Retiring with a Plan

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

2009-07-14T05:41:00.000-07:00

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.

Why Investors Do What They Do: Investor Optimism

2009-07-13T09:49:00.000-07:00

A Recent Gallup poll tells it all. Well some of it anyway when they suggest: "The sharp decline in Gallup's Index of Investor Optimism in June -- particularly the plunge in expectations for the economy -- suggests that investors may be losing some of their hopes for an immediate improvement in the U.S. economy later this year." In the last in our series on why investors do what they do, we will examine optimism.

According to the Gallup website, the survey for "The Index of Investor Optimism results are based on questions asked of 1,000 or more investors over a three-day period each month." Although these individual snapshots can help us see where we were, only optimism propels us forward. Unfortunately, these looks back in time have an effect on how we make future moves.

While we may see it as a screenshot of how we invest, the real hidden knowledge behind the poll is consumer spending. Asking questions such as whether you will be able to achieve your investment targets over the next twelve months requires you to know what those goals were over the previous twelve months and during that period, you switched gears (and how many times). The thousand who were surveyed were also asked to project those hopes and fears into the future five years from now.

Key to achieving any sort of optimism when it comes to investing is job security. With one in ten Americas out of work (a number that is without a doubt, much higher due to the lack of jobs for those entering the workforce for the first time and unable to collect benefits and for those who are disparaged and no longer receiving any assistance), stability of income and the potential for raises play a significant role in how we look ahead. Bernard Baumohl in his 2007 book "The Secrets of Economic Indicators" calls the poll not only intriguing "it measures the attitude of private investors" yet it "also happens to the one of the least known."

Optimism is a mood, a feeling that offers us hope. Richard L. Peterson author of "Inside the Investor's Brain" writes that "investor optimism about the stock market's future declined in tandem with prices". He continues by suggesting "intellectual assessment ("overvalued") is decoupled from their underlying feeling of optimism ("it's going up")."

In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior. Coupled with all of the investor behaviors we have previously discussed here, optimism can wreck the most havoc to a long-range portfolio, in particular one built to grow for retirement.

Morningstar recently reported that "Diversified Emerging Market funds benefited from a $4.9 billion inflow vs. a net outflow of $2.6 billion in 2008." Emerging markets will always be the quickest to recover in part because of their bargain basement prices and one of the few places where risk remains risky. In a previous month's post, I warned about some of these problems and how emerging market mutual funds might not all be full of stocks from countries that are actually emerging.

Optimistic investors have also begun to channel money into more riskier bond plays "Junk bond inflows have increased $12.6 billion in 2009 vs. a rise of $1.2 billion in 2008" and Morningstar also reported that "Investors have piled in $7.8 billion into natural resources and precious metals funds after withdrawing $2.1 billion from the same category in 2008."

Chasing returns, at least past returns is also part of the problematic herd mentality and feed directly on optimism. Pessimism, which every knows is the opposite of our topic, also gives investors a sense of needing to follow what other investors do.

Optimism will not ride the coattails of this recovery. Instead, any recovery will be the result of it.

Why Investors Do What They Do: The Effect of the Media Hype on Investors

2009-07-10T12:34:00.000-07:00

Has the hype in the media over the last several months had an effect on how your invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television.

Thomas Schuster, who wrote the book "The Markets and The Media" suggests that television news has changed the way investor's react and eventually what they do. "Novices," he writes, "receive their basic training in investment issues via the media, even via such an improbable candidate as television."

Because the news is interested in only short-term events, Mr. Schuster worries that that sort of focus "provides explanations which afterwards evokes an impression of logic". There is unfortunately no way for even a savvy investor to parse that sort of information, see a developing trend that encompasses both the past and the recently reported story and make any sort of logical decision. But people do.

And the reason for this is pure coincidence. Sometimes your perception and the reality of what is happening meet and when they do, their is often a seismic shift in not only how you view your investment strategy but fundamental values as well.

There is no rational for this type of behavior short of we just do it. We treat stock information garnered from television, even stations devoted to the interactions of business and their shareholders/investors as if it were information worth having. There has been some speculation that the real traders understand this and seek to profit from this sort of non-knowledge.

It is as they say, much easier to swim with the tide. And many traders are now focused on doing just that, predicting when their colleagues, other investors all begin to believe something is worth more than they know it should be worth. The benefit these traders have is knowing that they are investing on emotion and because of their cold-hearted approach to the subject, bail long before the rest of the group realize what it is that they don't know.

So what do we do? The best thing would be to cancel cable and turn off the television. But that isn't going to happen. So the following three suggestions might help.

First: examine why you did what you did in the first place - you know, before you began to question those motives. Chances are you were probably right. If you used your retirement plan according to the time-honor, take-a-lot-of-risk-when-you-are-young method of investing, you probably should go back to that. That is, if you have changed. The most recent news has sent folks scurrying for the less risky forms of investments in their portfolio largely in part because of how the news portrayed the stock market's reaction the global financial crisis.

If you did, keep in mind that "the crisis" affected everyone, equally it seems. The second thing to remember is that you are not the only one with a damaged portfolio. If you managed to keep your job, weren't too deeply in debt and for all intents and purposes, are saving more, your approach to retirement should not have changed. Although the economy (even the global one) will not recover evenly, it will in fact recover with time. If you had spread your risk across four or five sectors (growth - large, mid-cap, small-cap, international and emerging markets) you would have covered all of your bases and be on the way to a decent recovery.

Third thing to remember is that this will take awhile. If you do not feel as though you have enough time I have bad news: investments take time and worse, take their own sweet time returning to normal. But as renowned economist and thinker John Kenneth Galbraith once suggested, the market has no memory. But you will often recall the pain of a loss much more vividly than the market does and this will keep you from making the correct investment decision when you are most emotional, which is often in the aftermath of some new piece of news.

If you have a short horizon, you need to either lengthen it or reevaluate what your plan intends to do for you if you do not allow it to recover before you start drawing down the assets.

Next up: The negative effects of optimism.

Why Investors Do What They Do: Regret

2009-07-06T11:17:00.000-07:00

One of the basic assumption in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret.

Regret is a math problem believe it or not and has long been discussed as component of statistical gathering. In her book "The Nature and Growth of Modern Mathematics" Edna Ernestine Kramer suggests that by using Professor Leonard Savage's regret matrix, something she defines as "the difference between the actual payoff" as a result of "some pure strategy and the payoff he might have received" had the test subject known for example, what could have happened.

As an integral part of decision theory, Savage's 1951 study of the subject was not the first. Blaise Pascal may have been when he proposed his wager. Nor was it the last. Investors have a tendency to look for benchmarks. Mutual funds use benchmarks to tout their investment prowess. And the probability that doing either of these exercises as being worthwhile is debatable.

Investing, no matter how lonely that decision you make seems, is always a competitive one. Failing to realize that your decision's success needs to have taken into account how other people doing the same thing respond is often commonplace. Yet, this is often not decided based on any specific thought. You see where other folks are investing. If they flock, you flock. If they flee, you flee. Human nature actually and genetically wired for survival. And you make the decision on how to allocate based on what you fear most: risk.

But our big brains get in the way. This is where regret comes into the picture. Savage constructed a criterion he called the Minimax Regret. We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed.

This will result in a portfolio recovery period that will take you much longer to get back to even than someone who had not reacted or regretted their investment decisions. The market makers, those you placed your trust in, if blindly and unknowingly, made numerous wrong choices and everything fell in. The mutual funds that are used by you to achieve long-term gains have now repositioned their holdings to begin again in the aftermath of the last twelve months. Denying risk at this point (heading off to an index fund or worse, a target-dated fund) will not allow risk to play a role in your financial recovery.

