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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Retirement Success

April 30, 2013

Financial Advisor had a recent article in which they discussed a retirement success study conducted by Putnam.  Quite logically, Putnam defined retirement success by being able to replace your income in retirement. They discovered three keys to retirement success:

  1. Working with a financial advisor
  2. Having access to an employer-sponsored retirement plan
  3. Being dedicated to personal savings

None of these things is particularly shocking, but taken together, they illustrate a pretty clear path to retirement success.

  • Investors who work with a financial advisor are on track to replace 80 percent of their income in retirement, Putnam says. Those who do not are on track to replace 56 percent.
  • Workers who are eligible for a workplace plan are on track to replace 73 percent of their income while those without access replace only 41 percent.
  • The ability to replace income in retirement is not tied to income level but rather to savings level, Putnam says. Those families that save 10 percent or more of their income, no matter what the income level, are on track to replace 106 percent of their income in retirement, which underscores the importance of consistent savings, the study says.

I added the bold.  It’s encouraging that retirement success is tied to savings level, not income level.  Everyone has a chance to succeed in retirement if they are willing to save and invest wisely.  It’s not just an opportunity restricted to top earners.  Although having a retirement plan at work is very convenient, you can still save on your own.

It’s also interesting to me how much working with a financial advisor can increase the ability to replace income in retirement.  Maybe advisors are helping clients invest more wisely, or maybe they are just nagging them to save more.  Whatever the combination of factors, it’s clearly making a big difference.  Given that the average income replacement level found in the study was 61%, working with an advisor moved clients from below average (56%) to well above average (80%) success.

This study, like pretty much every other study of retirement success, also shows that nothing trumps savings.  After all, no amount of clever investment management can help you if you have no capital to work with.  For investors, Savings is Job One.

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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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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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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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Quote of the Week

October 22, 2012

No strategy can make up for inadequate savings or premature retirement.—-Rob Arnott, Research Affiliates

I like this quote a lot.  It gets at some of the factors that allow clients to achieve wealth, along with intelligent investment management.

  1. Savings, and
  2. Time.

Savings is usually more important than investment strategy, especially when a client is just beginning to accumulate capital.  Without some savings to begin with, there’s no capital to manage.

Time is important to allow compounding to occur.  This is often lost on young investors, who sometimes do not realize what a jump they will get by starting a portfolio early.  How many of us in the industry have met with the 55-year-old client who has just finished putting the kids through college and is now ready to start saving for retirement—only to realize they will need to save 115% of their current income to reach the retirement goal they have in mind?  Oops.

Save early and often, and give your capital lots of time to grow.

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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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Wealth Drivers in 401k Accounts

September 10, 2012

Putnam Investments recently completed a study in which they examined the wealth drivers in 401k plans for individuals.  (I first saw the discussion of their study in this article at AdvisorOne.  The full Putnam study is here.)  What they did was very clever: they built a base case, and then made various modifications to see what changes had the most impact in driving wealth.  Here was their base case:

They assumed that a 28-year-old in 1982 earned $25,000 per year with a 3% cost-of-living increase. The worker contributes 3% of gross salary to a 401(k) plan that receives a 50-cent match on the dollar up to 6% and has a conservative asset allocation across six asset classes. The hypothetical 401(k) also invests in funds in the bottom 25% of their Lipper peer group. By the time the worker turns 57 in 2011, income is $57,198, and the 401(k) balance is $136,400.

Then Putnam examined three sets of wealth drivers to see how they impacted the base case:

  1. They changed the 4th quartile mutual funds to 1st quartile funds, but kicked out funds after three years if they fell out of the 1st quartile.
  2. They looked at the effect of adding more equities to the mix, so they boosted stocks from 30% of the account to 60% and to 85%.
  3. They looked at quarterly rebalancing of the account.

