How Should One Invest in a 401k Late in a Career?


Dear SmallIvy,

How should a 60-year old be investing in a 401k account?

Thanks,

Pete

Dear Pete,

Unfortunately the power of investing lies in the value of time.  The stock market is an extremely turbulent animal.  Over long periods of time one is practically ensured a return exceeding inflation.  Over a period of a few years, however, things are far less certain.  Assuming that one is looking to retire in five years or less, that does not give enough time to invest in stocks and expect to have at least one’s original investment at 65 with any great certainty.  The current status of the stock market, having risen a great deal over the past two years, also does not appear to be a good entry point.

If one is able to put the money away for a longer period of time, say 10 years or more, the risk is reduced somewhat.  During the last decade the stock market was essentially flat, owing in part to the large build-up before the dot com bubble burst in the early 2000’s.  If one had been investing regularly, however, rather than simply dumping a large sum of money into the stock market in the early part of the century, one actually would have ended up with a significant positive return.  Ironically, the best return would have come because of the market crash in 2008.  By allowing shares to be purchased at values well below their intrinsic value, one was able to generate a spectacular return over the past two years.  So, part of the answer is that investments that can stay for 10 years or longer should be made at regular intervals rather than made all at once.

The other issue to consider is how much money will be needed in the early years of retirement.  Money needed in the first five years should be kept in money markets or other safe cash investments.  If the principle will not be needed but additional income is desired, one could invest in investments with higher yields.  Unfortunately the bond market, which is a normal place to find yields, is looking very pricey at the current time.  If prices retreat in the next few years shares of bond funds could be purchased.  Otherwise, one could invest in a mix of large cap stocks (which are more stable and tend to pay a higher dividend), convertible and preferred stocks, and REITs.  If some sort of utility stock fund was included in the investment choices that would be another possibility.  Most 401K funds have little in the way of investment choices, however.  If none of these other choices are available, investing a portion (perhaps half) in a large cap stock fund and the remainder in a money market fund may be appropriate.  If a bond fund is available and bonds drop in price, shares could be bought at that time to lock in higher yields. 

Understand here that the value of the stocks and bond funds may well decline in value over that time.  One must be willing and able to hold these funds and simply collect the interest and dividends to supplement other savings while the prices of the funds do whatever it will do.  One should not expect to make a substantial amount of capital gains in this short period of time, so buying funds with the expectation of selling them and living on the capital gains is not a reasonable expectation.  Over a suitable period of time the price should recover and grow.  

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

 

How to Invest a Large Inheritance


Investing an inheritance is different from investing income from work or sale of a house.  Some individual in your life has made a very generous gift to you in an effort to make your life better.  There is therefore a sacred trust that goes along with the money.

One would therefore like to use the money wisely.  One would like to preserve it such that the money can last.  Ideally the principle would remain and just the interest used to aid with expenses and purchases.  Given a large enough inheritance and prudent management, the money can last and benefit not just the primary beneficiary but heirs for generations to come.  For example, the money could be set up as a trust fund that pays for members of the family to attend college or buy their first homes.  Managed correctly, a substantial inheritance can last generations.  Managed poorly, it will not last out a decade.

If one is fortunate enough to receive such a gift, here are the steps to follow to make the money last:

1.  Never spend principle, only interest.  As long as the principle is never touched the amount will not decrease.  In general one can expect to withdraw about 8% each year without affecting the value of the account.  For example, if one receives $1 Million, one should expect to receive an income of up to $80,000 per year.  This assumes that the account is invested in stocks, which earn an average of 10-15% per year.  After withdrawing 8%, the remaining gain is used to battle the effect of inflation.

Another strategy, if one does not depend on the income, would be to withdraw nothing on years where the return is 10% or less and withdraw the total return minus 5% on years when the return exceeds 10%.  In this way money is only withdrawn when the return on the account is more than enough to make up for the withdrawals.

2.  Diversify.  The secret to preserving wealth is diversification.  By spreading money out into different types of investments, decreases in one type of investment will be offset be increases in another.  A smaller account (less than $500,000) should include stocks in several different sectors of the market including international stocks.   For example, buy index funds that include large caps, small caps, international stocks, bonds, and income producing stocks (think utilities).  Larger accounts should include some real estate as well, either directly or through the ownership of REITs.  One possibility would be to pay cash for a vacation house that is rented out most of the year.

3.  Invest in ways that beat inflation.  As mentioned in the first step, investment in common stocks and other inflation beating vehicles is needed.  Left in a money market account the funds will wither and decline with time.  Investments in hard assets such as gold will preserve the wealth but will not outpace inflation.  If you are planning to leave your wealth to your descendants five generations down the line with no one to care for the money, gold might be the answer.  Otherwise, stocks and real estate will do better.