Regret is a surprisingly destructive part of an investor's behaviors. Anticipating past history in making investment decisions allows regret (the "what if" is replaced with the "what if I don't") to strangle risk and not allow it to do the job it is supposed to do.

Next up: The media

Why Investors Do What They Do: Herding

2009-06-29T07:08:00.000-07:00

It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder.

The cautionary warnings about just such a strategy often fall on deaf ears. Few folks have the patience to wait out an investment that has performed well in the hope that if they shift their investment to a high-flying fund, they will do even better. There are several things to consider before doing this and lessons to be learned if you have ever done something like this.

First off, funds that maintain a steady amount of growth usually take all of the cost factors into consideration. Among those factors, turnover stands out. Many high flying funds that find themselves on the top ten lists, at least in the short-term, usually have very high turnover - which means, higher than average trading costs, a new manager that has shifted priorities or simply a manager rearranging where they are as the quarter or year ended. Turnover incurs trading costs that are directly passed down to the shareholder. Sometimes, they even create a taxable event if the fund has sold numerous winners from the portfolio to reposition the fund for another round of winning.

Those steady growth funds are often referred to as value funds. Value funds tend to look for undervalued, better performing companies. Growth funds, which dominate the marketplace, tend to look for companies that have more potential than proof of success. This leads to a higher underlying risk and increased turnover risk. While they may actually grow in value, these types of funds often undercut those profit numbers with higher than average fees.

Secondly, mutual fund investors often fail to consider the size of the fund or the size of the companies that the fund invests in. While there are thousands of companies to chose from, the majority of these companies are actually much smaller, more volatile because of their size and although they offer growth, they seldom have the long-term track record to prove investment-worthy.

And lastly, investors who herd seldom take into account the geographic area of those underlying investments. While the world faces the same economic challenges, the recovery will vary from one region to the next. Some parts of the global economy may recover more quickly (such as emerging markets) while more industrialized nations such as the US will take longer to embrace the economy recovery.

In Emilio Barucci' book "Financial Markets Theory" he describes herding as an "effect [that] arises because other decision makers may have information important for the decision maker". he points out that "fund managers care for their performance because their compensation, their career and the probability of being chosen in the future by investors depend on their performance relative to an exogenous benchmark or to the performance of other fund managers." he notes that the presences of these features, while not saying competition is bad, results in investor herding.

It should also be noted (and this comes as a warning as well) that herding is most prevalent after a crisis. But herding is usually based on a weaker set of reporting requirements, opaque regulations, somewhat lower accounting standards, reputation and most importantly, potential. Alan Lewis wrote in his 2008 book "The Cambridge Handbook of Psychology and Economic Behaviour that there is absence of knowledge on the subject when it comes to long-term results or opportunity suggesting that there are "deeper, structural underpinnings of investor behaviour [sic], including their investment beliefs and the way investors justify their behaviours to others."

Next up: Regret

Why Investors Do What They Do: Diversification

2009-06-25T01:01:00.000-07:00

In his classic book "Portfolio Selection" co-Nobel prize winner Harry Markowitz describes his topic as something other than securities selection. He suggests that a "good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies."

Diversification often involves numerous human emotions and misuse of it is often the result of some of the topics we have already discussed (loss aversion, narrow framing, anchoring and mental accounting with herding, regret, the impact of the media and optimism all as yet discussed). But diversification is a way to avoid being wrong. It is a way to avoid regret. And when you are wrong, you tend to be really wrong.

These feelings of "wrong-ness" are often the result of events beyond our control. Non-economic influences can derail the best efforts of an investor along with weather, military actions, even the health of the President. As Markowitz suggests: "Uncertainty is a salient feature of security investing".

In order to avoid too many economically obscure references to diversity we will boil the discussion down to two theories: the expected utility theory and the case-based decision theory. The first theory suggests that if the investor is indifferent to an investment, in other words they are so similar that she/he doesn't care either way, that this actually becomes a form of risk aversion and hardly ever produces good long-term satisfaction with those choices.

In the instance of Case-based decision theory, Mohammed Abdellaoui offers the following from his book "Uncertainty and Risk": "it is assumed the decision-maker can only learn from experience, by evaluating as act based on its past performance and on the performance of acts similar to it." This leads to chance decisions.

But what is often overlooked is that not only do you decrease your chances of being wrong, you by default increase your chances of being right. Diversification will spread the risk and as a result of that, may allow you to miss the next hot stock or mutual fund. Because it is impossible to pick the future based on the past - recall the reminder that past performance might not play a role in future results - diversification makes the chances of getting some of the hot property but not all of it.

Consider this simple question: if Rome is located between 41°54' North Latitude, which American city lies at a similar latitude - Boston, Atlanta or Miami? Most folks when asked this question go with either Miami or Atlanta and do so with more than reasonable assurance that they are correct. But Boston, with 42° 21' 29" N is actually the closest by comparison.

Unfortunately, as Robert Hagin author of "Investment Management" points out that people when people make investment mistakes - something that can afflict both professionals and non-professionals, they fail the old adage of "a problem is not what up don't know; it is what you do know."

The most difficult part of investing is removing guesswork and the wishful thinking you may have for the act. Not easy by any means. But much easier if you don't overthink the act of spreading your risk.

Next up: Herding

Why Investors Do What They Do: Mental Accounting

2009-06-23T06:57:00.000-07:00

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification

Why Investors Do What They Do: Anchoring

2009-06-19T07:40:00.000-07:00

So far, we have discussed loss aversion and narrow framing, trouble spots in any investors view of what they are trying to do. They may be investing in their retirement plan or simply making an economic (better yet, one with financial implications) decisions, but we often, as studies have shown, begin from some point of what we know. This is referred to as anchoring.

Unfortunately, anchoring is a bias. It is often included among other similar cognitive biases such as memory bias (which effects how we recall a situation after the fact) and confirmation bias (depends largely of what you already know and uses this information to skew your perception of what really is). Each alters what we see with something we already know and this drives businesses, who want to anticipate what you will do and more importantly, what you will buy and confounds psychologists, who have twisted the lab questions done on test subjects in every conceivable way only to find out that we have numerous cognitive influences mucking up the works.

But anchoring is particularly dangerous when it comes to investor reaction. An anchor is basically an expectation. We are not the kind of shoppers who go into a store, find a good and before we flip the price tag, try and determine what we will pay for it. But it is a good experiment that you can conduct on yourself. Time after time, you will find your expectations of the cost of the good, be it a television or a dress will be altered by what you perceive.

You will try and narrow down your choices to one that seems to be what you think something is worth. But that narrowing of thought, trying to get closer to the price tag (and feeling very smug if your bias towards the cost is exactly what the cost is) will not work across a broad spectrum of goods. In lab tests, subjects merely get "a good" and know little about what it is. But as soon as the item is revealed, adjustments are automatically made.

We generally have no real anchor when we begin investing except for the money we begin the process with. This becomes the anchor if you have nothing in the account. But in a upwardly moving market, an investor can quickly get swept up in a constantly readjusting balance. Once money is made, a new anchor is created in your view of that portfolio.

Investing however is never quite that simple. While we all enjoy growth, we tend to lose focus on the fickleness of the markets and the underlying worth of whatever it is we are buying. If a stock or a mutual fund has had a great run of it, even topping the top ten lists, investors will not see this as the top but the new value on which to anchor their expectations.

Consider what cognitive abilities (or biases) you may have used or borrowed from someone else. You watch the business news channels hoping for a tidbit of relevant information about which security you would like to buy. You peruse the web looking for confirmation of what you would like to believe is true. But what you are really doing is looking for an anchor using someone else's anchor to support your decision.

