How to Tell if Your 401k Plan Really Stinks


There is nothing wrong with the 401k, but there are a lot of really bad 401k plans out there.  If you’ve never invested, you may not be able to tell the difference.  But it is worth learning how to spot a bad 401k plan because it might be something to consider when looking at a prospective job.  You can also change your behavior if you have a bad plan to improve your investing options.  We’ll talk about this at the end of this article.  But first, here are some things to look for in your 401k.

1.  A lack of index funds.

In the world of investing, there are managed funds and index funds.  Managed funds have a whole team of managers who go out and find “investment opportunities” and “seek to manage risk while providing a reasonable return.”  The trouble is, the vast majority of mutual fund managers don’t do as well as the markets, and all of that research and pontificating comes with a hefty price tag.

An index fund doesn’t try to beat the markets.  It just buys stocks as dictated by some index, which is a hypothetical portfolio of stocks designed to track the behavior of some part of the market.  For example, in the early 20th century, Charles Dow wanted to have a way to see how the large industrial companies in the US were doing.  He chose a group of large industrial companies that covered the different industrial business areas at the time and pretended that he invested an equal amount in each company.  He then began to track what the value of that portfolio was compared to its value when it was formed and the Dow Jones Industrial Average was born.  About 90 years later, a company started an index fund that simply bought the stocks in the Dow Jones Industrial Average, and thus the “DIAmonds” index fund was born.  Unlike a managed fund, the index fund just buys what’s in the index and doesn’t need to pay a team of analysts and managers, thus the costs are a lot lower.

An index fund will typically have fees of 0.25% of assets or less.  This means it will cost you $25 per year if you have $10,000 invested.  A managed fund can have fees of 1% or more, meaning you’ll be paying $100 per year for each $10,000 invested.  While this difference may not seem like much, it means you’ll be making about 0.75% more each year in the index fund, which will add up to hundreds of thousands of dollars over your working lifetime.  A plan that lacks index funds stinks.

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2.  A lack of diversity of funds.

As a minimum, a good plan should have:

  1.  A total stock market index fund
  2. A total bond market index fund.

A better plan would also have:

3.  An international stock index fund.

4.  An REIT fund.  (An REIT is a mutual fund of investment real-estate properties, such as apartment buildings or malls, even cell towers and storage centers.)

The best plans would also have:

5.  Target-date retirement funds.

6.  Small and large-cap funds.  (Capitalization, or “Cap,” refers to the size of a company.  Small-caps are small companies, large-caps are large companies.  Mid-caps are – you guessed it – medium companies.)

7.   Growth and value funds.  (Growth funds invest in companies that are growing, while value funds invest in companies that are undervalued.   This is either buying what is doing well or buying what is considered cheap.  Both strategies work with one outperforming the other at different times.  Most index funds give you both, but some specialize in one or the other.)

Having choices allows you to tune your retirement investing.  The target-date retirement funds also allow you to put your retirement investing on autopilot if you wish.  If your 401k choices only include high-cost funds that don’t really tell you in what sector of the market they invest, your plan stinks.

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3.  Your plan switches in and out of funds.

This really isn’t so much the plan itself, but the people setting up the plan.  Sometimes the board who creates and manages the plan will change the funds available because some funds have not done well.  Assuming the funds don’t have high fees or something, the reason they may not have done well is that the sector of the markets in which they invest may not have done well.  For example, maybe you have a value index fund during a time when growth stocks are doing well, so the value fund returns 3% while the growth funds return 20%.  The board may see this and get rid of the value fund, substituting another growth fund in its place.

This is exactly the wrong thing to do.  Because growth stocks have done well, it means that they may have already gone up in price to the point that they are expensive.  Conversely, value stocks may now be especially cheap.  Think of going to the store and finding that strawberries have doubled in price, while grapes are selling for 80% of what they normally sell for.  While you don’t know what strawberries and grapes are going to sell for next week, you can bet that over time strawberries will not go up in price as much as grapes will.  The same is true for stocks.  While the timing is difficult, you will not do as well buying stocks when they are expensive after a big run-up as you will if you buy them after a drop when they are cheap.  If you find that your funds get dropped when they don’t do as well as other funds, other than due to the fact that the fees are high, your 401k plan may stink.

What to do if you have a stinky plan.

There is not that much you can do if you have a bad plan, but there are a few things.  These are:

  1.  Invest outside of your plan in an IRA.

You can open up an Individual Retirement Account (IRA) with any mutual fund company or brokerage firm.  This will allow you to get the same tax-deferral that you get with a 401k plan.  Inside an IRA, you can invest in almost anything.  If you open an IRA with a mutual fund company, you will often be able to invest in their mutual funds without paying a fee when you buy or sell the funds.  Tax laws may limit the amount you can put into an IRA if you have a retirement plan at work, but you may be able to put some into an IRA.  You will also probably be able to put the full amount (currently $5500 per year) in an IRA for a non-working spouse even if you have a 401k plan at work.

2.  Invest in a taxable account.

While not as good as an IRA, there is nothing from stopping you from investing for retirement in a taxable brokerage or mutual fund account.  If you invest in index funds and hold them for long periods of time, you’ll still pay very little in taxes each year.  While you may pay some taxes on capital gain distributions from the fund, as well as on dividend and interest payments, most of the time you’ll only see a big tax bill if you sell funds at a big profit. If you buy and hold, most of your money will be left to compound just like it would in an IRA or 401k.  In fact, your tax bills at the end may be lower than you’ll see with a 401k since capital gains rates, which you’ll pay on profits from a taxable account, are usually substantially lower than standard income tax rates in the top brackets, which is what you’ll pay for large 401k distributions.  You won’t see a tax break when you put the money into a taxable account, however, like you will when you put the money into an IRA or 401k.

You can also buy some individual stocks in a taxable account and not see a big tax bill (until you sell).  You just need to hold them for long periods of time, like ten to twenty years, rather than buying and selling stocks for a quick profit.  The good news is, you’ll do far better buying stocks for long periods than you’ll do trading.  This is like a win-win.  You can also reduce your taxes when you do sell by selling losing positions to offset gains in winning positions

3.  Be sure you still get the company match.

If you do decide to us an IRA or invest in a taxable account, you’ll still want to put enough money into the 401k plan to get whatever matching funds the company provides.  This is like getting a 100% or 50% return on your money right from the start.  If you do this, but your 401k plan stinks, you can always roll whatever is in your 401k plan to an IRA when you leave the company.

