Adding Less Risk: The Safe Harbor Option

There is no easy answer for how much risk is too much risk or too little. In the aftermath of this past year, plan sponsors are looking for a way to insure that those close to retirement have the money they invested over their careers there when they need it. The key word is insure. And it is the industry that offers this sort of product that is being considered as a possible option. But are annuities the option worth considering?

One of the most difficult things to do is provide protection for already accumulated money in a defined contribution plan. Currently, even in what the industry refers to as megaplans, the options are limited to targeted-dated funds or some sort of option that offers fixed income protections. These types of options adjust the level of stock market exposure as the employee ages, shifting from more aggressively invested dollars to more conservative investments.

The reason for the increased popularity of these products is the result of a Congressional mandate. Target-dated funds were made the default investment for those entering the workforce replacing other less retirement oriented funds such as money market accounts. This allowed the worker to begin investing for their retirement in what the industry called the best option for those who do not know what to choose.

But now, with the focus on asset preservation rather than the typical asset accumulation, a particular concern for older workers nearing retirement, the pension industry is considering annuities. There are several problems with this, first and foremost being the involvement of the insurance industry.

Annuities are designed to be purchased as a stand alone product that provides guaranteed income. The insurance company makes certain commitments to how much you will receive in retirement from accumulated assets. The cost of this quasi-investment/insurance product is high in the first seven years of the purchase and the underlying investments made by the insurer are designed to provide the insured with a lifetime income.

The introduction of such a product in your defined contribution plan presents all sort of problems, not only for plan administrators but for the participants as well. According to Pensions and Investments Online, this would involve tweaking the already suspect target-dated funds. (I say suspect in large part because they have yet to prove they are able to do what they were designed to do.)

PIonline suggest that these target-dated funds could allow their investors to buy "slivers" of an annuity from several insurers. This would keep some of their money invested even after they retire and some of it as guaranteed income.

The second option and probably the most costly would be to offer a "guaranteed lifetime withdrawal benefit". This would essentially allow the investor to roll the assets they have accumulated in the annuity where the insurer would offer income based on a high water mark withdrawal based on a certain percentage. This would, insurers suggest, provide income even when the market moves in unsavory directions during retirement.

Robert Reynolds, chief investment office at the conservative Putnam Fund has been making noise since taking over the once powerful investment house. Among his proposals:

Mr. Reynolds would like to create "a national insurance charter and an FDIC-like fund to back up lifetime income guarantees". This will essentially force employers and employees to consider this option. The FDIC-like fund, not federally insured but instead insurance company guaranteed would offer protections for assets already accumulated.

Involving Washington is the trickiest part of his proposals. He would like Congress to add tax incentives to both employees that participate and employers who offer matching contribution "that would require "employers to offer a lifetime income option, either through annuities or other insured methods".


Of course for such a move to pass muster, the insurers would need to have set "caps on the equity exposure in target-date funds as they become mature". Such action would need the support of legislation that would "require employers to enroll all of their workers in 401(k) plans automatically and increase their contributions over time." This would put pressure on the smallest of firms to comply, a costly maneuver and force the largest firms to take away what some feel is the most important aspect of the 401(k) plan: choice.

This would also jeopardize the portability aspect of the plan. Few insurers would continue to cover an employee after they leave a firm and would probably not participate in a rollover to an individual retirement account (IRA). The reason: no former employee would continue to pay the outsized costs on an individual basis which could be spread over a large group inside a 401(k) plan.

“Usually after a tough period like this you're presented with an opportunity to make the system better,” Mr. Reynolds said in an interview. “We need to fix 401(k)s, which have become the retirement plan of this country. At Putnam, we want to get out in front of the issues.”

This is scary talk indeed.

Rebuilding Your Wealth: What's Wrong with the 401(k)?

Your 401(k) is in trouble. While the concept of a self-directed retirement plan is, at least in theory a good idea, it was never meant to be all there is. So many components go into a the proper operation of such plans, it is hard to get a bead on which move is right and which might spell disaster.

