Cage Match: Pension vs. 401k

June 26, 2013

Chuck Jaffe recently had a good retirement article on Marketwatch.  He covered a number of topics, especially longevity estimates, but he also had the most succinct explanation of the difference between how a pension and a 401k plan works.  Here it is:

In the days when corporate pensions were the primary supplement to Social Security, Americans were able to generate a lifetime income, effectively, by putting everyone’s lifetime in a pool, then saving and managing the pooled assets to meet the target.

The individuals in a pension plan would live out their lives, but the actuaries and money managers would adjust the pool based on the life experience of the group. Thus, if the group had a life expectancy of living to age 75 – which statistically would mean that half of the pensioners would die before that age, and half would die afterwards – longevity risk was balanced out by the group experience.

Now that we have shifted to making individuals responsible for generating their lifetime income stream, there is no pool that shares the risk of outliving assets.

The bold is mine, but the distinction should be pretty clear.  With a pension plan, you’re covered if you live a long time—because your extra payouts are covered by the early mortality of some of the other participants.  It’s a shared-risk pool.

In a 401k, there’s only one participant.  You.  In other words, you’re on your own.

With a 401k, the only way to cover yourself adequately is to assume you are going to live a long time and save a lot to reserve for it.  If you’ve got enough assets to cover yourself to age 100, the most negative outcome is that your heirs will think very fondly of you.  If you are covered for only a few years of retirement, you’ll need to either keep working, eat Alpo, move in with your kids, or possibly take up motorcycle racing and sky-diving.  None of those sound like great options to me.

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The Million-Dollar Illusion

June 11, 2013

Over the weekend, the New York Times had an article about retirement and the million-dollar illusion.  What, you may ask, is the million-dollar illusion?  Quite simply it’s the idea that $1 million dollars will be ample for retirement.  Jeff Sommer writes:

…as a retirement nest egg, $1 million is relatively big. It may seem like a lot to live on.

But in many ways, it’s not.

Inflation isn’t the only thing that’s whittled down the $1 million. The topsy-turvy world of today’s financial markets — particularly, the still-ultralow interest rates in the bond market — is upending what many people thought they understood about how to pay for life after work.

“We’re facing a crisis right now, and it’s going to get worse,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “Most people haven’t saved nearly enough, not even people who have put away $1 million.”

The article proceeds to go through the math of low interest rates and increasing longevity.  This is not new, but sometimes it is difficult to get clients to focus on the big picture.

The big picture is not whether the most recent quarterly return on their balanced account was +6.3% or +6.4%, but whether that account balance was $300,000 or $3 million.

Since industry sources suggest that only 3% of retail accounts ever have balances over $2 million, it’s probably most important to focus on savings.  This might be particularly important with younger clients, who, by and large, do not have defined benefit pensions to supplement Social Security.  (In fact, it’s not clear how Social Security might be modified or eliminated by the time they get around to collect it.)  The one thing younger clients do have on their side is time—time to contribute steadily to their 401k and to an outside investment account. With enough nagging from a qualified investment advisor and a reasonable investment plan, there is no reason that clients shouldn’t succeed.

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From the Archives: Life Expectancy at Retirement

May 13, 2013

retirement Life Expectancy at Retirement

Source: The Economist, via Greg Mankiw.

Americans, as well as citizens of many other advanced nations, now spend about twice as many years in retirement as they did a generation or two ago.  Aggressive saving and adherence to a well-thought-out investment plan are more important today than they have ever been.  It is a big mistake for today’s 65-year olds to no longer consider themselves to be “long-term investors.”

—-this article originally appeared 3/1/2010.  As you can see from the graphic, the average US 66-year old retiree spends another 15-20 years in retirement.  That’s long enough that investment performance is going to be important.

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Current Income

April 12, 2013

Investors lately are in a frenzy about current income.  With interest rates so low, it’s tough for investors, especially those nearing or already in retirement, to come up with enough current income to live on.  A recent article in Advisor Perspectives had a really interesting take on current income.  The author constructed a chart to show how much money you would have to invest in various asset classes to “buy” $100,000 in income.  Some of these asset classes might also be expected to produce capital gains and losses, but this chart is purely based on their current income generation ability.  You can read the full original article to see exactly which asset classes were used, but the visual evidence is stunning.

Source: Advisor Perspectives/Pioneer Investments (click to enlarge)

There are two things that I think are important to recognize—and it’s hard not to with this chart.