With principle preservation, diversification, and investments that beat inflation, that inheritance can last your whole life and for many generations to come.

Please leave a comment or email  vtsioriginal@yahoo.com.  We’d love to hear from you.

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

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Social Security is a Ponzi Scheme


Social Security is a Ponzi Scheme.  If you are counting on it for your retirement, unless you are planning to retire within the next ten years or so, it is very unlikely that you will be receiving payments for all of the years you are retired.  Planning to live on Social Security in retirement is therefore not a plan, which is why saving for retirement is that much more important.

So what is a Ponzi scheme?  Investors are told that they can make great returns by having their money managed by some star investor.  As money is collected, some of the money that is collected from later investors  is given out to the first people who “invested,” who are told that their investment resulted in a great return.  The rest of the money is kept by the person or people running the Ponzi scheme. As long as the scheme collects money from new investors, the managers have money to pay the oldest investors, and therefore they can keep the scheme going.  Eventually, however, they run out of new investors.  At that point they stop paying out money, pocket whatever is left, and flee the country.  

So how does Social Security work, and why do I say it is a Ponzi Scheme?  Social Security is a program by which individuals and their employers are forced to contribute a portion of their pay each paycheck.  Individuals who work for themselves are forced to contribute both their own share and the amount the employer would have paid in what is called “self-employment tax.”  Despite the accounting gimmicks that are played in the Treasury and the “statements” that are sent out to make the program appear like a pension plan, the money is not saved or invested as it would be in a pension plan.  The money is instead used to pay for current retirees.  Money that is left over goes into the general treasury and is used for general purposes.  Given that the budget deficit is over $1.5 T for the US Government, all of the money sent into Social Security is being spent and then some. 

So, just like a Ponzi scheme, the first investors are paid by the later investors.  Also like a Ponzi scheme, it works as long as there is more money coming in than is going out.  Also like a Ponzi scheme, the trustees (Congress) are spending the extra money they don’t need to pay out in current distributions.  In the case of Social Security, the assets being spent are being replaced on paper with government bonds , but because the money to pay for Social Security and the money that is used to pay the holders of those bonds comes from the same entity, the bonds will be worthless if the Government doesn’t have the money to pay for the Social Security benefits that are owed.  The only real difference between Social Security and a Ponzi Scheme is that at least the return for the investors who are paid by a Ponzi scheme is respectable.  The money collected for Social Security is more than the amount that would be required to fund a comfortable retirement, and yet few would be able to live on what Social Security pays out.  Instead of getting $50,000 per month, as an investment account would return, payments are $1500 per month.

I’m hoping that readers will now see why the claim that investing Social Security assets in private accounts would be “risky” while the current system is “safe” is utterly ridiculous.   In one case there is a chance that the account value may decline somewhat in a given year, but the long-term return on stocks is more than 10%.  In the other case all of the money is spent and none is saved, leaving the “investor” to hope that there will be enough money collected when he/she is ready to retire to receive a distribution.   In one case some of the money may be lost in some years, in the other all of the money is lost every year.  Note also that the return on Social Security has been terrible, and one would be doing better than the status quo even if the money were invested in bank CDs.

The other take-away point is that one should not plan on Social Security to be there to support one’s retirement.  Even the formal trustees of Social Security and Medicare (a couple of individuals whose job it is to evaluate the financial state of these entities and report to Congress)  say that the programs are going bankrupt (see their own words:  http://www.ssa.gov/oact/TRSUM/tr10summary.pdf).  These are the people in charge of tracking such things, so they would know.  Note that they say the reserves won’t be exhausted until 2037, but that assumes that the Government will be able to repay the bonds that are held as IOUs in the trust fund.  With trillion-dollar deficits each year, the ability of the government to repay those bonds becomes more and more in question. 

For years the system functioned, and even allowed for extra funds to be siphoned off and used elsewhere in the budget because there were more people paying in than taking benefits.  Now, with the baby Boom generation retiring and people living longer, the number of people paying in will not keep up with the number taking out.  Starting this year, the amount taken in by the program is less than the amount paid out.  That trend will get worse as the years progress.  If looking for security in retirement, save 10-15% of your income each month.  That is the only way to maintain one’s standard of living in retirement.

As far as Social Security payments go, consider it just another tax.  Sure, money is paid in, but that money is being spent on Government and services now so all are receiving the “benefit” of their contributions now in the form of government programs and services.  It is not a retirement account where you should expect to get back what you paid.  With time the benefits will be reduced, with the retirement age ever higher in hopes that most people will die first and never collect, and the monthly payments will become ever lower in real dollar terms.  The best one can hope for is that the amount of money collected to pay for these paltry benefits will not be increased.  That can only happen, however, if individuals will demand an end to the program and be willing to give up the money that they put into  it already.  That money is no longer there – it has already been spent.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. 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. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.