So let's briefly examine some of the do's and don'ts of 401(k) investing:

Do: Participate. No matter how little your employer offers in the way of incentives, called matching contributions or even if they offer none at all, you need to be in the plan. Plan on a minimum contribution of 5%.

Don't: Believe that it isn't any good. There are a great many of these employer sponsored plans that are essentially worthless. They charge fees that are too high, offer too few good funds from which to chose, and lack good any real fiduciary responsibility (something the employer is required to do).

Do: Buy funds. There will, in almost every plan on the planet, be mutual funds to choose from in your 401(k). Mutual funds are essentially investors who feel as thogh the effort of pooling money spreads diversity and risk over a greater number of stocks than they would have been able to purchase individually. A fund manager is the person(s) you hire to make investment decisions for this group. The fund will charge fees for this.

Don't: Buy company stock. A lot of 401(k) plans are designed to force you to buy the company's stock. Some will do this by limiting any match to this purchase and prohibit you to sell those shares. This is still not a good reason to buy this stock or any other. When you put too much money into one stock (same goes for buying too specific of a fund in large quantities) you run the risk of jeopardizing your portfolio's overall performance. This is where many 401(k) plans got into trouble.

Do: Diversify. For many people, diversification is simply purchasing an index fund (a fund that tracks a particular sector be it the total market of the Standard and Poors 500 list of the top market capitalized companies. (Capitalization refers to the number of shares outstanding multiplied by the share price.)

Don't: Index funds/Target-dated Funds/ETFs. Index funds are very tax efficient and charge very low fees to manage. This is due to their passive nature. Once the index is bought, until the index is changed, there is no more trading. As money comes in from investors, it is simply used to purchase more stocks of the companies in the index. (Use index funds outside of your 401(k) and pay the taxes on them while the rates are still historically low). Target dated funds are a relatively new product and just about every 401(k) has something like this. They may call it a life style fund. These funds pick a date in the future when you would like to retire and the fund manager gradually alters the fund's focus from aggressive (although many are not too aggressive) to a conservative format as the fund gets closer to the target date (of your retirement). ETFs are not a good idea for 401(k) plans because they charge the employee each time they purchase more and in a 401(k), this happens every time you get paid.

Do: Pay attention. If you have built a portfolio that is diversified (some growth, some value, some international or emerging markets and further spread these funds to include large, mid and small cap areas) you will need to open your statement or check it online each month. Look for changes in fees, changes in the 10 largest holding and any statements that the fund manager might make.

Don't: Overreact. When markets rise, don't try to adjust your underlying funds to follow. When markets swoon, stay where you are. In a rising market, because of dollar cost averaging, you will buy less as the price goes up. In a falling market, you will buy more as the share price is discounted.

Do: Think first. Your 401(k) is your future, directed by you. Never withdraw money from this fund either by loan or by any other means. This single action will take years to fix. If you leave a company, roll your 401(k) into an IRA.

Don't: Panic. Things will get bad but they never stay that way. Your 401(k) is not a cash account and should not be eyeballed to save you from financial bumps in the road - even those bumps seem like they will last for a long time.

The Beginning Investor's Dilemma

Where to begin? This question has stymied beginning investors since the time the market began. These days though, the question is twofold: why should I begin and where will I get the money?

Time remains the single best attribute to investing early and equally important, often. The powers of the equity markets are confusing unless you remember two basic rules:

There is risk;

And if you take no risk, there will be no reward.

That risk demands you put money somewhere. For the beginning investor, the best place is in a mutual fund. Your 401(k) at work is often a healthy list of choices. (Keep in mind, the number of choices available don't always signify the quality of the plan.) Among the most common types of funds in these defined contribution plans (so called because you define how much you will contribute) are index funds, growth funds, bond funds, balanced funds, and some combination of the lot.