  1. Short-term interest rates are incredibly low, especially for bonds presumed to have low credit risk.  The days of rolling CDs or clipping a few bond coupons as an adequate supplement to Social Security are gone.
  2. In absolute terms, all of these amounts are relatively high.  I can remember customers turning up their noses at 10% investment-grade tax-exempt bonds—they felt rates were sure to go higher—but it only takes a $1 million nest egg to generate a $100,000 income at that yield.  Now, it would take more than $1.6 million, even if you were willing to pile 100% into junk bonds.  (And we all know that more money has been lost reaching for yield than at the point of a gun.)  A more realistic guess for the typical volatility tolerance of an average 60/40 balanced fund investor is probably something closer to $4.2 million.  Even stocks aren’t super cheap, although they seem to be a bargain relative to short-term bonds.

That’s daunting math for the typical near-retiree.  Getting anywhere close to that would require compounding significant savings for a long, long time—not to mention remarkable investment savvy.  The typical advisor has only a handful of accounts that large, suggesting that much work remains to be done educating clients about savings, investment, and the reality of low current yields.

The pressure for current income might also entail some re-thinking of the entire investment process.  Investors may need to focus more on total return, and realize that some capital gains can be spent as readily as dividends and interest.  Relative strength may prove to be a useful discipline in the search for returns, wherever they may be found.

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Retirement Stress

March 20, 2013

AdvisorOne ran an interesting article recently, reporting the results of a retirement study done by Franklin Templeton.  Investors are feeling a lot of stress about retirement, even early on.  And given how things are going for many of them, feeling retirement stress is probably the appropriate response!  In no particular order, here are some of the findings:

A new survey from Franklin Templeton finds that nearly three-quarters (73%) of Americans report thinking about retirement saving and investing to be a source of stress and anxiety.

In contrast to those making financial sacrifices to save, three in 10 American adults have not started saving for retirement. The survey notes it’s not just young adults who are lacking in savings; 68% of those aged 45 to 54 and half of those aged 55 to 64 have $100,000 or less in retirement savings.

…two-thirds (67%) of pre-retirees indicated they were willing to make financial sacrifices now in order to live better in retirement.

“The findings reveal that the pressures of saving for retirement are felt much earlier than you might expect. Some people begin feeling the weight of affording retirement as early as 30 years before they reach that phase of their life,” Michael Doshier, vice president of retirement marketing for Franklin Templeton Investments, said in a statement. “Very telling, those who have never worked with a financial advisor are more than three times as likely to indicate a significant degree of stress and anxiety about their retirement savings as those who currently work with an advisor.”

As advisors, we need to keep in mind that our clients are often very anxious over money issues or feel a lot of retirement stress.  We often labor over the math in the retirement income plan and neglect to think about how the client is feeling about things—especially new clients or prospects.  (Of course, they do feel much better when the math works!)

The silver lining, to me, was that most pre-retirees were willing to work to improve their retirement readiness—and that those already working with an advisor felt much less retirement stress.  I don’t know if clients of advisors are better off for simply working with an advisor (other studies suggest they are), but perhaps even having a roadmap would relieve a great deal of stress.  As in most things, the unknown makes us anxious.  Working with a qualified advisor might make things seem much more manageable.

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Target Date Fund Follies

March 7, 2013

Target date and lifecycle funds have taken off since 2006, when they were deemed qualified default investment alternatives in the Pension Protection Act.  I’m sure it seemed like a good idea at the time.  Unfortunately, it planted the idea that a glidepath that moved toward bonds as the investor moved toward retirement was a good idea.  Assets in target date funds were nearly $400 billion at the end of 2011—and they have continued to grow rapidly.

In fact, bonds will prove to be a good idea if they perform well and a lousy idea if they perform poorly.  Since 10-year future returns correlate closely with the current coupon yield, prospects for bonds going forward aren’t particularly promising at the moment.  I’ve argued before that tactical asset allocation may provide an alternative method of accumulating capital, as opposed to a restrictive target-date glidepath.

A new research paper by Javier Estrada, The Glidepath Illusion: An International Perspective, makes a much broader claim.  He looks at typical glidepaths that move toward bonds over time, and then at a wide variety of alternatives, ranging from inverse glidepaths that move toward stocks over time to balanced funds.  His findings are stunning.

This lifecycle strategy implies that investors are aggressive with little capital and conservative with much more capital, which may not be optimal in terms of wealth accumulation. This article evaluates three alternative types of strategies, including contrarian strategies that follow a glidepath opposite to that of target-date funds; that is, they become more aggressive as retirement approaches. The results from a comprehensive sample that spans over 19 countries, two regions, and 110 years suggest that, relative to lifecycle strategies, the alternative strategies considered here provide investors with higher expected terminal wealth, higher upside potential, more limited downside potential, and higher uncertainty but limited to how much better, not how much worse, investors are expected to do with these strategies.

