3 Strategies To Manage Withdrawals When You Retire During A Bear Market

March 13, 2019

The stock market has taken investors on a pretty wild ride over the past several months. It is during these volatile times that we experience a higher number of calls from people who are concerned about their retirement savings and wondering what they should do. My most concerned callers are those who are getting close to retirement. With the bells from the 2008 financial crisis ringing clearly in their heads, they are asking, “What should I do if I retire into a bear market?”

Here are three different strategies to consider that can allow you to still retire when you want to without the market fluctuations (or downturn) affecting your plans or causing you to run out of money sooner than you originally projected.

Strategy #1: The bucket strategy

To use some jargon, this is also called the time-based segmentation approach. With this strategy, you think of your money in 3 hypothetical buckets that are aligned with your spending needs and the time line for those needs. For example:

Bucket 1 (Short-term): This is the money that you anticipate needing to withdraw over the next 3 to 5 years. Most people will put this bucket in cash or in very conservative investments. The idea is that this money is protected from market down turns, while the rest of your investments can have time to recover (aka grow back with the market) before you need to begin withdrawing them.

Bucket 2 (Medium-term): This bucket is the money that you may need within a 5 to 10-year period. Most people would invest this bucket in medium and longer-term fixed income assets such as bonds or bond funds.

Bucket 3 (Long-term): This is basically the rest of your money, which you estimate you won’t need to withdraw for 10 or more years, and therefore what you want to keep growing. You’ll typically use stocks (aka equities) for this bucket, as you’ll have time for this money to recover from any longer-term bear markets and ideally will continue its growth over the years.

My colleague Chris Setter wrote in greater detail about the Bucket Strategy here.

The drawbacks: It can often be difficult to trust the process and not let emotions get in the way. During up markets, you may feel like the cash you set aside is just not working hard enough and that you should take on more risk.

Likewise, during down markets you might start feeling anxious and like you should move your money into cash for safety. Both reactions can hurt you, as it is nearly impossible to time markets and more often than not you will only contribute to a reduction in how long your money will last.

In addition, it can be challenging to manage money you have across different accounts like tax-free, taxable, and tax -deferred accounts as you may want to keep different types of investments in different types of accounts (for example, higher growth in a tax-free account like a Roth so that you can earn tax-free growth, while municipal bonds earning tax-free interest make more sense in a taxable account.)

What can make it work better: Sticking to your plan and having a strategy in place to replenish and reallocate your buckets while being mindful of the type of accounts your assets are invested is the key to success with this strategy.

Consider funding your short-term bucket by using the more conservative short to medium term bonds in your medium-term bucket, as they are typically the assets that will be most stable. To replenish your medium-term bucket, you can take the gains from the assets that have grown in your long-term bucket and reallocate them.

Ideally you are following an appropriate asset allocation strategy based on your goals, time horizon and cash needs, so this should flow into your existing investment process.

Strategy #2: Essential vs discretionary

With this approach, the goal is to take retirement savings that you need to fund essential expenses (such as housing, healthcare and daily living expenses) and invest them into assets that produce guaranteed income such as annuities. The remaining savings would only be used for discretionary expenses (like travel, non-essential home improvements, etc.) and would remain invested in more growth-oriented vehicles such as stocks.

The drawbacks: The drawback to this method is that some discretionary expenses might actually be considered essential to an individual with a certain retirement lifestyle in mind. If for some reason their discretionary assets did not last, then those individuals might have preferred to continue working until that lifestyle could have been accomplished versus living more frugally in retirement.

What can make it work better: If that’s the case, then maybe think of your savings again in 3 buckets, but with different labels: the Essentials, the Discretionary Non-Negotiables (such as a country club membership), and the truly Discretionary (like taking your whole family on a Disney cruise when times are good, versus just hosting the grandkids at your home when the market is down).

Individuals looking to secure a minimum retirement lifestyle could then place the expenses that are essential and non-negotiable into guaranteed income buckets, and the remaining assets to the truly discretionary items that they would not really miss if push came to shove.

Strategy #3: Structured systematic withdrawals

A systematic withdrawal refers to the process of taking money out of your retirement accounts based on regularly scheduled fixed (percentage or dollar) amounts. For example, a popular systematic withdrawal rule is the 4% rule. The idea behind this rule is that you can “safely withdraw” 4% a year from your savings for the duration of your retirement and as long as you stick to that amount or less, you shouldn’t (in theory) run out of money.

The drawbacks: As my colleague Scott points out in his article, the drawbacks include not taking into account the timing at which you retire (for example, a 40% down market) or the various income needs, lifestyle, and family dynamics of individuals. In other words, one size doesn’t fit all, which means there is no guarantee that the 4% rule in and of itself is the best approach for you.

What can make it work better: This approach can work in the above considerations as long as you also build in decision rules around certain triggers that would lead you to take action during certain market events. For example, perhaps you would reduce your withdrawal percentage during down markets, and/or possibly tap into stable and liquid assets (such as a cash savings account) to help meet your needs while allowing the investment assets that have taken a beating some time to recover.

For example, a colleague of mine shares that he plans to keep 3 years of expenses in cash, and when market downturns occur he might reduce his withdrawal to 3% and supplement his needs from his cash reserves.

How to decide which is right for you?

Since there really isn’t a one size fits all approach, setting up these rules will require thought, foresight and planning.

All of these strategies require you to have an idea of what your annual financial needs will be – use these 5 steps to help determine the retirement income you are aiming for, and then consider consulting with a qualified and unbiased financial planner to help you determine what the best retirement withdrawal approach is for you. They can also help you maintain and update your strategy as you go along.

With proper planning and preparation, anyone can develop a strategy that can outlast the scariest of bear markets, while helping to ensure that your savings can last to infinity and beyond!

 

 

 

 

 

Are You Investing In The Right Account For Your Goal?

March 12, 2019

When it comes to investing, we talk a lot about “asset allocation” but what about “asset location?” Are you investing in the right account(s) for your goal(s)? Let’s take a look at some common financial goals and which account(s) might be best for them:

Emergency fund

The key here is easy access to your money in case of an emergency. Most tax-advantaged accounts have restrictions and penalties for most withdrawals, but the Roth IRA is an exception. You can withdraw the sum of your contributions at any time and for any purpose without tax or penalty. If you withdraw earnings before 5 years and age 59 ½, you’ll probably have to pay taxes and a 10% penalty on those withdrawals, but the contributions always come out first.

Buying a home

A traditional or Roth IRA can be a good choice here since you can withdraw up to $10k penalty-free (and tax-free from a Roth IRA after 5 years) for a home purchase if you and your spouse haven’t owned one in the last couple of years. (Since Roth IRA contributions can always be withdrawn tax and penalty-free, the $10k limit can be applied just to the earnings.)

You may also be able to borrow from your employer’s retirement plan to purchase a home and have a longer time period to pay it back than with a regular retirement plan loan.

