Let’s face it for the majority of people when it comes to investing and the stock market their knowledge is extremely limited. As such Wall Street has developed ways to make it seem as though investing is not that hard and that “anyone can do it.” They even developed phrases to make it seem simple.
Mutual funds have become the investment of choice for many as they build in diversification and professional management. A simplified version of an “all in one” investments would be a fairly safe way to describe it. But what happens when mutual funds start to become too complicated for the average investor? Wall Street looks for ways to make it even simpler…
Introducing the Target Date fund.
Target date funds (or lifecycle funds) are the new kid on the block (outside of ETFs) for investment simplification and are now found in virtually all employer plans (i.e. 401k plans). In the federal government’s thrift savings plan (TSP) they are known as the L funds. They are easy to recognize as they typically have dates associated with their nomenclature. For example, 2010 fund, 2030 fund, etc. The basis for the name is to coincide with the perceived retirement date of the investor in the fund. For example, a person with a 2010 funds is expected to be entering retirement around the year 2010.
The fund’s objective is geared towards keeping the investments more risky (heavily weighted towards stocks) early on in the investment period and as one gets closer to retirement the fund would become more conservative (less risky) in nature. Of course this is all accomplished within the fund so the investor does not need to do anything. It all happens automatically. Well if you have paid any attention to the headlines recently, this has not exactly been the case. During a recent hearing about target date funds SEC Chairman Mary Schapiro noted that “returns of 2010 funds last year varied from -3.6% to -41%.” Now how is that possible?
Well like most things not all target date funds are built alike or similar in investment philosophy. In other words, some funds have a greater allocation to stocks or bonds longer than others. So in a year like 2008 when the sock market went down by 38 or so percent, a target date fund with a 2010 date and a high exposure to stocks (possibly as high as 70%) would have had terrible performance last year. And so the red flags were raised with investors of these funds. Remember their retirement is only a year away…thus the scrutiny that has come to target date funds.
There are over 250+ target date funds and chances are you only have one in your employer plan. The choice is probably offered by the company that administers the plan but there are multiple versions of the same fund at different companies. You only have one of the available options. So hypothetically if you have a 2010 fund offered by Fidelity your exposure to stocks would be 42% whereas the same 2010 fund from AllianceBernstein has 67% allocated towards stocks. (I just checked their websites.) For people who are risk adverse the latter is probably be too risky for someone a year away from retirement. Especially when the fund is supposed to be reducing its exposure to stocks.
Enter the Glide Path…
Huh, what? Glide who? Yes glide path…chances are you have no idea what I am referring to but you should. Glide path refers to the pace at which the fund becomes more conservative over time. If the glide path is lengthy (or slow to take place) you might have an exposure to the stock market a lot longer than you expect.
Last but not least, many people are using the funds incorrectly and are unaware they are doing so. It all has to do with asset allocation (how much money you have allocated to the various sectors of your portfolio). Target date funds tend to be funds made up of other mutual funds from within the same fund family. Simply put, a fund of funds. So by their vary nature the proper way to use them is to use them exclusively without using any other funds. Many times investors are using the 2010 fund, 2020 fund and the 2030 fund thinking they are getting more diversification but that is not the case. By investing in other funds you cause the asset allocation of your portfolio to be out of whack and can make the portfolio a lot less efficient, more risky and sometimes more costly (greater fees).
As I stated earlier with Wall Street nothing is ever as simple as it seems and target date funds are yet another example of this. If you choose to use target date funds please take the time to do your due diligence on them or seek the counsel of a qualified financial professional. Remember there are no short cuts when it comes to Wall Street.
First let me start off by saying that Black America and the world as a whole has lost a truly extraordinary person in Michael Jackson. His contributions to society are priceless and there will never be another like him. It seems as though in these past couple of years we have lost some true legends in the game: Luther Vandross, Shawn and Gerald Levert, Barry White, Wayman Tisdale, James Brown, etc. Having said that…what can we all learn from their passing?
Life is short.
For some it is shorter than others. We all at some point in time have felt that we have lost a loved one too soon or perhaps wish a loved one was still around so you could express thoughts that you were never able to express. All of this goes to how precious life is and that we all only have one to live. We don’t know when our time on earth will end, doesn’t it make sense to plan for it ahead of time?
Time and time again I see families devastated by the passing of some one unexpectedly. A couple of days ago there was a train crash of the Metro in Washington DC in which 9 people were killed. One of which was a 23 year old who had a child and had just opened a hair salon in Maryland. She could not have imagined when she got on that Metro train that that day would be her last. Upon hearing her story I immediately started to wonder: Did she have life insurance? Who will take care of her child? Did she have a will? Does the family have the money to bury her? Chances are the answer to these questions is no. But why is that?
Think about it…
First, young people have an invincibility complex and believe nothing will ever happen to them.
