Retirement Planning: Estimated Recovery of Your 401(k)

We all suffered losses in our retirement plans. We all saw the account balances in our 401(k) drop significantly from their lofty heights in January 2008. The biggest problem with the stock market crisis was not who lost the most - according to the Employee Benefits Research Institute it was those with the highest account balances - but why.

Had you been in your employers plan for less than five years, your account balance did drop, by almost 50% in some instances. But because this group generally made much more in contributions than they received in actual returns, their balances did not fail below zero. Even older workers who began to use these plans at age 55, still have positive balances in their accounts.

Folks who had the largest account balances, generally those in the study group aged 55-64 years old were seriously impacted by the downturn, losing on average 17%. According to EBRI, this median number and losses associated with it were due in large part to an overexposure to equities.

Despite all of the cries to diversify, to protect assets from just this kind of market correction, and the attraction to those gains offered by staying in equities far beyond when it would be considered wise, older retirement plan investors felt the pain to a much greater degree than younger investors/co-workers.

So what should you do if you are aged 55 or older? What should you do if you are younger, aged 20-34 or if you fall in-between those ages?

The older investor, had they stayed put in their original investments, continued to contribute and withdrew no monies from the plan either with loans or withdrawals of cash, will see their portfolios - and this is an estimate - recover in two to five years based on a modest market recovery of 5%. If you made moves to diversify after the fact, such as moving assets into safer investments such as lifestyle/target-dated type funds or simply moved into investments with less equity exposure, the recovery time could be twice what it would have been had you done nothing.

According to the EBRI: "Estimates from the EBRI/ICI 401(k) database show that many participants near retirement had exceptionally high exposure to equities: Nearly 1 in 4 between ages 56–65 had more than 90 percent of their account balances in equities at year-end 2007, and more than 2 in 5 had more than 70 per-cent."

There is a tendency for investors is to concentrate on the short-term rather than long-term performance. This is especially true of younger investors who realized outsized gains in their portfolios during the last four years. They were better suited to risk and were more likely to see those gains as justification to continue to channel money into their plans. Older investors, who may have been good contributors as well, felt larger losses in their portfolios because they had amassed larger balances.

In this type of market downturn, buy and hold may have been the best method of retaining long-term growth - but only for younger investors. Older investors had to learn the lesson of diversification the hard way. But either group, if they have the time and a modest market recovery, should see their balances return in less than a decade.

Retirement Planning: The Danger of Opting for Lazy

The Pension Protection Act of 2006, quite possibly the worst piece of retirement legislation to ever take hold, has some employees allowing their employers to do what they are too lazy to do: diversify their accounts, select the right age-appropriate funds and move allocations. Your contribution might stay the same. It is where that money is going that creates long-term and possibly adverse problems for workers who believe they are on the right path.

The PPA is a business-friendly bill that gives employers new abilities. Some of these changes, which can be blamed on a more economical plan for the employer, do not always translate into a better option for the employee.

An employer can look at the cost of their current plan and deem it too costly to maintain. When this decision is made, the funds that were currently chosen by you are shifted into similar types of funds. That is, if you do anything at all.

When there are changes in your plan, you receive notification, often twice before the event. Failure to react to these changes within the given time frame (often thirty days) allows the employer's new plan sponsor to make changes it deems best for your age. The problem with this kind of power is threefold: One - only on the rarest of occasions does the employer have enough information about your finances to make a good decision; two - the new group of mutual funds in the plan may not resemble the allocations you made previously; three - the default options often do not take into account your personal risk tolerance.

In other words, lazy now has a price.

This can have the most devastating effect on younger workers. They often have the poorest understanding of the age appropriateness of their investments. Some have simply under-invested in equities, preferring to avoid what they have witnessed with older co-workers and their parents. In other words, they do not want to lose money. In other words, they are avoiding risk.

Your employer can change that. New plan sponsors can offer to switch funds on you, to allow you greater exposure to equity risk while switching older workers to less risk exposure. They do this by enrolling unsuspecting (although, as I said, notified in advance) employees into target-dated funds.

I have raised suspicions about these types of funds, their ability to perform better than a simple index fund, and the possibility that these funds (more like a fund full of funds from a particular family and not all of them good) will do better over time. Target-dated funds have no track record and more importantly, no guarantee that the manager at the helm will be able to mix and blend the right investments to achieve growth and capital preservation.

Michael Malone, managing director of MJM401k, a 401(k) consulting company in Phoenix suggests that this is still only a possibility. He said, “There is a degree of paternalism associated with it. If we look at the allocations that employees have, there have been more cases than not that those allocations and selections of funds aren’t necessarily the best things for them.” He warns against doing nothing: “But if you want to maintain your existing elections, you can move back into any elections you want.”

