Friday, May 30, 2008

Retirement Planning at 20-years-old

Retirement saving is best done early and consistently. Retirement planning, the roadmap to how you will spend your after-work life is not as easy ­ especially when you are in your twenties.

Alyce P. Cornyn-Selby once wrote, "Procrastination is, hands down, our favorite form of self-sabotage." And who can deny that this is the single biggest hurdle we will need to jump in retirement planning.

As twenty-year olds, fresh out of school, whether it be high school, trade school, or college, we see the world in terms of the here and now. We are young and that youthful exuberance gives us the false sense that time is endless. We are undeterred, full of hope and rich in the belief that time is on our side. And in a way, it is.

We have our first job and with it, our first taste of financial independence. We divvy up our paychecks in terms of what it will buy: x-amount of dollars for rent, transportation, clothes and entertainment and not always in that order. Few twenty-year-olds are able to see the value of saving at this age. There are simply too many opportunities to seize and fun things to experience.

And your retirement plan should not take away from that time in your life. It should compliment it. But there are three things you must confront first before you begin the party that twenty is.

First, you need a financial mentor. This can be your parents, an uncle, aunt, grandparent or even a co-worker. This person will need to be older and wiser than you and someone you can trust.

This person will be nothing more than a sounding board for your financial decisions. They will, if they do the job correctly, play a sort of devil's advocate. Many of the big financial decisions we will make at this age will involve the use of credit. A financial mentor will allow you to ask yourself, while asking them, "do I need this now or can I wait until a time when I can afford it?" They will offer you a look at the mistakes they have made and what they would have done differently. Their experience becomes your lesson plan.

The second element of a retirement plan requires a clear understanding of how compounding works. When I am explaining compounding to beginning investors, I often tell use the story of the "Sultan'.

President Jackson once gave a gift to the Sultan of Muscat (now called Oman) after the ratification of a treaty between the two nations.

The gift was a silver coin with the minted date of 1804 (although the coin was actually struck in 1834) that was "sneaked" out of the country via secret emissary. Remarkably, the coin remained in its original condition for almost 150 years before it was purchased by the family of the late Walter Childs of Brattleboro, Vt. in 1945 for $5000.

The coin was then placed in a vault for the next 54 years. Until, of course, it was auctioned off for 4.14 million dollars!

Despite the "wow" factor of that fortune, many of you would be just as surprised to know, had that $5,000 been invested in a simple index fund that follows the S&P 500 (the 500 largest companies trading publicly in the US), you would have made $400,000 more than Mr. Child's family did when they took the coin to auction.

The key to compounding is beginning small, doing it consistently, and starting early. If your first job offers a 401(k) plan, a tax-deferred investment plan, sign up for at least a 5% deduction. In all likelihood, that small of an amount of pre-tax income will not affect your take-home pay.

The last thing you will need to do is avoid using credit for purchases under $500. That's right. Put the cards away until you absolutely need it.

At this level of borrowing, the purchase in more likely to be financed with a fixed rate, more apt to come after serious consideration, and it will probably be more of a necessity than a whim. A purchase of that size is much easier to add to your budget ­ the available money you have to spend on your life¹s necessities.

The best thing you do at twenty is develop a retirement philosophy that let¹s you live within your means ­ cash for everything that costs less than $500 to avoid unnecessary and unsustainable debt. When you do this while investing a small portion of your paycheck each week ­ just a 5% deduction from your payroll, you will be on the right road to retirement. If your employer doesn¹t offer a tax-deferred plan, have $25 a week automatically deposited into a savings account that you can set-up for automatic deductions to an IRA.

We will return to our retirement glossary next week.

Tuesday, May 27, 2008

G is for Gross Income - Retirement Planning

We continue our look at some of the important factors of a good retirement plan. This alphabetical look at what you need to know continues with a look at gross income.