If analysts make forecasts or predictions based on past performance and then offer the disclaimer that future results are not guaranteed. They have used past results to anchor their bias as to whether things look rosy or the future is bleak for the stock.

Anchoring is tougher on a retirement account largely due to the set and go approach that most investors use in these types of accounts. Unless severe market downturns capture our attention in the news, we tend to leave these accounts to their own devices, channeling a portion of our earnings into them each week.

But when we do look at those quarterly statements, and many of us have for the first time in a while, we have an idea of where we should be. And it will be much higher than is probably reported. That's because we aren't so good at making predictions or estimates.

Look at it this way. Suppose you invested a thousand dollars in an IRA account and added $100 a week to that account. Over the course of 25 years you would have put $114,429 (adjusted for inflation at 3% on the real value of $131,000 actually contributed) in the account. If the money grew over that period at a modest 5%, which for that stretch of time is below average even with last year calculated into the mix, you would have added almost $135,000 in earnings (also adjusted for inflation).

Now suppose your portfolio balance of $249,402 dropped 30% or $74,802. Wouldn't you still be in the black? With an inflation adjusted contribution of $114k, haven't you protected your money and even grew it by $40k. Because you constantly shift your anchor or readjust your estimates higher, your expectations follow.

This is due in large part to a small target. Your balance may have grown substantially since you began investing but what occurred caused you to miss the target. I am not a shooter but I know that when a person does aim and fire, they are often narrowly focused on the target when in fact we should be making broad sight adjustments.

Next up: Mental Accounting

Why Investors Do What They Do: Narrow Framing

2009-06-12T04:41:00.000-07:00

In our previous discussion about loss aversion, we looked at what was the beginning of Kahneman's prospect theory. Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk. More importantly, a discussion about regret.

When you (or as you are often referred to when being discussed by economic types, an agent) moves into the stock market, be it through individual ownership or through mutual funds, you are changing your wealth allocation. Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret.

This regret is the result of accessibility and the misuse of the different decision rule. Accessibility is what it is: information that is readily available almost instantaneously through any number of mediums and the ability to enter into the market without restrictions. The different decision rule is described in Walter L. Wallace's book "Principles of Scientific Sociology": [the agent]"chooses whichever means optimizes the end in question". This thinking is looking for what could be crudely referred to as the most bang for the buck. Freud called this the pleasure principle.

Narrow framing demands a high equity return both now and in the future. Does this take into account market shifts, both up and down? Not really nor is a realistic approach in the long-term. But loss aversion and narrow framing are not separate thinking.

One of the most famous examples was described by Paul Samuelson, a noted economist, Nobel Prize winner and the person who bridged theoretical and applied economics. When he offered to flip a coin, the prize being $200 if the flip went his colleagues way of loss $100 if the flip went Samuelson's direction, the colleague declined on both accounts. This is loss aversion. When the perception that the loss is greater than the possibility of winning, the investor tends to freeze.

The different decision rule is often described as a way to optimize the end so as not compromise or to incur the minimum amount of cost. Luigi Guiso of the Einaudi Institute for Economics and Finance Via Due Macelli in Rome tested narrow framing using the lottery question, much like Samuelson's coin flip. What he discovered was that if you allow the subject of the test to have time to think about their personal economic and financial situation before you asked them whether they would like to win twice as much as they might lose, they were more apt to attempt to try the game of chance. He wrote: "attitudes towards regret and reliance on intuition rather than reasoning are likely to drive the tendency to frame choices narrowly."

In their book "The Routines of Decision Making" By Tilmann Betsch and Susanne Haberstroh, the authors suggest that the more routine a decision is - such as investing for retirement - the more likely a person was to resist forecasting. In other words, even if the recent economic downturn had been forecasted, and in some instances it was, the person who might be most at risk of losing value in their 401(k) because of out-sized risk or an overabundant share of their portfolio in their company's stock, might have ignored what was obviously a warning. The markets had routinely ascended along with the value of the portfolio and they had seen this as a reoccurring event that probably would not end in the foreseeable future.

This problem is best manifested in the doctor's office. Your physician gives you news about your health that you are skeptical about or might be life-altering depending on your decision. How do you decide how many second or third opinions you garner to help you decide? Suppose those decisions don't jive with how you are feeling?

Next up: Anchoring

Why Investors Do What They Do

2009-06-11T06:54:00.000-07:00

A recent report done by Dalbar, inc. of Boston suggests that investors often do things that hurt what they are attempting to do in numerous ways. Using information aggregated from the Investment Company Institute (ICI.org, a company that tracks and support the mutual fund industry), The Standard and Poors Company (the standard bearer of indexes) and Barclays (which publishes an index of bonds), the company has found that there are numerous influences, both external and internal, that have an effect on how well a portfolio of mutual funds (or stocks for that matter) perform over the short-term and long-term.

They identifies nine areas where investors thought they were right, when they were in fact, ignoring signals that the approach they were taking may have led to, even exacerbated losses rather than gains. The report cites these facts from the study to support these claims:

* For the 20 years ended December 31, 2008, equity, fixed income and asset allocation fund investors had average annual returns of 1.87%, 0.77% and 1.67%, respectively. The inflation rate averaged 2.89% over that same time period.
* Equity fund investors lost 41.6% last year, compared with 37.7% for the S&P 500 Index.
* Bond fund investors lost 11.7% last year, versus a gain of 5.2% for the Barclays Aggregate Bond Index. This disparity is largely due to the underperformance of managed bond funds caused by mortgage-backed securities.
* With an annual loss of 30% last year, asset allocation fund investors fared better than equity fund investors.

The first of these nine ares, which we will examine over the next nine posts, deals with loss aversion. Falling squarely into the realm of behavioral finance, numerous academics have sought to model a realistic estimate of how investors react in certain circumstances, whether those reactions were realistic given those circumstances and how financial decisions are evaluated and eventually made.

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that "since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones." They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker.

How you frame the argument (in an investor's mind), even if it is the same problem, directly affects how the investor reacts. Frame it negatively, and the reaction often leads to risk taking; frame it positively and the investor will chose a risk averse solution.

The battle between what "would happen" if a decision is reached is often overshadowed by the repeated decision making based on what has already occurred. Economists refer to this as a continuous process suggesting that an investor might become overconfident and that generates irrationality.

Martin J. Pring once said, "For most of us, the task of beating the market is not difficult, it is the job of beating ourselves that proves to be overwhelming." According to Stanford University Business School paper published in July of 2006, "the principle of loss aversion is not derived from any theory of behavior or more basic psychological principles, but is an ad hoc principle introduced to account for a range of phenomena involving tradeoffs between losses and gains." In other words, most investors seek the status quo.

And to change the status quo, investors need a motive. What happens if those motives are fuzzy or ill-defined? The paper, written by David Gal cited an experiment done by Kivetz and Simonson which "offered diners a reward program in which they could receive a free meal at a dining hall after having paid for a certain number of meals. In a between subject design, they found that sushi lovers would actually prefer a reward program which required the purchase of 10 sandwiches and 10 sushi platters to a program which required only the purchase of the 10 sandwiches. Although the former option was dominated by the latter, sushi lovers perceived a relative advantage in that they would likely have eaten the sushi anyway. Based on this relative advantage, sushi lovers inferred that they were getting a "bargain" in an absolute sense."

When information is fuzzy though, it is difficult to determine what the status quo actually is. If you were offered a 50% chance of losing $100 or a 50% chance of winning a $100, the trade-off might seem relatively straightforward. The better bet is to not take the bet at all. What is needed although is a clear preference of what the status quo is.

