Thursday, August 27, 2009

Your Retirement: The Double-edged Sword of Inflation

No one among us dislike lower prices for basic goods. If gas is inexpensive, our sentiment on the economy improves in tandem. If food prices fall, our personal budgets rejoice with the addition of some financial breathing room. Inflation has this effect like no other measure available in the economy.

And although the measure is of a basket of items (goods and services, ironically with food and fuel removed because of their volatile nature), it is a lagging indicator and open to refinements and adjustments. Yet it is still the number we associate with spending. How far each dollar will go is especially important in tougher economic times (and they don't get much tougher).

The inflation rate over the last nine years picked a year ago last month at 5.60% due in large part to the cost of oil - not the commodity itself but the effect it was having on the "goods" in the basket of measurable items. But since then, as oil prices fell, so has inflation. Last month it had turned negative at 2.10% (Here are the rates since January 2009 by month: 0.03%, 0.24%, -0.38%, -0.74%, -1.28%, -1.43%, -2.10%).

The bad news for seniors (and any other contract pay raise linked to COLA or cost of living adjustments), their benefits (or wages) will not increase in any noticeable fashion. Some seniors, if they pay for Medicare with a deduction from their Social Security, due to the increase in premiums, this lack of inflation will be easily mistaken for a cut in benefits.

Now, for some reason, which we will speculate on a little further on, the IRS is attempting to index your 401(k) deduction to this rate. If they are allowed to do this, and Congress can intervene before it takes place in 2010 tax year, your maximum contribution you are eligible to make will fall $500 to $16,000.

For most, this is a mote point. Far too many people are unable to make the maximum contribution in a time when employers have slowed, if not ceased matching employee contributions. But for those who can, this is a backdoor tax that could be the first step in drawing additional revenue for the government, at a time when it is needed most.

Exactly how much potential revenue is not known. There is still some legal wrangling to even see whether this can be done - it never has before - but I would be willing to wager that Congress will not act.

Folks who max out their 401(k) on salaries of $60,000 or less will need to have the rules rewritten in their workplace to allow for a contribution of that size to be made. Contributing 33% of you pre-tax income to your 401(k) would leave with a small paycheck (if you contributed just 5%, you would take home about $220 more than someone who made a maxed out contribution - which also includes some room for the employer to make their match) but a huge retirement nest egg, particularly if you have an early start of the process.

This will, without a doubt, have the biggest effect on high wage earners. Even with 14 million workers idle due to layoffs or other economic situations, the US work force totals 154,504,000. If the IRS is permitted to enact this change in deductions and assuming that the top 10% of the wage earners, the folks most likely to make that sort of sacrifice and you use the lowest tax bracket in the group, the government would, in theory, net an additional $2 billion in revenue.

So for the vast majority of wage earners, setting aside and investing any available pre-tax cash into your 401(k) plan is worth doing. Even if your employer has suspended their match or significantly altered it from the year prior, continue to use this type of plan.

And while I have you, I need to re-emphasize the difference between savings and investing. When you put money away in a retirement account, be it a self directed contribution or an automatic withdrawal via payroll into a 401(k) plan, you are NOT saving money. You are investing. My belief is that this may have been part of the problem with these plans; folks thought that they were saving when in fact they were investing.

Investing comes with certain obligations such as knowledge of risk and your tolerance to it as well as a keen sense on how to use that information over a long period of time.

If I could get everyone to call this what it is, I think we could approach this whole retirement situation with a more clear goal and calculated approach.

Tuesday, August 25, 2009

The 401(k) Returns... Almost

Your 401(k) is still in trouble. As the stock market rallies (although some think that September and October, historically bad months for the stock market will correct this), as the economy recovers (although consensus agrees for the most part that the recovery is not so much a bounce as a leveling off) and as unemployment remains the lagging indicator (along with housing), the effort at funding your future through your 401(k) languishes. Why? The employer is seeing that incentive to invest, the 401(k) match as not worth reinstating to pre-2008 levels.