Retirement

If your employer offers a match, start there so you don’t miss out on the free money. Once you’ve maxed the match, you can also contribute to an IRA if you prefer having more flexibility than what your employer’s plan offers. An HSA can also be part of your retirement savings since the money can be used penalty-free for any purpose at age 65 (and will still be tax-free for qualified medical expenses including some Medicare and long term care insurance premiums).

Education

The most popular option is a 529 plan, which allows the earnings to be withdrawn tax-free for qualified education expenses. The plans are run by the states and each has different investment options. You’re not required to contribute to the plan for the state you live in or where you child goes to school, but some states offer special state income tax breaks for contributions to your own state’s plan.

If you prefer more flexibility, you can also contribute to a Coverdell Education Savings Account, which has similar federal tax benefits, but contributions are limited to $2k per year and the money has to be used by the time the beneficiary turns 30. Finally, you can withdraw money from an IRA penalty-free for education expenses, but make sure you’re not jeopardizing your retirement.

Of course, if you max out the contribution limits of any of these accounts or just don’t want to tie up your money, you can always contribute to a regular taxable account too. If you’re still not sure which account(s) makes sense for you, consult with a qualified and unbiased financial planner. Just don’t let indecision about which account to save in prevent you from saving at all!

Too Busy To Manage Your Investments? Here Are Two Possible Solutions

March 08, 2019

I don’t know about you but there are days when I am so busy that I have to look at my iPhone to figure out the day of the week. When you throw picking investments into the mix and most people stick their heads in the sand (probably to take a nap) rather than deal with it (unless, of course, it’s something you’re interested in!). As much as I would love to encourage taking a break, I do not encourage one for your investment accounts. As hard as you work, your money should be working for you.

Luckily, the investment world understands this and has created simple, low-cost methods for managing investments. The two most well-known options are investing in an asset allocation fund and investing with a robo-advisor. Which approach you pick depends on your goals, your investment strategy, how involved you want to be in the investment management process, how much of a say you want with your investments, and how much you’re willing to pay. Here’s a review of both.

Robo-advisors

Robo-advisors provide automated online portfolio management advice, typically without a human financial advisor. Many robo-advisor companies use the same software as human advisors but only offer portfolio management advice for generally lower fees. Most of their investment choices are low cost ETFs, although a few offer stocks and other types of investments as well. Some robo-advisors also offer features to help you minimize taxes in accounts outside tax sheltered accounts like a 401(k) or IRA.

Robo-advisors are popular in part due to the minimum amounts needed to invest. Some companies have no account minimums while others require as a little as $100 a month to invest. This makes them a great option for those who want investment advice but may not have the minimum assets to work with a human financial advisor.

For those who want a human touch, don’t worry. Many investment management companies these days are offering robo-advisor options with a dedicated human financial advisor for a slightly higher fee, but less than what you’d pay to work with someone who might come to your house or invite you to their office.

A robo-advisor might be a good fit for you if…

A robo-advisor may be a good fit for hands-off investors who enjoy low cost investment management and are comfortable using online services. This is also a great option for those who may not have the minimum assets to work with a financial advisor but want the quality of financial advice. If you want a more customized portfolio based on a brief risk tolerance questionnaire, robo-advisors may offer the best solution for you.

Asset allocation funds

Asset allocation funds are mutual funds that are usually pre-mixed with equities, fixed income, cash equivalent and sometimes alternative investments, giving you instant diversification. The fund can be mixed in various ways and typically rebalanced to maintain the desired mix of stocks and bonds.

The title of the fund often gives you clues as to how your funds are mixed. A balanced portfolio is generally a mixture of about 50% stocks and bonds. Lifecycle or target-date funds start off with a higher percentage in stocks and gradually become more conservative as the investor approaches a pre-determined date, which is retirement in most cases. Lifestyle funds are allocated based on risk level (e.g., conservative, moderate or aggressive).

An asset allocation fund might be a good fit for you if…

An asset allocation fund may make sense for those who are in retirement plans such as a 401(k) or IRA and want a fund that does all of the work for you. If you are looking for a true one-stop-shop then asset allocation funds may be for you. If you are not comfortable with online services but want a similar hands-off level of portfolio management you would get from an advisor or even a robo-advisor, an asset allocation fund may be a good alternative.

Reviewing the pros and cons of each

Both asset allocation funds and robo-advisors have pros and cons. The key is to evaluate your needs and wishes to make the best decision for you. Some of the questions to answer are as follows:

How comfortable are you using online services? Robo-advisors require a certain degree of computer literacy and comfort not needed with an asset allocation fund.

How customized do you want your portfolio to be? Robo-advisors typically base their advice off of a questionnaire and you may be able to tweak the asset allocation or change the answers to the questions asked to modify the portfolio. On the other hand, an asset allocation fund is setup based on very broad criteria such as your retirement age and basic risk tolerance level, which may not give you the best allocation for your investment needs.

How much are you willing to pay? Since many robo-advisor firms use ETFs or index funds, the cost can be cheaper than some asset allocation funds, particularly the funds that are more actively managed, although you may find an asset allocation fund in your company’s 401(k) that is cheaper than any robo-advisor.

What type of investments do you want to have in your portfolio?Most robo-advisors use ETFs, although some use stocks. An asset allocation fund is a mutual fund.

What level of service do you want? Some robo-advisor firms can help you maximize tax savings. An asset allocation fund generally does not offer ways to save on taxes.

Once you have decided if you are going to choose to invest with a robo-advisor firm or in an asset allocation mutual fund, do your research to choose the best firm for your needs – this can go a long way to helping you find the right investment strategy to help you reach your goals. Then you can spend more time on the rest of your life!

How Do You Decide Where To Open An Investment Account?

February 22, 2019

When it comes to investing, once you’ve decided how to divide your money between types of investments, which investments to pick, and what type of account to contribute to first (401k or IRA, pre-tax or Roth) there’s another decision you’ll need to make: where should you actually open the account?

If you’re just contributing to your employer’s retirement plan, there’s not much of a choice. On the other hand, if your tax accountant just told you to open your first IRA, leaving the comfort and safety of your workplace benefits can be intimidating. Alternatively, you may already have outside accounts but feel unsatisfied with your current broker/mutual fund company and are looking to make a switch.

A range of options

When I started my financial career, it was pretty simple. There were full-service brokers that also charged full commissions and there were no-load mutual funds and discount brokerages that offered little or no help to investors. Now, there are a range of options in between that can give you some of the best of both worlds. Here are some questions to consider:

Are you looking for investment advice?

If so, your choice of advisor may dictate where you invest. There are generally 3 ways you can go for advice. I’ve worked in all three environments so I can tell you that they each have their pros and cons.

1. Traditional full-service broker. One option is to use a traditional full-service broker that charges a commission for investments that you purchase through them. For example, a full-service broker may charge a “load” for mutual funds, which can sometimes be as high as 5.75%. Be aware that for some investments, such as annuities and class B and C mutual funds, those commissions can be hidden as part of another fee.

