula to calculate the compound interest future value of something. Here's the 'secret' formula:

FV = PV * ( 1 + i )^N

PV = present value
FV = future value (maturity value)
i = interest rate in percent per period
N = number of periods

When estimating the future cost of something the i represents the rate you expect that something to go up in real terms. To learn about real rates of return see this previous post.

So lets work through an example. I have a daughter who will enter college in 12 years. The cost of attending a university in my state is currently about $17,000 per year, so in todays dollars I would need $68,000 to pay for her education.

PV = $68,000
FV = future value = ?
i = interest rate in percent per period = 6% (nominal college inflation)-3%(expected general inflation rate) =3%
N = number of periods = 12 years

FV = $68,000 * ( 1 + .03)¹²

If you are like me you don't have one of those fancy TI calculators you kids use, but that is okay. to solve the ( 1 + .03)¹² part you just add 1 and .03 then enter 1.03 times 1.03 into your basic calculator and hit the enter button twelve times. That gives you 1.4685. Now multiply $68,000 by the 1.4685, and presto, you find you will need about $99,860 (lets call it an even $100,000) in inflation adjusted dollars to send little Debbie off to college when the time comes.

Finally, when you are planning for retirement the 'how much will I need?' question is usually answered with a per year income figure. Here you have to estimate what you would need if you retired today. You don't need to adjust this amount for inflation because we will be adjusting investment returns for inflation as we go. So just figure what you would need today (you should make adjustments for children that are grown and gone, and any debts like your mortgage that you expect to be paid off.)

From this income need you should subtract any pension, social security, or annuity income you will receive during retirement. This leaves you with the annual income needs you will have to pay for yourself. For example; I need $50,000 in retirement income. I expect to receive $1,400 a month or $16,800 in social security benefits and a company pension of $12,000 per year. That leaves me with a shortfall of $21,200 per year that will have to come from my investments.

If you have read my post on safe withdrawal rates, you'll remember that the estimated real rate of return on your investments is your maximum withdrawal rate. Let's say my expected real rate of return is 5%. To estimate how much I would have to have in savings and investments to fund the $21,200 per year shortfall in retirement income I would simply divide $21,200 by .05. This tells me I need to have $424,000 in investments to fund the balance of my retirement income needs.

Kitchen Table Planning - Safe Withdrawal Rates

How much money you can take out of your investments without running out of money is a critical question when building any financial plan. As a member of the Financial Planning Association I hear from other members and read in the financial press many theories on how to calculate a safe withdrawal rate. Some of the ideas put forth are elegant, some are complicated, and all ultimately fail because they attempt to do the impossible, which is to predict a future event. The future is unknowable, so having any degree of confidence in any method of projecting historic calculations on future events is dubious at best. There is a reason the SEC requires the disclaimer that past results are not indicative of future returns.

The uncertainty of safe withdrawal rates is one of the reasons I advise clients to try to be debt free when they reach retirement age. If your house is paid for and you have no consumer debt, your living expenses can be managed much more easily. You can adjust your lifestyle without too much pain to cope with unexpected events, and adjust withdrawal rates to protect your nest egg.

That said, I do believe having a financial plan gives you a much greater chance of success than not having a plan, and you must select some withdrawal rate that you believe (or maybe hope) to be safe to complete any retirement planning calculations. So here I go with what I believe is as good a way of calculating your safe withdrawal rate as any.

If you've been reading this blog a while you know about estimating your rate of return for a diversified portfolio, and you know how to calculate your real rate of return. My simple if imperfect suggestion for calculating your personal safe withdrawal rate is to use the expected real rate of return of your portfolio. This amount is already adjusted for inflation and you will probably have to make some adjustments along the way anyway. If you can afford to take less, great! Your odds of success are probably improved. Oh, and one other thing, when you reach retirement try to keep one years living expenses allocated to cash, this will help if things get really dismal. Having a large cash reserve will preclude you from having to sell other securities at in opportune times. At least for a year.

Kitchen Table Planning - Real Rate of Return

When you are working on your kitchen table plans, you will need to understand real rates of return. Your real rate of return is simply your investment return less the anticipated inflation rate.

For example if you have calculated your expected portfolio return at 8% and you anticipate that inflation will average 3% then your real rate of return is 5%.

This is important because over long periods of time inflation will erode the value of the dollars you have available to pay for a financial goal. If you are planning for retirement the dollars you will need to provide a certain level of income 20 years from now will be significantly higher than the dollars you need to retire today. If in fact inflation averaged just 3% over the next 20 years then todays dollar would only buy $0.55 worth of groceries when you reach retirement.

I see this often. Someone will say 'I have $500,000, I think I should be able to earn 8%, so I should be able to spend $40,000 each year.' Unfortunately this isn't how to achieve a worry free retirement. If you earned 8% you would have to reinvest 3% to offset inflation leaving you with 5% to spend. So the couple in the above example could only take an income of $25,000 from their $500,000 nest egg.