For those of you who may not be aware, the 401(k) replaced the pension decades ago as companies divested themselves as guardians of your future. Pensions were the repayment for loyalty, human capital and profits. The 401(k) on the other hand was directed by the employee. Business used the incentive of the company match, a dollar for dollar investment up to a certain percentage as a way to encourage loyalty, human capital and profits.

Then the economy turned sour. And in the process of cost cutting, many companies eliminated or greatly reduced their company match. The question is: will matching of employee contributions ever return?

The short answer is yes. The long answer is: they will no longer resemble the employer contributions we have all become used to receiving.

Businesses face two problems when they decide to cut their 401(k) match. Neither is very appetizing and may even cost the company more than they bargained for.

For most plans, reinstating their 401(k) will not happen until 2011. Because of what is known as a safe harbor rule, reinstating the company match needs to be in the books by November of the previous year. To take effect in 2010, companies will need to feel as though the economy is on stable footing. This is not yet clear and may not be clear by the fall.

If the economy recovers at a faster pace than anticipated and jobs begin to return before 2011, the competition to get and in many cases retain good employees by offering these incentives will be missed. This could be a costly mistake for businesses looking to get and keep quality workers.

If the economy merely levels off, these employers will have time to see if some new techniques, currently being offered by Starbucks, might be the way of the future. Starbucks is breaking the mold for 401(k) plans by changing the incentive to profit based contributions. In other words, the company does better and in return, you get something for your retirement besides what you invested.

Will it work? Will other businesses follow? Possibly yes to both. The current corporate thinking is leaning towards less incentives believing that their plans were too generous in the first place. If your company has struggled through these tough economic times, particularly if you are associated with the automotive industry, those incentives, many experts agree, will never return.

A great number of other industries are planning to ease back into the incentive by offering substantially less in matching contributions and promising to raise those levels once they are assured the economy has recovered.

Some may simply be waiting to see of the Starbucks model works.

Does this mean the end of the 401(k)? No. Instead, you will have to earn more, put away more and invest with slightly more risk than you would like to assume. This means keeping your money out of staid index funds and target-dated funds in favor of investments that could do better. For some, this will be re-entering a high-risk investment model that did not pay off previously, evidenced by the cutting many nest eggs by a third or more when the market soured.

The next year will prove to be among the most interesting of the recovery.

Tuesday, August 18, 2009

Which Recovery is Good for Your Retirement?

We are at or near or nowhere near a recovery. No one knows. But that doesn't stop the speculation and with good reason. Most investors try and position themselves near where they feel the seeds are planted - the green shoots if you will. But this recovery, which had devastating long-term effects not only on retirement plans but the investors who use them to secure the future, is different than previous returns to normalcy.

In the recent past, we have had three major blows to the economy. 1973 was a good example of an oil driven recession. Most Americans were caught completely by surprise. For many people, it was the first time they had ever felt globalization in their paychecks. And more than just the long lines at the pumps brought this realization to their front door steps.

The recession that began in the third quarter of 1973 was not initially inflation driven. In fact, it was the nominal interest rate of 10.2% and inflation rate of 7.4% (if they seem high compared to our current rates, they are), the collapse of investments, consumer withdrawal and the overall lack of spending that pushed the unemployment rate to almost 10%.

The recovery was spurred forward by a huge tax rebate engineered by Alan Greenspan. And while inflation seemed to come under control, albeit briefly, unemployment rose as some industries that are traditionally hurt during a recession - housing, manufacturing - took longer to recover. By 1980, the trouble with banks (deregulation led to riskier lending practices, higher federal deposit minimums) only added to the problem. By 1982, the prime interest rate was at 20%.

Banks failed, Savings & Loans collapsed and the corporate tax increase and the deficit spending by the government instituted by the Reagan administration all contributed to the length of the recession. But it was the contraction of available money (money supply) by the Federal Reserve that caused the downturn. And helped its recovery by 1984. By that point, inflation was down to 3.2% and two million Americans had returned to work.

