Thursday, December 30, 2010

Using Mutual Funds in 2011 for Investment Success

Everyone wants investment success. And everyone has the tools at their disposal to do so. If that is the case, why aren't our retirement plans doing far better than they are?

You have mutual funds if you have a 401(k). Individual Retirement Accounts (IRAs)hold mutual funds as the primary investment and despite their use throughout the world of investment and retirement planning, too few people have a positive attitude about what this tool can do for them. Most of the negative propaganda comes in spite of the ease of use, often lower expenses than any other investment tool, accessibility, better transparency (or well on the way to providing better insight) and often, tax efficiency. Some do this with great effort; others revamp their portfolio only when an index is restructured.
So what are mutual funds and how can they improve your life in 2011? There are only two types: actively managed or those indexed to a specific grouping of investments. From there, it gets complicated but getting from there is where the whole traffic jam of ideas begins. It makes no matter, which school of thought you ascribe to if you do at all: everyone needs and actively managed group of mutual funds and a passive group if you expect to do anything worthwhile in 2011.

In the coming year, one which is predicted to be quite good despite my doubts, which I will put forth in couple of days with my year-end look at 2011, diversity will deliver more than simply chasing one ideology of the other. The "indexers believe that these sorts of funds are all you need to succeed in any year. Offset by relatively low costs, these funds make up for hoping that that through diversity they can achieve better than average returns for those who invest in them.

As a group, index investors are a fervent bunch. They espouse this investment as the be-all-to-end-all tool and in doing so, give those who chose the other camp - the actively invested mutual fund - to wonder if they may be right. There are reams of research that indexers point to as the reason why they believe this approach. But passively sitting back and letting the market determine your investment outcome is not for everyone.

Actively managed mutual funds are structured in the same way as index funds: a portfolio of investments (stocks, bonds or both), a manager (be it one, more than one or a computer), disclosure and regulatory rules that they must abide by, and performing as billed, if not better. The difference in who picks what is in the fund. Index funds are determined by an index published by such notables as Standard and Poors or Russell or Wilshire. Actively managed funds contain investments picked by management.

Both bring like-minded investors together to pool their money and in doing so, offset the risk and cost of having to build a similar portfolio on your own. Actively managed funds try and outperform their index counterparts in large part because it is these indexes, right or wrong, in which their performance is gauged and graded. If they do better than an index, investors notice, add their money and create increased opportunities for the fund manager to increase those returns with additional acquisitions.

It doesn't always work and some comparisons are unjust (how can you compare a fund with fewer than 100 holdings to one where 500 are held?) and do not paint a true picture of performance. But in tandem, they might work for different reasons for everyone interested in a more profitable 2011.

In times of turmoil, everyone feels pain. When the whole of the marketplace dropped precipitously in 2008, no investor escaped. Some were damaged more than others but as a group, we all felt pain in some form almost at the same time. Investors who simply plowed money into a 401(k) or loaded up on their own company's stock and thought that investing was a world of do-no-wrong, were given a rude awakening. Those that traded actively on their own and were beginning to feel some invincibility creep into their results were caught unaware as well.

And in the past year, investors in US stock funds did what they had done in the previous three, withdrew more than they invested, Called outflows, they impact mutual funds harder than the selling of shares from your own portfolio. These outflowing funds are produced with the sales of a portion of the portfolio. And every such move impacts the remaining shareholders in the mutual fund.

Inflows, or your money pouring into a mutual fund comes automatically in a 401(k), through deductions into an IRA and self-deposited by individual investors. Yet only a handful of people I speak with everyday likes the idea of a mutual fund as an investment and if last year was any indication, think fund focused on the US stock market alone is not the path to financial success.

Why? We want simple things to work extraordinarily well. Nothing does but we expect it of mutual funds. We want low fees, we want moderate risk and we want to know that our money is safe from market interruptions and taxes. And at the same time, we want growth, to retire early and to have our investments perform without hiccup for decades. Only mutual funds can do this - even if we dislike the idea.