For bonds, the commission can take the form of a reduced yield. In addition to many of the big names like Merrill Lynch and Smith Barney, many banks, credit unions, and insurance companies offer investments this way.

Advantage: You only pay for the advice you take and it can be cheaper in the long run than paying a percentage of your overall account every year.

Disadvantage: These “advisors” may be tempted to sell you products that make them money rather than you. If you go to a financial advisor and he/she tries to convince you to invest in insurance products right off the bat, you may want to keep shopping – there is a place for those investments, but that’s often a red flag that the advisor is looking to make the most money for themselves rather than help you grow yours.

2. Independent registered investment adviser (RIA). They generally charge you an annual fee, usually around 1% of the assets they manage for you, or in some cases an annual retainer or hourly rate. Your investments are usually held at a separate discount brokerage firm like Charles Schwab, Fidelity, or TD Ameritrade, or at an independent brokerage that you’ve probably never heard of. This separation can help prevent Bernie Madoff-type fraud, but it also means that you may have to go to one place for advice and another for administrative issues.

Advantage: You can get more objective advice and often more comprehensive financial planning.

Disadvantage: Fees can be higher in the long run and many RIAs won’t even accept clients with accounts smaller than $250k, or often $500k or more.

3. Discount brokerage. Several discount brokers like Schwab, Fidelity, and Vanguard have also started offering advice at a lower cost. The depth of the advice depends on how large your account is, but their starting threshold is generally lower than an RIA, and they tend to charge less as well. You might also be able to get some free fund recommendations if you’re willing to forgo ongoing management and simply rebalance your portfolio periodically.

Advantage: Lower balance required and lower fees.

Disadvantage: You most likely won’t ever meet face-to-face with your advisor and their advice will be limited strictly to your investments, which may not take into account your personal goals for the money.

What do you want to invest in?

If you can’t answer that question, you may want to revisit the previous one. If you do know what you want, this is the question to start with. After all, some companies may not even offer the particular type of investment you’re looking for, and some places may charge more for it than others. For example, it’s generally cheapest to buy Vanguard and Fidelity funds directly from the source. Your choice of investment should determine your provider, not the other way around.

How do you invest?

How you’ll invest matters too. If you’re actively trading stocks every day, you might want to look for in-depth research, trading tools, and quality execution, along with low fees for trading. On the other hand, those factors won’t be as important if you’re just buying a few mutual funds to hold, where you should be more focused on ongoing fund fees.

What are the fees?

Either way, costs are an important consideration because they can really eat into your returns over time. Fortunately, competition has driven commissions on stocks down to as low as $2.50 a trade at Just2trade, and many brokerage firms offer a variety of mutual funds without any loads or transaction fees (NTF or non-transaction fee funds) so see if any of them offer the funds you want for free.

If you’re transferring from another company, the previous company may charge you a hefty fee on the way out, but some companies will rebate those fees, up to certain amounts, back to you if you transfer your account to them. Finally, look out for maintenance fees, especially on IRAs.

How convenient is it?

Once you’ve narrowed your search, see how close the brokerage firms’ branch offices are to you or if they even have one (many only do business over the phone or Internet). Some brokerage companies also provide FDIC-insured banking services. In addition to allowing you to have everything in one place, these accounts can pay more than traditional bank accounts and may even rebate your fees for using another bank’s ATM.

Your choice of brokerage companies probably isn’t something you want to decide based on which office you happened to walk by or which television ad you remember. It will affect how much and what type of advice you get, what investment options are available to you, how much you pay in fees, and your overall investing experience. There is no one best choice for everyone, but some will certainly make it easier for you to achieve your goals than others.

What To Watch Out For When Seeking ‘Non-Traditional’ Investments

February 20, 2019

The stock market is guaranteed to do one of two things: go up or go down. Because so many Americans are dependent on their 401(k)’s as their primary source for retirement, as a financial wellness coach I start to hear more investor discontent when the market is not doing well. When the market is going up, people tend to be content but when the market goes down, many investors go on a quest in search of the perfect investment.

Beware of “outside the box” investments

One of the most dangerous questions an investor can ask an advisor is, “Do you have anything other than mutual funds, stocks or bonds that give me a better return without taking on risk?” The reason I consider this a dangerous question is this is where an investment is often introduced that is hard to understand.

I recently read a story about an athlete that had sued his financial advisor for misconduct. Before I go further, let me emphatically state that the client is not at fault in cases of advisor misconduct. When I hear stories like this I can guess that the investment was something other than a traditional account before I read the details. One reason is the fact that most large firms have substantial checks and balances on advisors. It is difficult for the advisor to operate in felonious activity with traditional investments, but if there is some one-off, unique investment then an unscrupulous advisor may circumvent the built-in safeguards.

The reason most advisors stick to a narrow listing of investments is because that is what they are trained in. When clients ask for something different, the advisor may be able to pull some product off the shelf that functions differently, but in my experience those products tend to have a narrow application. Conversely, I have seen investors, in an effort to get away from traditional investments, squeeze themselves into investments that may have higher risk with a lower opportunity for return.

The exotic investment is never as easy as it sounds

If you move forward with something that’s different from the more typical stock market investments expect some rockiness. When going the road less traveled there is a reason there are not droves of others on the same road. Recognize there may be some risk that not even the person recommending it may be aware of. For example, pay close attention to the need for additional tax filings and keep track of any costs for those filings. This should count against your total rate of return.

Concierge service sounds nice, but beware

If someone is recommending an investment that may be complex, be mindful of trusting the advisor to make everything easy. If you are investing in real estate, expect to have to deal with tenant difficulties and repairs. If you are investing in a franchise, expect to see good and bad months. If you have an advisor or consultant telling how great things are going all the time you need to dig deeper – whoever is shielding you from the realities of these investments is not doing that for free and whatever they are paid will eat in to you returns.

It is ok to ride the downturn

You don’t have to stick to just stocks and bonds. I, along with many planners on our team, own investment real estate and other non-traditional investments not available through a brokerage firm. This is just a warning to make sure you have the time and risk appetite for these type of investments.

A buy and hold strategy of a stock- based portfolio can be difficult to watch on the downside but if your investments align with your goal it is ok to see down periods. A downturn is not a loss unless you sell at the bottom. If your allocation is reasonable and time is on your side, stick to it.

 

 

 

 

4 Red Flags To Watch Out For Before Buying An Annuity

January 25, 2019

Annuities – the word itself can start WWIII in a room full of financial advisors. Some advisors think of annuities as the financial instrument of Satan and other advisors believe it is the Holy Grail for anyone in retirement. I am in the middle.

For the right person in the right situation, they work

I think for the right person, the right annuity can help someone generate the income needed to maintain his or her lifestyle in retirement. For the wrong person, an annuity can tie up money unnecessarily for years. The key (and the challenge) is for the consumer to fully understand both the benefits and risks of an annuity and to assess if the benefits outweigh the risks for their particular needs.

