Duffy's Bakery

Duffy's Bakery.

We walked the railroad tracks, then a short ways through the Connecticut woods, picking blueberries along the way. Trays of hot donuts, chocolate eclairs, and various breads fresh from the ovens. Treats offered up as we entered to see my Aunt Sally.

At night Aunt Sally  brought leftovers back to the apartment in the Three Rows Greek village - the row house village of mill workers - many of whom didn't speak English.  The summer nights were long and hot, and we kids exploited them to the fullest.  After dinner we grouped among the row houses to start up a game of kick-the-can. We ran until it was pitch black - older kids, younger kids - all joined in.  The adults sat on the steps, talked and watched.  Many not long from Poland and other Eastern European countries.

Sweaty, laughing, jostling we made our way to our respective small apartments at the end of the night.  Shortly after bathing and eating a Duffy's Bakery donut, Uncle Ernest came in from his job as a mill guard.  He plopped in front of the little black and white TV set in time for the start of "Have Gun Will Travel."  We spent the summer watching his beloved Westerns including his favorite - "Gunsmoke."

Fast forward a few decades and I'm getting up in the dark.  I'm driving to Shady Grove Metro to get to downtown D.C.  Managing money for pension funds, corporations, and endowments.  On the best of days, it was 1 hour 25 minutes one way door-to-door.  On many days, it was considerably longer.  At the end of the day,  I return home in the dark.  I am paid more than I am worth - but so is 99% of the industry.  I have a big house, a big SUV, and a TV that gets at least 50 channels - I have never actually counted them, although I have been tempted on stressed-out nights when I could find nothing to watch.

Weekends came and I vegged out, pretty much oblivious until the alarm went off on Monday morning.  Stuff piled up.  I know because I'm in the process of downsizing and have been involved in getting rid of the stuff.  I mentioned this to a friend, and he recommended I watch George Carlin's routine on "Stuff."

Three Rows Greek Village is still there.  Mostly boarded up, although there are a few apartments still occupied.  The mills are closed, so it is no longer a gateway for immigrants into American life.  The factories moved South and then overseas - it's all part of America's economic  history.

And I wonder when in my life have I been the richest.  I wonder how we measure being rich.  Is it just about piling up dollars?  Bloomberg thinks so.  They have a list of "...the world's richest people."

When were you the richest?

The First Thing You Need to Know About Retirement

Source:www,capitalpixel.com

One of the first steps in retirement planning is figuring out where your income will come from as you transition from receiving a career paycheck to receiving a paycheck from Social Security, your nest egg, a pension, and possibly other sources.

Today, you can find out how much you can expect to receive from Social Security by spending a few minutes online to create an account. If this was a recipe on the Food Network, it would be rated at the "Easy" level.

Go to www.socialsecurity.gov/mystatement/.  Create an account. Write down your password and the answers to the security questions in a safe place (especially if you are approaching the age where you plan to start taking Social Security!).

You'll come to a page that shows the amount you are expected to receive if you begin at "Full Retirement."  Next click "View Estimated Benefits" as shown:

Source: Social Security Administration

This will give you three numbers:  amount you would receive today (if you are over 62 years old), amount you can expect to receive at your full retirement age, and amount you can expect to receive at age 70.

This, of course, is an important first step in retirement planning.  At what age to take Social Security is the next step, and here a number of variables and assumptions come into play including spousal benefits, longevity assumptions, other sources of income, etc.

While you are on the site, be sure to check that your earnings record is correct.  If you are looking for a source that analyzes the question of when to take Social Security, check out A Social Security Owner's Manual by Jim Blankenship.

If you are looking to do a good deed on this beautiful Memorial Day, pass this information on to someone you think might find it useful.

What Do Mutual Funds Cost?

Yesterday we looked at an approach to picking mutual funds for a 401 (k).  In particular we focused on the Maryland Supplemental Plan used by firefighters, teachers, police, and state and county workers. In other words a lot of people in Maryland participate in this plan to build a retirement nest egg.

We suggested, based on academic evidence and the recommendation of people like Warren Buffett and Burton Malkiel, that participants focus on low expense funds that track the market.

The question then becomes what is the difference in terms of dollars? Suppose we assume that the 3 funds that we considered yesterday each achieve an average annualized return of 7.5% over the next 20 years. After subtracting fees what will be the impact?

A neat little calculator to do this calculation is available at .http://www.marketriders.com/ . At the bottom of the page click Mutual Fund Fee Calculator .