Loss Aversion does exist but it is difficult to define and hard to expect. Studies have shown that historical data (past performance indicators) often lead us to make these decisions and yet, that same historical data may have little to do with what we may gain, or lose.

Next up: Narrow Framing of Investment Decisions

Retiring with a Plan: Is the Roth 401(k) Conversion Worth Trying?

2009-06-09T02:48:00.000-07:00

In 2010, you will be allowed to convert not only your current 401(k) plan but your IRAs and any 401(k) plan you might have rolled over into an IRA. The question: is rolling your retirement money into a Roth 410(k)the right move to make?

As with all financial decisions, this takes a little bit of planning and consideration. The conversion will cost you money, mostly in tax dollars paid because your 401(k) plan, IRA or rollover action, saved you from paying on taxes that a Roth 401(k) will require you to pay.

Traditional plans defer those taxes. But once you opt for the Roth 401(k) or even a Roth IRA, the taxes on the transferred amount will need to be paid. This is because the money invested in a Roth is done after taxes. The first consideration is whether you will be able to pay those taxes.

A Window Of Opportunity
You do have a window of opportunity though. Taxes due on these types of conversions in 2010 are payable in 2011 and you have two years to pay them. Estimate the taxes on what you have in these accounts based on your ordinary income tax rate. There are no penalties other than this in the conversion. But depending on the size of your account balance, you will need to set aside this amount starting before you make the conversion.

The simplest way to do this is to set aside the money in a separate account - preferably away from your emergency account. (An emergency account is savings set aside for emergencies and if you can have a minimum of three months set aside, you are well ahead of what you neighbor probably has.) On the other hand, this money should not be invested either. This is cash for taxes and has no risk potential. Some of you might be tempted to put it in a taxable indexed mutual fund to get some work out of the cash, but this would not necessarily be the wisest choice.

This is also an opportunity best used for those who are above the current $100,000 a year income threshold. These folks have been unable to save more for their retirement because of this ceiling. Expect this group to do this in droves - if they are smart. For the rest of us, the transition may not be worth it.

Many of us are underinvested as it is. We cannot accurately see what the future tax rate will be on these invested dollars yet we can be assured that we will not have the same tax rate as we do know. If studies are correct, most of us will be in a far lower tax bracket, lower than most of assumed we would be in come retirement.

Keep in mind that if you do exceed the AGI (adjusted gross income) of $100,000 the conversion doesn't necessarily mean that you will be able to contribute more. There is way around this. If you were to make nondeductible contributions to a Traditional IRA and roll them into a Roth IRA in 2010, but only the contributions, not the investment gains, that part of the rollover is not taxable. The gains on those "nondeductible" contributions would however be taxed.

Ultimately a Tax Issue
Phase-outs are linear, meaning what you make determines the level of contribution. Because this is a tax issue and you should always consider speaking with a tax professional first, the following is just a guide to see where you fall in terms of income, phase-outs and contribution levels.

If you are a Single filer, your Roth contribution limit is reduced when your modified AGI or adjusted gross income exceeds $101,000.00, It is eliminated completely when it reaches $116.000.00

A person wishing to determine their contribution status if they are Married Filing Jointly will find their limit is reduced when their modified AGI exceeds $159,000.00 and is eliminated completely when it reaches $169,000.00. When it falls in between those amounts, the linear contribution phases in. For instance, if you were half way between, your contribution would be reduced by 50%.

Another tax filing status might affect your contribution levels differently. A person Married but Filing Separately, (and) Living Apart would find their Roth contribution limit is reduced when the AGI income exceeds $101,000.00. It would be eliminated completely when your modified adjusted gross income reaches $116,000.00

Those choosing the Married Filing Separately, or Other has a limit as well. These folks will find their contribution is reduced when their modified AGI exceeds $0 and is eliminated completely when your modified adjusted gross income reaches $10,000.00.

Once it exceeds those limits, you will not be allowed to contribute.

But as with all financial investments, they are not static. They may in fact be worth less. Because of that, you may want to look into a IRA Recharacterization.

Retiring on Time: The 401(k) Accumulation Problem

2009-06-07T08:50:00.000-07:00

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."

Trash Talking Mutual Funds

2009-06-04T03:06:00.000-07:00

As I drift around the web, I inevitably end up on some other blogger's site as they talk about investing, mutual funds or retirement. While everyone is guaranteed an opinion online, these missives may be as balanced as a morning spent watching Fox News.

And sometimes, I leave a comment of my own. Today, was one of those days.

Dr. Scott Brown, Ph.D., a.k.a. The Wallet Doctor, is a successful futures trader, real estate investor, and stock investor. Dr. Brown who hold a Ph.D. in finance from the University of South Carolina wrote: "These funds are also sold and managed on pure hype, short term trading, and with key information withheld from the public."

He continues after explaining briefly the history of how mutual funds grew, leaving out key tax code changes that created the 401(k) and the IRA during the time frame in question. He adds: "Many mutual funds are able to cheat the public with excessive fees because investors don't understand how these big costs destroy their profit. Mutual funds have no interest in educating investors because it is easier to hoodwink the ignorant!

"Don't put your trust in mutual funds unless they are fully indexed." And even though Mr. Brown suggest that he knows what the SEC really thinks about funds, he never does tell us what they are doing to regulate the industry.

So I asked Dr. Brown: "Tell me I am wrong":

Indexed mutual funds are too tax efficient to be locked inside a retirement account such as a 401(k).

While the low costs (fees) are always attractive and can lead to more profits, all index funds are not created equal nor do they charge the same fees. Some make up for their low fee structure by charging the individual investor $3,000 or more to make an initial contribution - far more than anyone would suggest the average investor plunk down at any one time.

Mr. Levitt did have a great deal of trouble back in 1993 (he referred to the former SEC chairman's divesting of common stock into mutual funds and some of the difficulty he had with transparency). But the industry has come a long way since and while it has further to go, the journey is at least headed in the right direction.

Actively managed mutual funds are far better for the average investor than buying individual stocks for three reasons: they can offer diversity and research; they can offer the ability to purchase new shares without charging each time you do, and they take they mental maniac out of the investor experience - the one that wants to sell on the way down, buy on the way up and mostly fails at determining their own risk tolerance.

Yes, far too many funds chase the same stocks. But it is the ETF that causes the wildest, end-of-the-day trading and market gyrations - not mutual funds.

Most folks equate the failure of 401(k) retirement accounts on mutual funds when in fact, more folks were invested in their own company stock, often upwards of 50% of the portfolio and often because this was the only way to get the company to match.

The creation of so many mutual funds is a result of the mimic effect. Those 500 funds that were in existence in 1980, that grew to over 8,000 by 2003 were the result of marketplace diversification. They sliced and diced the markets down into ever increasingly specific areas. Yet you fail to mention the same sort of slice and dice market done by the ETF markets.

Now that the SEC is back in the hands of an administration that cares, I expect their job will be much more focused and far less scattered than it was over the last eight years.

Mutual funds, while not perfect are much better than they were and are improving all of the time.

SIMPLEs and UNI-DBs for Small Businesses

2009-06-01T08:42:00.000-07:00

When the tax laws were written for small businesses, they were often much more generous. For instance, an employer with only him/herself as an employee can save enormous amounts of money for their retirement - far more than the employee or business owner at a much larger company.

Today we discuss the SIMPLE IRA and the Solo or Uni Defined Benefit Plan for small business in the last of our three part series.

The SIMPLE IRA, named because those letter stand for savings incentive match plans for employees, are a much cheaper and far less complicated way for small employers to establish and administer than a traditional 401(k).

