Retirement Planning: DCA matters - right?

There is a school of thought circulating that dollar cost averaging is not smart investing. For those of you unfamiliar with the term, it is how your 401(k) plan works and why it works so well. You essentially make a contribution determination - usually a percentage of income which is taken before taxes ore levied - and each paycheck, you buy share of whatever investment you have chosen in your retirement account.

The concept is basically simple enough for most every investor to understand, even embrace. One, the investment is steady and in many cases affordable and painless. Because of its automatic nature, you need only check your statement every quarter to make sure the money went into the account and went where it was supposed to go.

DCA also benefits the average retirement investor with some control over the numerous errors that plague most investors. By doling out money evenly, your investments are bought based on affordability and not on the decision of the herd. Herd decision making relies on following the rest ofthe investors as they sell or buy and experience with this sort of mentality suggests that they usually buy when the markets are on the way up and sell as they descend.

DCA does something unique. It allows the investor to buy less as the herd buys more and to buy more as the herd sells. Imagine a share of a mutual fund costing a dollar. You allocate one dollar of your paycheck and you buy one share. But the market goes up and the share now costs $2. DCA restricts your enthusiasm at joining the herd and allows you to only buy one-half a share. the shares you already own have increased in value so you aren't missing the upswing. You just aren't throwing more money at something that may be over valued.

Now imagine the opposite happening. The share falls in value to 50 cents. Your dollar buys two shares and while it is true, your other shares have lost value in the process, the investment thinking here is that over the long-term, there will be more upsides than downsides. This means that you will be buying the same share at a discount.

Are there any downsides to this investment strategy? Some think so. One gentleman I was discussing this with suggested that folks using a 401(k) plan should never forget that this is investing. I couldn't agree with him more on that point. He went on to say that even the most passive investing requires some diligence and dollar cost averaging takes that diligence away. That is a downside but not an insurmountable one.

He thought that all of the money in a given year should be sent to the most conservative fund available in the employee's 401(k) and then redistributed to funds that are doing better. While this may work for some people, few of us know how mutual funds operate, whether the markets are favorable or not and often we find out after the markets have made the decision for us, and lastly, our 401(k) do supply the rapid response some of this thinking implies.

It does require a skill level and command of all of the emotions and biases that plague even seasoned investors. It obligates us to be better educated - but for most of us, we need time to get to that point. It is always my hope that we do attempt to become better acquainted with the way our money is being invested. But in the mean time, the concept of dollar cost averaging serves far too many of the average investors too well to be discarded.

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.

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 Target2025.com/BlueCollarDollar.com

Adjusting the Dream of Retirement

Since the advent of blogs, the ability to complain has gone beyond grumbling to your co-worker and on to the world stage.  Much of the complaining has been egged on by writers looking to fire up your anger and make you face the consequences of a period of time when wealth seemed like it was attainable for everyone. The sad truth is that this simply was not possible for everyone and for the vast majority of us, the reality was a harsh and somewhat rude awakening.

Outraged, we looked to the government to save us from ourselves and when they admitted that this was not possible for everyone, we did what was expected: expressed our outrage. In a recent post on the AFL-CIO blog by former news reporter Mike Hall, the suggestion that Washington should wake-up and come to terms with a $6.6 trillion retirement deficit lays the responsibility on the wrong party. yes, that is a lot of money. Yes, it has impacted everyone (with the exception of the highest wage earners).  And yes, it does make me just as angry as you might be.

But I blame myself and in many instances, you should blame you.  Mr. Hall suggested that this multi-trillion dollar deficit will prevent us from the "hope to maintain your current standard of living when you retire".  To do that, you would need to have enough income in retirement to match what you currently earn.  With few exceptions, your retirement income is designed - and if properly funded - to replace only 70-80% of what you currently earn.  With few exceptions, the vast majority of us do not plan our retirement based on these assumptions.

Let's consider those assumptions.  Retirement still is and always has been a combination of elements working in tandem. The first is your own ability to live within your means.  This allows you to build some sort of savings/investment plan to meet your needs when you no longer want to work.  And for the majority of the current workforce, some reliance on Social Security.


It is amazing how many people who are close to retirement believe that Social Security will somehow survive without some adjustments. Minor tweaks to Social Security will happen.  But it will have the greatest effect on those who are still decades away from drawing on the program. It does remain solvent and will do so in the near future - long range though, several things have to happen.

The size of the group contributing needs to increase. If the government does anything it should be to focus on the current wave of cash hoarding by the country's largest corporations. This means more employed workers contributing which means more revenue.