Source: MarketRiders

For our example let's assume that $5,000 is i-nvested in each of the 2 higher cost fund offerings in the "Large Cap" sector looked at yesterday. The Neuberger Berman fund has an expense ratio of .69% and the Parnassus fund has an expense ratio of .75%.  For those in other plans, you may very well notice that the funds you are offered have expenses considerably higher even than these!

Click "Calculate My Fees" and you'll find that the annual fees are $74.00 and the value of the portfolio, under the assumption of a 7.5% return, after 20 years is $36,998.40.

Source: MarketRiders

Go through the same exercise and put in $10,000 for VIIIX , the low cost Vanguard fund that tracks the S&P 500.  You'll find that the portfolio value is $42,320.73 - 14% higher!

Granted, it's not going to be this clean in the real world. The funds will have differing returns. The surest outcome is that VIIIX will perform close to the S&P 500. The difference between the 2 alternatives could in fact be greater than 14%.

But think of this- if the portfolio is $1.0 million and the difference is 14% then it equals a number of years of payouts. Typically a safe withdrawal amount if taken to be 4%. This would be $40,000/year from a $1.0 million portfolio. The 14% difference (after just 20 years!) amounts to 3.5 years of draw downs.

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

Oriole Esskay Hotdog Race and Investing

Last night found me at Camden Yards (courtesy of an invite from my buddy Mike) watching the Orioles whup up on the lowly K.C. Royals.  Walk-up tickets sold were the largest in the franchise's history, and the atmosphere felt like an ALCS playoff game. Excitement is building as the Orioles continue to lead the division and major league baseball in wins.

As those who have been out to the Yard know, one of the popular, albeit goofy, side entertainments is the Esskay Hotdog Race where three cartoon hotdogs race on the jumbo screen.  The crowd jumps up and down and yells for their favorite.

Anyways, it struck me that picking a favorite hotdog in the race is probably similar to how many 401 (k) participants pick their investments.

This particular problem was on my mind because, in the morning, I had met with a young lady who works for the county and sought my help "getting started and learning about investing."  She told me she was the first one in her family to invest and is excited to learn the process.

An important part of the process that sometimes confuses people is choosing which funds to invest in.

As I watched the hotdog race, I reflected that probably 20% or more of the baseball crowd had likely faced this issue, via the exact same investment vehicle The Maryland Teachers and State Employees Supplemental Retirement Plans.

So how do you choose which funds to invest in?  Some plans have a ridiculous number of choices, and this is one area where research has shown that too many choices can be detrimental.  Thankfully, the Maryland Plan has a reasonable number of choices.

Some participants throw up their hands and go with target date funds.  These funds set an allocation based on your expected retirement and make rebalancing moves over time.  This is OK and is a lot better than not participating.  But choosing funds directly is a less costly method that can more accurately reflect risk tolerance.

Picking Funds

By the time you've come to pick funds, you've already picked an asset allocation model.  The young lady and I agreed to start with the "Moderate Model" which is basically 60% stocks and 40% bonds. Even though she is young and can stand some volatility, we thought it best to start a bit conservatively.  I explained, since she will be contributing on a regular basis, that the best thing for her would be for the market to drop 50%!  What is important to her is where the market is 30 years from now - not what happens over the next few years.

The "Moderate Model" specifies 30% allocated to "Large-Cap Stock Funds."  The choices offered are shown in the following table along with 1-year, 3-year and 5-year performance numbers:

FUND	Ticker	Exp Ratio	1 Yr.	3 Yr.	5 Yr.
Neuberger Berman Partners Fund Inst.	NBPIX	0.69%	-7.81%	23.60%	-1.43%
Vanguard Instl. Index Fund Plus	VIIIX	0.02%	8.54%	23.47%	2.07%
Parnassus Equity Income Fund Inst.	PRILX	0.75%	5.73%	20.67%	5.97%
S&P 500			8.54%	23.42%	2.01%

There are actually 3 additional choices, but they are not "Large Blend."  "Large Blend" means that the funds blend value stocks (i.e., those with low P/Es) and growth stocks (i.e., those with higher than average earnings growth).

So how do we choose?  Is this like picking in the cartoon hotdog race?  Should we throw darts? Actually there are well-defined principles supported by academic research and recommendations from leading market analysts.  Those who support this approach include Warren Buffett, Burton Malkiel (author:  A Random Walk Down Wall Street), Charles Ellis (author:  Winning the Loser's Game), Andrew Hallam (author:  Millionaire Teacher), and, of course, John Bogle, founder of the Vanguard Funds.