This type of plan is indeed easier to manage and implement but there are a few rules you need to keep in mind before choosing a SIMPLE IRA plan for you and your employees. You are required to make a contribution for every worker who receives $5,000 or more in compensation. It doesn't have to be a lot but it has to be something up to but not exceeding $11,800 for the calendar year 2009.

The contributions may resemble an employer match, just like those used when larger companies match employee contributions to their defined contribution plans (401(k)) But the employee must first elect to contribute to the plan themselves and your match to their contribution can not exceed 3% of their salary.

Employers may also choose to make the contribution on the employees behalf, contributing up to 2% of each worker's wages, whether the worker contributes to the plan or not. This "non-elective" mandatory company match of 2% is required to be made on behalf of every employee.

Aside from the fact that the plan cost less to administer, the strings that tether the SIMPLE IRA might not be right for you or your company.

SIMPLEs have a built-in special tax penalty of 15% that is added to the 10% early withdrawal penalty for SIMPLE IRA withdrawals made within the first two years of opening a SIMPLE plan. Although your retirement plan should not be considered a source of income, this penalty can make it more difficult to access that money in times of dire emergency. (But please, consider every other option first before withdrawing built up investments in these plans.)

Because of that string, a SIMPLE IRA can be much less flexible than a 401(k) plan for the average small business. Keep in mind the following while considering this type of plan. Will you be the only employee? If so, a Solo 401(k) might be best. If you are planning to grow your business slowly, adding employees on as needed, you should consider that contribution requirement. An employer must make contributions for all eligible employees and while they are doing so, no contributions can be made to other qualified retirement plans.

The contributions you make to the employees plan belong to the employee immediately after they are posted. This immediate vesting can be troublesome for some seasonal type of employers who do not expect to retain employees or demand their loyalty for a long period of time.

Should you as an employer decide to end the plan, you must wait until the calendar year is completed and while you are waiting, you are obligated to continue with payments to the employee's plan. And here is something else you should consider: no loans are allowed.

If you however fit this profile: older than 50 and earning more than $120,000 per year, have no more that four employees, been in business for at least three or more years and are willing to make mandatory contributions to the plan for three consecutive years of $45,000 or more, there is possibly no better plan on the planet better than this one.

But these plans can be quite a bit more complicated and require you have help with the legalities. But you will find it well worth it especially if you are earing or expect to earn those sums now and in the near future.

KEOGH plans were put to the wayside with the creation of SIMPLEs. If you still have a KEOGH plan in place, the paper work to rollover the plan is relatively straightforward but still must be done by a plan professional. But I believe that if you do rollover a KEOGH, you, your employees and your retirement future will much better off for the effort.

FEATURE	Solo or Self Employed 401K	Solo-DB	SEP-IRA
Eligibility	One person only. (Multiple owners and spouses allowed, but no other employees)	Business owner and up to 4 employees	No limit on number of employees. (most organizations prefer the 401K )
Key Features	Low Cost ($0 to $25/yr) Contributions to plan are discretionary. IRS form 5500-EZ filing required for balances over $250,000 Roth 401k feature	Annual Fees (about $1600/yr +) Offers the largest tax- deductible retirement contribution permitted by law Mandatory contributions for at least 5 years	Very Low cost (about $15/yr) Contributions to plan are discretionary. contributions are made for one employee they must be made by the employer for all eligible employees
Loans	Loans are allowed	Loans are allowed	No Loans
Contribution Limits *	See Self Employed Owner Only Calculator or Contribution limits for max contribution limits.
Deadline to open plan	December 31 or End of company’s fiscal year	December 31 or End of company’s fiscal year	Up to time of tax filing
Deadline to contribute to plan	Employer contributions must be made by the employer's tax filing deadline plus extensions	Employer contributions must be made by the employer's tax filing deadline plus extensions	Before the employer's tax filing deadline plus extensions

Retirement Planning: Your Business Plan for Retirement, part two

2009-05-28T04:17:00.000-07:00

As I explained in part one of this series, more than just a great business idea makes a business successful. More than simply wanting to strike out on your own, make money as your own boss and create a reality out of a vision, a business, now matter how big or small must have an exit strategy for its creator. It might be a legacy, a business that you would like to see passed on to your heirs. It might be a stepping stone to bigger and better opportunities down the road. But what it should be, all things dreams of success aside, is a bridge to the day when you are no longer working.

To consider retirement at the onset of your company's creation is paramount to that goal. We may say we are working for the glory and the independence, the profits and the satisfaction but in truth, we are working for the payoff.

While the solo 401(k) is designed for the business of one, often times that business will grow to include other people. Product lines expand as your success grows. Contracting out work can be a temporary stopgap yet if you would like to see your business grow to entice more customers and control the quality of your projects, you may need to hire people to work with you in those goals, folks who share your ideals and passions, the same people who, because of their dedication will also be deserving of a piece of the profits generated.

A SEP-IRA can fill those needs nicely. But like all taxable events, the rules need to be followed. SEP-IRA or self-employed pension individual retirement account allows you, the employer of one or more, to share in the profits of your business by making contributions to this type of plan.

It acts just like a traditional IRA would with added feature of shifting contributions. In good years, the plan can allow contributions of up to $49,000 per employee. This contribution is tax deductible for the business and the growth of those funds is tax deferred. In years when the business profits falter or are simply subject to cyclical changes, the contribution can be lowered or eliminated completely.

SEP IRA is a retirement plan designed to benefit self employed individuals and small business owners. Sole proprietorships, S and C corporations, partnerships and LLCs qualify. In those circumstances, the company pays the business owner (you) a W-2 salary. In this situation, the annual SEP IRA contribution can be between 0% to 25% of the owner's W-2 salary up to the SEP IRA contribution limit. The caveat: you must also contribute to your employees the same percentage as was contributed to yours.

The contribution limits are slightly lower for an unincorporated business such as a sole proprietorship, unincorporated partnership or a LLC electing to be taxed as a sole proprietorship. In this instance, annual contributions are made into your SEP IRA account between 0 to 20% of your net adjusted self employment income. Either way, these are hefty savings allowances compared to the limits placed on other types of retirement plans.

One important thing to consider though: having a solo 401(k) as well. because a SEP-IRA is dependent on profits and if you have employees, sharing those profits with them, a solo 401(k), allowable as well alongside the SEP-IRA, gives you another opportunity to put away money for retirement from your income, which may not be reliant on the profits of the business.

Eligible employees must be at least 21 years of age and have worked for you for at least three years of the last five years. SEP-IRAs are easy to set up and cost effective, may have little or no paperwork to file with government and could net you a tax deduction of up to $500 for the first three years of the plan. Plans are administered by the employer through a mutual fund company. generally offering a simple basket of funds from which to choose.

While plan participants cannot borrow against their SEP-IRAs, they may roll them over to another qualified plan. And like all IRAs, are subject to the same withdrawal penalties and restrictions on age.

Next up: The simple IRA and the solo defined benefit plan.

Retirement Planning: Your Business Plan for Retirement, part one

2009-05-26T00:09:00.000-07:00

Those of us who write about personal finance will, almost by default attempt to explain your personal finances, even your marital finances, as a business endeavor. And as truthful as those analogies might be, it still doesn't prepare you for your own business. If the entrepreneurial spirit is truly alive, then chances are you have given some thought to opening your own business.

More than the business plan is needed. More than just that great idea; the one that you know is just what some consumer somewhere cannot live without. More than just that spirit of being your own boss. More than the freedom to call the shots, be the builder of your own destiny. Being in business for yourself is a huge risk against your retirement.

Your reliance on your skills will sap the very lifeblood out of you, leaving you thrillingly exhausted at the end of each day. It will be great and terrifying, all at the same time. And many of us will fund that venture with money that may not come directly from your previous employer's 401(k) - at least I hope not - but from money you could have put away for that future.