Does anybody really know how these things work?

The problem is that annuities are so complicated that most consumers and most advisors do not completely understand them. The training on annuities at most financial institutions centers on selling them. When I first became an advisor, my company assigned me to an area with a high elderly population. Big surprise – this area also had many annuity sales people.

After a few months in my new location, a client would stop by with a friend who wanted a second opinion on an annuity. Most of the annuities I reviewed were good and a great fit for the owner. Unfortunately, there also annuity contracts I reviewed that did not match the benefits the annuity owner thought they were getting.

Other annuities I reviewed did not match the needs or even long term goals of the annuity owner. These experiences gave me a unique window as to the “red flags” of a potentially bogus annuity salesperson and new perspective on how to help consumers.

Red Flag #1

Your advisor pressures you to sign an annuity contract before fully explaining the contract to you

When you get the annuity contract to sign, have the advisor go over all of your discussed benefits in the contract. Make sure that all of the promised benefits are listed in your contract (your advisor should be able to point them out). If anything that was promised is not in the print of the contract, do not sign. If needed, your advisor can have the contract redone to include your discussed benefits.

Once you sign, no matter what you thought you were getting, you are pretty much stuck with the annuity. Most states have a “free look” provision that gives you the option to get out of your annuity within typically 10-30 days (varies by state), but once that period has passed, it’s yours, even if it’s not what you thought it was.

Red Flag #2

You do not know your advisor’s background

There is an inherent trust people have in anyone presenting himself or herself as a financial professional. One of my friends was told by an aspiring financial advisor that, “All I really have to do is put on a tie and show up, and people are willing to trust me.” The only qualification needed to sell an annuity for most is an insurance license, which requires 20-40 hours of general insurance courses, 6-12 hours of ethics courses and passing an exam. No financial or retirement planning knowledge required.

To sell variable annuities, an advisor would also need at a minimum a Series 6 license. The qualification to getting a Series 6  is for the advisor to be affiliated with an organization that will sponsor them to sit for the exam and for them to pass the 100-question exam with at least a 70% passing score. In most states, an advisor may also have to pass a Series 63, which I personally studied for and passed within a 48-hour period.

This means someone can graduate from high school June 1, go through all of the training, pass the exams and hang a shingle outside of an office as a financial professional by July 1 with absolutely no experience. Ask about the professional experience of anyone managing your money and do background checks by going to your state’s Department of Insurance website and/or by using the Broker Check website.

Red Flag #3

Your advisor did not clearly explain to you why the annuity he or she wants you to purchase is a good fit for you

If you are switching annuities, make sure you understand exactly why switching is such as good idea. I reviewed an annuity sales proposal from a woman who was getting ready to switch from an old annuity to a new one (called a 1035 exchange). The advisor told her it was a good idea, but the client could not explain to me why it was.

Upon reading the proposal, I knew it was because there was no good reason for the exchange except for the commission the advisor would receive. The change would increase her surrender period and cost her more money in fees and the annuity actually had fewer benefits. Make sure you clearly understand how and why the annuity purchase meets your financial goals.

Red Flag #4

The advisor tells you that it is a “no risk” investment

No matter how good an investment is, there are always risks. The risk may be your money being tied up or your money going up or down with the market or getting a low rate of return, or it could be the risk that the annuity company goes out of business. The key is for the benefits to outweigh the risk and for some, the risk may be a deal breaker.

I reviewed an annuity for a friend of a client who wanted to withdraw the money for his child’s education. His advisor told him about all of the benefits but left out the 10% surrender charge for withdrawing his funds. What angered him about this is that he told me that he explicitly told the advisor that he planned to use some of the funds for his child’s education.

The bottom line

Do not sign anything you do not understand. If you don’t understand an annuity, ask questions until you do. Just like Smokey the Bear’s famous quote, “Only you can prevent wildfires,” you are your own best defense against bogus financial professionals.

Where Should You Save Extra Money: Into Your 401(k) Or IRA?

January 15, 2019

When I was a financial advisor, one of the key messages I shared with my peers and prospective clients was that the best way to save their money was to put just enough into their 401(k) plan at work to capture their employer’s match, but that any extra they wanted to save should go into an IRA (with me, of course.)

What I was taught by all the financial firms I worked with prior to finding my dream role at Financial Finesse was that the fees in 401(k) plans are “so high” that investors are always better off using non-employer based investment vehicles for their retirement savings beyond the match. This is a sentiment that’s often echoed back to me by employees who I work with via our Financial Helpline – they’ve been told the same fallacy.

I was SO WRONG in pretty much every instance

One of the biggest “aha” moments I had upon starting my work here as a financial coach was that this “rule of thumb,” which I had blindly subscribed to without ever actually verifying it, was wrong for pretty much anyone who works for a company with more than just a handful of employees.

Here’s why it’s wrong

When a company decides to offer a retirement plan such as a 401(k) to its employees, they assume what’s called a fiduciary duty – basically they become bound by a federal law that says that they have certain responsibilities around protecting the employees who participate in the plan. One of those things is making sure that their employees aren’t overcharged for the services provided by the 401(k) plan provider, including investment fees.

The thing is that mutual funds, like those offered in your 401(k) plan, HAVE FEES. But they can vary, often depending on how much is being invested in those mutual funds. So when large companies with thousands of employees offer a particular mutual fund to their 401(k) participants, they are typically able to negotiate much lower fees than you would be offered should you try to buy that fund yourself through a brokerage account.

Situations where you may pay more in your 401(k) than with a financial advisor

There are still instances where you might have investments that cost more inside your workplace retirement plan than you would pay outside:

  • When you work for a very small employer who may not have the negotiating power to get the fees any lower than retail rates (aka what you’d pay outside).
  • Your retirement plan offers unique investment options that aren’t typically available to average investors, therefore making it hard to compare those options to more standard mutual funds.
  • You choose actively managed mutual funds, where the fund managers try to beat the market, and you’re comparing those to passively managed mutual funds, where the fund objective is just to match the market it’s designed to mirror – actively managed funds are always going to have higher fees than passive/index funds due the nature of the fund itself.

How to figure out what fees you’re paying in all your investments

Every provider is different, so it would be impossible for me to give you exact directions on how to find this information inside your specific retirement account, but generally if you look under the investing or fund information area of your 401(k) website, you’ll find something that says “Fees and Performance” or “Fund Information” or something similar.

The fees are typically presented as a percentage of what you have invested, and are sometimes called “basis points.” When you see basis points, you just have to move the decimal two places. A fund that charges 20 basis points (in financial jargon, we sometimes say “bips” for bps) will cost .20% of what you have invested. So if you have $1,000 in a fund with a 20 bps fee, your fees would be $20 per year.