Low fees, moderate risk, safety and tax efficiency is a tall order with three of the four fitting the index fund bill. Safety is subjective and safer, even more so. But no equity index fund alone can do this. No bond index fund alone can do it either. Target date funds, hybrids of other equity and bond funds (and often a basket of such funds from the fund family) promise all of the above but have yet to prove they can deliver.

Yet three out of four isn't bad. Put this type of fund in a Roth IRA and put as much as you can in it, consistently over 2011 and you will do as well as this year has done (which looks to be two back-to-back years of double digit gains for the S&P500 index). Even if you do half as well as the 20% plus gain in 2009, you'll be way ahead of where you'd be otherwise.

In the other group, looking for growth, outsized returns and freedom from hiccups, look to your 401(k) where your employer may be retuning to offering a match in 2011. If they do, this is not so much free money as hedged money. A 6% match added to your 6% contribution gives you a lot more room to assume risk that you probably are. Retiring early is a dream even as we acquiesce to work longer. But it can be closer to a reality if two things happen: you invest more and use actively managed funds in your 401(k) to get there and the market corrects a little in the first half of the year. This means buying more for less and positioning yourself for a good 2011. Not 2010, but close.

Whatever your outlook for 2011, a tandem approach to investing - using index funds and actively managed mutual funds might be the best approach in the next year. Be cautious of only two things: this isn't advise and be careful you don't over-expose yourself in any one sector.

Next up, my predictions for 2011.

Paul Petillo is the managing editor of

Tuesday, December 21, 2010

Risky (Retirement) Business

Most of us make a flawed assumption about retirement. We save (or as I prefer, invest) for our retirement and do so based on the fact that the taxes we pay now will be the same when we retire. This sort of assumption, according to the Center for Retirement Research at Boston College, puts 51% of American households at risk of not having enough to sustain their pre-retirement lifestyle in a post-retirement world.

The CCR takes the view that if this nation stays on its current course, and nothing is done about the increased level of Federal spending, "government debt will increase from the 2010 level of 61 percent of GDP to 79 percent by 2020, 118 percent by 2030, and 180 percent by 2040." This sort of escalation will result in one of two things happening to offset those increases: the government will need to reduce spending or increase taxes - or both. Neither option bodes well for those planning on retirement.

The Center is focused on a broad-based National Retirement Risk Index (NRRI) that "measures the percentage of working-age households who are ‘at risk’ of being financially unprepared for retirement." Even if the taxes we pay remain the same as they are today, most American households will find retirement financially challenging. But what if they rise as the report suggests they will - or better will need to?

The report was issued prior to the extension of the Bush-era tax cuts, which had they been allowed to expire, would have increased the overall taxes most of us pay impacting the amount of money we currently save for retirement. As a group, we react to incentives or in the case of increased taxes, disincentives in predictable ways. 

First, we tend to invest less (if the pull back of the company match following the market downturn in 2008 and our failure to make up the shortfall in the wake of that decision is any indication) as we adjust our household budgets.

Those budgetary needs are real and present. But the future needs in retirement as a result are a real and present danger most of us are ignoring. Add the possibility (or the real likelihood) that taxes will increase in the coming decades from their current levels, and you have a recipe for financial disaster brewing beneath the surface.

The CCR projects that a value-added tax (VAT) would be necessary by 2020, and this tax, once introduced would need to escalate from 0.9% to 8.1% in the thirty years following its introduction. Social Security taxes would also need to increase from the current payroll tax of 12.4% to 14.7% by 2050. The group most at risk: older workers who have little time remaining in the workforce to increase their contributions to offset that shortfall. Younger workers would have time to adjust but the need to do so might cause a natural human reaction when faced with some tough economic decisions is to recoil, not regroup.

