When and How to Save for Retirement Addendum

Here is a good, basic article by Anisha Sekar for newbies that sorts out some of the confusion on when and how to save for retirement: When, and How, to Start Saving for Retirement .

My summary and take: 

#1 basic point:  first pay off high interest debt and set up emergency fund.

#2 basic point:  use company 401(k) up to the point of the company match.  IF YOU DON'T KNOW IF YOUR COMPANY HAS A MATCH, FIND OUT ON MONDAY MORNING BY ASKING YOUR BENEFITS PERSON.

#3 basic point:  if you can save more, then learn how to invest in low-cost, well-diversified funds and open up an IRA.  TO DO THIS, OPEN AN ACCOUNT WITH A DISCOUNT BROKER AND BUY THE ETFS ON LINE.  TARGET A PRE-SET ASSET ALLOCATION.

#4 basic point:  save as well in a taxable account.  The thing is that we don't know what the future brings.  Even though we may have the standard emergency fund established, our wants change over time.  Four years from now, you may want to buy a house, change professions, or start a small business. Too often these events lead people to tap their retirement funds.

The bottom line is that one day you will be 65 years old and, at that point, have choices available to you that depend on your saving habits today.  Putting this off until next month or next year may very well take away these choices.  By all means, don't let the confusion surrounding these different investment vehicles result in inaction and, thereby, steal your retirement!

Create an Income Stream Versus an Annuity

An ongoing conundrum in the financial community is why single premium immediate pay annuities (SPIA) aren't more widely accepted?  After all, they go a long way towards avoiding running out of money in old age (the number one fear of retirees), no matter what the market does.  Furthermore, used intelligently, SPIAs can be used to enable a retiree to take on a bit more risk in the other assets they own.

So what's not to like?  First off, retirees lose control of the money.  For example, suppose the retiree comes home and finds a leak in the attic crawl space?  The roofer guy is going to come out and tell the retiree he or she needs a new roof!  Where do you get the money from?  Hint:  not the annuity. Secondly, though useful, today the timing may not be right with interest rates close to historically low levels.  With the yield on the 10-year Treasury note at 2.50% and the Federal Reserve printing money akin to Anatasios Arnaouti on steroids, many feel that higher yields will be available down the road. Thirdly, most people would rather wallow in their own fear of a market collapse than talk to a silver-tongued insurance agent who has been trained to sell you products that will destroy a retirement portfolio faster than you can get out a high-powered electronic microscope to read the fine print.

So, does it leave the retiree at the mercy of the usual portfolio approach trying to beat the market?  Not necessarily.  Some are constructing a sort of hybrid portfolio whereby the allocation to fixed income is replaced partially with high dividend stocks.  This is not a couch potato approach in that it does require some time on the part of the DIYer but could pay high dividends (sorry, couldn't help it) if done correctly. And, as a matter of fact, a whole industry of bloggers (see below)  has arisen to help the DIYer in this endeavor.

 DIVIDEND PORTFOLIO EXAMPLE

To see one way to approach this, let's look at an account I recently set up.  We began with the usual important first step of doing an asset allocation.  This is for a couple in their 60s.  Income will become important to them shortly.  The allocation was 50/50 stocks/fixed income.  The stocks portion was invested in low-cost diversified index funds.

The twist came with the bond portion.  Instead of bond funds, the fixed income portion was invested in dividend stocks that have a dividend of 3% or greater.  It was decided that the dividend stock positions would be less than 5% of the overall exposure in the dividend sector, making each position less than 2.5% of total assets.  Importantly, it was agreed to carefully look at diversification - the last thing you want is to load up on bank stocks, energy stocks, etc.

With these specifications, here is a partial listing of the  portfolio that was constructed:

Source: Schwab

CLICK TO ENLARGE
You'll notice that NLY is in for a lesser amount.  It is a riskier issue with a yield in excess of 11%.  Its purpose is to juice up the yield of the portfolio a bit with the understanding that its dividend is considerably less secure compared to the other holdings.


The thing to get your head around is that, in one sense, you really don't care about the prices of the stocks.  After all, if you had put the money in an annuity, you would be dealing with an income stream!

Having said this, if prices move higher and this is a taxable account (which, in this case, it is), you have some options.  You can realize long-term gains if you find better replacements and can actually take advantage of tax-harvesting by capturing losses.