Other times you’ll just see the percentage, which is pretty straightforward. The bottom line is that if someone is telling you that you’ll save money in fees by investing with him/her instead of in your 401(k), check the facts. Ask for the expense ratio of what he/she is suggesting you invest in, then compare that to the expense ratio of the funds available in your 401(k) to be sure.

8 Things To Do When You’re Worried About The Stock Market

December 28, 2018

It’s been a rough ride lately in the U.S. markets. As I write this, the S&P 500 index fell about 5.8 percent during a short trading week, leaving investors feeling jittery. Part of the yield curve inverted, which means that short term interest rates are higher than some longer term interest rates. Is the powerful bull market we’ve had since the Great Recession beginning to wind down? If so, what should you do to prepare?

Whether this is normal volatility in a market that has room to grow or the beginning of the next economic downturn, recent events are a reminder that financial markets don’t go up in a straight line. Eventually, we’re going to have a bear market because that’s how the business cycle works. Over my adult lifetime, I’ve seen plenty of market bubbles and busts. Consider your worry about the market a sign that it’s time for a check-in on your investments.

1. Measure returns from where you started, not from the highest balance

It’s a natural tendency to look at the highest number on your 401(k) or brokerage account statement and then feel like you lost money when the statement balance is subsequently lower. You feel like you were counting on that sum, and now it’s not there anymore. Unless you sold at the exact moment when your balance was the highest, however, you wouldn’t have realized the gain, so it’s not very helpful to measure that way.

How did you do against your goals?

A more realistic approach is to measure your success vs. your goals. Has your account balance grown since you originally invested the money? Did you require a certain average annual rate of return or that your balance grow by a certain amount by a certain date to fund your goal?

What’s your progress so far? Are you trying to match or beat a benchmark using one or more market indices? (See Why Is An Index Important In Investing?) If you’re saving for a house down payment or an early retirement, and you’re still on track to meet that goal, that’s what matters – not whether you’re down 10 percent from the all time high.

2. Run a retirement projection

For most of us, funding a future retirement is a primary reason we’re investing. Now is an excellent time to run an updated retirement calculator to check your progress, given your savings and reasonable projections for your rate of return and inflation. You can use the Retirement Estimator for a basic check in to see if you are on track. You can also use the calculator to model different scenarios using different rates of return to see what happens.

Make sure you’re using a reasonable expected rate of return

When updating your retirement projections, it’s better to use a conservative expected rate of return. Research from the McKinsey Global Institute suggests investors lower their expectations for average annual US stock returns to 4 to 6.5%. If they’re wrong about it, you’ll be happily surprised, but if they’re right, you’ll be adequately prepared.

3. Check your risk tolerance

Try downloading our risk tolerance and asset allocation worksheet or use the questionnaire from your brokerage firm or retirement plan provider. Compare the results to your current portfolio mix. If they line up, you may not need to re-balance your investments. If there is a big discrepancy between your current investment mix and your ideal one, you may want to make some changes.

Know the difference between risk and volatility

One note about “risk” and “volatility.” Risk is typically measured in portfolio management by standard deviation. The more spread out daily prices are from the average price – either higher or lower — the higher the standard deviation of an investment.

If it were just math, it would be easier to stomach the volatility. But it’s your money! When most people think about risk, they think only about the downside risk – the risk that they’ll lose money and not be able to achieve their goals.

Try putting a dollar number on your risk tolerance. How much would you be willing to see your portfolio value drop in the short run before you’d throw in the towel? For example, if you need $50,000 in ten years to take a sabbatical, would you be comfortable seeing the interim value of your account drop to $45,000 (a 10 percent drop) in return for the possibility of a ten percent gain? How about $40,000 (a 20 percent drop)? If the thought of seeing your balance temporarily drop to $40,000 causes you indigestion, then maybe it’s time to lower your stock exposure.

4. Rebalance your portfolio if needed

Rebalancing back to a target mix of investments helps you keep the level of risk in your portfolio stable by taking some profits from those investment types that grew faster in value and buying more of the investment types that didn’t grow as fast or fell in value. Think about rebalancing as buying low and selling high.

Once you’ve re-checked your risk tolerance and run projections to see if you’re on track to meet your goals, you may or may not need to make some changes in your investment mix:

Examples of rebalancing:

  • If your current investment mix reflects your goals and risk tolerance, you probably don’t need to rebalance. For example: you’re planning to retire in 22 years, have a moderate risk tolerance and you’re in a 2040 target date fund.
  • If your investment mix is out of whack with your target mix, rebalance. During the past decade, many investors have become overweighted in stocks due to strong stock market performance. If your goal is to maintain 60 percent in stocks and you’ve got 80 percent in stock funds, it’s time to rebalance and move 20% back to bonds.
  • If your risk tolerance has changed and your target investment mix is different than before, that’s also a very good reason to rebalance.
  • If you’re within 5 years of retirement, consider building up a much larger cash position. In pre-retirement years, it’s generally a good idea to move at least 3 years of anticipated expenses to cash-type investments (think savings, money market funds, CDs, etc.). That way, if the markets are in a slump when you retire, you won’t have to sell investments at a loss to pay your bills and can wait for a market recovery. Make sure you’ve updated your risk tolerance. Many pre-retirees find that they want to take a lot less risk in their investments during the transition to retirement.

Not sure of the best ways to rebalance your portfolio? See 4 Different Ways To Rebalance Your 401k.

5. Put together a simple investment policy statement (IPS)

You may also find it helpful to put together a brief, written outline of your target investment strategy to use across all your accounts. An IPS doesn’t have to be fancy. Just set some targets for types of stocks, bonds and other investments (like real estate or commodities) that you want to maintain over time. See this Investment Policy Statement Template for some ideas and/or dive deeper here: Morningstar Course (free): Creating Your Investment Policy Statement and Investment Policy Worksheet.

6. Diversify

Are your investments as diversified as they could be? Diversification mixes different types of investments so that the gains of some investments offset the losses on others. That reduces risk (although doesn’t eliminate it). Different types of investments historically have delivered gains at different times – think U.S. stocks vs. international stocks or stocks vs. bonds.

If you’ve got a “plain vanilla” portfolio, consider the pros and cons of incorporating different types of investments to reduce volatility. Many investors are just in the S&P 500 index, for example, or only in stocks and bonds. If it fits your risk tolerance and goals, incorporating some non-correlating investments like real estate, commodities and hedge fund proxies (e.g., market neutral funds, managed futures, long/short funds, hedge fund ETFs, etc.) can help reduce risk and smooth out returns.

7. Build up your emergency cash

You may not know when the next recession will hit, but you can still be prepared. Recessions don’t just bring bear markets. For some people, they also bring layoffs. If you don’t already have 6 months in living expenses in an emergency fund, work to build up that account.