Have a burning investing question you’d like answered?  Please send 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.

Getting Income from Your Retirement Portfolio


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

A portion of your retirement portfolio should be dedicated to generating current income.  This means that you want assets in your portfolio to be sending you a check regularly so that you can pay for food, utilities, and other expenses you’ll have in retirement.  For example, if you own bonds they will send you an interest check twice per year.  Likewise, many stocks will send you a dividend check four times per year.  REITs (Real estate portfolios) will send you money from rents that they receive from properties in the portfolio.  All three of these types of investments will also send you capital gains distributions periodically from when they sell a security at a profit.  While you can also sell off shares to generate cash, it is better to have interest and dividend payments coming into your account so that you don’t generate brokerage commissions and other costs by selling.  Once you have things set up, it also means that you don’t need to do much of anything.

To show how the process works, let’s assume that I have a two million dollar portfolio, of which I’m using $1.5 M to generate income.  The other half-million I am leaving in growth stocks to keep up with inflation and get better returns than I can from income generating assets.  I’ll use a combination of bonds, dividend-paying stocks, and REITs to generate income.  Let’s say that I want to generate about $50,000 per year in current income from the portfolio.

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Looking through the Vanguard funds, I find the following:

Bond Funds:

Long-Term Bond Index – Yield 3.78%

Total Bond Market Index – Yield 2.96%

Long-Term Corporate Bond Index – Yield 4.42%

High-Yield Stock Funds:

High-Dividend Yield Corporate – Yield 2.89%

REIT Funds:

Real-Estate Index Fund – Yield 4.03 %

I’ll use these funds as building blocks to generate the income I want.  Bond funds tend to pay the most cash, but the higher-paying bonds funds are also riskier.  The amount they pay (in dollars) will also stay relatively fixed with time, while the value of a dollar will decrease due to inflation, so over many years my spending power will be reduced if I only buy bond funds.

The dividend-paying stocks don’t pay as much as the bond funds, but the amount that they pay will increase with time.  I may only get $5,000 from a dividend fund this year, but in ten years I may be getting $10,000.  An equal investment in a bond fund may pay $7500 this year, but in ten years it will still be paying $7500.  The dividend part of the portfolio will help me keep up with inflation.  The growth stock portion will do this as well.

The REIT fund will pay as well as some of the bond funds, but also will have some capital appreciation, helping to keep up with inflation as well.  It is also in a different sector of the economy than stocks or bonds, so the price of the fund may stay up when the stock and bond funds go down and vice-versa.  This adds stability to the value of my portfolio.

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The strategy is to utilize the higher-yielding bond funds to increase my returns, but also buy some lower-yield funds for security and to reduce volatility.  I’ll add dividend-producing stocks for growth of income.  I’ll add REITs to help provide income, stability, and some capital appreciation.

Let’s say that I invested as follows:

Long-Term Bond Index – $200,000, yearly income $7560

Total Bond Market Index – $200,000, yearly income $5920

Long-Term Corporate Bond Index – $300,000, yearly income $13,260

High-Dividend Yield Corporate – $300,000, yearly income $8670

Real-Estate Index Fund – $500,000, yearly income $20,150

My total income would be $55,560, which is $5560 above my goal.  This is fairly close to my goal, so I may say this is good enough and go with it.  The portfolio is nicely balanced, with 47% in bonds, 20% in bonds, and 33% in real-estate.  If I really didn’t need more than $50,000, I would probably shift more money into the high-yield stock fund, which would reduce my current income but increase my future income and get a little better overall return on the portfolio over time.

So there you have it – the strategy for setting up the income portion of your portfolio.  Develop a list of funds with their yields, allocate money to each fund, trying to spread the money out among bonds, dividend-paying stocks, and real estate, and then adjust the allocations until you reach your needed income needs.

Have a burning investing question you’d like answered?  Please send 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.

How to Use an IRA in Retirement to Fund Your Lifestyle


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Saving up enough for retirement is critical.  There are many articles on how you should be saving for retirement, putting money away into 401ks, and building up an IRA for retirement.  But what about when you get to retirement?  How do you put the hard-saved money to work to fund your retirement?  Do you convert your 401k and IRA to cash and put it into CDs?  Do you buy a bunch of bonds and live on the interest?  Or should you stay invested in stocks and use the capital gains to fund your retirement?  Here are some tips on how to unwind your IRA when the time comes.

1.  Hold on as long as you can

Hopefully you will have saved up enough money and cut expenses enough in preparation for retirement to not need to touch your IRA for the first several years.  So long as it is in the IRA, it continues to grow tax deferred (or tax-free, if it is a Roth IRA).  Unfortunately, the government is itching to get their money on those dollars, so they will force you to start withdrawing money.  For a traditional IRA, the age at which you must start taking withdrawals is currently 70 and ½.  This can and probably will change over time, however, so it is worth it to talk with your CPA to verify the tax rules and come up with a plan.  Get it wrong and you can end up owing a lot of extra money in taxes, so paying a good CPA a few hundred dollars is well worth the price.

There is a strategy in making withdrawals from an IRA.  Ideally you will have enough dividend and interest paying assets in the account to produce enough cash each year to cover the required withdrawal.  This means that you can just let the cash build up, withdraw it at the end of the year, and then let the process start again.  This will work for a while, but the required amount of the withdrawals will increase each year (the government wants it all out by the time you reach a certain age) so eventually you’ll need to start selling assets and pulling them out.

 

 

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2.  Sell your losers, hold your winners

Eventually you will need to start selling stocks and pulling money out of your IRA.  When doing so, start by selling things that are just not doing well and don’t have the promise they once had.  For example, if you bought a stock but the business you expected never materialized and the stock has been flat, you might as well sell it rather than sell shares in a company that is doing well instead.  Likewise, if you have a stock that has had a good run but now has reached a plateau and the growth rate has slowed considerably, you might as well sell it.  Since the tax paid will be based on the amount withdrawn regardless of how well you did on the investment, it doesn’t matter whether you are taking a loss or not.