You will always be able to take the early draw on SS.  While most experts agree that this is not a good idea, they are referring to the workers who can continue to work beyond the targeted retirement age. Plan your retirement based on this early withdrawal number. True, it is worst-case scenario but the true essence of plan is based on this concept; not shooting beyond what it possible.

You can also help your cause by contributing to an IRA or if your employer allows you, to their 401(k) plan.  Five percent a paycheck does not alter your take-home pay. While the $6.6T number quoted in Mr. Hall's piece seems daunting, it creates sensationalism and lacks solutions. Most of us need to keep in mind that a great deal of the wealth recently amassed and lost was due to a bull market that lasted between 1982 and 2000, much of which was due to the elimination of pension plans and the forced march to defined contribution plans. We can't go back.  But we can move on.

As for pension plans - still the great economic stabilizer - they are under pressure to reduce their impact on the employer.  If such a thing comes to pass, what it won't take away is what you already earned, just the projection of what you could have earned.  While austerity is a difficult pill to swallow, there are ways to increase your retirement opportunities.

Adjust the dream you may have harbored and do not want to let go. Get your house in order by imagining living on 30% less income than you do now. Underspend and over save/invest. Get healthy and stay that way - medical costs will have the greatest impact on your retirement income and doing this could save you thousands of dollars in medical bills that otherwise could have been spent on living expenses.

There is no quick or easy answer and like most problems facing the American worker these days, it relies on realistic assumptions, workable plans and a measure of hope that we will survive the current economic situation. I'm not sure the government can rescue us all - which means that some of us will need to learn how to swim.

I have some additional thoughts on the subject here.

Times have changed: Has your retirement plan?

I am alarmed with the amazing frequency of the most recent downturns and even more amazed at the swiftness of the recoveries. There was a time when, if the downturn was severe, the recovery took decades.  Now it seems as though it take less and less time from the top to the next top. This means that there will be more risk, more often. Running from it, may not prove to be the wisest move in the long run.

Among all of these age groups, diversity among as many asset classes as possible is still key. We are no longer in the “set it and forget it” world of retirement planning. The only way to keep your plan healthy is to run towards the danger.  It is the new retirement plan. 

A Change in Municipal Bond Ratings

This article previously appeared as a new feature at Target2025.com: Repercussion- A Retirement Review.

We are far from free of the clutches of the Great Recession.  The hold that the recent economic downturn has had on numerous types of investment portfolios will continue, even if, one the surface, it seems to abated somewhat in the equities markets.  The recent decision by Fitch, a bond ratings company, to revisit their grading strategies of municipal bonds may be simply cloaking the possible maturity wall facing bond investors.

Municipal bonds have historically been rated slightly lower when compared to corporate bond issues.  While the default rate for munis is much lower (0.7% compared to 2.1% default by corporate bonds) these debt securities used for public financing of roads, water, sewer and other public projects have often received a slightly lower rating.  This despite what appears to be a robust fiscal balance which includes increasing tax revenue, the ability to enforce revenue collection, control over expenses gives the municipality better flexibility, and the right of local communities  to tap reserves when needed.

The question is simple: will this change in ratings by Fitch (following a recent change initiated by Moodys), often moving munis up a grading notch provide better transparency or simply complicate the ability for buyers of these bonds to tell the difference?  This is of particular concern for those close to retirement looking to exert more stable control over their accumulated assets, fixing their projected returns and protecting capital.

It is our belief that munis will be approaching the same "bubble status" as mortgage backed securities attained just two years ago.  While Fitch claims to be looking at the long-term ("The aspiration is for Fitch’s ratings to demonstrate broadly comparable levels of default patterns over long periods") they may be looking at more historical data on the sector rather than the possibilities that in the near future, these securities might be facing the same trouble as the rest of the bond market might face in the coming years.

The "Maturity Wall", a point in the future when a great deal of corporate and Treasury bond issues mature and demand for debt might be overwhelmed by too many choices, often at higher prices and lower yields. Seeing that possibility will force investors to flock to munis if they feel as though they are immune.  They may well be in just as much trouble if the projects they are undertaking fall short of funding from the federal government.

More from Dan Seymour writing in BondBuyer

Can Wall Street be Trusted?

Now that we have healthcare reform, which can only help the retirement efforts of a younger population and control the costs of the older generation closer to the retirement goal, it is time to focus on the problems in the financial system.  This is no easy task.

Senator Christopher Dodd of Connecticut, chairman of his chamber's Banking Committee takes up the challenge beginning on Monday (03.22.10) with the same opposition and negative opinions circling the effort as President Obama's healthcare bill.  Only this time, Wall Street is being asked for their say-so.  So far, it has been about what they don't want; not what they are willing to give.