The next recession hit the world as consumer confidence (which had soared, declined) and consumer spending (spurred on by unrealistic optimism) became global players. We had developed into a nation of consumers and the world was now our producer. When we stopped spending with the first Gulf War and the rise in oil prices, the rest of the world's economy (the exceptions were Japan and Germany) fell.

The recession that began in 2008 is well documented and still lingering. But the signs of recovery are beginning to poke through. The problem is, what and when will it end and when it does, what will the new post-recession economy look like?

The credit shocks that the economy has felt are still reverberating. Bondholders will be offered riskier high yield bonds to help alleviate this debt burden. Current bondholders will be asked to lengthen the maturities on the bonds they currently hold and job creation will be the last piece of the puzzle needed to see any meaningful recovery.

Business are still testing their limits, stretching what few resources they have in an effort to position themselves for their shareholders. This pressure will keep job regrowth to a minimum as businesses figure out what to do next. Just as many investors have removed risk from their portfolios, so have the businesses we invest in (whether it be directly through stock purchases or indirectly, through mutual funds).

This makes planning for a retirement in this environment doubly difficult. Those close to retirement will have little time to bring their portfolio losses back to pre- 2008 levels quick enough to make a significant difference (the economy needs retirement in order to create jobs for people entering the workforce).

Those looking at a retirement ten-years and beyond have lowered their risk significantly as well, opting for index funds and indexed ETFs or by lowering their investment contributions. Both of these will force retirement further into the future.

Although consumers won't see raises for many years to come, the slowdown is allowing many banks the opportunity to work through the bad loans still on the books. Businesses will begin capital spending but only barely in the next year.

The key to benefiting from this recovery involves more than increasing your savings (which is considered an economic inhibitor) and getting your financial house in order (refinancing during these low lending rate events and realigning spending). The key is still investment and a healthy dose of investment risk. Confidence in the fact that you may not lose your job, you will keep your house and possibly even build that emergency savings account for the first time leaves the average person with a risk gap that only stocks can fill.

If you do not maintain at least a 5% contribution level and keep it in actively managed funds, those looking to pick stocks in this sort of market, you will miss out on some unusually attractive opportunities at rebuilding what you may have lost.

In other words, 90% of Americans will feel the recovery long before any other part of the economy will. They just won't realize it.

Tuesday, August 11, 2009

The All ETF 401(k)

Exchange Traded Funds, like many new products that have hit the investment market in the last ten years or so, have made steady inroads among hardcore investors looking to use these often specifically indexed funds to "park" money as a hedge against other trades or as way to take advantage of a broader market bet. These are professional maneuvers that come with costs and are probably not good for the average investor.

First off, let me explain what an ETF is. Exchange Traded Funds are basically index funds. Index funds are basically passive in nature, mimicking a published list of the stocks grouped together, such as the top 500 companies (published by Standard and Poors) allowing the investor to purchase a fixed group. They can also be broken down further to include numerous other indexes from mid-cap, small-cap and indexes of stocks from around the world. These funds, like their mutual fund counterparts have sliced and diced the world into segments.

For instance, if you think India is the next big hot spot. There is an ETF that buys the broad market along with some smaller regions in that country. Do you believe that Latin America will recover first? There is an ETF that allows you to play that economy. Perhaps you feel as though a stake in a commodity such as oil or gold is the next best place to invest. There are ETFs for that as well. Even bonds are covered.

ETFs, because they fall outside the realm of mutual fund regulation, also offer some savvy investor the ability to short (borrowing shares in the hope that the price will fall and then, buying the less-expensive shares) or leverage (using some stocks as collateral for purchasing more shares) or buy real estate without the REIT.

And while that sounds like a world we should all play in, for most of us it simply won't work.