There is a way to not lose out on that future as long as you apply some of the principles that guided your retirement plan before you struck out on your own. And if you tapped those funds, there are ways to recoup those lost dollars quickly.

But you have got to act fast. Right from the beginning. Without a doubt, you will need a salary from your business. And just like when you had that other job, the one with the 401(k), you should account for a pre-tax retirement contribution.

There are several ways to get going. First, we will discuss the easiest one to set up. In the next post, we will talk about other plans to think about as your business grows.

The solo 401(k) is for a sole proprietor, a business of one. It was created for people with great ideas, folks like you Your business can have a spouse for an employee but generally, the self-employed, the entrepreneur, the small business owner must go it alone. The good thing about solo 401(k): simplicity.

Simple to use and easy to maintain, you may contribute up to $13,000 of tax-deferred income with a bonus incentive thrown in for good measure in allowing you to add up to 25% of profit from your business as well. You might be living on tuna and crackers, but this type of plan can allow the start-up business owner the advantage of playing 401(k) catch-up in a relatively short time. The contribution limit is $41,000.

The relaxed rules that come with a solo 401(k) offer you the ability to decrease your contribution or suspend it altogether. By try not to. Because other rules in the plan might come in handy during some rough spots in your business's future. Known as hardship withdrawals, these loans against your solo 401(k) often have more favorable terms than those plans administered by larger enterprises. You might, at some point in time consider rolling over your previous 401(k) into your new plan.

Yet, like everything that seems too good to be true, there are a few drawbacks to the to the solo 401(k).

First, you need to find a plan administrator. Typically, these might be mutual fund managers but not always. The fund families are generally less expensive (trust and equity companies can charge anywhere from $400 upward to set up the account, and an additional percentage or fixed fee on the balance of the account) costing about ten dollars to set-up the account and 0.25% against the account balance, it may on the surface seem like a no-brainer to chose these folks. But the funds they offer you may add additional costs to the account in the way of fees and some fund families, like Fidelity want $10,000 upfront to begin with any fund.

Here is a list of plan administrators (a downloadable pdf.).

You should also consider your business's growth potential. If its quick, and you anticipate hiring employees, setting this kind of plan up may be a waste of time. Once your solo 401(k) is set up and your business grows, you will need to transition to a traditional 401(k) sooner than you would have liked to - or had the time to.

If you do anything, keep this in mind: this is a taxable event and should have the stamp of approval on it from someone who is a professional. Find a good one through references or very good friends.

Next up, the SEP-IRA.

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

2009-05-21T05:42:00.000-07:00

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.

Retirement Planning: What the Financial Planners are Thinking

2009-05-18T04:57:00.000-07:00

We have a multi-dimensional problem when it comes to retirement thinking. We want to pinpoint numerous factors in our retirement plan, when in fact, the effort might be wasted. Much like the physicist who wants to measure a particle, quantum mechanics explains that it cannot be done, in part because it would change the particle by trying to stop it. Making a retirement plan pause gives you no measurable assurance that where you are right now is going to be the right move somewhere down the road.

These financial planners, their opinion which many will still turn to even if their advice led us down this road in the first place, are still called upon to give direction. I have neighbors who fret over the fate of their retirement accounts yet as soon as a son or daughter wants to make a financial decision, the first step is to set up an appointment with a financial planner.

Now these planners are looking for a way to regain your trust - many still have your business but largely feel uncomfortable with the disappointed looks on your faces. To address this, they have begun offering some suggestions, which although not new, they are a shift from too much risk to finding a way to eliminate what they see as unnecessary risk.

In a recent article to financial planners, The Investment News offers some suggestions that will no doubt be taken by their lobby group to Washington. They think that Social Security will remain a part of a retirement plan. They do concede that fixing this program will require not only a cut in benefits but an increase in taxes. Not very imaginative but keep in mind, this group is not likely to waste too many braincells on a program that produces no profits.

Instead, they are focusing on readjusting their client's portfolio from (age-appropriate) risk to vanilla risk (read that as a long-term relationship with folks who seek a way to get ahead by taking a much slower vehicle). This could add as many as ten years to your working life.

The net effect of working longer - besides working longer - is a more fully funded plan. But that funding will not have realized its full potential without a certain amount of risk. Many planners, as they restructure your plan for you will move your money into more costly types of investments that, on the surface, offer less risk.

Not all index funds are created equally and the shift into target dated funds does not come cheap and in some cases, are not a proven way to soften risk. Index funds can suffer from what is known as style drift, a way to enhance the return of the index by taking on an actively managed methodology.

Target dated funds are still suspect. There is no proof they do what they promise and do it for less cost. I have had problems with fund companies selling these funds as the risk free, cost effective ways to save the retirement community. And planners have become one of the forward sales makers for this product.

Adding to the list of products this group is looking to sell to lawmakers is the right to annuitize retirement income at age fifty. The thinking here is so simple, it is almost backward thinking. They are suggesting that the investor in a defined contribution plan take their money and essentially take it off the table, guaranteeing it will be there when they retire. This would allow folks who were unsure about the future to "buy" an annuity, with its high fees and suspect growth aspect instead of switching to a lower risk platform.

The suggestion that employers begin a retirement plan for all employees that have failed to do so and docking pay to fund it, seems, at least on the surface, to be a good idea. A bit Orwellian but the strategy is worth looking at for all workers before something like this becomes law. After that, the employer may pick the plan and in doing so, may not fully understand their fiduciary responsibility. But then, they would probably hire a planner.

The Social Security Solution

2009-05-14T15:06:00.000-07:00

Its nothing new. I mean, the solution. I've been an advocate for it for years and have taken my lumps from plenty of conservatives for that stance. On the other side of the aisle, there has been a muted acknowledgment that it might work but they fear, as most rich folks do, that they will be basically paying and not receiving back. I like to call it the boomerang effect. What you put in they believe you should get back out, eventually.

Nobody who makes a lot of money, taps their ability to invest and believes in the markets will really much like the idea. Conservatives call it socialism but its more like social security. Not the name of the program but the net effect.

We all know about the impending doom of Social Security (and the other two often mislabeled as entitlement programs for the poor, Medicare and Medicaid). We have seen it coming for years as economist and actuaries have been tapped for their expertise and foresight at seeing the future. Sure they crunch numbers and look at folks who earn this or that and they can make a pretty good determination of how much will be paid out compared to how much will be going in. But is this mostly an exercise in futility? Some would call it politics? Others might even see it as polarizing.

It is one of the few government programs that needs to be balanced and rebalanced in order to work. The accompanying suspicions that this will burden future generations unfairly and unnecessarily are always announced as someone pointed out, at the same time there is a huge get-together of the nations health insurance providers.

But what makes it so prone to future bankruptcy? Too many people withdrawing from the fund and no one replacing the missing benefits? To much borrowing? Too much debt?

When solutions are bandied about, the always seem to point to a payroll tax increase, a retirement age increase or a benefit decrease. Some even think a combination of the three might be even more beneficial. A payroll tax of just under two percent would fund the program for 75 years. Increasing the retirement age, as is currently happening, and less people can collect benefits leaving more in the fund longer. A benefit decrease is self-explanatory and might just be economically devastating to a large group of retirees.

A means test would solve everything. The current program is fair to everyone. But any changes in benefits does not distribute evenly or fairly. A means test would place the right amount of benefits where they are needed most.