If a value-added tax were instituted, the retired worker would face some serious financial challenges that they may not have planned for while building their nest-egg. Granted, Social SEcurity tax increases would not impact this group, but once retired, each change in the tax structure, no matter how minute would lower the available amount of money they might need (and counted on) and i doing so, increase retirement risk.

In the wake of any fiscal policy changes to make up for the growing GDP, the CCR suggests that a higher target replacement rate would be needed. There is only one way to do this: increase contributions. Doing so would have the net effect of slowing the ability of any group to sustain a lifestyle current to the one they have and if they failed to budget for tax increases, put their retirement hopes and dreams in jeopardy.

Gen Xers would need to budget to spend less and invest more at a time when college debt, families and independence impact their day-to-day financial decisions. While this group can adjust their consumption rates to make up for the shortfall, it is unclear that they will. Late Boomers, those caught between the distant retires (Gen Xers) and the soon-to-be retirees (Early Boomers) also face risks. While those risks are not as great as their older cohorts, it would require them to make drastic cuts in how they currently live to make up for the projected shortfall in retirement.

The report concludes withe following statement: "If households were to respond by cutting savings as well as consumption, due to choice or necessity, the percentage of households ‘at risk’ would be larger.  This brief errs on the conservative side by assuming no behavioral effect." But we know better.

We know that you will make some bad choices between now and then. If tax levels rise while you are still employed, the impact will be direct on how much money you take home. If you realize that your retirement calculations are incorrect, you may conclude that working longer (rather than saving more and adjusting spending habits) is the only way to make for lost ground and a diminishing timeframe.

We know that you will perceive risk as the enemy and find ways to reduce your exposure to risk by reverting to more conservative investment schemes like target date funds. This will have the net effect of protecting your money while forfeiting potential growth opportunities. The younger you are when you recoil from risk, the longer it will take to reach optimum retirement levels. Ironically, avoiding risk while you are working increases your retirement risk.

There are options. The first and most obvious is increase your contributions. This is the right choice to make but comes with a caveat: you cannot increase your debt in the process, a normal reaction to lower daily spending opportunities because your budget has tightened.

The second and less obvious choice is to assume some risk either in your 401(k) or outside. It is true that the current tax rate will be extended. So why not pay the taxes for your retirement income now in the form of a Roth IRA while rates are predictable and lower than future rates?

Here's an idea worth considering: invest in your 401(k) up to 10% of your pre-tax income, match or no match (more if you can). Use the most aggressive funds in the plan to position yourself for the greatest amount of growth (if you are younger - Gen Xer or an Early Boomer). On the outside of that plan, open a Roth IRA and focus your investments on an index fund such as the S&P500.

Because of the tax efficiency of an index, paying the taxes in the future on what your tax-free principal has earned, even if they are higher, would be less than what your 401(k) or traditional IRA owner would pay. There is no fixed time to begin taking distributions (it is possible this could change but a lot of tax analysts think this is unlikely) and your estate is better served with a Roth IRA. Because you can begin distributions when you want, this could be an added boost for your retirement income in the advent of any tax increases in the future.

No one can say for sure that taxes will stay the same or go up. We do know one thing for certain: they will go up - as will inflation. If you aren't planning for this, you should and the sooner the better.

Thursday, December 16, 2010

The New Retirement Question: You may want to work longer, but will your employer allow it?

We know two things in this post or almost post-recession era we are currently in: One, older workers are returning to work or not leaving the workforce at all and two, younger workers who traditionally made up the bulk of the workforce, are being crowded out by this newer pool of older workers. Delaying retirement due to economic concerns that have stymied our financial well-being has been news for quite some time. But what if the new face of the workforce is slightly wrinkled and framed in grey?

According to a study conducted by and authored by Richard W. Johnson, Senior Fellow at The Urban Institute: "As the U.S. population ages and the number of Americans reaching traditional retirement ages increases, employers may need to attract and retain more older workers, many of whom are highly experienced, knowledgeable, and skilled." Basing the study on well-known assumptions, Mr. Johnson explores the shift in the workplace to accomodate the older worker who is increasingly choosing to hang on to their employment longer.

