What to Invest in with your 401k


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When investing your 401k money, it is critical to diversify, where you allocate your investments into different asset classes.  In a good 401k you’ll have choices of asset classes among:

  1.  Large US Stocks Index Funds
  2. Mid-sized US Stocks Index Funds
  3. Small US Stocks Index Funds
  4. US Bonds
  5. Real Estate Investment Trusts (REITs)
  6. International Stocks
  7. International Bonds
  8. Managed Large-Cap Stocks
  9. Managed Small Cap Stocks
  10. Emerging Growth Stocks
  11. Target-Date Funds
  12. Money-Market Funds

In a bad 401k fund, you may only have a few of these choices, and those that you do have will all be managed funds with big fees (of more than 1%).  A great plan may have even more of these choices, although the list above is more than adequate for good diversification.

       

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Given the choices above, here is how I would typically set up my 401k:

  1.  Large US Stocks Index Funds  (15%)
  2. Mid-sized US Stocks Index Funds  (20%)
  3. Small US Stocks Index Funds (20%)
  4. Real Estate Investment Trusts (REITs)  (20%)
  5. International Stocks  (15%)
  6. Managed Large-Cap Stocks  (10%)

Notice that I have about 25% in large US stocks, 40% in medium and small US stocks, 15% in international stocks, and 20% in real estate.  Factors that go into these decisions:

  • Sometimes large stocks do better than small and medium stocks.  Other times small and medium do better than large.  I want to be in both places so that I’m invested in those areas regardless of which is doing best at the time.
  • Over long periods of time, small and medium stocks will outperform large stocks.  I therefore have slightly more invested in medium and small US stocks (40%) than I do in large (30%).
  • I want to have things that may do well when the stock market is undergoing a correction.  Real-estate is normally fairly uncorrelated to stock movements (except for 2008, when a real estate bubble cratered the stock market).  I therefore have 20% in real estate, which will provide returns almost as good as the stock market over long periods of time since REITs have both rental income and appreciation of property values.
  • I have some money in a managed, large US stock fund, simply because the particular funds I have in my 401k have a track record of great investment returns when compared to the S&P500.  Normally I would forego these and just invest in index funds since the fees are higher for managed funds and performance is normally about the same as index funds, but so far the managers have shown themselves worth the fees charged in my case.
  • I have some international exposure as well.  Most of the time, the action is in the US, but during some periods international stocks do better.  I always want to be invested in whatever is doing well at a given moment.

       

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An important aspect if you want to do well is discipline.  You need to decide upon your allocations and stick with them through think and thin.  At times, it is difficult to stay invested the way I should.  For example, in late 2016 with the Brexit and other events, the international stock fund in my 401k has been doing poorly over the last year, while US stocks have been doing well.  I was very tempted to drop the international stock fund and just be in US stocks, given the performance.

This would have been exactly the wrong thing to do, however.  Since international stocks have been doing poorly, while US stocks have been on a roll, the price of US stocks has been bid-up and international stock prices have dropped and some stocks may be under-priced.  We may very well see a shift from US to international stocks as investors look for bargains outside of the US.  When that happens, I certainly want to be there.

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.

401K Changes that Would Work


IMG_0120401k plans are better than traditional pensions and way better than Social Security, if they are used correctly.  The issue is that they are not used correctly.  People are too timid and leave all of their money in the money market or treasury fund their entire careers, missing out of the growth they could have had if they had invested.  They don’t enter the plan until they are in their forties or fifties, or contribute far too little.  They are too aggressive when they are nearing retirement, usually because they are trying to make up time, and see a market crash wipe out half of their portfolio value right when they were ready to head out-the-door.  They borrow against their 401k plan, or take the money out entirely, and lose the effects of compounding.

These issues could be easily solved.  The reason they occur is the rules behind 401k plans that allow or even encourage behaviors that are destructive to the employees retirement.  People have no choice in the amount they contribute to Social Security or pension plans.  The employer or the government dictates how much of the employee’s pay is contributed and how much they provide.  And at least with Social Security, you have no choice but to participate.  You are enrolled whether you like it or not.  Employees can choose not to enter the pension plan at some companies, but most realize that they should and they do enroll.  Likewise, you can’t borrow against your pension plan or Social Security or take it out early.  In the case of pension plans, they are invested in a mix of stocks and income investments in a manner that is appropriate for the goals of the plan and the payouts that must be made.