3.  Shelter your Income generators.

It is also a good idea to try to keep dividend and interest paying assets in the IRA as long as possible.  Because you will pay taxes each year on the interest and dividends when you hold income stocks and bonds outside of the IRA account, while you will only pay taxes on the capital gains when you sell an equity that has appreciated in price, it makes sense to keep the income producing assets sheltered as long as you can.  I would therefore sell a stock on which I’d had a capital gain, withdraw the funds, pay the taxes and then reinvest in the stock again if I wanted to continue to own it before I would do the same thing with a stock I was holding for the dividend or a bond.

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

 

Have a burning investing question you’d like answered?  Please send 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.

Is a Buy-Write Fund Right for Your Retirement Account?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details.  The key things you need to know about buy-write funds are:

  1.  They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
  2. They are more volatile than bond funds but less volatile than stock funds.
  3. They won’t go up as fast as stock funds, but also won’t go down as much.
  4. You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
  5. They will perform the best of anything when markets are stagnant.

So there’s the minimal you need to know.  For those who want more explanation, please read on.

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What are call and put options?

You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company.  An option is a legal contract between two people.  This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date.  An option to purchase is called a call option, where the option to sell is called a put option.  It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer.  The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.

Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t.  A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now).  As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money.  Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.

To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date).  For example, this month all of the options expire on Friday, March 16th.

 

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Why would someone buy options?

Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price.  They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money.  Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house.  If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit.  This is really good for a one-year speculation.  If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit.  Leverage magnifies potential gains.

Options do the same thing.  You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock.  If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit.  (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.)  If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock.  This is why people use options, the potential to make a fast profit without putting too much money down.  This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them.  You therefore need to be right about both the direction and the timing.

What about writing options?

The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium.  The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer.  The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date.  Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time.  While the option buyer has the potential to make a lot of money, most of the time he doesn’t.  Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.

For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side.  You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return.  Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive.  It is like being able to make any stock into a dividend-paying stock.

Writing covered calls is not without risk.  If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never).  You are also setting a limit on your potential return.  If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money.  Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns.  In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower.  It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.

Is there an easier way than writing calls yourself?

Yes.  There are mutual fund companies that create buy-write portfolios for you.  For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio.  You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping.  In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing.  For example, in 2017 the fund provided about 11% in cash payments.  This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.

Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year.  For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%.  With income investment, however, you should be focused on the cash return you are getting and not the share price.  The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year.  In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.

Have a burning investing question you’d like answered?  Please send 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.

Eight Simple Steps to Start Investing


 

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Maybe you’ve been working on your personal finances for a while.  You’ve got a budget. You’ve paid off all of your debt (or never had any in the first place).  You’ve gotten your emergency fund together and have about $10,000 in cash sitting there.  At this point you’ve got a line in your budget called “Investing” and you’re starting to siphon money out of your income to a bank account that you’ve created to store up your investing funds until you have enough to get into the markets. But now you’re worried about what you should do, where you should invest, and even how you go through the actions needed to buy stocks and bonds.

Luckily, investing is a lot easier today than it was before about the year 2005.  Where in the past you would need to have a fairly large amount of money before brokers would even work with you, the mutual fund industry has answered the need for the common man (and woman) to invest and discovered that there are a lot of people out there needing such services.  At places like Vanguard you can set up an account and start investing with as little as $3,000 ($1,000 if you’re starting a retirement account like a traditional or Roth IRA).  You might be able to invest with even less at places like Charles Schwab and/or if you set up autodraft from your checking account.  With these accounts, you have access to a wide array of mutual funds, and even individual stocks and ETFs, all with a few clicks of a mouse.

Still, there are a lot of options and it is probably fairly intimidating for the new investor.  That is why I’m providing the Simple Steps needed to get started in investing.

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Step 1:  Pay off all credit cards.

Before you even think about investing, get rid of your credit card debt.  During a really good period in the stock market, you’ll get a return of 15% per year.  Long-term returns average around 10% (which is 7% after inflation).  You just can’t compete with a 19 or 25% interest rate on a credit card balance.  Just think of yourself getting a 25% return on the money you use to pay off credit cards.  Then, cut up your cards and get debit cards instead so that you won’t go into credit card debt again.

Step 2:  Start with a retirement account.

Someday you will want to retire, which means that you need to have retirement savings to last you for about thirty years, plus something like $500,000 to $750,000 to pay for healthcare expenses beyond what Medicare covers.  If you have a 401k or 403b at work, start there, putting in at least as much as your company will match.  Putting in less means that you are leaving free money on-the-table.  If your company matches the first 5%, you can effectively increase your salary by 5% by just putting 5% of your pay into your 401k.  If you don’t have a 401k plan at work, sign up for the pension plan if one exists.  Regardless if there is a plan at work, go to Vanguard or Schwab and start a Roth IRA.

Fund your retirement plans with 15% of your salary.  Start by putting whatever the company matches into your work plan (or whatever is required by your pension plan), then fund your IRA up to the yearly maximum.  If there is anything left over, put it into your work retirement plan.  Still have money left over?  Start a standard, taxable account at Schwab or Vanguard and fund that account.

Step 3:  Determine your retirement fund asset allocations.

Assets are things like stocks and bonds.  They are things that pay you money, adding to your income.  Standard asset types for investing include stocks, bonds, and real estate.  To determine you asset allocation:

  1.  If you’re less than age 40, start with 100% stocks.
  2. If you’re over age 40, start with your age minus 20% in bonds, 110% minus your age in stocks, and 10% in real estate.   For example, if you’re 45, you would start with 25% bonds, 65% stocks, and 10% in real estate.
  3. If you’ve worried about losing money and are very nervous, increase your bond allocation by 10% and reduce your stock allocation by 10%.  This will smooth things out somewhat.  For example, someone who was 45 would increase their bond allocation to 35%, reduce their stock allocation to 55%, and still have 10% in real estate.  Someone who was 20 would reduce their stock allocation to 90% and add 10% bonds.

 

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Step 4:  Select your retirement account stock funds.

Go through the funds you have available and try to find index funds.  If you can, select a total stock market index fund.  If that is not available, try to find a large-cap (like an S&P500 fund) and a small-cap (like a Russell 2000 fund) fund.  If index funds are not available (for example, in a 401k plan without the best choices), find the lowest cost stock funds available (try to find funds that charge less than 1% of assets invested) and select one that invests in all sectors of the market or one that invests in growth and one that invests in value.  Also find a fund that invests in international stocks, hopefully something like a total international stock fund.  Read the fund descriptions to find what the fund invests in and manager’s style, as well as total fees.  