Here's how it would (might) work:

We could shoot for a $15,000 a year retirement income as the threshold for full benefits; after that it would be reduced incrementally. Will this keep folks from investing for their future? Not really. If anything, it would allow people to draw on their retirement savings only as needed for longer. Add that to that threshold sum to the $15,700 estimated benefits thatand you have just enough to keep the retired person a consumer (which is really what we want them to be) and with enough cash to pay for their lifestyle. Retiring with more would only increase the quality of your retirement years and for those that focus on just such goals, they would not take their eye off of that target because they thought it might jeopardize the size of their SS check..

To make it fair, you could re-run the test every couple of years. That way, if a person with a reduced benefit (because they have so much that Social Security simply pays for pool maintenance) were to have a change in financial circumstances, they could be reconsidered.

If you consider the self-directed invested for retirement rates among all workers, most would not even come close to that mark, despite access to the markets. But many will and they will do it exactly the way they are now. But those that are not using the markets, and they number in the millions, will not be left as burden on the society you want to retire in.

The system was designed to keep the poorest from a poverty existence. We should restore it to its original purpose. It would have the net effect of keeping the economy moving and not burdening it (and their families) with poor retirees.

Happy Mother's Day: Do You Know Where Your Retirement Plan Is?

2009-05-10T08:48:00.000-07:00

We all have mothers in common. And on this day, besides remembering her with flowers, candy or breakfast in bed, there is no better time to begin planning for her future. I mention in my book "Retirement Planning for the Utterly Confused" that women often play a very diverse role throughout their working career. The roles they play, the numerous hats they don, are often the reason Mom doesn't have the financial strength when her working years are done.

She often leaves work to have children (not always and if your are a stay-at-home Dad, you would be wise to pay attention as well) and this is first instance of retirement interruptus. Her efforts at saving for the future, at a time when every financial advice giver agrees, are the best years for saving for that far off distant future, are put on hold. That one move can have long-term damaging effects.

She may hit other bumps in the road as well. Later in life, statistics show that it is often the woman who leaves work to take care of a parent in their golden years. This creates a cycle of disaster as the lack of preparation of the parent leads to a continuance of the problem that must be avoided. Adding another work stoppage seems to make the previous break for children even worse.

There is also the issue of being single. They may wait longer to get married, but no one problem for s secure financial future looms larger than the possibility they they will face their retirement years without a spouse. While this independence might seem attractive at first glance, your Mom may be under severe financial stress, shortening her lifespan in the process.

Sons and Daughters need to unite. Today (and the next day and the next) are the best times to take all of this into account.

Sons should not only be looking at their own mothers and mothers-in-law but their wives and daughters as well. In many instances, these women default to your experience with money. In many instances this is a grave mistake. Men, as it has been shown, are more emotional about money, willing to take bigger risks, and are often not focused on the big picture.

Sons, you need to begin the conversation. Is your wife saving as much as you are? Is she adequately insured for potential disability or even long-term care? Is she assuming enough risk to make her retirement investment grow?

Is your mother's finances in the best place to ensure it will not outlast her time with you? Are you financially prepared to deal with a health problem (has she named an executor, made a will, or otherwise let her intentions be known) or a loss of property? Have you made a plan to determine all of the possible scenarios that might play out, as difficult as something like that might be to do?

Is your wife (and daughters, if they are at least twelve years old) involved in how your financial house is structured? Are you guilty of financial infidelity, an act of risky behavior that you hide from the family's finances and fail to admit? Have you saved enough for a rainy day?

These are all tough problems to deal with. But ignoring only puts off until tomorrow what you should have planned for today.

Today is the day that Sons need to help your mother, your wife and your daughters have a better future. Daughters: Today is the day you need to get involved, open the conversation and make a plan for your future.

Oh, and Happy Mother's Day!

Retirement Planning: Close but Not Quite Close Enough

2009-05-04T08:30:00.000-07:00

More folks are looking at the past year with notable regret. They are looking at the fate of their investment strategy and wishing they had listened to the few who were warning of the coming investment storm or, promising to change their thinking in favor of a once-bitten-twice-shy approach moving forward.

Those closer to retirement are concerned that their current portfolio balance may not be enough to get them to retirement or, they feel comfortable with the current balance and want to protect whats left just in case. To those who have suffered losses, moving the whole of what you previously owned can be fraught with perils.

Your old portfolio was probably more open to risk and was not forward looking as much as it was now looking. You would check your portfolio and congratulate yourself for your investment savvy, even if the gains were due to market forces you knew little about as long as they trickled into your portfolio. But now we realize that this was not a very prudent approach. And as human nature dictates, we recoil from doing the same harmful thing again. (Although that same human nature is also responsible for our short-term memory, a hindsight look at risk that argues it was probably worth it; I'll try again.)

Leaving well-enough alone, even if it is not as well as you would have liked it to be, is actually the most prudent method for recovering those losses. Selling at the bottom, especially in a mutual fund, does not allow you the time to recoup and, if you you still have a long-term approach, shuns the idea that any recovery will take place. (In a previous post, I suggested that this could take as little as four to six years.)

But what do you do to change the habit of chasing market fads? First, leave the funds you currently own right where they are. This doesn't mean that you should ignore them completely. What it does suggest is no longer funding them if you are within five years of retirement.

Instead, use new money to take a new approach. Fixed income has become much more attractive post-meltdown and for good reason. There are some guarantees that your money will still be there when you retire. Building on your stock allocation with bond funds is not only wise, it has been highly suggested by many planners. (What those planners will also suggest is moving from one fund to another. Not wise.)

Municipal bond funds have become increasingly attractive. The reason I suggest buying munis through a bond fund is the relative inability of the average investor at determining the risk in these bonds. (Yes, there is risk. Some municipalities may be facing dire straights as a result of the current economy and will offer too high a return to attract investors.) But right now, munis have a sizable spread over Treasury offerings of similar duration meaning that, to attract investors, the yield is higher over the same period of time.

To fully appreciate what a bond can do for your portfolio, but a total bond fund that encompasses a broad swath of fixed income debt. Because there is risk and fees, don't think you can simply buy in and forget about it.

Inflation could create problems in the future diminishing the expected returns and making your invested dollar worth less even as the face value of it remains the same. Interest rates could fall as well and investors who purchase bonds outside of a bond fund are more vulnerable - provided they are aware of these two key elements: If you hold a security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity. But if you buy a bond that is considered a zero-coupon investment, you might face some interest rate concerns. Zero-coupon bonds make all their interest payments when the bond matures and because of that, they are the most vulnerable to interest rate swings.

Credit agencies rate bonds based on numerous factors. The higher the rating, the lesser the chance you will face a default risk. In other words, the higher the rating on the bond, the greater the likelihood you will get your principal back in tact. But on the flip side, the yield for this degree of safety is much lower than on a riskier bond.

Another good reason for using a bond fund is liquidity. Suppose you had one to sell and no one wanted it? And the last big risk factor is reinvestment. A bond you may be holding may be called back, a move that essentially allows the issuer to pay off the bond, return your principal and leave you looking for a similar bond with comparable yield.

Even those these risks persist, a bond fund helps alleviate them. I'm not so sure a Target-dated fund could do as well. In my mind, it would be like fighting a war on two fronts.

Retirement Planning: Bouncing Back

2009-04-29T11:04:00.000-07:00

For previous articles of interest on how to manage this current financial crisis, please visit our previous blog entries collected here at BlueCollarDollar.com.

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The most common question asked of me these days is when the markets will bounce back. Even with numerous issues plaguing the everyday lifestyle of the average American (debt, housing, and jobs to name just a few), the strength of the markets, in particular, that of their retirement plan, is still weighing heavily on their minds. While such focus and energy would have better used in the years prior to the current downturn, it seems to be a measure of confidence that things will get better.