Among those assumptions is a longer life. As the older population reaches retirement age, they are finding the ability to continue working a possibility in large part because the work these folks tend to do is less physically demanding that many jobs were just a decade ago. While financial concerns are most likely to enter into the newsworthy conversations, the study seems to suggest that this trend is centered more on women than men.

The result is increased complications both for the company, the worker and the benefits they might or should be receiving at that age. The result is an experiment unlike any conducted prior to this where the lines blur between what is full-time work and what is full-time retirement.

Phased retirement, the new buzzword in this process involves reduced hours and responsibilities that include some perks normally reserved for women and men in the workplace who temporarily leave because of families. Among those phased perks are "flexible work arrangements, including part-time employment, flexible schedules, telework, contract work, and job sharing."

For the employer, the fringe benefits often accessible to the older workforce, such as traditional pensions could open the door to age discrimination. And this could hurt women more than men. Even as women have made great strides over the last several decades in pay, benefits and workplace populations, it is this group that is most likely to continue, or want to continue working beyond the traditional age of 65. Men, despite the reports of longer and healthier lives, choose to retire more now than when the jobs they engaged in were more physically demanding and strenuous.

Because the focus of this report is on the effects various policies and practices surrounding this transitional time of a workers life, Mr. Johnson points out some of the incentives and disincentives for working or not. Social Security has been gradually pushing back the retirement age and will probably continue to do so in the coming years. Defined benefit plans or pensions further complicate this trend by penalizing the annuitized payment should the worker continue to be employed.

The shift over the last three decades to defined contribution plans (401(k)s, 403(b)s) are much more accommodating to this segment of the workforce that wants to work longer. They can continue to contribute to a DC plan long after the traditional pension retirement age has been reached, adding the potential for greater lifetime incomes in the process. Because of these types of plans, workers reaching retirement age are more likely to work at least two-three years longer than they may have previously anticipated.

The study also revealed that if the employer provides health benefits for early retirees. of which according to a 2009 study conducted by the Kaiser Foundation only 29% of the employers do, that person is more likely to retire. Take them away or not provide these benefits and the worker will stay on the job longer.

Because Social Security benefits are calculated on a 35 year work history, one that favors men who have never had any interruption in their work history, this group is more likely to take their leave from the workforce. For women, each additional year worked eliminates a zero earnings year that may have come due to family leave because of children or the need to take care of aging parents.

The question facing employers is whether to retain these workers. In most instances, the older worker is at the top of the pay scale and poses a greater cost on the health benefits provided. Mr. Johnson notes: "Another study found that employers were less likely to call back older job applicants than otherwise identical younger applicants (Lahey, 2008). And it takes laid-off workers age 50 and older much longer than younger workers to become reemployed, even though older unemployed workers appear to search just as intensively as their younger counterparts (Johnson and Mommaerts, 2010)." Even if the desire to work longer is there, the opportunities may be limited.

Employers have acknowledged that the pool of potential retirees in the coming years will have a negative impact on the skill level of their employees. Yet few have done anything to address this shortfall of talent and skill. "For example, in the Cornell survey only 26 percent of employers allowing phased retirement would provide the same health benefits to workers after they reduced their hours. About two-fifths of employers allowing phased retirement in the Cornell survey, but only 9 percent of employers in the Ernst & Young survey, would allow in-service pension benefits."

The problem will need to be addressed by Congress at some point. Women Boomers face the greatest challenge in the coming years as they attempt to make up earnings shortfalls and look to adjust their schedules to a more flexible arrangement.

Employers will also need to address the issue as well. they may say that the talent looking to retire is worth retaining. But their current policies don't suggest they are doing much in the way of providing incentives. They may say they desire the older workforce. In practice, they have yet to make substantive moves to permit this choice.