Step 5:  Find your retirement account Bond and Real Estate Funds

Go through the same process in selecting your bond and real estate funds.  Try to find a total bond index fund and an REIT index fund.  If you don’t have an REIT fund available, just add 10% to your bond allocation.

Step 6: Buy your retirement account funds.

You should be able to buy your funds using the website for your 401k or IRA.  Many sites will allow you to specify specific percentages of the account to put into each fund.  If that is the case, go ahead and set those percentages based upon the asset allocations you determined in Step 3.  If not, you’ll need to pull out a calculator or spreadsheet, do the math, then enter the dollar amounts.  Note that you will want to set your investment percentages in two different places, one for how to allocate the money you have in the account already, and the other for how to invest new funds.  Set both of these the same and matching the allocations you determined.

Divide the money within an asset category (stocks, bonds, real estate) equally to each of the funds in that category.  The exception is international stocks, which should be 20% of your stock allocation (so if you are investing 80% stocks, you would put 16 % of your account (80% x 20% = 16%) into international stocks and then 64% into US stocks and 10% into bonds and 10% into real estate.

Step 7:  Setup taxable brokerage accounts with Vanguard or Schwab if you have more money to invest.

Hopefully, after you are through putting money away for retirement, you’ll still have more money to invest.  Unlike your retirement funds, which you won’t be able to touch until retirement, money you invest in taxable accounts can generate additional income to enhance your life and hopefully make you financially independent before retirement.  Put 100% of your taxable investing accounts into stocks and only sell when you want to generate cash for something since you’ll be taxed each time that you do. As long as you don’t sell the shares, you won’t be taxed on the increases in value of your account due to increases in price of the funds in the account.  You will be taxed on the dividends and capital gains that the stocks in your funds are generating, but these should be small amounts if you buy index funds investing in the whole stock market.

If you want to, you can set these accounts up to spin off cash when the stocks in the funds pay dividends or there are capital gains.  You’ll then just magically see money appearing in your money market account with the fund company, with a larger amount n December (fund companies tend to move money around and realize capital gains at the end of the year.  This money will be taxable, but then can be used as you wish.  This is a great way to get extra cash without needing to sell shares.

Step 8: Wait until January 15th, then rebalance.

You should rebalance your accounts – set them back to your desired asset allocations – about once a year.  You should also adjust your allocations for changes in your age at this time (as you get older, you should be shifting more into bonds).  Luckily, most mutual fund companies also have tools to let you rebalance.  Just set the percentages you want into the tool and press the button.  Do this again every January 15th (or a date somewhere near then).

Have a burning investing question you’d like answered?  Please send 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.

How I Learned to Love the Bond


In case you haven’t figured this out yet, I spend a lot of time thinking about financial things and how money works.  I think about the effects that raising the minimum wage would have on low-wage workers (they aren’t good).  I think about why our healthcare payment system is so messed up (you don’t have clear prices, plus everyone is trying to get more than they pay for, so you don’t have an efficient, competitive market).  I also think about things like when using an annuity would be good (normally when you don’t really have enough to live on in retirement through investing).

One conviction I’ve had for a long time is that you should always be 100% invested in stocks (with maybe a little invested in REITs) unless you cannot afford a 50% loss or bonds are paying really high interest rates.  I reasoned that the return on bonds is always a few percentage points less than the return from stocks, so why should you give up a 10% return for a 6 or 8% return?  Having a 50-50 stock/bond portfolio when you’re 60-years-old will help protect you should the stock market decide to drop 40% like it did in 2008, but if you were worth $10M and could live perfectly well with $5 M, why would you want to own 50% bonds?

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And then I kept thinking and started to realize an issue with my convictions: While it is very unlikely that you will lose money in stocks if you hold them for more than 5 years, and very, very unlikely that you will lose money if you hold stocks for more than 10 years, that does not mean that stocks will always do better than bonds over a given five or ten-year period.  While the average return from a stock portfolio is 10-15% per year, that includes some great periods like the 1940’s-1950’s and the 1980’s-1990’s that really goosed the averages up.

A chart showing the annualized returns (the kind of return you would need to get each year at a fixed rate to end up with the same return) for the stock market (the Dow Jones Industrial Average – DJIA) during different decades is given below.  If you held the DJIA stocks from 2000 through 2009, sure you would be up, but your average rate of return would only be 1.07%.  If you held the DJIA stocks through the 1930’s, you would have actually seen a negative average return of -0.63% per year.

(Source of data:  http://www.stockpickssystem.com/historical-rate-of-return/)

During most 20-year periods, you would have been better off in the DJIA stocks than you would have been in bonds, assume a rate-of-return of 6%.  This is only true for seven of the twelve 10-year periods shown.  Of course, during periods like the 1930’s, many of your bonds would have defaulted, so being in bonds during that period would not necessarily have saved you either.  During the 2000’s, however, bonds returned about 6% annualized.  You would have therefore fared better in bonds from 2000 to 2010, but not as well as you would have in DJIA stocks from 1990 through 2010. For the period from 2000 through 2018 so far, you would be about even, but we’re seeing extraordinary returns right now, so the next few years may well cause stocks to outperform bonds again for the 20-year period from 2000 through 2020.

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So what does this mean?  If you have at least 20 years until you need the money, I would stay 100% invested in stocks.  A twenty-year-old who is just starting a 401k account should therefore be 100% in stocks, assuming she can handle the market fluctuations that such a portfolio would provide.  (If you can’t handle the fluctuations, consider adding 20-30% bonds, which will help to stabilize things a bit but not hurt long-term returns too badly.)  If you’re sixty-years-old and planning to start living off of your portfolio over the next few years, you might want to consider a 60-40 stock-bond portfolio even if you have a lot more money than you need in your portfolio and therefore could stand a big decline in the stock market without falling short of spending cash.  If you make it to eighty, you will probably get a better return from being entirely in stocks,  but you might very well do better with a stock-bond portfolio between now and age seventy than you will if you are entirely in stocks.