In other words, the only real question was how much better the alternative strategies performed.  (I added the bold.)

Every strategy option they considered performed better than the traditional glidepath!  True, if they were more focused on equities, they were more volatile.  But, for the cost of the volatility, you ended up with more money—sometimes appreciably more money.  This data sample was worldwide and extended over 110 years, so it wasn’t a fluke.  Staying equity-focused didn’t work occasionally in some markets—it worked consistently in every time frame in every region.  Certainly the future won’t be exactly like the past, so there is no way to know if these results will hold going forward.  However, bonds have had terrific performance over the last 30 years and the glidepath favoring them still didn’t beat alternative strategies over an investing lifetime.

Bonds, to me, make sense to reduce volatility.  Some clients simply must have a reduced-volatility portfolio to sleep at night, and I get that.  But Mr. Estrada’s study shows that the typical glidepath is outperformed even by a 60/40-type balanced fund.  (Balanced funds, by the way, are also designated QDIAs in the Pension Protection Act.)   Tactical asset allocation, where bonds are held temporarily for defensive purposes, might also allow clients to sleep at night while retaining a growth orientation.  The bottom line is that it makes sense to reduce volatility just enough to keep the client comfortable, but no more.

I’d urge you to read this paper carefully.  Maybe your conclusions will be different than mine.  But my take-away is this: Over the course of an investing lifetime, it is very important to stay focused on growth.

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Underfunded Pension Plans

February 4, 2013

Many large corporations still carrying defined benefit plans for their workers have underfunded pension plans.  For example, here’s an excerpt from a Wall Street Journal article on the issue today:

“It is one of the top issues that companies are dealing with now,” said Michael Moran, pension strategist at investment adviser Goldman Sachs Asset Management.

The drain on corporate cash is a side effect of the U.S. monetary policy aimed at encouraging borrowing to stimulate the economy. Companies are required to calculate the present value of the future pension liabilities by using a so-called discount rate, based on corporate bond yields. As those rates fall, the liabilities rise.

If you think that underfunded pension plans are only a corporate or government problem, you would be wrong.  Chances are that the underfunded pension plan is a personal problem, even if (or especially if) you have a defined contribution plan like a 401k.  In a corporate plan, the corporation is on the hook for the money.  If you have a 401k plan, you are on the hook for the money.  And, since there is a contribution cap on 401ks, it may well be that you need to set aside additional money outside your retirement plan to make sure you hit your goals.

Figuring out whether your retirement is funded or not depends on some assumptions—and those assumptions are a moving target.  The one thing you know for sure is how much you have saved for retirement right now.  You might also have a handle on your current level on contributions.  What you don’t know exactly is how many years it will be until you retire, although you can generate scenarios for different ages.  What you don’t know at all is what the return on your retirement savings will be in those intervening years—or what the inflation rate will be during that time.

As interest rates fall, pensions are required to assume that their investment returns will fall too.  That means they have to contribute much more to reach their funding goals.

Guess what?  That means you should assume that you, too, will see lower returns and will need to save more money for retirement.  When stock and bond yields are low, it’s realistic to assume that returns will be lower going forward.  Investors right now, unfortunately, are stuck with rates that are near 50-year lows.  It puts a big burden on investors to get cracking and save as much as they can while they are working.  A qualified advisor should be able to give you some sense of your funding level so that you can plan for retirement.


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Are You the Millionaire Next Door?

January 31, 2013

Clients, in general, are bad about even trying to figure out what their retirement number is—that is, the pool of assets they will need to maintain their standard of living in retirement.  Even more difficult is figuring out if they are on track.  One simple method is mentioned in The Millionaire Next Door, by Thomas Stanley and William Danko.  From Yahoo! Finance:

Thomas Stanley and William Danko, authors of the bestselling book “The Millionaire Next Door,” suggest that you simply take your age and multiply it by your current annual income before taxes from all sources (except for inheritances, which are only paid once). Divide the total by 10, and the quotient is what your net worth should be at that point in your life.

So, for example, if you are making $80,000 per year and you are now 45 years old, this simple formula suggests that to stay on track your net worth should be about $360,000.  There are a lot of assumptions that go into this, obviously, and there are better and more accurate ways to figure out if you are on track (for example, we use a % funded spreadsheet), but it’s a start.  Given current return expectations, this simple formula might understate what you will require, but anything that will motivate clients to get moving in the right direction is a help.