Because Exchange Traded Funds are traded throughout the day, investors using them can buy and sell a position without waiting for the 4pm close that mutual funds have. The downside: ETFs also create brokerage charges in and out of the position and because of that, do not give the impression that this is a park and hold investment. The double downside: this create volatility that rattles the market in the hour before the close.

There is also a transparency and a legacy issue. Despite the publicized passivity of the fund, there is not always a good indication of just what the index represents at any one given moment. They also have not been around long enough to compare to mutual funds. New ETFs pop up everyday as the world gets chopped up into increasingly smaller chunks. And this creates a problem as well. Index funds stick to the index they track or the index they claim to mimic. ETFs can have some style drift within the fund making them difficult to pinpoint with any real accuracy.

ETFs are index fund cheap as well. An upside for any investor looking to keep the overall expenses of investing at a minimum. They rarely mention the cost of trading these funds, just the convenience.

The question is: do they belong in your 401(k)? Sharebuilder thinks so and has announced their launch of a new program for advisers to sell. Designed to make the interaction small businesses have with these registered investment advisers (RIAs) easier and more seamless, low cost ETFs will make up 100% of what these plans offer.

According to ShareBuilder these "investment offering consists of a preset line-up of 16 ETFs from popular funds offerings like a S&P 500 ETF to important fixed asset categories like treasury inflation protected securities (TIPs) not common today in most plans. ShareBuilder 401k also provides five model portfolios to help make it easy for participants to get off on the right foot."

Once again, is this right for your retirement portfolio? While we have discussed how fees can eat up a great deal of the potential profits an investor might expect. And if they are hidden as they so often are (the fees I am referring to are more from the adviser end of things) as little as a one percent increase over what a small business is paying could impact returns over the course of a working career as much as 17%. Sharebuilder promises that this new plan will be less expensive to operate with features such as auto-enrollment and auto-rebalancing thrown in for good measure.

But by making the plan completely ETFs, the risk level drops considerably. The average employee will relinquish more control to index funds than is needed to raise your portfolio's earning potential. Small plans will have a limited number of the these index-type offerings narrowing the potential for better-than-average results. In fact, your results using only ETFs will be average.

ETFs can be used as a tool for investors. But to have them solely as a tool for those planning on retiring, seems to serve the adviser more than the client.

Saturday, August 8, 2009

Retirement Planning - 401(k) Transparency For Some

Your level of expertise often directly affects how well you do when it comes to investing. The financial acumen, the ability to sift through reams of documents, and to keep track of third party involvement is not usually the forte of the small business owner. They may be well versed in what they know, how to make and market their skill or product, how to keep employees loyal to your vision and how to think big. But add a broker or retirement plan sponsor to the mix, and most small business owners, thinking they have done good by their employees and themselves, don't go far beyond the handshake agreement they make with these financial firms.

And that is too bad. When a plan sponsor approaches a large corporation, chances are there are people within the company who specialize in watching for cost overruns. They are able to spend the time (or already know what to look for) sifting through the documents the sponsor has provided, looking for hidden fees that could impact not only the employees but the business itself.

Add to that, these sponsor have the ability to spread these costs over a wider pool of employees, essentially cutting the costs. But when these same sponsors appear on the doorstep of the small business, this is not often as clear to the purchasing manager as it should be.

While Congress is attempting to offer a solution, it will still require the small business owner to look at these plans in depth and on a relatively frequent basis. The impact of hidden fees can often be devastating to the invested dollars of the small business employee. It has been estimated that even a one percent fee, over a the course of a lifetime of retirement investing could cost as much as 17% in potential returns.

Changes in the way plans are sold, revising disclosure of the costs in real dollars rather than percentages would drive the small business owners to comparison shop. Recent studies have suggested that small business owners pay as much as twice what their larger counterparts do.