What would this look like?  Let’s say that you were invested 50% in Vanguard S&P 500 Fund and 50% in Vanguard Small Cap Fund with a $4 M portfolio at the start of 2017.  If you were to have shifted $800,000 from each fund into the Vanguard Total Bond Market Fund you would then have had $1.2 M in the S&P 500 Fund, $1.2 M in the Small Cap Fund, and $1.6 M in the Total Bond Fund.  In 2017 you would have received $24,400 and $18,350 in dividends from the S&P 500 and the Small Cap Funds, respectively, and $41,000 from the bond fund.  This means you’d have about $84,000 in income from your funds each year.  You would also make substantial capital gains in the stock fund during 2017, making $316,000 from the S&P 500 Fund and $213,000 from the Small Cap Fund.  This would mean that your total return for 2017 would have been about $613,000, or about 14% for 2017.

You would have done better during 2017 if you had been entirely invested in stocks, but if stocks had declined a bit during the year, you would still have $84,000 in income to use as needed while you were waiting for your stock portfolio to recover.  If 2017-2027 looks like 2000-2010, with the meager stock market returns during that period, you would gain about $400,000 over the period with an all-stock portfolio.  If you had the stock-bond portfolio, you would still gain about $1,080,000 through the period due to the dividends and interest payments that you were collecting during the time.  You would have substantial gains from your portfolio, rather than having a lost decade.

So, in conclusion, while you will probably do better with all stocks over long periods of time (two decades or more), you might actually do better if you mix in some bonds for shorter periods of time.  This is because the high stock returns are due to a few short periods, while bond returns are fairly steady and constant.  So don’t fear the bond.  Learn to love it for the steady returns it provides.

Have a burning investing question you’d like answered?  Please send 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.

Is an Annuity Right for Part of Your Retirement Funding?


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top.  The posts will appear in reverse order, with the newest post first. 

I have recently gained a new appreciation for annuities, or at least the promise that an annuity holds.  At one point I swore off annuities entirely and there are good reasons to do so.  These include:

  1. You can do better investing the money yourself.
  2. The fees can be high.
  3. You generally have little flexibility once you have made the purchase, and may need to pay a big fee to receive any of the money back.

But then I realized the true purpose of an annuity is the same as it is for any insurance product:

To shift your risk to the insurance company in exchange for the cost paid.

All annuities pay you a specified amount of money for a specified period of time in exchange for you handing over a load of money to the insurance company.  For example, you give them $100,000 and they agree to pay you $500 per month for the rest of your life.  In many ways this is like a pension plan where you receive payments, except this is from an insurance company instead of an employer.  In fact, many employers that still have pension plans use annuities to make the payments once individuals retire so that they don’t need to worry about it.  They just buy an annuity that pays the former employee whatever is needed when they retire and then the employer’s part is done.  You can create your own pension using an annuity if you commit your 401k funds or other retirement savings.

Now while there are probably as many different kinds of annuities as there are stars in the sky, since they are all just insurance polices and the types are only limited by the imagination of the companies that create them, there are really only two types of annuities that should hold any interest for you.  These are immediate annuities and deferred annuities.  And here we just want the plain vanilla types – no bells and whistles.

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Immediate annuities are just that – you give them money and they immediately start making payments to you.  These are used to provide regular income without needing to worry about what the markets are doing, buying and selling mutual funds, or performing other actions.  Deferred annuities pay after you reach some certain date, for example, starting to pay you $5,000 per month after you reach age 85.  These are used as insurance against outliving your money.

So why are annuities not as good as investing yourself, in general?  The reason is both that they charge fees (which can be big) and the return you get from an annuity, including fees, will not be as great as you would get if you had invested yourself.  For example, if you were to invest $1 M at age 65 in a balanced stock and bond portfolio, you would be able to receive about $40,000 per year, indexed for inflation, until you were age 95.  At that point you would have on average about $2 M in the account and have received about $1.8 M in payments during that time.  The $2 M would be able to buy about what $1 M can buy today, so you would effectively have all of the money you started with, plus have received an income to fund a $40,000 (in year 2018 dollars) per year lifestyle.

If instead you were to put the money into an immediate annuity, you might start getting paid about $75,000 per year, fixed.  If you then died at age 95, you would have received about $2.25 M during that period.  This sounds better than the $1.8 M you received from the investment portfolio, but the insurance company would keep the money you gave them when you died, leaving nothing for you to pass on to your heirs or from which to pay for your final expenses.  You would have gotten $450,000 less in income from investing, but would have $2 M in savings remaining instead of nothing.  Because an account can withstand about a 4% withdrawal rate without declining in value over time, spending at this rate can be done essentially forever, assuming no black swan market event occurs.

In addition, while you would start out better with the annuity, receiving $75,000 per year instead of $40,000 per year from the investment account, by the time you were 95 you would be receiving about $80,000 per year from the investment account where you would only be receiving $75,000 per year from the annuity.  While your spending power would start out greater with the annuity, the payments from the investing account would pass it up along the way and you’d be having a little more trouble meeting expenses with the annuity near the end.

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So why would you want to have an annuity instead of just investing yourself?  The beauty of the annuity is that you would (nearly) eliminate the risk of a market drop affecting your income.  Annuities also help protect you in the case that you live longer than average since many of them pay income until you die.  In fact, you’ll be able to utilize more of your money while you are alive using an annuity than you would investing yourself because, while you would need to limit your withdrawals to make sure you didn’t run out of money before you die if you’re investing yourself, the insurance company knows that if they sell 10,000 annuities, the average age at which people will die and distribution of ages is predictable and they can determine with a fair amount of certainty how much they’ll need to pay out.  They are therefore able to provide a higher payout per month than they could if they were just insuring a single person who might live to be 115.  If they know from historic data that the average person would live to age 84, for example, and how many people will live longer, they can determine the maximum payout they can make and not lose money.

Note that if you die young, say at age 66 when you buy the annuity at age 65, the insurance company would probably keep your whole $1 M.  This makes up for the people who live to be 100 and withdrawal more than the insurance company can make from their investment.  This is the nature if insurance – some people pay for more than they use to make up for those who pay for less than they use.     

And therein lies the reason that some people would want to use an annuity and others should invest for themselves.  If you are interested in leaving a lot of money to your kids or a favorite cause and you have enough money saved to allow you to generate enough income for expenses using 3-4% of the value of your savings each year, invest yourself.  If you don’t want to leave money, yet you don’t want to risk running out of money either, use an annuity.  You could also do a little of both, using an annuity for a portion of your savings to gain the additional income, but keep some invested in stocks to provide growth to allow you to increase your income should you live a long time and inflation starts really affecting the buying power of your annuity payments.