The bottom line for any investor, whether they be independent or enrolled in your company's defined contribution plan is to be aware of any shift. While you can change these fund allocations after the fact in many instances, why would you allow the fund sponsor to do the thinking for you.

If your company has a new 401(K) provider with a new group of funds, try to mimic your investments from the previous sponsor's offerings. This may be a bit more difficult because many of the changes are to plans offering less investment options, not more.

But opting to do nothing could cost you thousands of dollars of potential earnings over the course of career.

Retirement Planning: Making Realistic Assumptions about Retirement

The act of assuming is much like the act of predicting. It is subject to unknowns and is based on what we know happened, with a healthy dose of optimism thrown in for good measure. In retirement planning, the assumption of what you will need to live long enough to outlast your money can be a recipe for disaster that will not materialize until you are no longer able to do anything about it. In other words, you will be too old to fix the problem of not having enough money.

It is a common practice among advisers to suggest the following: You will have $20,000 in Social Security benefits annually; you will withdraw 4% of your retirement income per year; your retirement account will grow by 8% during the years you contribute and continue that pace after you stop working; the inflation will remain relatively stable at around 3.5%; and you will have no other source of income available such as a pension.

Each of these assumption may be wrong and this rate of incorrectness can lead to problems early into your retirement but late enough in it to do anything about it.

Let's begin with Social Security. The assumption that it will somehow go away is just not accurate. It will be there. But the earlier you tap into those funds, say at sixty-two instead of your mandated full retirement age, a target that is guaranteed to move further away as time passes, the smaller amount of those estimated funds can be assumed. So assume the worst and that you will not be able to tap that social program until you are well beyond 65. And if you do, it might be less than you had previously assumed, even if you will not outlive the benefit.

Now for the withdrawal rate. This is key to the long-term health of your retirement plan. I, along with numerous other people in this field have suggested that 4% is the rate you should chose when attempting to outlive your retirement savings. This however is based on a fully funded retirement plan that has you entering into retirement debt free.

The problem with debt is not what you owe on a loan(s) - although it is definitely troublesome to any income calculation whether you are working or not - it is what you will need to finance the rest of your days. Taxes will not go away. Both personal and property taxes will continue to act as a debt on your income and will rise in the future. Insurance will also create a debt-like obligation, not only for health but for property coverage for your home, your car, and any other property you might have. Upkeep on those properties will also increase over time acting as another strain on your income.

The growth number we often assume, the 8% return we are expecting on our investments may be too high. As we all know now, if you were to retire now or worse, be drawing on retirement investments, you are withdrawing money at a faster rate than the money can recover. Based on the last decade of returns, the number may be closer to 4%.

Inflation is another major concern. It is not going away and is even expected to climb in the years to come. While 3.5% may be an workable average and a fair assumption, it is not worthy of a worse-case scenario projection. The fact that your money will be worth less in the future should be calculated closer to 5%. This allows for some reverse growth and allows you to plan much better with fewer surprises later in life.

While the pension assumption - the fact that so few of us have one and even if we do, a plan that is not currently in trouble - is safe guess to make. Less than 25% of the working population has one. If you do, assume that it will pay 25% less or more, if you are beyond the cut-off point that the Pension Benefit Guaranty Corporation or PBGC insures. Pension plans pay the PBGC to insure these plans and they will only guarantee a certain amount. If you have a pension, calculate the worse-case scenario here as well. The 2009 PBGC guarantees can be found here.

The next post here will discuss the hard numbers.

Retirement Planning: A Good Retirement Plan (401k) Gone bad

Despite all of the faults with your 401(K) plan, from poor or limited choices, forced matches with company stocks, high management fees to name just a fee, your plan may not be getting any better soon. Is waiting around for improvements worth it?

The Company Match
The incentive called the company match may have been tossed to the wayside in this current economic cycle. And for good reason. Many business were forced to take drastic measures to stay afloat as consumers spent less, credit got tighter (for both their customers and capital expenditures) and labor costs seemed to rise (although in truth, they didn't actually go up as much as sales went down).

The 401(K), created for allow for additional savings for wealthier individuals looking to add to their retirement accounts in the presence of a fully funded pension plan, has been misused by many of the folks who are enrolled. As a self-directed plan (defined contribution plan), the responsibility of the employer to provide you some reward for years of service and your precious human capital diminished (the plan need only present you with choices), offer some advice (albeit generic), and direct non-participant employees to a default investment (as per the poorly written Pension Protection Act of 2006 - a misnomer if there ever was one).

The company match, a contribution by your employer that offered you free cash for every dollar you contributed on your own, up to a certain percentage (most commonly 3%) has been halted or scaled back by many employers. Some have switched their matching rules to include only stock with rules that make moving the plan more difficult.

Even if your company no longer matches, continue to participate in the plan. The pre-tax incentive is enough to make the plan worthy of your money. How much is often the questions I hear the most. And the answer is relatively simple: a 5% contribution to your plan will probably net you the same after tax income that you would have received had you made no contribution at all.