The process is straightforward:  pick funds that have low expense ratios and closely track the overall market.  This leads us to choose the Vanguard Fund with its .02% expense ratio and close tracking of the S&P 500 stock index.

As you go through this exercise, you notice that the low-cost index fund is not the best performer over some periods.  That's fine and to be expected.  It may not even be the best performer in the future.  What you get when you pick a low expense ratio fund that tracks the market is a fund that will beat 8 out of 10 competitors in a long-term race.

One point that gets a bit tricky is style.  Are the funds really "Large Cap Blend?"  To check this, go to Morningstar and put in the ticker symbol.  Do this for PRILX, the Parnassus fund listed above, and scroll down a bit.  You come to what is called the "Style Box":

Source: Morningstar

We find that, rather than a Blend, it appears the manager has tilted towards Growth.  A sausage has snuck into the race!

Scrolling down on the same page will show you as well that the fund has a brand new manager!

Disclosure:  The information here is intended for education purposes.  Individuals should do their own research or consult with a professional before making investment decisions.

Create Income in Retirement

Source: www.capitalpixel.com

There are two kinds of people in my world:  accumulators and decumulators.  I try to get the accumulators - those contributing to their nest egg on a regular basis - to look at the current market craziness as an opportunity.  They should care about the market 10, 20, 30 years from now.  Volatility presents an opportunity. Decumulators, on the other hand, have to be careful and ensure that they have a plan to handle volatile markets.

One product that can help in this, and which I've discussed on several occasions, is the single premium immediate pay annuity (SPIA).  This creates an income stream and essentially is a way to get back to a defined benefit situation.

One product I haven't mentioned is longevity insurance.  The concept is similar.  Pay a lump sum today for a guaranteed income when you reach 85 years old, say. This is an insurance product.  Die at 84, and you have received the comfort of knowing you would not run out of money but nothing more.  Live to 108 years old and you win, and you have an income to the end.  Best of all, it is relatively inexpensive.

An excellent overview of these products is given in Seeking Pension Replacement in Retirement by Mark Miller of Morningstar.  I would recommend that retirees and those entering retirement carefully read this article.  In fact, if you know any retirees (your parents, for example), have them read the article.

Also, if you are a member of AARP, send in the postcard from their monthly magazine to New York Life to get a quote.  Get a quote from Met Life.  A little research can save a couple of bucks.

Important caveats:  only consider a SPIA (other types of annuities can be hazardous to your financial health) and understand that, when you purchase an annuity, you lose control of the funds!

Disclosure:  I don't sell insurance and do not have a license to sell insurance.  This information is for educational purposes only.  Individuals should get professional advice based on their specific situation before making investment decisions.

Monte Carlo Analyses - Useful or Not?

Financial planning is challenging because of the number of unknowns.  We reach a point where we aren't generating a career-type paycheck, from which date we need to generate an income.  We don't know how long we need to generate an income, the rate of inflation, or what market performance will be.

We can start by making point assumptions on the unknowns.  We can assume we'll live to be 100, inflation will average 3%, and our investments will earn 7%.  Then, given the desired income and our income sources, we can see whether our plan will succeed.  As we think about this, we realize that it is way too simplistic.  One important observation is that sequence of market returns and inflation are important.

An "elegant" way around this problem is to carry out a Monte Carlo analysis where many paths are generated for inflation and market returns.  Then, of the paths generated, we can get a percent of success determination (I hesitate to use the term "probability" because we are using a sampling technique - it is not exactly like flipping a coin which is, in fact, a probability).

I put elegant in quotations because, like many things mathematical, a Monte Carlo analysis can project a greater degree of determination than is actually obtained.  As such, it has the potential to be abused by  practitioners to present an aura of expertise.
 
Suppose 80% of the paths succeed?  What does this tell us?  Is it good practice to report to a client that his plan will "fail" 20% of the time?  Does it require more elaboration?  To put it bluntly - does a Monte Carlo analysis with an 80% success ratio mean that 20% of the time the client will end up eating dog food?  Is the client hearing what we are trying to convey?

This issue has been examined by Michael Kitces in Do Our Brains Really Even Know How To Evaluate A Monte Carlo Analysis? on his blog Nerd's Eye View.  Michael is perhaps the brightest young financial planner in the country, and his blog is a must-read for those interested in the cutting edge of financial planning research.

My own take is that Monte Carlo analysis is valuable at higher rates of failure.  For example, if the failure rate is 60%, you probably need to work longer, save at a greater rate, or draw down a smaller income stream.  On the other hand, if the failure rate is 20%, then examining flexibility issues comes into play.  Can the client cut down on spending for a few years to get back on a successful path?