As far as what an annuity can and should pay you. realize that the insurance company will invest the money, probably mostly in common stocks if they don’t use the money to underwrite other insurance policies,.  The most they could pay would therefore be equal to the withdrawal rate they could make for the average life expectancy and have the money last.  As an example, if a person who is 65 buys and $1 M annuity and the insurance company figures out that the average person in the buyers risk-pool is likely to live 30 years, they could pay about $5368 per month or $64,418 per year if they were able to make an annualized rate-of-return of 5%, or about $7337 per month or $88,050 per year if they were able to make an annualized rate-of-return of 8%.

The amount they would offer would be somewhat less than this since they would take a fee off-the-top to pay the person selling you the policy, plus the insurance company would want to make a profit from the policy to make it worth their time, plus they may want to pay a bit lower than they would expect to make in case the markets don’t perform well during the period and don’t return as much as they were expecting.  They might therefore offer you $4500 per month if they were expecting to make 5% instead of the $5368 per month that they were expecting to make investing the money.  If there is ample competition (and you should shop around to make sure you get the maximum pay-out you can while still using a solid provider), you should get a reasonable return and their profit should be reasonable for the risk they are taking and their costs.

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Annuities are also a great choice if you have not saved as much as you really should have.  For example, if you have only saved up $250,000 by retirement, plus you have a home worth $500,000, you could maybe downsize or move to a lower-cost area and pull $350,000 out of your home.  (You could also possibly use a reverse-mortgage if you wanted to stay in your home, but again you would be paying a lot of fees in doing so.)  You could then take the $600,000 you had available and maybe buy an annuity paying $3,000 per month, or $36,000 per year.  Combined with Social Security, you should be able to make it through, although it might get tight if you live a long time after retirement.  You should therefore work as long as you can and build up all that you are able before you retire.  This will both increase your possible pay-out and reduce the number of years you’ll be in retirement.

But what if you want to have a good chance of spending most of your money, but want to get a better return that you will from an annuity?  If you have saved enough to fund your monthly expenses from investment returns, there is a way that you can invest yourself and still use more of your money than you will if you limit yourself to a 3-4% withdrawal, yet still have a low chance you will outlive your money.  The secret is to start out conservative, but then increase your withdrawal rate as you go.

For example, if you had $1 M and retired when you were 65, you would start out at 4%, or $40,000 per year.  At this rate there is a good chance your portfolio value will not drop at all (in inflation-adjusted terms).  If you wanted to be even more conservative, you could limit yourself to 3%.  After five years, at age 70, you could start spending at a rate that would exhaust your savings in 30 years, assuming some reasonable rate-of-return.  For example, as shown before, a 5% rate-of-return would result in a yearly payment of $64,418 as shown before.  Because your chances of living to 100 are fairly low (depending on the ages of your parents when they died, your current health, and other factors), you are fairly safe increasing your spending and starting to spend down your savings at this rate.

If you are still worried, you could also take some of the money and buy a deferred annuity that kicks in at age 90 or something.  Since it is unlikely that the insurance  company would expect you to receive many (or any) payments from this policy, the amount you would need to contribute to receive enough income for expenses at age 90 and beyond would be fairly low.  Plus, your expenses at age 90 if you live that long will likely be fairly modest.

Have a burning investing question you’d like answered?  Please send 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.

How Every 16 Year-Old with a Job Can Retire a Millionaire


I’ve been encouraging a couple of twins who I’ve known since they were five to start an IRA since they are now 17 and working a job at a grocery store.  An IRA, or individual retirement account, is a little gift from the government that allows individuals to save money either tax-deferred or tax-free.  They come in two flavors: Traditional and Roth.    A traditional IRA is tax-deferred, meaning you pay no taxes on the money you invest or any of the money you make in the account until you withdraw it at retirement age.  With a Roth IRA, you pay taxes on the money you invest, but then pay no taxes on the money you withdraw or the interest it earns.

So how would these little wonders turn a 16 year-old into a millionaire at retirement?  Well, if one of the twins were to open an IRA and put $4,000 in it, and then invest entirely in a diversified stock mutual fund like the Vanguard Total Stock Market Fund, it would double in value about every six years. Because it would double eight times between the time they were 16 and 65, every dollar they put into it would be worth $256 when they reached 65.  This means that $4,000 would be worth about  $1 M at retirement age, even if he invested nothing else after putting the original $4,000 away.

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If he invested in a traditional IRA, he would also save on the taxes on the year he put the money into the IRA.  If he were in the 10% tax bracket, he would get to keep $400 more of his money right now, so it is like he gets extra money for making the investment.  Went he withdrew the money from the IRA at age 65, however, he would be taxed on the money he was withdrawing.  If he were in the 25% tax bracket during retirement, this would mean that he would actually only get $750,000 after taxes.

If he invested in a Roth IRA, he would not get a tax break now, so he would pay $400 more in taxes now.  But when he withdrew money at age 65, he would get to keep all of the money he earned, tax-free.  This means he would get to keep the whole $1 M.  The only catch is that he would need to find the extra $400 to invest.  (In fact, if he invested that extra $400 he got to keep from taxes when he invested in the traditional IRA, putting in $4,400 instead of $4,000, he would end up with the same amount of money after taxes as he would have had with a Roth IRA if his tax rate at retirement were the same as it was when he was working.)

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For the twins, I’m advising they go to Charles Schwab since they offer an IRA account with a $1 minimum investment.  This means they could put whatever they can this year, even if it is only $100, an then add to it as they can.  If they could get used to putting in $20 per paycheck, that would get them to a little over $1,000 per year.  They could also go to Vanguard, but they require a $1,000 minimum to start.  Both are great companies with a wide selection of funds to choose from for investments.

Filling out the paperwork and opening the account only takes 15 minutes or so online.  Because they are minors, the twins would need to have a parent be a custodian on the account until they turn 18.  After opening the account, they would just need to send in a check or send money from a bank account electronically, then choose investments.  At Schwab, I would start with the Schwab Total Stock Market Index Fund (SWTSX).  At Vanguard, I would buy the Vanguard Total Stock Market Index Fund if I had the minimum $3000 to invest, otherwise I would choose the 2065 Target Date Retirement Fund which only has a $1000 minimum.