In Retirement Planning, G is for Gross Income

There are very few downsides to owning a Roth IRA. Of course there is the tax advantage. After five years, the money can be withdrawn tax-free. Unlike a traditional IRA, all of the withdrawals are taxed at your regular income. (The reason for this difference is based on whether the money was taxed prior to deposit – traditional IRA deposits were a deduction from taxes whereas a Roth IRA is funded with after tax contributions.)

A traditional IRA requires you to take withdraws by age 70 ½ (actually the date is April 1st in the year following your 70 ½ birthday). A Roth does not have any such requirements, allowing you to keep the money invested until you need it – if ever. And that “if ever” allows you to pass the Roth IRA on to your heirs who, although they would be required to take distributions, would find the added income from the inherited Roth IRA would be tax-free.

While there is no guarantee that your Roth IRA will grow without set-backs – what you pick for your investments determines the portfolio’s possibilities, the ability to save more is restricted not only by age but by gross income.

Age and Income

Your contributions before you reach fifty-years-old are limited in both the Roth IRA and the traditional IRA to $5,000. But after fifty, the annual contribution jumps to $6,000 with adjustments being made thereafter based on inflation.

But gross income also plays a role in how much you can contribute. More specifically, modified gross income. If you are single, that income cannot exceed $101,000 and if you are married, filing jointly, the income limit is set at $159,000. Modified gross income is calculated using IRS publication 590 (turn to page 61) and does not include any Roth conversions you may have made in the current tax year.

What if you make too much? It is a nice problem to have but to avoid not investing at all, the IRS allows you to make non-deductible IRA contributions. Conversions have income limits as well ($100,000 a year for individual or joint filers – sorry, married filers filing separately re not allowed to convert). But hold onto the non-deductible IRA until 2010 and convert without penalty.

There are still taxes to be paid on the conversion however but they can be spread over the following years (2011 and 2012).

A is for Asset Allocation

B is for Balance

C is for Continuity

D is for Diversity

E is for (Tracking) Errors

F is for Free-Float

Thursday, May 22, 2008

Retirement Planning - F is for Free-Float

F is for Free-Float

One of the best reasons to use an index fund in your retirement plan that is modeled on the benchmark S&P 500, besides the low cost is the methodology employed by the index to get the best possible measure of how your investment is doing. While all of the stocks in the S&P 500 are considered large-caps, the way they are capitalized is not necessarily uniform.

The simplest way to determine market capitalization is to multiply the price of the shares times the number of shares. This unfortunately makes the mistake of including shares of stock that are held inside the company and are not available for trade part of the company’s total worth.

A company is only as good as the price of its shares. The more shares that are available to the marketplace, the better this yardstick becomes as a measure. Closely held shares that are literally “off-the-market” blur the overall picture.

By using a method called free-float, the indexes can accurately determine what the true market value of a company is. The S&P 500 uses this method in its index.

Free-float drops those restricted shares, ownership holdings and other blocks of stock not available for the public and considers only the shares that could be traded.

These broad indexes have had a reputation for long-term out-performance. Out-performance is a nice way of saying they did better than funds that are similar and for some very obvious reasons. The high cost of running an actively managed fund means that the actively managed fund must overcome those costs in performance percentages before they can begin to post competitive returns.

A is for Asset Allocation

B is for Balance

C is for Continuity

D is for Diversity

E is for (Tracking) Errors

Saturday, May 17, 2008

Retirement Planning - E is for Errors - Tracking Errors

E is for (Tracking) Errors

Indexes play an important role in retirement planning. Numerous people use them for their ease of use and convenience (many are located in your company sponsored 401(k) plans) and most importantly, their low cost.

The index funds that do the best job do so because they excel at penny pinching. And that takes more than just a smattering of skill. They must maintain the underlying portfolio, making moves seemingly in an instant each time the index re-balances (doing so before the rest of the traders increase the price of the stock that was added and deflating the stock that is being sold out of the index).