8. Take advantage of volatility IF you’re aggressive

Are you a hands-on investor with an aggressive risk tolerance? Periods of high market volatility also present opportunities, but only for those who are comfortable with the financial equivalent of skydiving. There are new ways to “trade volatility,” including volatility ETFs, futures on the VIX (the volatility index) and options on market indices. My husband, Steve, spent time this past week using his mighty math powers to successfully trade volatility ETFs. I’m not that hands-on, nor am I that much of an aggressive investor, so it’s not something I’d do myself.

What’s the bottom line? Recent market volatility is an alarm clock reminding us that it’s been a great bull run, but there may be some roller coaster times ahead. Make sure you’re buckled in.

What I Learned In 2018

December 26, 2018

Editor’s note: As 2018 draws to a close and we launch 2019, I’ve asked each of our bloggers to reflect on their own personal goals, plans or thoughts on the past or upcoming year. Our hope is that you not only draw inspiration from our sharing over the coming weeks, but also that we are all able to feel more connected through our shared human experience and recognize that no matter where we are on our personal financial wellness journeys, that we all have similar hopes, dreams and struggles. Happy holidays! Here’s what Erik has to say:

As we approach the end of the year, it’s a good time to review your progress toward your financial goals and begin thinking about your goals for the new year.

Tracking toward FIRE

In my case, my main goal is to save and invest for financial independence/early retirement (now popularly called “FIRE”). Despite spending more on dining out than I wanted to this year, I’m currently still on track to achieve my goal of having enough assets to cover my basic expenses in about 2-3 years.

Celebrating my anniversary as a real estate investor

The most significant update is that next year will be my 5 year anniversary as a real estate investor. In reviewing the performance of my rental properties, the bad news is that the cash flow has been less than I hoped for, mostly due to higher than expected vacancies and maintenance expenses. The good news is that the properties have appreciated a lot more than I thought they would, which has more than outweighed the lower cash flow.

One thing I learned about myself

One thing I learned is that your risk tolerance can vary based on the type of risk with different investments. For example, I’m much more comfortable with the ups and downs of the stock market than the uncertainty of maintenance expenses, perhaps because I’m simply more familiar with stocks. I also like knowing that I can easily and quickly access my stock investments by selling them at any time, while real estate takes much longer to sell and the final sales price can vary considerably from its estimated value.

For these reasons, I’m considering selling at least some of my rentals next year and reinvesting the proceeds in a more liquid and diversified investment portfolio of stocks and/or index funds. At the very least, I’m no longer planning to buy more properties, especially with today’s higher mortgage rates.

How about you? Are you still on track for your goals? What lessons have you learned? What changes, if any, do you plan to make to your finances for 2019? It’s the perfect time to review those things this week.

How To Use Tax Loss Harvesting To Reduce Capital Gains Taxes

December 03, 2018

No one invests to lose money, but there can be times when selling investments at a loss can be helpful. It’s a process called “tax loss harvesting,” but it’s nowhere near as complicated as it sounds.

When does tax loss harvesting make sense?

First of all, this strategy only works for investments that are NOT held in a qualified retirement account like a 401(k) or a Roth IRA. So if you have stocks, bonds, mutual funds or exchange traded funds (ETFs) held in a regular brokerage or mutual fund account you may want to consider this.

How does it work?

When I was a financial advisor, one of my favorite clients was Hugh (not his real name). He had a lot of stocks in his portfolio that he was hesitant to sell because he didn’t want to pay taxes on his gains, even when he was ready to get rid of them. We got around that by helping him take advantage of his stocks that were down.

First, we looked for any investments he had that were down since they had been purchased (aka they were trading at a loss). Sometimes he had stock that he had purchased multiple times, so some were at a gain and others at a loss. We focused on the shares that were purchased at a higher cost and were negative at the moment and sold everything we could that had lost money since they were purchased.

Paying attention to short-term versus long-term

After selling everything we could at a loss, we started looking at what type of losses they were. Anything that we had sold that Hugh had owned for less than a year were short term losses. That meant that if we had stocks that we wanted to sell that had made money in the short term (less than a year), we could generate the same amount of short-term gain and not have to pay any taxes because the short-term losses canceled them out.

Then we looked at the losses where the shares had been held for more than one year. Those losses were used to cancel out the profits that he had from stocks that he owned for more than one year. So again, that meant no taxes on those profits.

How a market downturn actually helped

Then 2008 happened. For several years leading up to that market crash, we had helped Hugh reduce the taxes on his investments by using tax loss harvesting, but during 2008 and the years before the market came back, unfortunately he had a lot of stocks he could sell for a loss.

The good news is that when you “harvest” a loss (aka you sell something for less than you paid for it), you get to carry forward anything you don’t use that year. So we were able to harvest a lot of losses in 2008 that Hugh was able to use in the following years of the market recovering while making money for him without paying taxes on those gains.

Getting a deduction for some of your losses

It gets even better though. If you have more losses than gains in any single year, you can use up to $3,000 of those losses as a tax write-off against your regular income. So Hugh was able to claim a tax deduction in 2008 and a few more years after that in addition to avoiding capital gains taxes, all while being able to sell the stocks he wanted to sell anyway!

Beware wash sale rules

One last thing that’s important to know. Like most things with the IRS, there is a catch. Since you are allowed to use losses to offset gains, the IRS wants to make sure you’re not taking advantage of the rules so they made a rule that says you cannot repurchase the same investment within 30 days of selling it for a loss, or you won’t be able to claim the loss. It’s called a “wash sale,” as in your loss is a wash aka it’s treated like you never even sold and re-bought the stock.

So if you’re really just looking to take the loss and “reset” your cost basis on a stock you ultimately want to keep holding, you have two choices:

  1. Leave the money in cash for 30 days and then repurchase the same stock or fund; or
  2. Buy a different but similar investment.

For example, if you are selling a tech stock to claim the loss, but you really want to still hold that stock, you could use that money to buy a technology ETF that includes the stock you sold. Or if you are selling a fund, consider a slightly different fund in the same category.

I hope that you make a ton of money on your investments, but when you have those inevitable losses, remember that a loss today could be your best friend on April 15th!

How To Know If You’re Paying Too Much For Investment Advice

November 13, 2018

A question that I often get is, “Am I paying too much for investment advice?” This really boils down to a question of value, which like beauty, is in the eye of the beholder. So, while you may be paying more than another investment option, if you’re receiving sufficient value for the investment advice, it is worth the additional cost. Here’s how to know.