 

So what else do you need to know about IRAs?  Well, there are some important rules:

  1.  You must have earned income equal to or exceeding the money you put into the IRA during the year you put the money in.  This means you need to make at least $4,000 from a job or from running a business in 2018 if you want to put $4,000 in an IRA this year.
  2. Right now you can put in up to $5,500 per year.  If you were to put $5,500 away each year between age 16 and age 35, you would be absolutely set for retirement, no matter what else you did financially.  (Lone exception, you must not touch the money in the IRA and it must stay invested in a diversified stock portfolio your whole working life.
  3. If you take the money out early (before retirement age), you’ll pay a penalty plus you’ll need to pay taxes on the money.  (Actually, there are a couple of exceptions with the Roth IRA, but why would you want to raid your retirement funds? Just stay invested.)
  4. With a traditional IRA, you’ll be forced to start taking the money out when you’re about 70 1/2 years old, so you may need to pay some hefty taxes then, especially if you invested a lot more than the original $4,000 and have several million dollars in the account.  With a Roth IRA, there is no need requirement to take the money out ever, so you could let it grow for another 30 years and leave it all to your heirs, if you wished.

Have a burning investing question you’d like answered?  Please send 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.

Building a Retirement Portfolio with Mutual Funds


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Let’s say that you have $2M saved up in your 401k and are ready to retire.  Let’s also say that you need about $50,000 per year to live on the first year, with that amount growing with inflation each year.  Today we’ll discuss how you would use a set of mutual funds to to generate the income that was needed while keeping up with inflation to avoid outliving your money.

The rule-of-thumb is that you can withdraw somewhere between 3% and 4% of your portfolio each year and have a very good chance of having it last through a 30-year retirement.  In fact, the balance could grow under a lot of scenarios.  Withdrawing $50,000 per year from a $2M portfolio would therefore be right in line  with the guidance, since you could withdraw about $60,000 per year and stay at the low end of the range.  You have done well saving and investing throughout your career to put yourself in good shape for retirement.

Ideally you would generate a lot of the income you need for expenses from income producing assets.  You would therefore put a portion of your portfolio in an income or a bond portfolio.  You would also want a portion of the portfolio to grow and keep up with inflation, so you would want to invest the rest in growth and value stock funds.

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We’ll use Vanguard funds as an example.  Looking through their list of funds for income funds, I find the Vanguard Total Bond Market Index fund.  This is a fairly safe fund, although the price could decline if interest rates rise or a serious recession occurs that causes several companies to default on their loans.  In general, as long as I planned to hold this fund regardless of interest rate changes such that price drops due to rising interest rates would not be an issue, chances are good that I would not have any issues.

It is described at the Vanguard website as:  “This fund is designed to provide broad exposure to U.S. investment grade bonds. Reflecting this goal, the fund invests about 30% in corporate bonds and 70% in U.S. government bonds of all maturities (short-, intermediate-, and long-term issues). As with other bond funds, one of the risks of the fund is that increases in interest rates may cause the price of the bonds in the portfolio to decrease—pricing the fund’s NAV lower. Because the fund invests in all segments and maturities of the fixed income market, investors may consider the fund their core bond holding.”

This fund is yielding about 2.5%, so a $1M investment would be paying about $25,000 in interest each year, plus a capital gain from time-to-time.

There is also the High Yield Corporate Bond fund, which is paying about 5.1%, or about $51,000 per $1M invested.  This fund is more risky since the bonds it is investing in are low quality, meaning the companies would be more likely to default than they were with the first fund.  During a recession, I would see some bigger losses in this fund, so I would want to limit my exposure despite the higher yield.  It is described at the Vanguard website as:

“Vanguard High-Yield Corporate Fund invests in a diversified portfolio of medium- and lower-quality corporate bonds, often referred to as “junk bonds.” Created in 1978, this fund seeks to purchase what the advisor considers higher-rated junk bonds. This approach aims to capture consistent income and minimize defaults and principal loss. Although this is a bond fund, high-yield bonds tend to have volatility similar to that of the stock market. This fund may be considered complementary to an already diversified portfolio.”


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I would also look at REITs, which invest in real estate and also generate a reasonable cash return due to the properties in which it invests.  The Vanguard Admiral REIT fund is described as:

“This fund invests in real estate investment trusts—companies that purchase office buildings, hotels, and other real estate property. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a portfolio already made up of stocks and bonds. The fund may distribute dividend income higher than other funds, but it is not without risk. One of the fund’s primary risks is its narrow scope, since it invests solely within the real estate industry and may be more volatile than more broadly diversified stock funds.”

It is yielding about 4.3%, or $43,000 per year for a $1 M investment.  REITs would move around a bit since their value depends on the value of the properties it holds, rents they can charge, and other factors.  This portion of the portfolio would also have a growth component since the property values would increase with inflation and as fewer properties were available to buy for a growing population.

You would want your investment mix to be maybe 50% income, 50% growth at 65 years old, so that would leave $1M to invest among these three funds.   I would probably put 50% in the safer bond fund, 25% in the junk bond fund, and 25% in the REIT fund.  This would result in an income of:

Total Bond Fund: $500,000 invested, income $12000/year

High Yield Bond Fund:  $250,000 invested, income  $13,000/year

REIT Fund: $250,000 invested, income $11,000/year

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Your total income would therefore be about $36,000 per year, so you would be about $14,000 per year short of your income goal.  The remainder would need to come from selling stocks off each year, plus a little bit of income from dividends.  For stocks I would look at the Large Cap Index Fund, which is paying out about 1.8% per year, the Small Cap Index Fund, which is paying out about 1.4%, and the Total International Index fund, which is paying out about 2.8%.  With the remaining $1M I would put about 25% in the international fund, and then put 50% in the large cap fund and 25% in the small cap fund.  This would generate income as follows:

Total International Fund:  $250,000 invested, income $7,000 per year

Large Cap Index: $500,000 invested, income $9,000 per year

Small Cap Index:  $250,000 invested, income $3500 per year

So your total income from your stock portfolio would be about $19,500 per year.  Summed together with your bond portfolio, this would equal $54,500 per year in income.  Because you are actually generating more income than you needed, you could either reinvest a portion of the income each year into stocks or bonds.  You could also cut your bond exposure a little and let more of your money grow at the faster, stock market rates.  You could expect a growth rate of about 8% on average from your stocks.