What's in the Plan
Companies have been forced to scale back or change plan administrators. In some cases, this is warranted. Many plans had too many options and far too frequently, contained products that were ill-suited for the average investor (although in many instances, the average 401(k) investor confused what they were doing as savings and because of that confusion, made them less-than-average participants in the plan).

Determining the worthiness of the underlying investments is even more difficult. Some companies offer a lot of funds; some only a few. Some offer a wide variety of mutual funds across a wide spectrum of possible investments; some offer only a group of index funds focused on specific types of investing (large-cap through small-cap, growth through value through balanced, and target-dated funds).

One of the most fundamental aspects of a well-constructed plan is not eliminating too much risk. Because the plan is built on a 'pay the taxes later' concept, there should always be a certain level of risk involved. I have long been an advocate of keeping investment mainstays such as the S&P500 index funds on the outside of your retirement plan. Doing so will force you to pay the taxes on the fund now, rather than later and because capital gains taxes are still historically low and the fund is very tax-efficient, paying the tax now will give you all of the money in the fund whenever you need it.

Fees are a Consideration
Always compare a fund against its peer group rather than against some index for more than just performance. Most fund managers want you to look at an index that, in most instances, does not reflect what they are trying to do. Take for example the S&P500. This index is not necessarily considered a growth sector. Although there are companies in the index that are growing, the largest in that group are dividend paying (often) behemoths that might be better categorized as value plays.

But fees that are too high, as compared to their peers, act as an additional drag on your investment. The best way to get these funds out of the plan is to complain. If the plan is charging fees that are excessive, employers might be paying too much as well and employees might under-participate in the plan because of it.

Self-directed is not the same as set-and-go. In fact, the more control you have over your investment decisions, the more difficult it becomes. Take a moment to review our examination of why investors do what they do and how you can benefit from a new approach to your plan.

Why Investors Do What They Do: Investor Optimism

A Recent Gallup poll tells it all. Well some of it anyway when they suggest: "The sharp decline in Gallup's Index of Investor Optimism in June -- particularly the plunge in expectations for the economy -- suggests that investors may be losing some of their hopes for an immediate improvement in the U.S. economy later this year." In the last in our series on why investors do what they do, we will examine optimism.

According to the Gallup website, the survey for "The Index of Investor Optimism results are based on questions asked of 1,000 or more investors over a three-day period each month." Although these individual snapshots can help us see where we were, only optimism propels us forward. Unfortunately, these looks back in time have an effect on how we make future moves.

While we may see it as a screenshot of how we invest, the real hidden knowledge behind the poll is consumer spending. Asking questions such as whether you will be able to achieve your investment targets over the next twelve months requires you to know what those goals were over the previous twelve months and during that period, you switched gears (and how many times). The thousand who were surveyed were also asked to project those hopes and fears into the future five years from now.

Key to achieving any sort of optimism when it comes to investing is job security. With one in ten Americas out of work (a number that is without a doubt, much higher due to the lack of jobs for those entering the workforce for the first time and unable to collect benefits and for those who are disparaged and no longer receiving any assistance), stability of income and the potential for raises play a significant role in how we look ahead. Bernard Baumohl in his 2007 book "The Secrets of Economic Indicators" calls the poll not only intriguing "it measures the attitude of private investors" yet it "also happens to the one of the least known."

Optimism is a mood, a feeling that offers us hope. Richard L. Peterson author of "Inside the Investor's Brain" writes that "investor optimism about the stock market's future declined in tandem with prices". He continues by suggesting "intellectual assessment ("overvalued") is decoupled from their underlying feeling of optimism ("it's going up")."

In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior. Coupled with all of the investor behaviors we have previously discussed here, optimism can wreck the most havoc to a long-range portfolio, in particular one built to grow for retirement.

Morningstar recently reported that "Diversified Emerging Market funds benefited from a $4.9 billion inflow vs. a net outflow of $2.6 billion in 2008." Emerging markets will always be the quickest to recover in part because of their bargain basement prices and one of the few places where risk remains risky. In a previous month's post, I warned about some of these problems and how emerging market mutual funds might not all be full of stocks from countries that are actually emerging.

Optimistic investors have also begun to channel money into more riskier bond plays "Junk bond inflows have increased $12.6 billion in 2009 vs. a rise of $1.2 billion in 2008" and Morningstar also reported that "Investors have piled in $7.8 billion into natural resources and precious metals funds after withdrawing $2.1 billion from the same category in 2008."

Chasing returns, at least past returns is also part of the problematic herd mentality and feed directly on optimism. Pessimism, which every knows is the opposite of our topic, also gives investors a sense of needing to follow what other investors do.

Optimism will not ride the coattails of this recovery. Instead, any recovery will be the result of it.