Paul Petillo is the managing editor of 

Wednesday, December 15, 2010

Your Retirement: It is Still up to You

The stock markets seem to be poised for what has been termed often as the "Santa Claus rally". Consumers, at least according to business surveys, are beginning to spend. And this is all occurring, while in the shadows, the economy or its numbers remain little changed. That and most of us are still suffering from investment paralysis. 

Here we are, years after the fall of 2008, and the average middle class worker still has an account balance that is far from where it should be - if they plan on retiring. When most of us think is retirement age, we think in terms of what has been the generally accepted retirement age. This unfortunately is a failure on two fronts: yours and the plan sponsor.

Your responsibility is in the contribution.According to a Wells Fargo survey (pdf) conducted among 357 plans, middle class is defined as: "those aged 30 to 69 with $40,000 to $100,000 in household income or $25,000 to $100,000 in investable assets and those aged 25 to 29 with income or investable assets of $25,000 to $100,000." This group knows that they will need more than $300,000 to fund a basic retirement yet, on average those balances fall far short of that goal with $20,000. Is it any wonder that this group is increasingly buying into the notion that working longer is a fact of life in the post-downturn world?

Most of the middle class group contributes only about 7% of their pre-tax income to these plans. And if the survey is any indication, much of the fault lies in the employer's approach to these plans. The study suggests that employers are concerned about their legal liabilities in helping their employees even as they acknowledge the shared role in helping those workers.

These fiduciary concerns are widespread among plan sponsors who worry that should they provide advice, and that advice doesn't meet employee expectations, they will see the plan sued. 

This has led these employers to look for plans that offer third party advice, shifting the liability to another player. What they fail to embrace is that using a TPA (third party administrator) doesn't lessen the liability. While 89% of the plan sponsors understand that there is a need for retirement help, only 71% (as of 2009) think that they should help those employees understand what the plan can do for them.

In order of importance, and in reality, employers do something else entirely and your defined contribution plan's ability to get you there is reflective of this lackluster effort. Only 35% of the DC sponsors surveyed think that education is important, 22% encourage greater participation and increased contributions, 9% think investment diversification is important while only 2% facilitate the planning process by pointing out what is need in retirement and helping their employees use the plan to achieve this.

Are more funds in the plan the answer? Some DC sponsors believe they are and are looking to increase their offerings. But often, plans with more than fifteen funds aren't necessarily giving the employee more choices that suit their needs. The new choices are often in the form of target date funds and other more conservative investment offerings. This is often done at the exclusion of more suitable offerings (such as aggressive mutual funds for younger workers). Once again, they fear retribution for suggesting anything akin to risk.

DC sponsors are worried about what the industry calls investment paralysis. Too many funds, studies have suggested, often have lower overall participation rates that those with 15 fund or fewer in their plans. Because there is a growing movement to offer auto-enrollment, choosing a fund for that new employee often requires the plan to carry a wide variety of target date funds to pinpoint a "potential" retirement year.

But understanding the need and acting on it, from both a participants point-of-view and that of the DC sponsor are often far from what they are actually doing. Plan sponsors need to understand more than just the investment array, plan design, distribution options, education and communication, and fees charged by the plan. It is their fiduciary responsibility, one that carries legal risks if mishandled, to measure their plan's impact. Only 15%, according to the survey do so.

The employer still offers matching contributions in many defined contribution plans. But how and what are a matter of debate. Many still offer matches that are tied to company stock, put restrictions on access to those matching funds, and use the auto-increase contribution system as a way to offset raises. Often, maintaining the 401(k) plans they might have, as many of the companies surveyed suggested, is done for the sole purpose of getting and retaining new employees. This, in light of less-than-robust private hiring, might come at a reduction of other benefit programs.

If you are still in a DC plan and your employer's match is not as adequate as it should be, this doesn't let you off the hook. You still need to save more, much more than you are presently doing. While it is true that 5% is the cut-off point where pre-tax contribution investments don't impact take-home pay, some sacrifice on the employee's end is needed. And this should be done,match or no match.