Retirement focused Americans should be wary of WS efforts to soften the reform ("The fact is that there is relative uniformity in the financial-services industry that something ought to be done as long as it is reasonable," says T. Timothy Ryan, president and CEO of the Securities Industry and Financial Markets Association, or Sifma, a trade group representing hundreds of securities firms, banks and asset managers), enforce the Volcker rule (re-write of the Bank Holding Company Act, which would prohibit proprietary trading and hedge-fund sponsorship for "systematically important" institutions with assets of $50 billion or more) and make everyone in the financial system accountable ("We would hate to oppose this -- and we haven't been").

From Barron's.

This article previously appeared as a new feature at Target2025.com: Repercussion- A Retirement Review.

Retiring on Time: The 401(k) Accumulation Problem

There have been numerous reports over the years that we have a problem with self-direct retirement plans such as the 401(k). These reports suggest that we are not taking full advantage of the process and worse, we underestimate how much of what we may have accumulated in these 401(k) plans will be available as a percentage of our retirement income. In other words, we simply have not used the plans the way they were intended and we haven't invested enough.

Accumulation
Everyone who has a 401(k) has heard this before: invest at least what your company matches. The company match is the best way a business can help their employee invest in the future. There is no obligation to do this, just as there was no obligation (unless contracted through a labor organization) to fund a pension. As pensions disappeared and 401(k)s stepped in to replace these defined benefit plans, companies began helping employees direct their savings by offering a matching contribution of up to, and sometimes more than 3%. That meant, in order to get the full company match (the free money the business was going to deposit into your account) you needed to put at least 3% of your pre-tax income away.

For most folks, 3% is not even missed. In fact, many people could contribute up to 5% without changing their take home pay. Because the contribution to the plan is done before taxes are taken out, the after-tax take home is almost identical to what it would be had you had 5% taken out before taxes.

So why are so many of these plans not only underfunded but under-invested? I believe that there are two reasons, neither of which has been fully addressed. One is the fact that company stock is, for the most part, what is offered by the matching contribution, not the funds in available for investment. Far too many companies saw their generosity as simply creating a larger shareholder base. These "shareholders could not sell the stock and because of that, were forced to hold what they may have wanted to sell or redirect into other more lucrative investments in the plan's portfolio of offerings. Eliminating this practice may have saved hundreds of millions of retirement dollars. Two is the lack of understanding about that pre-tax math benefit I just mentioned.

According to a recent report from Boston College, which opens with the caveat that what is being reported may no longer apply in light of the economic downturn, suggesting that it might be worse rather than better, they found "In theory, a typical worker who ends up at retirement with earnings of about $50,000 and who contributed 6 percent steadily with an employer match of 3 percent should have about $320,000." That $320,000 potential account balance was, for the sake of the study considered simulated. Why? Because the report continues with this fact: "actual holdings of $78,000 for those 55-64 are dramatically lower than those simulated for the hypothetical worker." (As low as $54,000 on average.)

Add a thirty percent loss due to the market downturn, the possibility that job loss or other financial hardship forced some folks to tap those accounts for day-to-day needs, and the chance that like so many folks I have spoken with recently, switched all of their holdings to a target-dated type of mutual fund (one that picks a retirement year and readjusts portfolio holdings from risky but only mildly so to conservative as they age and near the target date) and you have a real problem on the horizon.

Generosity Wains
With six million people out of work and more yet, disparaged, business realize that this benefit (along with insurance in many instances) is not worth maintaining. Losing this match is not the end-all for this type of plan. Although it does make it more difficult to grow without the free money.

Not impossible but somewhat harder. More companies than ever are suspending the matches until they see some sort of economic change. Some have reduced the dollar for dollar basis to half of that amount, contributing fifty cents for every dollar contributed. Some have explained that halting the company match is better than cutting the workforce by 3%.

While it is difficult to determine whether this employer generosity will ever resume to the pace it was on prior to 2008, some things have not changed. The employee who still had a job was not likely to change their contribution rate based on the news. And less than half of those eligible for these plans, used them. The good news: the last time we had a similar downturn (2001), the suspension of company matches was only temporary.

Match or no match, you must keep putting money into these accounts.

Match or no match, you should, if possible increase your contribution.

Match or no match, you should not withdraw any of these funds no matter how bad things get.

Match or no match, the report concludes that: "The time may have come to consider returning 401(k) plans to their original position as a third tier on top of Social Security and employer-sponsored pensions."