Index funds track a broad index of companies in almost every instance, due to size. Growth funds may also be a type of index fund or one aimed at a particular group of companies. Bond funds invest in debt, which makes you a sort of lender (but in a mutual fund, without many of the problems associated with the transaction). Balanced funds look to provide some stocks and some bonds and usually tell you right up front how they allocate their investments.

The combination of the lot is represented by a growing sector called lifestyle funds or target-dated funds. These fund reallocate their holdings over the course of an investors career. The employee picks the date they would like to retire, say 2040 and the fund manager does the rest. As your holdings grow in tandem with your years in the plan, the fund gets more and more conservative.

Beginning investors are attracted to these because they are advertised as buy and forget. But they should be aware of the problems that may be associated with this type of investment. First, they don't have much of a track record. Even in the recent downturn, some very conservative funds (with short retirement dates targeted) did not beat the S&P500. Secondly, I worry that some fund families are using these new funds to prop up laggard funds that have done extremely poorly and lost many of its core investors.

While you are educating yourself on the subject, choose an index fund.

Now, where to get the money? If you set aside 5% of your income in a pre-tax situation (and 401(k) plans are just that), you will not feel a change in your take home pay. Do this even if your company doesn't match your contributions. (Some used to, some companies still do but to a much lesser degree and some never have added a contribution, usually dollar for dollar up to a certain percentage.)

If you have no defined contribution plan, use your tax refund (you know the one you plan on getting in about five months) to open an IRA.

No matter when you begin, waiting is no longer an excuse.

Retirement Planning: Do You See What I See (in your 401K)?

Last year, Rep. George Miller, a California Democrat and chairman of the House Education and Labor Committee was not sure that folks understood how much their 401K plans were costing them over the lifetime of investing. He introduced a bill to the committee, interviewed mutual fund heavyweights like John Bogle of Vanguard Group, and eventually tried to get the legislation through Congress. He failed.

Now he is taking the same bill and trying again. Rep. Miller believes that it is what you don't know about that retirement account that could harm you more than the possibility of a market downturn. He acknowledges that the downturn stripped a great deal of wealth from many retirement portfolios. But he feels as though the hidden costs in these plans took them down further than they needed to go and, even as they fell, these fees continued to cost the investor.

Your 401K may be paying fees not only for the administration of the plan but also for the funds in the plan. This can often be hidden from investors when the markets are doing well. The problem for employers is much the same for the individual investor: although much of the language has become easier to read, it still has a long way to go to achieve full transparency.

Over a 20-30 year working career, these costs can deeply impact a retirement plan. Trading fees, investment fees, advisory fees or stewardship fees according to John Bogle's testimony last year can strip up to 75% of the plan's balance if unchecked.

Fixing this problem is not as easy at it sounds. Mutual funds continue to be less than forthright when discussing fees, shifting them to administer plans while declaring that their overall expenses are lower. Turnover rates within the fund, the presence of other funds with in the fund (often the case with life style or target-dated funds) hide other fees within fees, and the fact that what is often considered value funds may in fact be something much more risky all give the investor a veil of cost-effectiveness that might not be there.

Mr. Miller is shooting for disclosure first but openly shows his disgust for what is happening to these accounts, good markets or bad. In his opinion, and this blogs as well, the fees come after the average investor dutifully invests their money.

Some of the options on the table include the index fund and its availability in the average 401K plan. But as we have found out, this is not always as clear an option fee-wise as some would believe. And with SEC investigating the target dated funds, the offering that has caught fire recently as investors sought to protect their money by moving into a fund that promises to adjsut risk over time, shooting for disclosure is the right first step.

In the meantime, here's what you can do. Stick to only a handful of funds, spreading your investment among three to four sectors such as large-cap, mid-cap and small-cap funds with a fixed income (preferably something encompassing as much of the bond market as possible. Keep your index fund investment on the outside of your 401K plan - better to pay those taxes now rather than later. And until target-dated funds fess up and disclose what they really are, stay away from them. A little time and diligence can provide you with the same type of investment at a far lower cost.