Once set up, the next step, which takes all of 30 minutes, is to do an Excel sheet showing dividends received:

The portfolio will be comprised of approximately 20 stocks.  The bottom line is to seek to have income increase over time.  This, of course, won't happen with a bond.  Buy the 10-year Treasury note and you'll get a fixed interest payment every 6 months for the next 10 years.

Here's the bottom of the Excel spread sheet:

The arrows show that already the dividends have increased and, in fact, they will increase this month with the final payment due in.  The goal is to see them double approximately over the next several years.

Obviously, unlike the annuity situation, the investor has control over the assets.  If  the roof leaks or Aunt Maude in Stuttgart Germany kicks the bucket, the investor can sell assets to pay the roofer guy (or gal) or get on an airplane to Stuttgart.  A DOWNSIDE IS THAT THE YIELD WILL BE LESS THAN WITH AN ANNUITY, AT LEAST AT THE BEGINNING!  This is because, with an annuity, you are receiving an actuarial rate based on a group's mortality.

The newbie DIYer should be able to find on his or her brokerage site a history link that shows all cash flows that come into an account.  This is a convenient place to track your dividend receipts to put into your Excel spreadsheet.  In Schwab, it looks like this:

If this intrigues you in the least bit, you should realize you can go at it at whatever size you want.  For example, if your asset allocation calls for 40% fixed income, you could consider putting 20% of your fixed income allocation in dividend stocks and think of the allocation as your personal annuity!

The obvious question is how do you find good dividend-paying stocks without having to spend an inordinate amount of research effort? Actually, today this is easy because there are several really good blogs dedicated to finding good dividend payers.  Here are a few:

DIVIDEND GROWTH INVESTOR , DIVIDEND MANTRA, DIVIDENDS4LIFE .

Disclosure:  This post is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

Comment on Risk Tolerance Questionnaires

Here is a good, short article from the online Financial Planning site on risk tolerance questionnaires by Alan S. Roth:  Why Risk Tolerance Questionnaires Don't Work.  For those who might not know, risk tolerance questionnaire are a favorite tool of the financial planning crowd, frequently presented with an aura of scientific precision.

But this scientific precision is too simple.  In fact, at the extreme, some people are taking unnecessary risk!

In the article, William Bernstein (author of The Four Pillars of  Investing) poses the question: “if you’ve won the game, why keep playing?”

This question is especially relevant today with the S&P 500 and other indices at all-time highs.  It takes me back to the year 2000 when I attended an event for investment professionals and a young investment professional was bragging about his $3.0 million portfolio of internet stocks.  Someone asked why he didn't sell and take a profit, and his response was "with a portfolio going up $50,000/month, why would anyone take a profit?"

This young man was hardly the exception.  Back then, many had a portfolio they could have retired on comfortably at a young age but let ride. 

Later, someone told me he eventually finally sold out after the portfolio had dropped to $150,000.

The same behavior frequently occurs with state pension funds where they become fully funded, or close to fully funded, as markets rise but then become more aggressive with their asset allocation.  All of this points out the astute observation, made in the article, that risk tolerance isn't some stable magnitude that can be measured by a risk tolerance questionnaire.  Instead risk tolerance changes as markets change.

I would add that there is a difference between a highly volatile market that is trending upwards versus a highly volatile market trending downward!

Year-to-Date Performance - 9/30/2013

My favorite investment chart is the BlackRock 20-year sector performance.  It details the relative ranking of asset classes on an annual basis as well as the performance of an easily replicated low-cost diversified portfolio comprised of 65% stocks, 35% bonds.  The diversified portfolio returned 12.2% over the 12 months ended 12/31/2012 and 7.9% on an average annualized basis over the past 20 years.

The diversified portfolio allocation is an appropriate benchmark for individuals in their 40s and even early 50s, depending on risk tolerance.  The table contains sufficient data, however, to construct a benchmark for any specific allocation; and, in fact, the allocation can be changed over time--as it should be as the individual ages.

Voluminous data from unbiased academic studies have been presented over the years showing that a diversified portfolio of low-cost funds outperforms upwards of 70% of active managers over the longer term after all costs are taken into account.  These studies cover various time periods, countries, asset classes, and investment methodologies.  In line with this data, the low-cost diversified approach warrants consideration as a benchmark for investors.  It shouldn't go unnoticed that the approach economizes on the investor's time.