The sad part is, if people were to put all of the money they are putting into Social Security (about 13% of their paycheck) into a 401k plan and invested it properly, everyone who worked their whole life would be set for retirement.  There would be no issue paying for living expenses and medical bills.  The senior discount would vanish since most seniors would be multi-millionaires.  Unfortunately, people don’t think about their futures and plan.  They either see the big pile of cash they’ll need to build up to have  comfortable retirement as being either too difficult to achieve or retirement too far out in the future, so they sabotage themselves.  Much as I hate to see central government planing and control, some regulation is needed to nudge people in the right direction.  Unlike Social Security, where the government has proven that they’ll just squander any money given to them, however, government involvement should only extend to preventing people from drawing the money out to soon, not enrolling at all or not contributing enough,  or investing the money in a way that is too timid early or too aggressive late.  Here are some regulations that would make 401k plans the path to comfortable retirement for all:

1.  Required enrollment.

Employees should be required to contribute at least 5% of their pay to a 401k plan to ensure they’re putting enough away for at least a basic retirement.  While I hate to force people to do anything, it is for the good of society to not have a group of destitute retirees.  As an incentive to contribute more, the rules could eliminate the need to make a Social Security contribution if at least 10% of an employee’s paycheck is being contributed to a 401k, between the employee’s contribution and the employer’s.

2.  Forbid withdrawals until age 62, then limit withdrawals until age 70.

There is no good reason for people to be pulling their retirement savings out early, and again, doing so subjects society to the burden of carrying a lot of destitute old people.  No withdrawals should be allowed until the employee has reached at least the age of 62 (which also encourages people to work longer and reduce the number of years they’ll need to be supporting themselves with their savings).  To prevent people from pulling all of the money out at age 62 and blowing it, they should only be able to pull out a portion, like 5%, each year until they are age 70.  Hopefully by that point they will have learned that it is a good thing to take the money out slowly since then the account has the ability to recover and generate more money and they’ll continue that behavior from then into old age.

3.  Eliminate borrowing of funds.

Just as funds should not be withdrawn, they should not be borrowed.  If people want to pay down credit cards, start a business, or upgrade their home, they should find the money elsewhere than their retirement savings.  People shouldn’t live beyond their means at the expense of their retirement funds.

4.  Remove the money market option for those under age 58.

There is zero reason for anyone to have a dime in a money market fund within a 401k account until they are getting close to using the money.  Removing this option would force employees to invest the money, which would allow the money to grow and prevent inflation from reducing their spending power in retirement.

5.  Require a professional money management option.

Most people know little about investing.  An option where a professional money manager just invests the money for employees should be included.  This would be similar to a traditional pension plan, except the money manager could invest for groups of employees separated into different age brackets instead of investing everything as one big account.  Because there would just be a few, large accounts (maybe three), instead of a lot of little accounts to manage, and because the manager would be investing in mutual funds instead of individual stocks, the cost would not be very much.

6.  Limit the contribution of company stock by employers.

Some employers like to issue company stock as their contribution instead of giving cash because cash is more precious.  This puts an employee in a risky position since he/she then has a big position in one company – their employer’s.  They could both lose a job and see their 401k decimated should the company misread market conditions.   A reasonable limit, such as 1% of salary, should be placed on the amount of company stock that can be issued by a company for a 401k contribution.  Alternatively, require a company match at least 5% of salary with cash before issuing stock so that the employee at least has 10% of his/her salary going into the 401k in a diversified manner before concentrating in company stock.  Employees should also be able to sell shares that a company distributes to them immediately and shift the money into mutual funds where it will be appropriately diversified.

7.  Require low-cost index fund options in each plan.

Research has shown that low-cost, passive funds will beat out high cost, actively managed funds over time.  Unfortunately, some employers only have high cost funds available.  Every 401k plan should at least have the choice of a large cap, small cap, international, and bond index fund in their investment mix.

8.  Auto-enroll employees in a target date retirement fund.

Even when they do enroll (usually through automated enrollment), many employees tend to wait to get into their 401k plans and make their investment choices, sometimes for years.  Currently, many 401k plans auto-enroll employees in a money market fund, meaning they are losing money to inflation until they shift the money somewhere better.  Instead, they should be auti enrolled in a target date retirement fund so that at least they’ll have a reasonably good investment plan until they get the time and motivation to take a little more active role.

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

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

Financial Options for Paying for Retirement


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So perhaps you’ve been saving and investing for years, and now retirement is in your sights.  The question now is, “How do I use the money in my retirement accounts and other savings to pay for things in retirement?”  Today I thought I’d discuss some considerations and ideas.

How much income can I receive each month?

The first consideration is how much spending money will you have in retirement.   This information might also point to the need for a part-time job or other source of income in retirement.  A fairly good rule-of thumb is that you can withdraw about 3-4% of your net worth per year from your retirement account without the value declining in value in real-dollar terms.  (Here “real dollar” means dollars adjusted for inflation so that you’ll have the same amount of spending power as the years go on.)  If you withdraw more than this, you will be spending your portfolio over time and eventually run out of money, assuming you live long enough.

For example, let’s say you have a portfolio (401k, IRA, savings, etc…) totaling $750,000.   You would be able to spend about 0.03*750,000 =  $22,500 per year without seeing the value of the portfolio decline and be able to leave your heirs about the same amount of money when you died.  Monthly this would be about $1875.  If you were just paying for a family of two, had the house paid off, drove old cars, and didn’t do much, this might be sufficient.  If you wanted a bit more of a lifestyle, you might need to work a part-time job to help with expenses.  You could also consider options such as selling your home and downsizing to increase the investment portion of your net worth.  If you pulled out $40,000 per year, the value would decline over time, meaning you might run into an issue in your 80’s or 90’s.