Second, statistics state that even though nearly 80% of people know they need a will they never get one. In this case a will is important not only to tell people who gets what (most common reason thought of for wills) but also for her to name a guardian for her child legally. Otherwise people can actually fight over who will get custody of the child. (Think Anna Nicole controversy).
Third, most people (young people included) feel as though they do not need life insurance because they will live a long life or that the insurance at their job will be enough. Here is the problem in this case…she didn’t have a job, she was self employed so there is no “employer” provided insurance. Even if she had a job if she left it then her coverage would have ended.
Now you would think that someone like Michael Jackson would have these things in place however only time will tell. I can’t tell you how many times people feel that there will be time to get things in place. Think about James Brown’s estate and how people fought over where to bury him or the fight taking place over Martin Luther King Jr.’s estate. I believe it took nearly a month for James Brown to get buried because he did not have the documents in place.
Insurance should be the staple of every household and quite frankly could be the cornerstone of wealth and legacy building for African American families of the future. No other vehicle allows a person to leave lump sums of money to the next generation for a reasonable cost in comparison to the benefit. Case in point, if Michael Jackson had gone to an insurance agent last week and got a policy for 100 million dollars (knowing he was about to go on tour), made one premium payment and then died. His beneficiaries would be receiving 100 million dollars in the near future. Now imagine if all families did the same thing? True legacies and generation building would begin to take place in the African American communities.
If you haven’t done so now is the time to get your affairs in order including any insurance you may need.
Wow! It looks as though the hits keep coming. Here is a segment by 60 minutes (April 2009) that outlines how retirees have fared by investing in 401k plans…
It goes without saying that investors today are scared about the current state of the stock market and their retirement accounts. For many, years of savings have been wiped out by the recent downturn and for some about to retire it could not have come at a worse time. So the question remains, with all the market fluctuations that take place, how do you make money in the stock market? The answer is simple in nature yet so complex in practice.
We all know how to make money in the stock market, right? BUY LOW and SELL HIGH. Seems fairly straight forward yet investors don’t seem to be able to do it. Why is that? Well because we are human beings and we have emotions (and the internet). You see, Wall Street knows that investors are motivated by two things: fear and greed. And they use this to their advantage as they play on investor emotions. Characters like Jim Cramer and television stations like CNBC and Fox Business play a vital role in the manipulation of investor psyche. Wall Street knows that the novice (average) investor will always buy at the wrong time and sell at the wrong time almost like clockwork.
Fear runs investors emotions causing them to sell precisely at the time when they should be buying and buying at the time they should be selling. Don’t believe me….how many people do you know (including yourself) have sold investments AFTER they have gone down in value? (I am not referring to rebalancing.) Did your hand go up? Okay maybe not yet.
Now how many people do you know have said “I am waiting for the stock market to hit the bottom or start going back up before I put my money back in? (By now I am sure to be speaking about someone you know.) Investors are happy to buy stocks that are going up in value (buy high) and only sell stocks after they have fallen in value (sell low). This is the major mistake investors keep making and they keep wondering why they don’t seem to be able to make (and keep) money made in the stock market.
Investors by nature continually BUY HIGH and SELL LOW, the exact opposite of what you are supposed to do. Chances are the time you are thinking about selling is the time you probably should be buying and vice versa. The internet plays a role as well as we all have 24/7 access to account values further stimulating your FEAR and GREED hence causing poor investment decisions. “My account is losing money therefore I need to sell or the market is going up therefore I need to buy”…a perpetual cycle.
Depending on your situation chances are you are much better off staying invested IN the market as opposed to trying to TIME the market (waiting for the bottom). Keep in mind that the stock market is viewed as a long term investment strategy and market timing cannot be done by anyone. Case in point…if I knew what the market was going to do would I tell you for free on television every day? I have always wondered about that…
Here’s my conspiracy theory…
If I had the platform of being on a television everyday (like CNBC) and had a built in audience of millions and perhaps needed to sell a position I maintained…what would I do? I would tell everyone within the sound of my voice that XYZ company is the greatest thing since sliced bread, right? What would happen is that everyone would go out and buy that stock causing it to go up in value and now I can sell it. Thank you Mr. Novice Investor.
In part one of this series I alluded to the fact that qualified retirement plans (i.e. 401k plans) may not be the most efficient way to save for your retirement. From that post you may get the impression that they are bad investment vehicles. As I previously stated for some people they are and for others they may not be. It all depends on your individual situation.
What I am hoping to convey here in Part 2 is that tax qualified retirement plans (QRPs) are some of the most misunderstood investment vehicles despite the fact they are nearly 30 years old. I hope to shed some light and perspective on some the other points related to 401k, 403b, TSP, etc., that many people simply overlook and never mentioned in mainstream media.
So why is “max out your retirement plan at work” the holy grail of retirement advice offered by so many people? I pondered this question years ago and really found it led to basically one reason…because everyone else says so. (I expressed the rationale in Part 1 – tax deferral and lower taxes in retirement). However what I also found out is that these plans have other features that “everyone else” fails to mention.