But tying your mood to such fickle places as the market can be difficult at best. What we hear on the evening news and through web reports on the subject is a daily moving number, sometimes up and just as often, down. But like all measures, it depends how much on where you stand as to what you see.

To simply look at the popular Dow Jones Industrial Average (a grouping of the largest industries in the US and representative of those industries) is not enough. Although when hear those numbers, they can offer hope and despair, and lately, at the same time. Knowing that the value of the Dow is down significantly from its plus 14,000 point high last year to its recent rebound to over 8100, gives the average sideline viewer hope while at the same time, dashing that hope.

But a lot goes into the making of those numbers and the theory of how long it will take this index to get back to even. Dividends play a role in how the index performs but does not show up in the index's number. Just about every member of the Dow has cut its dividend as its share price fell. This keeps the percentage of shared profit (what shareholders get in return for holding the stock is a portion of the profit, calculated as yield and divided into the share price - a $1 dividend on a $20 stock is a 5% yield). Sometimes, the drop in the DJIA does not stop the dividend payment from dropping. This increases the value of the stock even if the share is worth less - in the index.

Deflation (a decline in prices because folks aren't spending and credit is too tight to use borrowed funds to buy products) or inflation (the effect of a currency being worth less than the goods it previously purchased) can have an effect on the index but it doesn't show up in the number.

And because the Dow represents only 30 companies, it is not often indicative of the market as a whole. And because the Dow changes over time, with new companies being added while older ones are deleted from the index. One of the biggest gaffs the DJIA ever did was removing IBM, which while it was absent, performed better than the 30 in the index.

So when you hear that the market is down, don't fret. It will recover. If it does so in an historical fashion, it could take as little as four years to regain its former glory and as long as eight. But rest assured, these are simply efforts at looking back, adding in some often excluded facts and mixing it in with a little hope.

Which is why many folks who ask what they should do often here me say - do nothing but focus on fees and expenses.

Some Retirement Account Suggestions

2008-07-08T05:00:00.000-07:00

A recent Boston Globe article offered this: "When millions of U.S. investors open their second-quarter retirement account statements soon they might be disappointed with their dividends, analysts say.

"Most investors will find their stock and bond funds in 401(k) and individual retirement accounts sank between April and June amid skyrocketing fuel prices and a slowing economy." The temptation many fear is that these individuals will begin tapping those plans, seeing the balances as better used for day-to-day living expenses rather than day-to-day expenses in the future.

You should avoid touching that 401(k), now posing more as a 201(k) after recent market turmoil for two reasons: One, if you are well away from retirement (say fifty or below) you are looking at a long time for the markets (and your savings tied to those markets) to recover.

The second reason has more to do with why. If it is for debt relief, then scale back your contribution and use the extra cash towards debt (contribute only what matches). If it is for market relief, reduce the fees in your plan and index your savings. Normally, I suggest index funds be held outside your defined contribution plans for the better tax treatment but with the markets sending mixed signals and more aggressive funds failing to offer fee relief, perhaps the switch would make the losses less painful.

These times do make pensions (defined benefit plans), those antiquated savings stabilizers (like Social Security) look awfully good. I just hope next time some politician suggests privatization, that we remember these trying times.

Where You Live; What you are Worth - Retirement Planning and Credit

2008-07-07T05:45:00.000-07:00

Do you live in a state where housing has taken a big hit? Do you live in, near or around a place where credit has all but dried up and foreclosures have appeared like so much acne before prom night?
Have you felt immune to the downside fallout of those events because you pay your bills (and more importantly, your mortgage) on time, have little or no debt and money in the bank?

The credit crisis is about to make itself known to millions of Americans who otherwise would have felt as though all of that bad financial news was not their concern. Even folks who have pristine credit, the very ones who use at it is supposed to be used and were proud of the lending power (credit limit) these credit issuers gave them. You were a good risk.

Lately though, credit card companies are estimating, or should I say, re-estimating that risk and its worth to their bottom line. Bad loan decisions and the overall tightening credit market has forced many lenders to rethink their generosity and with that, how much money you can borrow. What was previously a five figure credit limit on home equity lines and credit cards has been reduced often by as much as 90%.

What can you do?
In most instances, nothing. If the financial institution you do business with decides that there is overwhelming risk in your ability to pay off balances, even if you have done so faithfully in the past, the credit limit can and in many cases, without warning, be reduced. Primarily, this seems to be targeted towards small business owners who rely on those credit limits for business and travel decisions. But it is finding its way into the average person’s financial lives as well.

If there is so much as a hint of financial stress in your credit score, even if you don’t live in a state with a high degree of foreclosures, you will eventually come under scrutiny. Best thing to do is maintain your credit score. Do this by paying your bills on time and by communicating with your lender. In many instances, they would like to assess their risk and remedy the situation to not only their best interest, but yours as well.

They may lower or waive any fees on the account or renegotiate the terms of the current loan. Do this by threatening to shop around. There are some better risk-situated financial institutions willing to lure business away from competitors.

The last thing you can do is reconsider the project you might be starting around the house. Determining the value of a remodel has gotten more difficult with the best changes coming from structural improvements rather than upgrades to living spaces. Exterior maintenance and things like electrical, insulation, and plumbing will be more worthwhile fix-it projects than a new kitchen or bathroom.

Small businesses might reconsider the need for certain business trips in terms of return on that investment of time. In some cases, the credit companies may be unwittingly making a business decision for you.

Retirement Planning: The Annuity as a New Idea?

2008-07-01T05:15:00.000-07:00

When the new ideas seem complicated, they are not workable for the average investor/employee. Pensions were simple. You worked and when that long career was over, you were rewarded. The advent of the 401(k), a Wall Street invention unlike any other profit generating idea ever created, was offered to the most captive group of investors, add a little fear of the future and you have the perfect income producing vehicle.

And then, say it could be better. Say it needs to be improved. Say it is not really our fault – we are smart enough just not as logical as previously thought. There are far too many of us not using these tools and far too many potentially profitable fees left uncollected.

Which gives folks like Professor Merton, the John and Natty McArthur University Professor at Harvard Business School and a winner of the 1997 Nobel Memorial Prize in Economic Sciences an opportunity.

Its just too bad Prof. Merton mentioned annuities. He actually had my attention until that point. Perhaps I should begin with the thinking about retirement allocation that he so deftly describes as" "But that knowledge won't qualify you to decide how much mid-cap European stock you should have in your portfolio, any more than it would enable you to perform surgery on yourself." True enough, but removing a splinter is simple surgery; transplanting a heart on the other hand is not.

If knowledge and time truly are the only obstacles - although I believe that the ever complicated financial products that are available are designed to make us feel less than qualified to remove even a simple splinter, then Wall Street should demystify the process.

If annuities were truly the solution, then businesses could once again create a pension with guarantees. Why they don't is quite easy to answer: They do like the cost structure.

Retirement, as we have come to dream about, is a time in life when we can rely on an income that we worked hard for and the time to enjoy it. Granted, this has been redefined with every passing day - each uptick in inflation, each economic downturn and each political misstep with taxes and spending, keep that dream from fully developing.

But I should emphasize that the single biggest drag on any retirement savings is the cost of getting there. We can play "minimum/maximum needed income" games all day but the simplest solution would be to give the employee a financial review on the same day businesses take the time to give them appraisals. Having the employee opt for channeling their next pay raise or bonus into a long-term plan might be all the incentive they need to continue to work harder all while giving the employee a sense that the company is more than just a "gatekeeper" and closer to the good old days of pensions, when the company seemed to actually care about loyalty and rewarded it with a defined benefit.

Now I fully realize that we will never be able to go back to those days, but annuities - an investment/insurance hybrid of dubious nature and questionable need is not the answer.