Here is an update showing the approximate performance of the diversified portfolio for the 1st nine months of 2013:

Weight	Fund	Return (%) 9 months ended 9/30/2013	Expense Ratio
35	AGG  (Barclay’s Aggregate Bond Index)	-2.00	.08
10	EFA (EAFE Index)	14.46	.34
10	IWM (Russell 2000)	27.69	.24
22.5	IWF (Russell 1000 Growth)	20.68	.20
22.5	IWD (Russell 3000)	20.19	.21

 
The overall return of the diversified portfolio was approximately +13.06% over the first 9 months of the year.

Disclosure:  This post is intended for educational purposes only.  Past performance is not indicative of future performance.  Individuals should consult a professional or do their own research before making investment decisions.

Bernanke in a Box

 One prerogative of blogging is an occasional rant.

Here's one lesson from recent Fed history:  transparency is great WHEN YOU HAVE A PLAN, not so much WHEN YOU DON'T.  In trying to reduce uncertainty and volatility, our Fed Chairman, the esteemed student of the Great Depression, has ramped it up.  Ah yes...unintended consequences!  Now markets are totally confused, and every piece of economic minutiae going forward will be analyzed to death as capital markets try to divine Bernanke's take on it.

What we see unfolding is starting to look more and more like the Greenspan exit.  Recall Greenspan went out riding on accolades from fellow governors and others praising him as the greatest (apologies to Ali who is the greatest) and a maestro only to find out in short order that he had set the stage for the worst economic downfall since the the 1930s by pandering to Wall Street.

But let's review the downfall to gain some perspective. In 2003 Greenspan and, yes, Bernanke pushed short-term interest rates to the historically low level of 1% and kept them there for a year.  This in the face of a robust housing market.  By pouring gasoline on a fire, this was the single action that caused the housing boom and consequent bust.  It wasn't greed by various groups, etc., although they played an important role in carrying it out.  To be absolutely clear, let's restate it as follows:  if short term rates had hovered around 3%  as was normal prior to the Greenspan/Bernanke manipulation, there would have been no housing crisis as we saw it.

There is a lot of pussyfooting around on this subject, so it deserves some emphasis.  Many point to Wall Street's greed as the culprit for the 2008 debacle.  Well here's some news, folks.  Wall Street has been greedy since the first gatherings under the buttonwood tree.  Wall Street's ongoing thrust has always been to make a killing anyway they can.  They will use inside information, front trade, and rip away the retirement years of the nation's workers by charging unconscionable fees.  They'll structure products filled with toxic product that even Einstein couldn't understand and sell the product to your local school district.  Whatever it takes!  The point is that Wall Street and the investment banking community, including the ratings services, didn't just get greedy in 2008.

On Bernanke's watch, he has tried unsuccessfully over the short term to reignite inflation and, in the process, pushed investors (including retirees and Pension Plans and the whole investment community) into a much riskier posture than they should be in or desire to be in.  This was undertaken by the Federal Open market Committee with eyes wide open.  Another way to view this is to understand that assets aren't being allocated by free market forces but by the a Fed micro-managing interest rates.

Again, to be clear, it is important to understand that, in controlling interest rates, the Fed is controlling prices and, in this instance, the most important price in the economy - THE PRICE OF MONEY! Think about it - you can have a mortgage payment of $2,600/month or $2,200.  You can borrow $15,000 at your bank to put on an addition or buy a car, and your monthly payment depends on the Fed setting interest rates.

I would be remiss if I outlined the problem and didn't indicate a solution.  Here it is.  Instead of a Federal Reserve that micro-manages the price of money, how about the Fed going back to Volcker's approach that broke the back of inflation by controlling the growth rate of money in the economy.  Let the millions of economic entities that daily make asset allocation decisions set the price of money.  This is called a free market economy.   Granted this requires a dramatic drop in arrogance.  It means admitting that the market knows better than the Central Bankers what interest rates should be.  For what it's worth, you can be sure it's not coming from Yellen.  She's steeped, as are present governors, in the Soviet-style price control mindset.

As you think about this, here are a couple of other points to throw into the mix.  Whenever there is a debate in DC, it seems that the higher ground is taken by debaters asserting what the founding fathers intended.  Along the same lines, what if we revisit the intentions of the creators of the Federal Reserve 100 years ago.  It is beyond dispute that then (as today) people didn't trust big banks.  Thus, they came up with a somewhat convoluted system IN ORDER TO PREVENT CONCENTRATED POWER OVER THE NATION'S MONETARY POLICY.  They specifically intended for the regional banks to  pull the levers.  Instead, today, power resides in DC to the extent that the Fed Chairmanship is said to be the second most powerful position in the world!

