Retirement Planning: The Danger of Opting for Lazy

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

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

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

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

In other words, lazy now has a price.

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

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

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

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

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

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

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

Retirement Planning: Making Realistic Assumptions about Retirement

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

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

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

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

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

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

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

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

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

The next post here will discuss the hard numbers.

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

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

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

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

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

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

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

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

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

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

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

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