If your employer's 401(k) plan is not as robust as it should be or doesn't fit your age needs, open an IRA or Roth IRA on your own. Contributing to both plans (10% to your 401(k) and the maximum allowed to an IRA or Roth IRA) is your responsibility. While we still look to the company we work for for guidance, and even to the point where we believe they care about us and our retirement future, the facts are not bearing this fuzzy feeling out in the surveys I have read.

As Laurie Nordquist, director of Wells Fargo Institutional Retirement Trust said: "If people aren't willing to pay for advice they are going to get a more vanilla approach to planning," adding, "But a simple plan is better than no plan."

Paul Petillo is the managing editor of

Friday, December 3, 2010

Is it Management or Retirement Planning?

It seems you can't pick up a paper, read about it online or see on television these days without the conversation turning to the dire straights the economy is in. This gives us cause to worry because we know all too well what it's like to be close to retirement. But I have always been concerned with the phrase. Just saying it make the whole process seem like a carrot on a stick, always within sight; never quite reachable. Why does it have to be like that? is I there perhaps a better way to planning for retirement? Possibly the key is in the management.

From the minute you put your first dollar to work for you in 410(k) or an IRA, you were close to retirement. Age suggested you were closer but we soon learned that it wasn't so much a date on a calendar that determined the retirement scenario. It was the date plus the money you had invested.
Unfortunately, this is sort of backwards. The approach can be forgiven in part because we are constantly exposed to planning as the key to getting from that first dollar to that toes-in-the-sand-drink-in-your-hand place called retirement. Planning offers us some solace that we are doing something. What we find out too late is that "something" in more prone to failure than we had previously anticipated. So we back-off, give-up, resign ourselves, or worse, make the same mistakes again.

Why would we, knowing what failure tastes like continue to make the same mistakes? We are groomed to do what we have always thought was the right thing to do: plan. Fredrich Hayek, the Nobel prize winning economists suggested that you can't possibly know everything at once - there is simply too much data and it is happening too fast. Trying to collect in one place to make a decision is only asking for trouble. There is an African proverb that suggests only a fool test the water's depth with both feet. So why do we think we can jump into retirement using only one tool?

We are conditioned in our business dealings to think that we can control various aspects of the world around us, bending it to our will. But these are simply reactions to what has already passed. And that further conditions us to accept failing as long as, according to Francois Gadenne, CFA, who is the current co-founder, chairman and executive director of the Retirement Income Industry Association in Boston: "To succeed we must fail, early and often -- and cheaply."

Writing in a recent edition of AdvisorOne, Mr. Gadenne sought to reverse the planning of retirement by suggesting that it should be a management of funds. By building what he calls a funded floor, you are essentially unable to make big bets about an uncertain future. He blames the current state of retirement on the idea of central planning. Central planning becomes rationale on top of failed rationale and that is not based on what could happen but rather who is in charge when it did.

He writes: "Retirement income advisory processes should work like market prices rather than like central planning because, once we move beyond didactic examples, central planning cannot be smart enough or large enough or coercive enough to overcome the knowledge problem in the real world." In some ways, he seems to be deflecting the blame, something we are very comfortable doing when it comes to our money. Planners should merely advise and review that advice annually.

This seems to give advisors some distance between what you are doing and what you should be doing it. That chasm can become incredibly wide and because you are mostly conditioned to react to after-the-fact events, it is now you, not those who advise you, who are responsible for your failure to manage while trying to make a plan succeed.

Because retirement planning - or management - is often so far away and the people involved in the earliest stages of this process have probably drifted away, it is a wholly "you" process. You bring the mistakes that you have been conditioned to bring. When things get risky and when the risk costs too much, you take fewer of them because you know that they are less expensive. And because the retirement pundits also suggest that the earlier you start, the better opportunity you have to weather the downturns that await us, we accept them, regret them and learn to move on. And often repeat them.

Paul Petillo is the managing editor of