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401k Abuse

January 18, 2013

With the elimination of traditional pensions in many workplaces, Americans are left to their own devices with their 401k plan.  For many of them, it’s not going so well.  Beyond the often-poor investment decisions that are made, many investors are also raiding the retirement kittyBusiness Insider explains:

Dipping into your 401(k) plan is tantamount to journeying into the future, mugging your 65-year-old self, and then booking it back to present day life.

And still, it turns out one in four workers resorts to taking out 401(k)  loans each year, according to a new report by HelloWallet –– to the tune of $70 billion, nationally.

To put that in perspective, consider how much workers contribute to retirement plans on average: $175 billion per year. That means people put money in only to take out nearly half that contribution later.

That’s not good.  Saving for retirement is hard enough without stealing your own retirement money.  Congress made you an investor whether you like it or not—now you need to figure out how to make the best of it.

Here are a couple of simple guidelines:

  • save 15% of your income for your entire working career.
  • if you can max out your 401k, do it.
  • diversify your portfolio intelligently, by volatility, asset class, and strategy.
  • resist all of the temptations to mess with your perfectly reasonable plan.
  • if you can’t discipline yourself, for heaven’s sake get help.

I know—easier said than done.  But still, if you can manage it, you’ll have a big headstart on a good retirement.  Your 401k is too important to abuse.

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Seven (Obvious) Steps to a Sound Retirement

December 11, 2012

When I first read this retirement article by Robert Powell at Marketwatch, I thought the advice was useful, but obvious.  Subsequent experience has led me to believe that while it may be obvious to a financial professional, it’s not always obvious to clients.  Clients, it seems, have pretty fuzzy thinking about retirement.

Here’s a retirement step that to me is obvious—but a lot of clients haven’t done it, or haven’t thought about it in a very complex way.  From Mr. Powell’s article:

1. Quantify assets and net worth

The first order of business is taking a tally of all that you own — your financial and non-financial assets, including your home and a self-owned business, and all that you owe. Your home, given that it might be your largest asset, could play an especially important part in your retirement, according to Abkemeier.

And at minimum, you should evaluate the many ways you can create income from your home, such as selling and renting; selling and moving in with family; taking out a home-equity loan; renting out a room or rooms; taking a reverse mortgage; and paying off your mortgage.

Another point that sometimes gets lost in the fray is that assets have to be converted into income and income streams need to be converted into assets. “When we think of assets and income, we need to remember that assets can be converted to a monthly income and that retirement savings are important as a generator of monthly income or spending power,” according to SOA’s report. “Likewise, income streams like pensions have a value comparable to an asset.”

One reason retirement planning is so difficult, according to SOA, is that many people are not able to readily think about assets and income with equivalent values and how to make a translation between the two. Assets often seem like a lot of money, particularly when people forget that they will be using them to meet regular expenses.

Consider, for instance, the notion that $100,000 in retirement savings might translate into just $4,000 per year in retirement income.

I put in bold a section that I think is particularly important.  With some effort, clients can usually get a handle on what their expenses are.  If they have pension income or Social Security benefits, it’s pretty easy to match income and expenses.  But if they have a lump sum in their 401k, it’s very difficult for them to understand what that asset means in terms of income.

After all, if they are just looking for an additional $3,000 per month in supplemental income, their $400,000 401k balance looks very large in comparison.  They figure that it will last at least ten years even if they just draw the funds out of a money market, so 20 years or more should be no problem with some growth.  At least I can only assume that’s what the thought process must be like.

Sustainable income is an entirely different matter, as clients almost never factor inflation into the thought process—and they are usually horrified by the thought of slowly liquidating their hard-earned assets.  No, they want their principal to remain intact.  They are often shocked when they are informed that, under current conditions, some practitioners consider a 4% or 5% income stream an aggressive assumption.

And, of course, all of this assumes that they have tallied up their retirement assets and net worth in the first place.  Lots of retirement “planning,” it turns out, works on the “I have a pretty good 401k, so I think I’ll be all right” principle.  I have a couple of thoughts about this whole problem.  What is now obvious to me is that clients need a lot of help understanding what a lump sum means in terms of sustainable income.  I’m sure that different advisors work with different assumptions, but they are still often not the assumptions your client is making.

Some practical steps for advisors occur to me.

  1. Encourage clients to track their assets and net worth, maybe quarterly, either on paper or on a spreadsheet.  At least they will know where they stand.  A surprising number of clients nowadays are carrying significant debt into retirement—and they don’t consider how that affects their net worth.
  2. Talk to them about what you consider reasonable assumptions for sustainable income.  Maybe you’re still using the good old 4% rule, or perhaps you’ve moved on to more sophisticated methods.  Whatever they are, start the conversation long before retirement so the client has a chance to build sufficient savings.