But these smaller employers do not have to wait until legislation comes down the pike to make changes yourself. Demand disclosure of fees. Require those fees to be listed in real dollars. And understand the importance of small 'nickel and dime' costs in the long range rewards that could be had by not only you, but your employees as well.

Monday, August 3, 2009

Retirement Planning - H is for Hedge Funds in Disguise

If you have a pension, you are probably invested in some way in hedge funds. They have been described as the gated community of investing in part because they require large amounts of available capital - and I mean millions of dollars worth. Because pension plans need diversity and risk, they often benefit from some of this sort of 'outside of the mutual fund regulatory world' type of investment approaches. Twenty-five percent of them do. The individual investor often consider the "average investor"has barely any exposure. Mutual funds would like to tap that marketplace and in all likelihood, your 401(k) will be seen as prime hunting grounds for these newer funds.

Among these investment techniques is the ability to short a stock, use various types of arbitrage and options trading while others simply act as a fund of funds or a mimic fund to a larger successful brethren. Many of these techniques have netted investors huge sums of money in return for this risk. As the market fell 39% in 2008, hedge funds experienced losses of a far less (20%).

So if one of these funds turns up in your 401(k) list of available investments, should you buy it? Yes and no.

If you do not know what shorting a stock is, then probably no. Shorting a stock is a trader technique of borrowing shares of a stock in the belief that the stock will go down in price. When it does, the fund (manager) buys the borrowed shares at the new lower price.

If you are unsure how arbitrage works, then this might be a reason to stay away as well. Arbitrage attempts to capitalize on price disparities. The could come from underpriced mergers that are about to happen or from the difference between a convertible bond and the option to buy the stock. Yes, its complicated and risky.

If you have no clue what it means to neutralize the market, then avoid the pitch that these are essentially conservative funds. They are conservative - by comparison to other hedge fund activity - but they are by no means without risk. In fact, recent numbers show that these types of funds - that use a method of protecting the fund's holdings, usually stocks that are chosen to outperform, by using short positioning in broader indexes or options to keep the gain within a certain range. The returns on these funds can run from a negative 22% to a positive 13% over the last twelve months.

Should you look at these funds as part of your portfolio? Probably not... unless you have managed to embrace your inner risky person. If that is the case, then owning a ten percent stake in a fund that works like a hedge fund might work. They cost less than a hedge fund but I would be willing to wager, more than twice what you are paying for an average, run-of-the-mill actively managed fund.

Chance are, if you do have access will come to you as 130/30 fund. Although 100% of the money in the fund is invested, an additional 30% is borrowed as a short sale. This gives the illusion of being invested 130%. (Visit here for a discussion on the various types of risk and here to learn more about 130/30 funds.)

Once again, it pays to keep in mind what kind of investor you are, how much risk you can tolerate and when it is you plan on using that retirement investment as income. Keep in mind that these types of funds have only the smallest of track records.

Saturday, August 1, 2009

Rebuilding Your Wealth: Could Savings Sink Us?

There is an old philosophy joke that goes something like this: A man catches his wife in bed with his best friend. As the husband asks “what’s going on here?” his friend replies “are you going to believe me or what your eyes tell you?”

That is about where we are in this economy. There are plenty of reasons to see things are beginning to improve and yet, it is still difficult to see these improvements. The recent rise in spending (0.3% with an earnings increase of 1.4%) is curiously coupled with the recent rise in savings. How can that be? Or better why can that be?

Even those of us who fall squarely on the side that disagrees about the Obama administration’s attempt to fix this economy with a government spending program so massive the numbers simply boggle the imagination can agree that if it works it will be good to be wrong. Those of us who think that this is exactly how you fix the problem that over six months ago belonged to another president, are hopeful that we will be right because it would be no fun to be wrong.

Seeing what you want to see is of course, nothing but a defensive posture we all are capable of assuming when things look bleak. In his 1993 book titled “How We Know What Isn't So”, Thomas Gilovich suggests the endowment effect might have something to with this. He writes, “ownership creates inertia that prevents people from completing many seemingly beneficial transactions.” For the economy to move in a direction that many considered beneficial, keeping your money close will not necessarily have the same desirable effect as if you began spending it.