Why Investors Do What They Do: The Effect of the Media Hype on Investors

Has the hype in the media over the last several months had an effect on how you invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television.

Thomas Schuster, who wrote the book "The Markets and The Media" suggests that television news has changed the way investor's react and eventually what they do. "Novices," he writes, "receive their basic training in investment issues via the media, even via such an improbable candidate as television."

Because the news is interested in only short-term events, Mr. Schuster worries that that sort of focus "provides explanations which afterwards evokes an impression of logic". There is unfortunately no way for even a savvy investor to parse that sort of information, see a developing trend that encompasses both the past and the recently reported story and make any sort of logical decision. But people do.

And the reason for this is pure coincidence. Sometimes your perception and the reality of what is happening meet and when they do, there is often a seismic shift in not only how you view your investment strategy but fundamental values as well.

There is no rational for this type of behavior short of we just do it. We treat stock information garnered from television, even stations devoted to the interactions of business and their shareholders/investors as if it were information worth having. There has been some speculation that the real traders understand this and seek to profit from this sort of non-knowledge.

It is as they say, much easier to swim with the tide. And many traders are now focused on doing just that, predicting when their colleagues, other investors all begin to believe something is worth more than they know it should be worth. The benefit these traders have is knowing that they are investing on emotion and because of their cold-hearted approach to the subject, bail long before the rest of the group realize what it is that they don't know.

So what do we do? The best thing would be to cancel cable and turn off the television. But that isn't going to happen. So the following three suggestions might help.

First: examine why you did what you did in the first place - you know, before you began to question those motives. Chances are you were probably right. If you used your retirement plan according to the time-honor, take-a-lot-of-risk-when-you-are-young method of investing, you probably should go back to that. That is, if you have changed. The most recent news has sent folks scurrying for the less risky forms of investments in their portfolio largely in part because of how the news portrayed the stock market's reaction the global financial crisis.

If you did, keep in mind that "the crisis" affected everyone, equally it seems. The second thing to remember is that you are not the only one with a damaged portfolio. If you managed to keep your job, weren't too deeply in debt and for all intents and purposes, are saving more, your approach to retirement should not have changed. Although the economy (even the global one) will not recover evenly, it will in fact recover with time. If you had spread your risk across four or five sectors (growth - large, mid-cap, small-cap, international and emerging markets) you would have covered all of your bases and be on the way to a decent recovery.

Third thing to remember is that this will take awhile. If you do not feel as though you have enough time I have bad news: investments take time and worse, take their own sweet time returning to normal. But as renowned economist and thinker John Kenneth Galbraith once suggested, the market has no memory. But you will often recall the pain of a loss much more vividly than the market does and this will keep you from making the correct investment decision when you are most emotional, which is often in the aftermath of some new piece of news.

If you have a short horizon, you need to either lengthen it or reevaluate what your plan intends to do for you if you do not allow it to recover before you start drawing down the assets.

Next up: The negative effects of optimism.

Why Investors Do What They Do: Regret

One of the basic assumptions in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret.

Regret is a math problem believe it or not and has long been discussed as component of statistical gathering. In her book "The Nature and Growth of Modern Mathematics" Edna Ernestine Kramer suggests that by using Professor Leonard Savage's regret matrix, something she defines as "the difference between the actual payoff" as a result of "some pure strategy and the payoff he might have received" had the test subject known for example, what could have happened.

As an integral part of decision theory, Savage's 1951 study of the subject was not the first. Blaise Pascal may have been when he proposed his wager. Nor was it the last. Investors have a tendency to look for benchmarks. Mutual funds use benchmarks to tout their investment prowess. And the probability that doing either of these exercises as being worthwhile is debatable.

Investing, no matter how lonely that decision you make seems, is always a competitive one. Failing to realize that your decision's success needs to have taken into account how other people doing the same thing is often commonplace. Yet, this is often not decided based on any specific thought. You see where other folks are investing. If they flock, you flock. If they flee, you flee. Human nature actually and genetically wired for survival. And you make the decision on how to allocate based on what you fear most: risk.

But our big brains get in the way. This is where regret comes into the picture. Savage constructed a criterion he called the Minimax Regret. We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed.

This will result in a portfolio recovery period that will take you much longer to get back to even than someone who had not reacted or regretted their investment decisions. The market makers, those you placed your trust in, if blindly and unknowingly, made numerous wrong choices and everything fell in. The mutual funds that are used by you to achieve long-term gains have now repositioned their holdings to begin again in the aftermath of the last twelve months. Denying risk at this point (heading off to an index fund or worse, a target-dated fund) will not allow risk to play a role in your financial recovery.

Regret is a surprisingly destructive part of an investor's behaviors. Anticipating past history in making investment decisions allows regret (the "what if" is replaced with the "what if I don't") to strangle risk and not allow it to do the job it is supposed to do.

Next up: The media