Here is a partial list of what I found:
1. Lack of Education - Many participants do not know how their plans work or how to choose from the investments being offered.
2. Not liquid - Money in QRPs is not available for use and are subject to taxation and possibly a 10% penalty until age 59 ½.
3. Lack of Control / Flexibility- Participants are limited to the use of investments offered by the employer and must ask for permission to get their own money, loans typically limited to 50% of account value
4. No Transparency – Participants do not know what fees their employer charges inside the plan (see hidden fees of 401k plans).
5. Government Regulation – Congress is constantly changing the laws and regulations.
6. Required Minimum Distributions - Law passed by Congress that you MUST start taking the money out of the plan at age 70 ½ or face a 50% penalty!!
7. Higher Taxation in Retirement – Contributions to QRPs could actually raise your taxes in the future (discussion below).
I could keep going but I think you are starting to get the picture. The most fundamental point that is missed by almost everyone is that 401ks, 403b plans, TSPs, etc., are all PLANS FOR FAILURE (at least that is how they are positioned)!
Think about it…if you are maximizing the contributions to these plans (limit of $16,500 in 2009 – $22,000 if over age 50) and you do this consistently over your working career – how could you be in a lower tax bracket? By merely doing what everyone is telling you to do, you will have so much money in this retirement plan when you start taking the money out you SHOULD be in a higher tax bracket, right? After all if you have 2 million dollars (hypothetically) in your plan chances are you are not going to just withdrawal 20,000 to live off of, are you?
If you withdrew just 5% ($100,000) to live on, add in whatever other money you have then presto! You are in a higher tax bracket! The flip side to this type of thinking is that you are planning to be poor in the future. After all to be in a lower tax bracket would mean that you do not have a lot of money and therefore will fall into a lower tax bracket. I am going out on a limb and will say that this is not what you are envisioning for your retirement.
So if you do everything right you should want to be in a higher tax bracket in retirement since that would mean you have a lot of money! Now the trick is finding out how to be in the higher tax bracket (more money) AND paying less in taxes (lower tax bracket).
So as you can see there are both advantages and disadvantages to qualified retirement plans and becoming better educated on the ins and outs of these plans is paramount to your financial future.
For the vast majority of people their retirement plan at work will be their largest source of retirement savings. Whether it be a 401k for the private sector, 403b for teachers and nonprofits or the Thrift Savings Plan for the military and federal government workers, theses accounts more or less work essentially the same way. So I ask one simple question….why do you contribute to these plans?
You see conventional wisdom tells us we should max out our 401k plans at work because we:
1. Get tax deferred growth of our retirement savings
2. Get a tax deduction for the contributions to the plan.
Now both of these statements are true and the human resources representative probably reiterates these statements at every benefits meeting. However I wanted to take a closer look as to why such advice may not be so prudent for workers today. Before I begin let me preface my remarks by stating that for some people a employer plan is the best way to save for their retirement simply because it is a forced savings plan that happens automatically. That aside let’s take a closer look at the 401k plan….
Question…are current income tax rates high or low? Nine times out of ten the answer to this question is that tax rates are too high. After all taxes are everyone’s greatest expense. However in reality, looking back over the history of income taxes, we currently enjoy some of the lowest tax rates in history right now (regardless of what you hear Congress bickering about on a daily basis).
Speaking of history did you know the 401k plan was established in the late 1970s? Back then the highest tax bracket was 70%! Putting it into perspective, our current 35% tax rate was 70% back in the 1970s. So theoretically it made sense back then that you could possibly be in a lower tax bracket in retirement since today’s (2009 rates) are lower than those of the 1970s. After all that is why you are deferring the taxes today, right? Because you will be in a lower tax bracket in retirement. Keep in mind that it is entirely possible to make less money and remain in the same tax bracket. (see link above)
Now this is where it gets a bit tricky. You see no one knows what future taxes will look like but if we were to make a friendly wager as to whether or not they would be higher or lower in the future, what would you bet? I will bet you would say higher. After all we have Social Security, Medicare and Medicaid all in trouble financially, wars in Afghanistan and Iraq to pay for and a national deficit over 11 trillion dollars (just to name a few potential reasons).
So if that is the case, that taxes will be higher, why are you deferring taxes today to pay taxes in a higher tax bracket in the future? And remember that you are simply DEFERRING the taxes not eliminating them as they will need to be paid one day.
I know what you are saying, “but I also get a tax deduction on my contributions” so I am paying less in taxes today. I absolutely agree with that statement as well. But as previously stated saving money in a low tax environment will be of little consequence if taxes are higher in the future. The government will recoup all the “tax savings” it gave you simply by having a higher tax rate on a larger amount of untaxed money.
Think of it this way, if you were a farmer and had a large harvest every year would you want to pay taxes on the seed (the smaller amount) and get the crop tax free or pay tax on the crop (the larger amount)? Government currently gives you a tax break on the seed and taxes your harvest (after years and years of retirement savings).