The results were pretty interesting.  Picking “better” funds, in concert with the replacement strategy, was actually $10,000 worse than the base case!  The portfolios with more equities had their balances boosted by $14,000 and $23,000 respectively—but, of course, they were also more volatile.  Rebalancing added $2,000 to the base portfolio balance, but slightly reduced the volatility as well.

All of these strategies—fund selection, asset allocation, and rebalancing—are commonly offered as value propositions to 401k investors, yet none of them really moved the needle much.  (Even a “crystal ball” strategy that predicted which funds would become 1st quartile funds only helped balances by about $30,000.)

Then Putnam explored three variations of a mystery strategy.  The first version improved the final balance by $45,000; the second version boosted the balance by an additional $136,000; and the third version blew away everything else by adding another $198,000 to the $136,000 base case, for a final balance of $334,000!

What was this amazing mystery strategy?  Saving more!

The three variations simply involved moving the 401k deferral rate up from 3% to 4%, 6%, and 8%.  That’s it.

The mathematics of compounding over time are very powerful.  Because this study looked at the 1982-2011 time period, higher contributions had time to compound.  Even moving up the contribution rate by 1% dominated all of the investment gyrations.

The power of compounded savings is often overlooked, almost always by clients and even frequently by advisors.  Often one of the best things you can do for your clients is just to get them to boost their deferral rate by a percent or two.  They might squawk, but in six months they will usually not even notice it.  Then it’s time to get them to boost their deferral rate again!  Over time, people are often shocked at how much they can save without really noticing.

Clients often obsess over their fund selection and investment strategy, when they really should be paying attention to their savings rate.

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How Your 401k Really Grows: Savings

August 16, 2012

CNBC ran an interesting article on the 401k market today.  Fidelity Investments handles about 12 million 401k accounts which they report on, in aggregate, periodically.  Here’s what I found most interesting from their recent release:

Over the past 10 years, about two-thirds of annual increases in account balances have been due to workers’ added contributions and company matches, with one-third the result of investment returns.

Surprised?  You shouldn’t be.  While investment performance is important, so is savings.  In a very slow decade for the market, the bulk of 401k growth came from new contributions.  Even in a stronger market for financial assets, it would not be surprising to see most of the increase in balances coming from savings since the average 401k balance is only $72,800, according to the article.

The savings rate is another area with plenty of room for improvement.  The article notes:

The average employee contribution in Fidelity-administered 401(k) plans has remained steady at around 8 percent of annual pay for the past three years.

8% is a good start, but most experts recommend something closer to 15%.  Given the current low-yield environment, seeking out investment returns wherever they can be found and saving as much as possible are going to be critical keys to 401k success.

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Advisors to the Rescue: Savings Edition

July 16, 2012

There’s already lots of evidence that individuals on their own don’t do very well investing.  Compounding your net worth is extra difficult when you also don’t know how much to save.  (As we’ve shown before, savings is actually much more important than investment performance in the early years of asset growth.)

An article at AdvisorOne discussed a recent survey that had some surprising findings on consumer savings, but ones that will be welcome for advisors.  To wit:

The survey found that, regardless of income level, more than 60% of consumers who work with an advisor are contributing to a retirement plan or IRA, compared with just 38% of those without an advisor.

Furthermore, 61% of consumers who work with an advisor contribute at least 7% of their salary to their plan. Just 36% of consumers without an advisor save at this rate.

The guidance and education that advisors provide their clients to bring on these good saving habits translate to higher confidence, too. Of non-retired consumers with an advisor, half said their advisor provided guidance on how much to save. More than 70% of Americans with an advisor say they’re confident they’re saving enough. Just 43% of consumers without an advisor felt the same.

The differences in savings are really shocking to me.  Less than half of the consumers without an advisor are even contributing to a retirement plan!  And when they do have a retirement plan, only about a third of them are contributing 7% or more!

Vanguard estimates that appropriate savings rates are 12-15% or more.

I find it interesting that many consumers point out that their advisors gave them guidance on how much to save.  It is pretty clear that even simple guidance like that can add a lot of value.

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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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