How can I generate the income I need?

The second aspect is how you use the money in your portfolio to generate the cash needed to pay for living expenses.  Here there are basically three options:  1)  Invest a portion of the portfolio in income producing assets to generate regular payment, 2) Sell some assets each year to raise cash, and 3) Buy an annuity to pay the income you need.  Let’s look at each of those options.

1.  Invest a portion of the portfolio in income-producing assets to generate income.

This is the traditional way of generating income for expenses.  It works well in times when interest rates are fairly high (not the current period).  Many people simply invested in bank CDs to generate income, but while the dollar value of bank CDs remains constant, value will be lost to inflation each year, plus the rate of return will always be lower than other options like bonds, real estate, and dividend-paying stocks.  You can choose this option if interest rates are sufficiently high to generate the income you’ll need and you’ll have enough left over to invest in growth assets like stocks to prevent inflation from reducing your rate-of-return in the future.

Typically the percentage of income investments when you retire should be around 50%, so if you can generate enough income from bonds and dividend-paying stocks using about half of your portfolio or less, while investing the remainder in growth stocks that will increase in value with time. this could be a good option.  Note that as you age, you would shift a greater percentage of your assets to income assets to increase the amount of income you receive each month to account for inflation.  When you were 80, you might be 70-80% in bonds and 20% in growth stocks.  You could buy individual. stocks and bonds, but it is usually easier to buy an income fund.  Also note that the higher the return you’re receiving, the higher the risk you’re taking.  It is generally a good idea to spread the risk out between safer, lower paying bonds and more risky, higher paying bonds.

2.   Sell some assets each year to raise cash.

The first strategy is probably best if you have just enough money to generate income for retirement.  If you have more than enough, you might still put a portion in bonds to help smooth out the volatility (having about 20% in bonds will greatly reduce the price level of value fluctuations in your portfolio without greatly affecting your total return), but plan on selling assets each year to raise cash for expenses.  Because growth stocks will provide greater returns than bonds and income stocks over long periods of time, this will provide more money to use in retirement and/or pass on to the next generation.  There will be volatility, however, so you need to have enough of a cushion to weather most market downturns that may occur.  This means you really should have at least twice the portfolio value required to generate the income level you really need since a 50% decline in stocks over a short period is not common, but it does happen once-in-a-while.

Part of using this strategy involves using cash to provide the money you need during the years when the market declines and you need to wait for the market to recover before selling more shares.  Since the market usually recovers within a year or less (although there are exceptions like the Great Depression), having a cash cushion will usually provide the time you need to avoid selling shares too cheaply and locking in losses.  Since having a loss over a five-year period is almost unheard of, having between three and five years’ worth of cash is a conservative strategy.  (Note “cash” here means bank CDs and money market funds – not $100’s in your mattress.)

If using this strategy, some level of opportunism should be used.  If there are years when the markets do really well, use the opportunity to raise some cash.  In years when the markets decline, maybe wait to sell unless your cash drops below some threshold, for example, 2 years’ worth of expenses.

3.  Buy and Annuity to provide a monthly payment.

When you buy an annuity, an insurance company invests your money and pays you a guaranteed amount per month for the rest of your life (or some other period depending on the terms of the annuity).  Because the insurance company wants to make money, they will always pay you less than the amount you could have received if you had just invested it yourself using strategies 1 or 2 above.  The difference is that the rate-of-return each year would vary if you invested yourself, where it would be guaranteed (provided the insurance company didn’t default) with the annuity.  The insurance company would get variable returns by investing your money, but make a higher return overall, where you would get a lower, but fixed (guaranteed) return.

Clearly, annuities have drawbacks.  The income they pay is often fixed in dollar terms, so your buying power may decline over the years due to inflation.  If you die young, your money may be gone so you may not have anything to leave heirs.  As stated above, you will not, on average, do as well with an annuity as you will do investing yourself (assuming you invest appropriately).  The exception may be if you live a really long time, but for everyone who lives exceptionally long, someone dies exceptionally early.

If you do choose to buy an annuity, avoid the fancy annuities that promise things like additional returns based on the market performance or other bells and whistles.  Just buy a simple annuity that pays a fixed amount (perhaps indexed to inflation), either immediately or at a certain age (if you’re worried about running out of money late in life) .    If you want to also get some market returns, hold back some cash and invest it yourself outside of the annuity.

Note finally that there is no reason to just choose one of these strategies.  You can mix and match them.  You could buy bonds and income stocks to generate some income, but also sell some stocks to raise cash to supplement what the bonds were paying, particularly in times like now when bonds aren’t paying much.   You could also buy an annuity to pay for something critical like food and basic necessities, then use bonds and growth stock sales to pay for luxuries like travel and home improvements.

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

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

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