Numerous reasons have been given as to why Americans have chosen to rebuild their depleted accounts rather than spending some of this cash. Beginning with building emergency accounts to offset any potential hazard that, if it hasn’t already happened (it probably won’t) from occurring. There is also some speculation that the growth in these accounts is the direct result of the poor performance of our retirement accounts.

Both of these reasons seem to be not only believable but also just plain old good sense. Just about everybody who writes about personal finance will tell you, the ability to tap back-up cash (the amounts vary from between three, six or twelve months of income) in times of crisis is the first rule of a healthy personal balance sheet. It is unrealistic for the majority of us but good advice nonetheless. The most troubling aspect is the shift from what made us feel good (our ballooning retirement balances) to what we think will make us feel good (our fledgling savings accounts) now.

When it came to investing, I can be relatively safe in suggesting that we all thought we knew what we were doing. Those of us that took the time to study our options, did a little research and chose the investment that we thought would best fit our tolerance for risk probably thought you were doing better than most. This phenomenon is based on one of the most well researched topics among psychologists.

Our retirement accounts were an extension of our assessment of our own abilities. Mr. Gilovich writes: “ the average person purports to believe extremely flattering things about him or herself – beliefs that do not stand up to objective analysis”. Our self-serving assessments as Mr. Gilovich calls them make it difficult to “apportion responsibility for our success and failures”. When the market performed well and by default our investments, we took full credit of our skillful strategy and savvy. When the market failed to perform, giving up years of gains, we were quick to blame external circumstances.

Now we look to savings to save us and help us feel endowed once again. There are three problems with this approach and why it will stigmatize this recovery. The first being our assessment of risk is somewhat askew. We have more or less rubber-banded from fully stretched to a restive state. We have removed out-sized risk in favor of none.

The second problem facing the economy is that savings and our logic for keeping it stashed away is not logical. Our motives at regaining self-esteem through building a savings account will have the exact opposite effect on who and how you perceive yourself. You look for retirement to happen one day and you reason, when I reach it, I will have six months savings stashed away in the event that I might need it. More troubling, what if that is all you have?

By rebuilding (or in many cases building) a savings now might jeopardize the economy in ways you haven’t considered. Although much of the income increases recently reported were due to increased overtime by skeletal staffs, there is far less opportunity to invest or even where to when you are out of work. Those that still are employed have not yet returned to the markets as employer incentives such as matching funds have dwindled. Many pension plans have been frozen. To reverse this trend, some one needs to buy something.

There are goods but few buyers. The nature of the transaction, which does not necessarily need to be motivated by credit, has not shown an equal recovery as compared to what we saved in the same period.

Third, the opinion makers, the people we listened to when we were investment geniuses are not making any sense to us anymore. This motivation makes us turn to those that tell us what we want to hear. Studies support the idea that we look for not only the kind of information we want to hear but how much we need to ingest. Things are bad and you hear: could get worse; could be you; you should prepare. Things are good and you listen to experts that advise you on the ways to keep it good. Even when we find information that doesn’t jive with our thinking, we will dig around until we find something that supports what we want to believe. We want to be comfortable that what we are doing is what we should be doing.

John O'Donohue, poet, philosopher, and scholar, looks at the Irish imagination in his book Anam Cara observing, “To the inferior eye, everyone else is greater. To the indifferent eye, nothing calls or awakens. To the resentful eye, everything is begrudged. To the judgmental eye, everything is closed in definitive frames. To the greedy eye, everything can be possessed. To the fearful eye, all is threatening.”

Without risk, what we see is what, better yet all we will get. John Burroughs wrote: “A man can fail many times, but he isn't a failure until he begins to blame somebody else.” And no one will want to take the blame for what the next year holds as his/her own because of it.