 

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Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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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.

Retirement Investing Choices: Annuities


This is part of a series of posts for an online class on how to use your investments to fund your retirement.  To find other posts in the series, select the category  “Retirement Investment Class” under “Retirement Investing” at the top. 

Now that we’ve discussed how much you need to save for retirement and provided some information on mutual funds and ETFs, we can start to discuss some of the different investment options for your retirement portfolio and their role in the big picture of things.  Today we’ll start with an asset called an annuity.

An annuity is an income vehicle issued by an insurance company.  In exchange for turning over some of your money to the insurance company, they agree (guarantee) to pay you a specified amount of money for a specified period of time, which could be the rest of your life.  Because annuities are insurance contracts, there are all sorts of different types, limited only by the insurance company’s creativity in designing a product they hope they’ll buy.

The main benefit of an annuity is the guaranteed income.  That guarantee comes at a price, however, in that the income you receive will be less than the income your money could have generated if you had invested it on your own.  They should therefore be used when security is more important than return, or if you simply don’t want to fool with things and are willing to accept less in exchange for your time and effort.  Annuities are a fix-it-and-forget-it type of investment.

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The most basic type of annuity, called an immediate annuity, simply pays you a specified amount of money starting immediately for a prescribed period of time, often the rest of your life.  For example, let’s say that you buy an immediate annuity at age 70, giving the insurance company $1 M.  They may in exchange give you $4,166 per month, or $50,000 per year, for the rest of your life.  If you live to age 90, you would then have collected $1 M back from from the policy.  If you live to age 100, you’ll have collected  $1.5M.

All policies are different, so you should read the terms carefully, but many policies would simply keep your original $1 M investment when you died.  So if you die at age 71, you would have only receive $50,000 back from the insurance company for the $1 M you gave them.  They would make out very well on the policy.  This makes up for the people who live to age 100, and is the nature of insurance – they make lots of money from some policies to make up for the others where they lose money.  Some policies might reimburse your heirs a portion of the investment if you die before a certain age, but this is not a certainty.  Again, the are contracts between you and the insrance company and can all be different, so you should carefully read and understand the terms (and maybe have an attorney or CPA read the policy as well) before you buy anything.

 

Another popular type of annuity doesn’t pay right away, but instead starts to pay when you reach a specified age in the future.  These are useful if you’re worried about running out of money later in life.  For example, at age 50 you could buy a policy that starts to pay you a monthly amount at age 80.  The earlier you buy these policies, the less they cost for a given pay-out (since you’re taking a chance that you’ll never reach that age, plus you’re letting the insurance company use your money for all of those years).  These can be a very useful way to guarantee that you won’t be destitute should you live a long time.  They are also relatively inexpensive since there is a real possibility the insurance company may get to keep the money and never pay out anything.  The later in life the policy starts pa, the less it should cost.

While there are limited exceptions (insurance companies spend a lot of money doing calculations and making sure that they come out ahead), on average you’ll not do as well with an annuity as you would have had you invested on your own.  While you might be taking some of the insurance company’s money if you live to age 100, most people will not live past 85 or 90.  Taking the same example of a $1 M nest egg described above, if you had invested the money instead of buying an immediate annuity, a properly designed portfolio of stocks and bonds should allow you to withdraw about $30,000 – 40,000 per year for the rest of your life, indexed for inflation, without ever touching the principle.  This means you could have withdrawn about $1,050,000 between the ages of 70 and 90 and still have had $1.6 M to leave to your kids when you died.  This is compared to receiving $1 M from the annuity and having nothing to leave your kids.

If you lived to age 100, you’d have withdrawn about $1.8 M from the portfolio, versus receiving $1.5 M from the annuity, and now have $2 M to leave to your kids (which will buy what $1 M buys today).  Investing on your own, instead of buying an annuity, will generally result in you both receiving more income while you are alive and in you having more money to pass on to your kids.

So, with an annuity, you’re trading risk – the risk that you won’t invest well or that the markets just won’t cooperate – in exchange for giving up some return on your money.  The insurance company now takes on this risk and needs to find ways to invest the money to ensure that they have enough money to pay the policy holders while still making a reasonable profit.  They set their pay-outs in such a way to make sure that they cover this risk, on average, just like how set their car insurance rates high enough to cover claims and still make money.  The amount they pay is also generally fixed (for example, $50,000 per year), so your spending power will decrease over time due to inflation.

You may worry that an insurance company may charge you way too much for an annuity, resulting in a huge profit for them, but market forces should generally take care of this for you as long as you do your part and compare products from several different providers to get the best deal.  As long there are enough insurance companies out there competing for your business, you should get the maximum return possible with the insurance company making just enough money on your policy to pay the person who sold it to you, keep the lights on, and make a reasonable profit for their shareholders.  You’ll still be paying for all of this overhead, but that is what you are trading for the security of a monthly payment instead of the less unpredictable returns from an investment portfolio.  Just make sure you do your part and shop around for the best return, since once you buy in it is expensive to undo the deal, even when you can.

Realize also that people selling annuities to you generally make a commission from the sale, which both adds to the cost and makes them eager to sell you something, even if it isn’t the best thing for you.  Many of these salesmen know little about what they’re selling.  They just know what they’ve been told to tell you to get you to buy.  In general the choice to buy an annuity should be yours, not the result of a high-pressure sale, and you should take the time to read the policy and review it with whatever professionals you need to make sure you’re making a good decision.

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Some annuities also make offers of additional potential returns based on the stock market or come with other bells and whistles. While this may sound enticing, you’ll do better just buying a smaller annuity and investing the rest of the money yourself.  Remember that the insurance company needs to make money, so the returns they’ll provide will be well lower than market returns.  Only buy annuities when you want a guaranteed return, not as a way to invest in the stock market.

Finally, know that the guaranteed return from an annuity is only as good as the insurance company who you buy the policy with (and whomever they sell it to).  If we see another Great Depression, it is very likely that the insurance companies would all go broke and leave policy holders in the lurch.  Because they need to invest the money in the markets themselves, if most businesses are going bankrupt, they would not have the money to pay out the payments each year in a collapsing market.  Note that the supposed “great recession” was nothing like the Great Depression.  Luckily such market events happen fairly rarely.

Have a burning investing question you’d like answered?  Please send 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.