A second point concerns whether the FOMC has any clue on what they are doing.  Point one is their forecasts which, literally, are a joke.  Forecasting GDP out 2 to 3 years is ludicrous.  You can examine the record yourself.  Suffice it to say that it's not just the emperor; but, in fact, the whole monetary policy committee is naked.  Thirdly, and this to me is most telling, ask Bernanke if 10 years ago he could imagine (in his wildest "expert on the Great Depression" dreams) how an economy could have reported inflation under 2% with the Federal Funds target rate at essentially zero percent and the Federal Reserve monetizing the debt to an extent greater that the annual Federal deficit.

Any economist confronted with these policy facts would have made a good model for Edward Munch.

But where are we headed from here?  It is accepted with absolutely no question that interest rates jumped 1% because of the talk of reducing the tapering by $10 billion (a scary thought in its own self). But maybe the cause and effect is over emphasized.  After all, this rise in rates has been predicted for a long time.  If it continues, it will be an upheaval because there will be a massive re-shifting of portfolio assets and could take the economy South.

Part of the problem is that past policy has pushed investors into assets they don't understand.  I'm "boots on the ground," so let me give a simple example.  I see people who I ask about their holdings in bonds. They tell me that they read up on bonds and they read that, by holding individual bonds, they can't lose money!  They don't understand even that the 10-year bonds they bought 3 years ago, priced at $105.5, will drop to $100 at maturity and could go below $100 over the next 12 months with a big enough push upwards in interest rates.  Many have zero understanding of corporate bond spreads and the impact on prices if spreads widen.

Sometimes I think the FOMC understands these underlying market dynamics about as well as they understood credit default swaps in 2007.

Going forward, if this all leads to a nasty collapse, Bernanke and his committee will thankfully have those they can point the finger at and blame.  Front runners here are Congress, emerging markets, and the Far East.  Part of the job requirement of central banking today is being able to cast blame elsewhere.

Target Date Fund Flaws

Here is an excellent, eye-opening article by Robert Powell at MarketWatch on Target Date Funds.  For many, target date funds are excellent investment choices.  They take care of the asset allocation question by investing in low-cost index funds without the plan participant needing to know anything about investing or needing to adjust allocations over time.  But, as you might suspect, target date funds aren't always a good choice.  Some providers just can't resist exploiting the lack of knowledge on the part of participants by throwing in high-cost funds.

Powell cites "...Legg MasonTarget Retirement Series (1.47%); Franklin Templeton Retirement Series (1.36%); State Farm Lifepath Series (1.27%); and Invesco Balanced-Risk Retirement Series (1.19%)..." for having higher-than-average costs.

The article recommends that, if your 401(k) plan has higher-than-average cost target date funds, you bring it to the attention of the plan administrator.  The plan administrator is usually a fiduciary and, thereby, by law required to act in the best interest of the Plan participants.

All of this is of even greater significance in that target date funds are the typical destination for those who don't opt out of the company 401(k).

Online Book Discussion - Millionaire Teacher

The second online book discussion of Andrew Hallam's Millionaire Teacher will kick off with a meeting at the Miller Branch of the Howard County Library System on Tuesday, 9/24/2013 at 7 p.m.  You don't have to come to the meeting to participate.  All you have to do is read one chapter per week and check into the blog.

Unlike decades past, today we are responsible for managing our own retirement.  But, we haven't been given the basics on how to proceed.  We wonder if we're saving enough, do we need an advisor, which funds should we invest in, should we take the investment advice of our stock broker brother-in-law, and countless other issues.

Andrew, and many others, argue that these basics of financial literacy should be taught in school.

Please pass this on to anyone you think might be interested.  As you can see from the syllabus on the blog, we'll cover many essential topics--such as how to avoid excessive fees in building a retirement portfolio, how to get time on your side in the investment process, how to avoid the negative impact of emotions on your investment strategy, and even how to construct a portfolio conducive to your risk tolerance.  The next time you sit in a human resources meeting confronted with making a choice among numerous funds, you'll know exactly how to proceed.