Sound retirement isn’t obvious, and planning for it isn’t simple or easy.

Note:  The rest of the article is equally worthwhile.

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Affluent Investors Settle Down

October 17, 2012

According to a Merrill Lynch survey of affluent investors, they are beginning to adapt to the current economic and market situation as the new normal, as opposed to looking at it as a temporary period of high volatility.  Perhaps because they’ve now made that psychological leap, affluent investors are beginning to feel that their situation is more stable.  From a Penta article:

To prepare for a more volatile environment, this affluent group also is making efforts to control what they can by spending less, paying down debt, and generally “putting their lives in check,” Durkin said. Of the families surveyed, 50% said they’ve taken steps to gain greater control of their finances, like sticking to a budget (32%), making more joint investment decisions with a spouse (29%), and setting tangible goals (28%). One third of respondents said they’re living “more within their means.”

In other words, the affluent are adapting by toggling back their lifestyle and saving more.

Making that psychological shift is critical because it allows a lot of good things to happen.  It’s also perhaps a realization that although you can’t control the markets, there is a lot you can control that will impact your eventual net worth—namely, living beneath your means and saving more.  Being affluent, in and of itself, won’t build net worth.

Once a client has good habits in place, compounding kicks in and net worth tends to grow more rapidly than clients expect.  Clients are usually delighted with this discovery!

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Retirement Income Failure Rates

September 13, 2012

Retirement income is the new buzzword.  New sales initiatives are being planned by seemingly every fund company on the planet, and there’s no end in sight.  Every week sees the launch of some new income product.  There are two, probably inter-related, reasons for this.  One is the buyers right now are generally leery of equities.  That will probably be temporary.  If the stock market gets going again, risk appetites could change in a hurry.  The second reason is that the front-end of the post-WWII baby boom is hitting retirement age.  The desire for retirement income in that demographic cohort probably won’t be temporary.  The trailing edge of the baby boom will likely keep demand for retirement income high until at least 2030.

Much retirement income planning is done with the trusty 4% withdrawal rule.  Often, however, investors don’t understand how many assumptions go into the idea that a portfolio can support a 4% withdrawal rate.  The AdvisorOne article Retirement in a Yield-Free World makes some of those assumptions more explicit.  The 4% rule is based on historical bond yields and historical equity returns—but when you look at the current situation, the yield is no longer there.  In fact, many bonds currently have negative real yields.  Stock market yields are also fairly low by historical standards, leading to lower expected future returns.  Here’s what the author, professor Michael Finke, had to say:

Estimating withdrawal rate strategies without real yield is a gruesome task. So I asked my good friend, occasional co-author and withdrawal rate guru Wade Pfau, associate professor at the National Graduate Institute for Policy Studies, to calculate how zero real returns would impact traditional safe withdrawal rates.

When real rates of return on bonds are reduced to zero, Pfau estimates that the failure rate of a 4% withdrawal strategy increases the 30-year failure rate to 15%, or just over one out of every seven retirees. This near tripling of retirement default risk is disturbing, but it is not technically accurate because we also assume historical real equity returns.

If we use a more accurate set of equity returns with a market-correct risk-free rate of return, the results are even more alarming. The failure rate of a 4% strategy with zero bond yield and a zero risk-free rate on equities is 34% over a 30-year time horizon. If real bond rates of return do not increase during a new retiree’s lifetime, they will have a greater than one in three chance of running out of money in 30 years.

The bottom line is that low expected returns may not support a 4% withdrawal rate as easily as occurred in the past.  (There may be a couple of more efficient ways to withdraw retirement income than the 4% rule, but the basic problem will remain.)

The practical implication of lower expected returns for future retirees is that they will have to save more and invest better to reach their goals.  Retirement income will not be so easy to come by, and behavioral errors by investors will have a greater impact than ever before.

We may not like what Bill Gross calls the “new normal,” but we’ve got to deal with it.  What can clients and advisors do proactively to ensure the best shot at a good retirement income stream?

  • encourage savings.  Maybe boost that 401k contribution a few percentage points and hector the client for regular investment contributions.
  • diversify by asset class, investment strategy, and volatility.  Don’t put all your eggs in one basket.  It may become important to pursue returns wherever they are, not just in stocks and bonds.  Diversifying your equity return factors may not be a bad idea.  We love relative strength, but value and low volatility mix well.  And it’s probably not a good idea to put all of your assets into cash or highly volatile categories.
  • get help.  There’s a wealth of evidence that good advisors can make a big difference in client outcomes.  A steady advisor may also reduce the chance of bad investor behavior, which can be one of the biggest barriers to good long-term returns.