Any difference between the index’s benchmark and the underlying portfolio is considered a tracking error. These tracking errors are particularly pronounced during an unsettled market. Index fund managers may have enormous amounts of cash sitting idly on the sidelines as the markets adjust to news.

They would like to invest it but they, much like the rest of us, are gripped in fear that where they put their money will be the wrong place. Unsure of beefing up one position in favor of another, the money languishes, largely un-invested, while the benchmark moves ahead in most instances, completely unfazed by these decisions.

Measuring These Errors

Just when you thought all you had to do was buy and index and forget about it, along comes this paradox. But how do determine how much of an error is acceptable? The simple answer is chose a fund that is closest to the benchmark. But in the real world, that fund may not be accessible to you (perhaps it is too costly to buy into to or your retirement plan at work doesn’t offer such a beast). In that case, use this measure.

If over the course of a year – not a quarter or a half a year – your index fund’s return is more that five basis points lower than the return posted by the benchmark, you should consider moving your money.

A is for Asset Allocation

B is for Balance

C is for Continuity

D is for Diversity

Retirement Planning - D is for Diversity

D is for Diversity

Diversity creates more problems for retirement investors than we have space here to count. More than one study has revealed that fear of making the wrong choice stops us from making any choice at all. It is no different when you need to make a choice about which mutual fund to put in your 401(k). The problem is, which fund is the right fund?

Many mutual funds often have default investments for new enrollees. This is a way to get you participating without too much effort. But your employer doesn’t always hire the best fund families to run the plan and the choices might be limited. No problem.

The single greatest way to gain immediate diversification is with an index fund that tracks the S&P 500 index of the largest companies. This Goldilocks index – never too hot, never too cold, but just right – is the perfect investment to use as you begin your retirement journey. Once you learn more about how to make your plan work, you will need to diversify to include an index that tracks the rest of the market.

A is for Asset Allocation

B is for Balance

C is for Continuity

Thursday, May 15, 2008

Retirement Planning - C is for Continuity

Retirement Planning: C is for Continuity

One of the keys to getting from point A (your working days) to point B (your retirement days) is continuity. A retirement plan thrives on the steady flow of cash to work its long-term magic. It can never stop.

These days though, a walk down a grocery aisle or a visit to the gas pumps is almost we need to remind us that our dollar is not going as far as it once was. So you might find yourself looking for ways to free up a little extra spending money for the month. You might even find yourself eyeing the 401(k) contribution you make weekly and are seeing that money better spent in the here and now. It is a human reaction to survival.

If you must lower your contribution, limit yourself to the level of your employer’s matching funds or 5%, whichever is higher. This amount will not have an impact on what your take home pay would have been had you stopped participating completely. Keep that money funding your future. One note of caution, try to save more if things improve. You need to pay yourself first and the key is continuity.

A is for Asset Allocation
B is for Balance

Monday, May 12, 2008

Retirement Planning - B is for Balance

As we continue our alphabetical look at the wide variety of investment terms that are thrown about - in such a way as to generally assume you know what is being spoken or written - we will look at balance.

B is for Balance

There has been entirely too much emphasis placed on the need for balance. I firmly believe that in order for each part of your plan to work, it needs to have time to develop. Few people are willing to ride market unrest out, constantly tweaking their portfolio of mutual funds to get the same return, quarter over quarter, year over year.

Not only is this difficult for professional money managers, it is nearly impossible for the average investor to do.

There are far more important things to “waste” our time doing. If you follow some basic rules, you will be fine.

Ask The Right Questions

Among the first things you should ask yourself is “why did I buy this fund?” If it was because you found the long-term returns to be in line with your goals, then let the fund manager work out any kinks the market might throw his/her way. Check the fund each quarter but focus on the yearly prospectus. You should also keep those dollars invested. A down market is a buying opportunity for investors who use dollar cost averaging.

What is DCA?