Or you may say 'I will need $1,000,000 to provide extra income in my retirement. How much should I be saving each year to end up with $1,000,000 when I retire?' Here you must use your real rate of return to calculate the payments required to reach your goal because you want to achieve the purchasing power of $1,000,000 today at some point in the future.

It is sometimes hard for folks to grasp this concept, but to come up with any real financial plan you must understand and know when to use real rates of return.

Longevity Insurance

According to the National Center for Health Statistics a man living in the United States who reaches age 65 has a life expectancy of another 17 years and a woman who reaches sixty five has a life expectancy of 20 years. In fact according to Wikipedia 1 in 50 women and 1 in 200 men living in the United States will attain the ripe young age of 100.

Statistically, life expectancy is the point where 1/2 of a group will be dead and of course the other half will continue living. So half of the women living in the US that are 65 will live to be older than 85, and half of the men will live to be older than 82.

That is a long way to get to where I wanted to start. With expanding longevity in the US, making sure your money lasts longer than you do becomes increasingly harder. Defined benefit pensions are going the way of the dinosaur so individuals have to shoulder an increasing risk of longevity (which I believe is a good problem to have as far as problems go).

Enter your friends from the insurance industry who are willing to sell you longevity insurance.
Some think the policies are over priced but I believe it is an option that some should consider. here's how it works:

Let's say a 65 year old male needs $50,000 a year of income in addition to his social security benefits. Guessing that inflation will average about 3% annually this gentleman will need just over $90,000 to buy the same amount of groceries when he reaches age 85. For about $131,000 he can buy a longevity insurance policy that will guarantee him $90,000 a year in income beginning at age 85. Doesn't sound like too bad of a deal so far, but remember less than half of the men age 65 today are expected to live long enough to collect even one cent (that's right if you die before age 85 you get nothing and the insurance company keeps all the money).
Still if you are one of the lucky ones who lives long enough to collect you'll be ahead after about a year and a half.

If you have reason to believe you'll live a long time this could be a good deal. If like Mickey Mantle you feel "If I had known I was going to live this long I would have taken better care of myself" then maybe it's not for you.

Delayed Gratification

According to the Social Security Administration about 50% of retirees claim social security benefits as soon as they become eligible. Yet benefits are reduced from 5.5% to 6.5% for each year you take benefits before your normal retirement age, which is currently between age 65 and 67 depending on your date of birth.

For anyone who is still working it makes little sense to begin collecting benefits early. Working claimants will loose $1 of benefit for every $2 earned above $12,960. In many cases this could wipe out the benefits altogether. So if you continue to work you should think twice about taking benefits at age 62.

Because social security benefits are based on age but ignore gender, and women tend to have longer life expectancies than men, it normally would make sense for females to claim benefits as soon as possible, but again if you plan to work beyond 62 you should carefully examine if delaying benefits will result in higher net income.

At age 70 social security benefits reach their maximum so there is no point in delaying beyond that point. So the real question for those who continue to work is whether to claim benefits between normal retirement and age 70. A good way to judge when to claim benefits is to compare the cost of buying an immediate annuity to provide this same income over a single life expectancy. Insurance companies are great actuaries, so this method can show you the present value of future benefits at various ages. Many web sites can provide immediate quotes for this type of annuity, allowing you to make a comparison of benefits quickly and privately.

The "new math" of the distribution phase

American Funds has issued a new white paper discussing the distribution phase of an investment portfolio. It brings to light some interesting points and is well worth the read. To access the report please click here.

Stamps Prices Increase Again This Month

The US Postal Service has announced yet another increase in the price of a postage stamp. This is old news but I bring it up to illustrate how inflation can erode our buying power. Take a look at the images on the left. In 1976 a first class stamp cost only 20 cents, later this month it will reach 41 cents. That is a little over double the cost in the last 31 years. Some of you may remember all these stamps, for some it will represent a span of time longer than their years on earth. No matter, the point is this period of time represents relatively benign inflation rates. A postage stamp has averaged just a 2.3% inflation rate over this last 31 years yet
your cost of living has doubled. Even small inflation rates can be
devastating over the span of a human life. So what can you do
to protect yourself?

You should understand that real return (gross return after taxes and inflation) is the true measure of your progress. If you are currently earning 5% on a CD or money market account your after inflation return is about 2.5%. If you earn 10% from a stock investment your after inflation return is about 7.5%, about three times the after inflation return of a fixed income investment.

If you are retired and living on a fixed income portfolio you can only spend around 2.5% of your portfolio value each year. The rest has to be reinvested just to keep you even with inflation, or else you should
expect to eat half as much 31 years from now!

Converting your investments from the accumulation phase to the income phase does not mean things get easier, in fact providing a reliable long term income stream from your investments is more challenging than accumulating those assets to begin with.

A 529 Plan For Your Retirement Years?

Here is a good story about a unique use of 529 college savings programs. Bottom line, if you are interested in studying at home or abroad when you graduate from your first career, you can use a 529 plan to pay for it!

• May be eligible for state tax deduction
• Investments grow without taxes and when spent for accredited higher education withdrawn without taxes also
• You can name a contingent beneficiary

Check it out here.
Courses here.

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