The good part of all this, I think, is that it gets the planner and the client to focus on the dynamic nature of the process.  Financial plans need to be revisited.

I think we may even have to take a step back and reconsider what we mean by "success."  "Success" is defined as "not eating dog food" in the Monte Carlo results.  Many clients, however, define
success as dying broke.  The client who ends up with $4 million in the analysis is a "success" but not so according to his or her goals.  The real success metric may be the percentage of paths leaving a client with $100,000 or less.

For those interested in an easy-to-use program based on  Monte Carlo simulations, I recommend the T. Rowe Price Retirement Calculator.  It is free and straightforward.  Use it at least annually.

Telephone Consult

Last night I did a phone consultation with a couple from Oregon--a beautiful part of the country I once drove through with my son on one of our cross-country camping trips.  We motored down the coast to see the Redwoods of California.  An awesome experience I recommend to one and all.

My first clients in Oregon (Yeah!), Fred and Wilma (made-up names to protect the innocent), had done their homework and were knowledgeable about investments.  They had a really good understanding of their income sources and living expenses.  Fred is a retired contractor and receiving Social Security.  Wilma will retire at year's end, is an accountant, and is 58 years old.  Fred is a Navy veteran and receives medical care there. Health insurance for Wilma will be a challenge since she is 58 and has a ways to go to get to Medicare. She assured me they are up to the challenge because she and Fred have been self-employed for years and obtain their health insurance through the business.

Once Wilma retires (1/2013), they will need to draw down approximately 3.7% of their investment assets.  After 4 years, Wilma's Social Security kicks in.  Then they will require a lot less from their investments, and they will easily be able to live the lifestyle they desire.  In fact, they may want to ramp up their spending, then, if they so desire.

Fred was familiar with the T. Rowe Retirement Calculator and agreed with me that he should revisit it at least yearly.  Spending only a few minutes putting in the inputs quickly reveals, by generating a Monte Carlo analysis, whether you are on the right path.  This is a tool everyone approaching retirement should be familiar with.

On the investment front, they had read Solin's excellent book, The Smartest Investment Book You'll Ever Read, and had selected a portfolio conforming to their risk tolerance.  The portfolio is comprised of well-diversified funds with 60% in fixed income and 40% in stocks.

Their broker is TD Ameritrade, and I suggested they consider commission-free ETFs offered by TD Ameritrade and utilize the low-cost, index funds.  In fact, I looked them up and recommended specific funds to match the asset classes of their portfolio.  For example, their portfolio required 8% U.S. Small Cap and I recommended VB, a Vanguard ETF with an expense ratio of 0.16%.

Fred and Wilma are members of AARP, so I suggested they send in the postcard in the monthly magazine that provides a quote on a single premium, immediate pay annuity with New York Life.  My guess is that the annuity would pay Fred about 5.8%.  Thus, if he put $100,000 into it, he would get $483/month as long as he lives.  If he dies before he is paid out $100,000, his beneficiary (most likely Wilma) will get the balance.  Think of it like Social Security (except it isn't adjusted for inflation!) or a pension.  The idea is to reduce market risk.

We talked about location of investments - put stocks in the taxable accounts and bonds in the IRAs to the extent possible.  We talked about drawing down the taxable accounts first to let the IRAs (qualified accounts) grow tax free as long as possible.

In addition to their stocks and bonds, Fred and Wilma have a couple of real estate properties where they have long time tenants who are interested in buying the properties.  This gives them diversification and a wild card in the event funds are needed.

On the planning side, a couple of issues came up that couples need to think about because they have the capacity to upset the apple cart.  One I suggested they look into is umbrella insurance.  The fact that we live in a litigious society means there is always a risk we could get sued for everything we own. Umbrella insurance is a protection against this and is relatively inexpensive.  I suggested they talk to the provider of their automobile insurance and get a quote.

A second risk is long-term care.  And it is expensive.  I suggested they look into the type of policy that covers 3 years jointly . In other words if Fred used 2 years ( for example, if he got Alzheimers), then Wilma  would still have a year.

There are a lot of Fred and Wilmas out there who have worked hard, lived within their means, accumulated a nest egg, and who have given considerable thought to their financial situation in retirement.  When you think about it, planning for 25 years or longer where you don't have a work-related paycheck coming in can be daunting.

Contrary to the impression you might get from the popular press, however, many couples have thought it through and, as a result, are looking forward to an enjoyable retirement.