Dollar cost averaging or DCA is one of the single most important ways to build a retirement portfolio. The method invests money each month directed to your defined contribution plan in equal amounts. This allows you to buy more shares of your mutual fund when the price is low and less when the price is high. It employs one of the basic market principles better than most investors would and does it with no effort.

There are several reasons that this works. Suppose the mutual fund you purchased was selling shares for $5. For each $5 you invested, you received a share in the fund. The market, doing what it does best changes based on an innumerable amount of factors. In some instances, this makes the share appreciate, increasing the price and in others, the price goes down.

When the price increases to $7, your designated investment dollars does not see that as a buying opportunity. Your five dollars instead buys only a portion of a share, in this case, only about three quarter of a share. In this instance, it keeps you from buying shares that might be overpriced.

But if the market goes down and the share price decreases to $2.50, your five-dollar investment has bought a share and a half. Investors have a difficult time controlling the desire to buy more when the markets are on the way up and selling when they are declining in value. DCA solves this.

In your Retirement Plan

The idea behind it is simple and is employed with great success in your company-sponsored plan. In those plans, money is automatically taken from your paycheck. If you are using a traditional 401(k), it is done before taxes are taken from your paycheck. If you are participating in a Roth 401(k) it is taken from after-tax dollars.

In both plans, a steady stream of cash is invested for your future. IRA users have some different challenges facing their use of DCA to its best advantage. Often, IRA investors opt for sending their mutual funds a check each month. This allows them to act based on current headlines.

If this sounds like something you are doing, set-up your contribution to be done automatically and write that amount in your budget. This will give you the opportunity to take advantage of all of the magic the DCA offers.

Previously: A is for Asset Allocation

Friday, May 9, 2008

Retirement Planning - A is for Asset Allocation

Today, we begin a look at the alphabet soup that has become investing and more importantly, retirement planning. For most people, the concept of saving is already understood, the downside effects of having debt has been completely drilled in - from every angle imaginable, and the importance of a retirement plan or planning strategy is absolutely necessary to prevent financial disaster when we hit or sixties or seventies.

A is for Asset Allocation

When there is market turmoil, one of the first things you should examine is how well you have allocated the assets in your retirement portfolio. This is no easy task.

If your 401(k) was properly allocated a year ago, before the economy slowed down, with mutual funds that were focused on growing your money and with your risk tolerance in mind, you will be fine. Fundamentally, not that much has changed.

Smart investors know they need to give their portfolios twelve months to fully utilize the plan. History has shown that with time, many of the imbalances that have a stranglehold on the markets will loosen their grip and things will return to normal.

Hold tight, time will come to the rescue.

What is asset allocation?

How those assets are positioned in your retirement portfolio however is a different matter.

In a retirement plan, asset allocation takes on a different meaning. In your portfolio, you should have basket of mutual funds that focus on different parts of the market. This method of investing protects you from swings in the market that is often specific to one group of investments. The markets rarely fail altogether.

The most recent example of this happened in early 2008 when the stocks of banks and other financial institutions began to falter. The most famous was the failure of technology stocks in 2000. Had you not allocated your assets properly, you would have felt a greater loss than the market as a whole did. Asset allocation protects you from this.

The Right Mix

In order for asset allocation to work, you need to determine two things: your age and your risk tolerance. Age is not so much a reference to how old you are but how far off in the distant or near future your retirement is.

Your risk tolerance is a reference to how much of your investments you are willing to put to the test.

If you are in your twenties, it is generally assumed that you should be the most tolerant of risk, investing in growth mutual funds and able to overcome any short-term problems.

Allocation assets becomes much more important once you reach forty, beginning to temper your risk and protect some of your assets. By age sixty, you should be investing a conservative mix of stocks and bonds.

How to get the Right Allocation

Perhaps the simplest way: invest in target funds that save for a future retirement date. These types of funds gradually change your assets over the years, essentially re-allocating for you.