Investing, even in good times, is not an easy endeavor.  With low or non-existent real yields, it may be even tougher for a while.

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More on the Value of a Financial Advisor

September 5, 2012

I noticed an article the other day in Financial Advisor magazine that discussed a study that was completed by Schwab Retirement Plan Services.  The main thrust of the study was how more employers were encouraging 401k plan participation.  More employers are providing matching funds, for example, and many employers have instituted automatic enrollment and automatic savings increases.  These are all important, as we’ve discussed chronic under-saving here for a long time.  All of these things together can go a long way toward a client’s successful retirement.

What really jumped out at me, though, was the following nugget buried in the text:

Schwab data also indicates that employees who use independent professional advice services inside their 401(k) plan have tended to save twice as much, were better diversified and stuck to their long-term plan, even in the most volatile market environments.

Wow!  That really speaks to the value of a good professional advisor!  It hits all of the bases for retirement success.

  • boost your savings rate,
  • construct a portfolio that is appropriately diversified by asset class and strategy, and
  • stay the course.

If investors were easily able to do this on their own, there wouldn’t be any difference between self-directed accounts and accounts associated with a professional advisor.  But there is a big difference—and it points out what a positive impact a good advisor can have on clients’ financial outcomes.

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Five Ways to Draw Retirement Income

July 20, 2012

Figuring out how to turn your portfolio into retirement income is a tricky thing because there are two unknowns: 1) you don’t know how the investments will perform, and 2) you don’t know how long you need to draw income.  A recent article from the Wall Street Journal discussed how to optimally tap a nest egg.  It references a study by Morningstar (a link to the Morningstar paper is included in the WSJ article) that compares five different methods.

The authors also propose a metric to determine how “efficient” the retirement income distribution method is.  Some of the methods are fairly heavy on math and count on the investor to use a mortality table and to determine portfolio failure rates using Monte Carlo simulation.  Others, like the 4% rule, are pretty basic.

The math-heavy methods work well, but in practice it might be a little more difficult to get a client to specify if they would prefer the calculation be made for a 50% chance of outliving their money or a 10% chance of outliving their money!  In my experience, clients are much more interested in methods that offer a 0% chance of outliving their money. Actuarial methods are somewhat dependent on the Monte Carlo simulation having a return distribution similar to what has been experienced in the past.  These methods might struggle in the case of a paradigm shift.

As far as simple methods go, the RMD (1/life expectancy or distribution horizon) method and the endowment method are both preferable to the 4% rule.  The RMD (required minimum distribution) method is easy to calculate and simple to adapt to whatever time horizon you choose.  The endowment method (taking a constant % of the portfolio) has the advantage of being relatively efficient over a wide range of asset allocations—not to mention that it has been tested in practice for decades.  Of course, both of these methods take into account the changes in the portfolio’s value, so your distribution may not rise every year.  In practice, endowments often smooth the portfolio value to reduce the income volatility.

The traditional 4% rule (withdraw 4% of the portfolio each year and adjust for inflation) is the worst of the rules tested.  It’s pretty easy for capital to be depleted if a difficult market occurs early in the retirement period because the withdrawals keep accelerating as the market value declines.

The robust methods (RMD and endowment) significantly reduce your chances of ever running out of money, but you have less certainty about year-to-year income as a result.  It’s what I would opt for, but every client’s situation is different.

With thousands of baby boomers hitting age 65 every day now, the Morningstar study deserves a close reading and a lot of thought.


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The Big Trend: Professional Asset Management Within the 401k

July 10, 2012

According to a Vanguard report, one of the big trends in the 401k market is the move toward professional asset management.  An article at AdvisorOne on this topic says:

One-third of all Vanguard 401(k) plan participants invested their entire account balance in a professionally managed asset allocation and investment option in 2011, according to Vanguard’s How America Saves 2012, an annual report on how U.S. workers are saving and investing for retirement.

The report notes that “the increasing prominence of so-called professionally managed allocations—in a single target-date or balanced fund or through a managed account advisory service—is one of the most important trends in 401(k) and other defined contribution (DC) plans today.”

Two things concerned me about the report.  I’m not at all surprised by more and more 401k participants moving toward professionally managed allocations.  QDIAs (qualified default investment alternatives) make sense for a lot of participants because they are legally allowed to be your entire investment program.  I was surprised about the make-up of the account allocations, given the problems encountered by target-date funds during the last bear market.