Step 1: Evaluate your current advisor

  • Performance: Your year-end statements should list your after-fee return for that year, so gather those statements to create a list of what your returns were.
  • Fees: Your fees are often listed in percentage terms so get out your calculator and convert that to dollars so you can see what you are actually paying. For example, your statement might say you pay 110 basis points, which is essentially 1.1%. If you have an account worth $100,000, that means your annual fee will be $1,100.
  • Compare: If you are considering a new investment advisor, make sure you are clear on their advisory fee in addition to any underlying mutual fund fee. For example, if they charge 1.1% and then put your investments in a mutual fund with a fee of 45 basis points (aka .45%), then your total fee is actually $1,550 ([$100,000 x .011] + [$100,000 x .0045]).
  • Risk: Evaluate how much risk your current advisor is taking. Your statements should give you a percentage of stocks, bonds (fixed income) and cash.
  • Compare that to your risk: Complete the Risk Tolerance Profile and Asset Allocation Worksheet to determine how much risk is appropriate for you to take, then compare that to see if your current advisor is taking an appropriate level of risk for you.
  • What else do they do: Finally, consider what your advisor does that you value. This can be face to face meetings, invitations to events, guidance on estate issues, etc. Note, this may not be what the advisor believes that you should value – remember that value is in the eye of the beholder.

Step 2: Evaluate other offers

  • While you won’t have year-end statements for other advisors, they can provide you information about how a portfolio that they would recommend to you performed (or you can enter it into this calculator to see for yourself). Make sure you are looking at after-fee (aka “net”) returns (both the advisory fee and mutual fund fees).
  • Is there anything that the new advisor provides that you value? Is there anything that they do not provide that you value?
  • Look for them to be suggesting a portfolio that takes an appropriate amount of risk, not the one that has the highest return.
  • Finally, consider the points made in two of our other posts about investing: Two Investment Approaches for Busy Professionals and Is Robo Advising Right for Me?.

Step 3: Evaluate your options

  • Value is determined by and unique to you. It is not value in the eyes of your advisor, friend, neighbor, etc. Value can be almost anything.
  • Compare after-fee returns over time (10 year or 5 year — as a long-term investor, you want to know what long-term results to expect, not what’s happened recently, which can be skewed by current events). If the return of option A is lower than option B, ask yourself if you get enough value from B the make it worth trading into higher returns – it may not always be.
  • In other words, a higher cost option may be appropriate if they provide enough value to you.
  • If the more expensive option or the option with the lower return has sufficient value to you, it is the appropriate one for you.
  • Past returns are no guarantee of future performance. This means basing your investment decision on the one with highest return last year is not a good strategy.
  • Additional ways an advisor provides value, beyond those mentioned above, include things like:
    • They balance you out so that you don’t make emotional investing decisions.
    • They help you invest for a variety of goals with different timelines, rather than just for highest performance.
    • They return your calls and answer your questions in a way that makes sense to you.
    • They provide advice on money they don’t manage, such as your 401(k).
    • They help your family members, even if they don’t make money off them.
    • They provide comprehensive financial planning that tells you what you need to do to achieve your life goals.
    • They help you make decisions around college funding, Social Security strategies or even making the most of your workplace benefits.
    • The list goes on…

No matter what, there is no black and white standard that says how much is “too much.” If you don’t feel like you’re getting value in return for what you’re paying, then it’s time to research other options. You may find a much better value out there. Or you may find that you need to adjust your expectations.

 

How To Invest For Income In Retirement

October 26, 2018

All your working life you’ve been saving and investing some of your income for retirement. Now you are getting ready to leave full time work and begin to spend it. How do you figure out how to invest so that your money lasts for what is hopefully a long and happy life? Whether you are a DIY investor or working with an advisor, consider these general guidelines for investing to generate retirement income:

Create both fixed and flexible sources of income

Right now, you have investments that you own. If you are like many retirees, it may make you nervous to spend your assets. Income, on the other hand, is psychologically easier to spend. Rather than spending them down, think about how you can invest some of your assets to create income.

One possible goal of retirement income planning is to create both fixed and flexible income. Fixed income is income you can rely on to arrive at predictable times and in predictable amounts. Social Security is fixed, for example. Ideally, you would create enough fixed income to cover all your fixed, must-pay monthly expenses like housing, transportation and food.

Ways to create fixed income besides Social Security

Pension annuity: Most pension plans have distribution options that include several level monthly payment options as well as a lump sum distribution. Choosing the annuity will offer you level monthly payments, which you cannot outlive in most cases. Married couples can choose a “joint and survivor” option, which makes monthly payments until the death of the second spouse. Not sure if it makes sense to take the monthly annuity or the lump sum? See this blog post for guidance.

Create your own pension by buying an annuity: The traditional pension is an endangered species, so if you don’t have one, you can create your own personal “pension” by purchasing an immediate annuity with some of your retirement savings. Per ImmediateAnnuity.com, a 65-year old man in North Carolina would receive $527/month in exchange for $100,000. This turns your lump sum into a monthly income stream.

Immediate annuities vary from insurance company to insurance company, so run the numbers and do your research before you sign on the dotted line. Remember, you’re looking for consistent monthly income that covers just your fixed expenses. Don’t use all your assets to purchase an annuity. Otherwise you may not leave yourself enough flexibility to meet variable expenses like vacations and entertainment, or unexpected larger expenses like a dental emergency, a new car or a new furnace. Click here to learn more about the ABCs of annuities and here for some situations where they might make sense.

Bonds: A bond is a fixed income investment where the investor is essentially loaning money to a corporation or government entity for a fixed period of time at a fixed or variable rate of interest. There are many types of bonds, with different features and different levels of investment risk. You can invest in them directly or through bond mutual funds, closed end funds or exchange traded funds.

Bond interest is often paid semi-annually, so retirement income investors typically look for a diverse portfolio of bonds so there is some interest coming in every month. The base of a diversified bond portfolio should be “investment grade” bonds, which are issued by companies with a high credit quality, and U.S. Treasury securities, which are bonds issued by the U.S. government. Click here to learn more about how bonds work and how to build a bond ladder.

Dividend-paying stocks: Dividends are a share of company profits paid out regularly to shareholders. High quality, dividend-paying stocks can provide quarterly income, as well as the potential for appreciation. Like bonds, there are several types of dividend-paying stocks, with different features and different levels of investment risk. Dividends from preferred stock (which generally don’t have voting rights) tend to be higher than dividends from common stock.

You can invest in dividend-paying stocks directly or through stock mutual funds, closed end funds or exchange traded funds that focus on dividends. Funds in this category are usually described as “dividend income,” “dividend,” or “preferred stock” funds. Make sure to do your research and read the prospectus before investing.

If you hold dividend-paying stocks in a taxable brokerage account, look for shares which pay “qualified dividends.” Those are taxed at lower long-term capital gains tax rates of 0 to 20 percent, depending on your total income. Learn more about dividend-paying stocks here.

Real Estate Investment Trusts: A Real Estate Investment Trust (REIT) is a company which owns or finances income-producing real estate. Most REITs are publicly traded on major stock exchanges, but some are private. By law, REITs must pay out 90% of their taxable income in dividends annually. REIT dividends are usually taxed as ordinary income. You can invest in publicly traded REITs individually and through closed end funds, exchange traded funds and mutual funds.

While REITs hold portfolios of rental real estate or mortgages, remember that they have many of the same risks as investing in stocks. Generally, it’s a good idea to limit your REIT exposure to 5 to 10 percent of your portfolio, and just like stocks, REITs aren’t a fit for every investor. Adding real estate to a diversified portfolio of stocks and bonds can usually reduce portfolio volatility though.