In 2011, 33% of all Vanguard participants were invested a professionally managed allocation program: 24% in a single target-date fund (TDF); 6% in a single traditional balanced fund, and 3% in a managed account advisory program. The total number is up from 9% at the end of 2005.

I am amazed that target-date funds are preferred to balanced funds.  No doubt target-date funds are an improvement over investors hammering themselves by trading in and out, but target-date funds have some well-publicized problems, not the least of which is that they tend to push the portfolio more toward bonds as the target date nears.  That could end up exposing retirees to significant inflation risk right at the time they can least cope with it.  It seems to me that a balanced fund with some ability to tactically adjust the portfolio allocation over time is a much better solution.

The other significant problem I see is that savings rates are still far too low.  Consider these statements from the AdvisorOne article:

The average participant deferral rate rose to 7.1% and the median (the median reflects the typical participant) was unchanged at 6%.

and then…

Vanguard’s view is that investors should save 12% to 15% or more.

I added the emphasis, but it’s easy to see the disconnect.  Investors are saving 6%, but they probably need to be saving more than 15%!

Advisors, for the most part, have very little control over their client’s 401k plans.  Clients sometimes ask for advice informally, but advisors are often not compensated for the advice and firms are sometimes reluctant to let them provide it for liability reasons anyway.  (A few advisors handle client 401k’s through the independent brokerage window, but not every plan has that option and not every firm lets advisors do it.  It would be great if the financial powers-that-be could figure out a way to reverse this problem, but the recent Department of Labor regulations appear to be going in the other direction.)

If you’re an advisor, it’s probably worthwhile to have a serious discussion with your clients about their 401k plans.  They may not be handling things in the optimal way and they could probably use your help.

Your client may need your help


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New Study on Retirement Reality

June 21, 2012

A new study by Aon Hewitt weighs in on how much savings you should have for retirement:

To have enough money for retirement, Aon Hewitt says, people will need savings on their retirement day that are 11 times their old annual pay.

With that level of savings, the researchers say, each year of retirement people can replace 85 percent of the pay a person was used to receiving annually when working. This assumes an average lifetime to age 87 for men and 88 for women.

Besides savings from 401(k) plans, the researchers assumed people would also receive Social Security. So Aon Hewitt figures the average retirement will require your savings and Social Security to provide 15.9 times your last year on the job. The calculations were based on methodology from the 1981 President’s Commission on Pension Policy and the Aon/Georgia State University Replacement Ratio study.

People preparing to replace 85 percent of their pre-retirement annual income per year would get 29 percent of their living expenses from Social Security and 56 percent from savings.

Having 11 times your old annual pay at the point of retirement doesn’t happen by accident.  The image below says it all–commit early to be a consistent saver.

Source: Carl Richards

HT: iShares

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From the Archives: A Wakeup Call for Investors

June 5, 2012

If you have money left over after paying your bills, you fall into the category of “investor.”  You could invest your surplus money in having a good time in Vegas, a mattress, a bank savings account, or any manner of financial instruments.  Some investments have a financial return; others only a psychic return if you are lucky.

Most people invest for a simple reason: to provide income when they are no longer able to work.  Some people might actually want to retire, so they invest to provide income for the time after they voluntarily choose to stop working.  To get from “investor” status to actual retirement status, a few difficult things have to happen correctly.

1. You actually need to save money.  And you have to save a lot.  In today’s America, this means becoming a cultural outlaw and foregoing some current consumption.  Welcome to the radical underground.

2. You need to save the money in assets that produce income or capital gains.  (Income-producing assets are nice, but capital gains can be spent just as effectively.)  These assets are often volatile, leveraged like real estate, or intangible like stocks and bonds.  Scary stuff, in other words.   Investing your surplus funds in Budweiser, while it may confer certain social benefits, will not provide a retirement income.

3. You need to manage not to muck up your returns.  The DALBAR numbers don’t lie.  To earn decent real returns, you need to select  quality money managers and/or funds and then leave them to do their work.

4. You need to be able to do realistic math.  For example, most people think their home is a great investment—but they never subtract from the returns all of the property taxes and maintenance that are required, or remove the effects of leverage.  Every study that does shows that homes are not a good financial investment.  In addition, in order to make a projection of how much money you will require to retire, you need to be able to make a reasonable estimate of your real net-net-net returns (after inflation, taxes, and expenses) over your compounding period.  Investors, imbued with overconfidence, almost always make assumptions that are far too bullish.

Jason Zweig has an excellent article in the Wall Street Journal discussing realistic assumptions for net-net-net rates of return.

Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%.

All other major assets earned even less. If, like most people, you mix in some bonds and cash, your net-net-net is likely to be more like 2%.

Mr. Zweig points out that many investors, even some institutional investors, are assuming net-net-net returns of 7% or more.  When he asked truly sophisticated investors what return they thought was reasonable, he got very different answers.

I asked several investing experts what guaranteed net-net-net return they would accept to swap out their own assets. William Bernstein of Efficient Frontier Advisors would take 4%. Laurence Siegel, a consultant and former head of investment research at the Ford Foundation: 3%. John C. Bogle, founder of the Vanguard Group of mutual funds: 2.5%. Elroy Dimson of London Business School, an expert on the history of market returns: 0.5%.

The reality is pretty shocking, isn’t it?  This is why the investor has an uphill battle.  And the consequences of messing any of the four steps up along the way can be pretty steep.  In Mr. Zweig’s eloquent words,

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

Saving too little can become a big problem.  I would add that ruining your returns by thrashing about impulsively will only add to the amount you will need to save.  Almost everyone has a number in mind for the amount of assets they will need in retirement.  Try redoing the math with realistic numbers and see if you are really saving enough.

—-this article originally appeared 1/19/2010.  Americans are still under-saving to an alarming extent.  Given that we are currently in a very low yield environment, a high savings level is more important than ever.

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Never Underestimate Inertia!

July 8, 2011

The law of unintended consequences strikes again.  A few years ago, in 2006 to be exact, legislation enabling automatic employee enrollment in 401ks was passed in order to boost retirement savings.  An article in the Wall Street Journal suggests that automatic enrollment might be having the opposite effect.

Under the law, companies are allowed to automatically enroll workers in their 401(k) plans, rather than require employees to sign up on their own. The measure was intended to encourage more people to bulk up their retirement nest eggs—a key goal in a country where millions of people aren’t saving enough.

But an analysis done for The Wall Street Journal shows about 40% of new hires at companies with automatic enrollments are socking away less money than they would if left to enroll voluntarily, the Employee Benefit Research Institute found.

More people were getting enrolled in the plan, but the initial contribution rates were set at lower levels than new enrollees typically selected on their own!

More than two-thirds of companies set contribution rates at 3% of salary or less, unless an employee chooses otherwise. That’s far below the 5% to 10% rates participants typically elect when left to their own devices, the researchers said.

Some of the plans have automatic escalation, but even these plans did not seem to go far enough.

An October study by EBRI and the Defined Contribution Institutional Investment Association found that, depending on their incomes, 54% to 73% of employees would fall short of amassing enough money to retire if they enrolled in their companies’ 401(k) plans at the default-contribution rate and were auto-escalated by 1% a year to a maximum of 6%.

The net result has been a mixed bag.  Enrollment rates have climbed from 67% to 85%, but contribution rates have dropped!

Among plans Aon Hewitt administers, the average contribution rate declined to 7.3% in 2010, from 7.9% in 2006. The Vanguard Group Inc. says average contribution rates at its plans fell to 6.8% in 2010, from 7.3% in 2006. Over the same period, the average for Fidelity Investments’ defined contribution plans decreased to 8.2%, from 8.9%.

Vanguard estimates about half the decline “was attributable to increased adoption of auto-enrollment.”

Obviously, it’s not the auto-enrollment itself that’s the problem.  It’s simply that most of the plans have the automatic enrollment savings rate or the top escalation rate set way, way too low—and Big Brother underestimated inertia.

The study found that if people were auto-enrolled at 3%, they were just too lazy to proactively change it to 10%, or whatever.  If you are in charge of auto-enrollment at your firm, the obvious fix is to start it at 6% or so, and escalate it 1% annually, up to 15% or so.  A few more people might opt out due to the higher initial rate, but—again, due to inertia—most people would leave it alone and thus have a chance at a decent retirement.

Don't let inertia get the best of you


Financial advisors, on the other hand, know all about inertia.  Advisors have to fight client inertia all the time.  Inertia is closely related to the behavioral finance construct of fear of regret.  Clients don’t want to make a mistake that they will regret, so they take no action at all.  Philosophically, of course, taking no action is also taking an action, but clients tend not to see it that way, despite the fact that in the long run, opportunity cost usually dwarfs capital loss.

Markets offer infinite opportunities for error and regret (much of which is unfortunately actualized by the typical retail investor) but you can’t let a little thing like that dissuade you.   That’s why one of the most important functions of a financial advisor is to get clients to do the right thing at the right time.  Disciplined use of relative strength can often be a big help in that regard.

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