Maintain purchasing power over the long term

Inflation has been low for the past two decades, but it hasn’t always been that way. Remember the interest rates on passbook savings accounts in the seventies? When you were working, you could rely on your salary increasing (at least somewhat) to keep pace with inflation.

In retirement, if you don’t include investments that generally move up when inflation does, you’ll be losing purchasing power. Click here to read more about protecting your portfolio from the effects of inflation. Investments that can help your portfolio from the inevitable rising cost of living include:

Stocks: A well-diversified portfolio of individual stocks, stock mutual funds or exchange traded funds that grows in value over time can offer a hedge or partial hedge against inflation. Some of the hedging effects come from dividends and some from growth. Wharton School professor Jeremy Siegel suggests that to best insulate a portfolio against inflation, it is necessary to invest internationally. For many retirees, some growth will be required to maintain purchasing power given that a typical retirement could last twenty to forty years.

Treasury-inflation protected securities: TIPS are treasury bonds that are indexed to inflation. The interest rate remains fixed, and the principal increases with inflation and decreases with deflation. It’s best to hold TIPS in a retirement account to protect against paying taxes on phantom income if the bonds adjust upwards.

Inflation adjusted annuities: If you have chosen to purchase an annuity, consider purchasing one where the payment is indexed to inflation. Like a traditional annuity, an inflation-protected annuity pays you income for the rest of your life, but unlike a traditional annuity, the payment rises if inflation rises. Consequently, the initial payout is likely to be lower than with a traditional annuity.

Rental real estate: Real estate tends to perform well with rising inflation. Rental income generally keeps pace with inflation, and inflation can increase the value of your property. However, being a landlord is not for everyone, and it’s difficult to get a diversified rental income portfolio without a large investment. Direct real estate investing has both advantages and challenges. If you are considering rental real estate, take this quiz first.

Prepare for longevity

According to the Social Security Administration, the average 65 year old man today is expected to live until age 84.3, and the average 65 year old woman until age 86.6. Since these are averages, that means some of these 65 year olds will live longer. That’s going to cost some money.

A longevity annuity is a new financial product that helps protect you against the risk of outliving your money. It typically requires you to wait until very late in retirement to begin receiving payment – e.g., age 85 or later. Once the payout period begins, it offers income for the rest of your life. The IRS permits the purchase of longevity annuities within retirement accounts, subject to certain limitations, and they are excluded from the calculation of required minimum distributions (RMDs).

 

A version of this post was originally published on Forbes

Is It Time To Get Out Of The Stock Market?

October 25, 2018

We’ve all heard the advice to “buy and hold” when it comes to investing, but when is it time to “sell and let go?” Surely we aren’t expected to just keep on investing forever and never spend any of that money, right?

What about when the market begins to behave erratically like it has recently – down one day; up the next. Down. Down some more. Up a bit. Up, no wait, it’s down again. It’s enough to make some people motion sick and when that happens, they just want to get off the ride. Just as we wouldn’t hop out of a moving roller coaster the first time our stomach does a few flips, nor should we jump out of the stock market when the returns get bumpy. Let’s all keep our arms and legs inside the car and wait for it to arrive safely back at the platform before we move. But when is that, exactly? Are we there, yet?

Why do we react this way?

Whenever the stock market takes a dip or a swerve or a dive, and the news headlines begin screaming about how the market is “plummeting,” “crashing,” or some equally anxiety-inducing description, our inner lizard brain (a section called the amygdala) begins to twitch and send us into fight or flight mode. Since we can’t exactly fight the stock market, many of us turn to flight and run away by selling our stocks and embracing good old, dependable cash.

Which, logic dictates, is exactly the wrong thing to do. Remember the advice to “buy low and sell high?” Your amygdala just told you to run away from the perceived pain and sell low. Bad amygdala. Bad.

Our fight-or-flight response is quite natural, and it serves us well whenever we need to escape a burning building or react to an unexpected letter from the IRS. It is not so helpful when making investment decisions. Still, there must be a time when it is okay to get off the stock market roller coaster, right? Yes, yes there is.  Several in fact.

Who should sell

Eventually, for most of us anyway, we will need or want to sell those investment dollars because we need the cash so we can buy something important or support ourselves in our golden years. It might also be time to re-balance the mix of stocks, bonds, cash and whatever else you’ve selected for your portfolio because one or more of these categories has grown too heavy relative to the others. Also a good reason to sell (and reinvest).

All of the following are good reasons to take some money out of stocks, regardless of what the market is doing on any given day:

  • You are taking too much risk when considering your limited investment time frame and/or your physical and mental well-being. It is a good idea to periodically measure your risk tolerance and adjust your investments accordingly.
  • You will need this money soon, such as within the next 3-5 years. This might be a down payment on your future house or vacation home, college tuition bills, etc. Whatever the purpose, make sure it is a goal that you already had in place and have been investing toward for several years already. Start moving these funds into cash (CDs or money market accounts) so the dollars will be there when you need them.
  • You are trying to make up for lost time. Sometimes we get a late start with saving and investing for our goals. The temptation is to “bet it all” and invest aggressively in stocks in the hopes of hitting an economic home run and earning 25% on our investments like we recently enjoyed during the 2017 stock market. This may be tempting in theory, but in practice it can be a lousy idea. Remember the 2008 stock market? Down 33.8%. Plummeted. Crashed. Burned. Could you live with that kind of a drop in the short run? Me, neither. Better to re-balance to a more reasonable mix of stocks, bonds, and cash and start aggressively saving instead. Shovel as much money as you can into your retirement plan at work, your IRA, and your spouse’s IRA. As one of my CPA friends is fond of saying when asked how much to save for retirement, “Save until it starts to hurt, then save a little more.”

How to feel healthier (and wealthier) when the market does crash. And it will.

Instead of using market crisis headlines as a reason to fret about our investment performance and beat ourselves up over allegedly bad decisions, we could decide to use this energy as an opportunity to review why we made those investments in the first place (comfortable or early retirement, putting kids through college, etc.). Have any of those reasons for investing changed? Are these dollars we are going to need in the next five years or is their intended use still many years in the future?

If nothing substantial about your life or financial situation has changed, the best course of action is nothing. As in do nothing. Don’t move. Don’t change. Keep your investments right where they are and tell your twitchy amygdala to calm the <bleep> down.

Actually, there are some things we should do when doubt begins to creep into our minds regarding our investments:

  • Breathe.
  • Relax.
  • Remind ourselves that this is what buying low (and selling high later) feels like.
  • Turn off the news for a while. Maybe a long while.
  • Increase your retirement plan contribution at work by another 1%. (This is what buying low feels like.)

We can’t control what the market does, but we can control what we choose to do. And the worst thing you can do when it starts to go down is get out, unless you shouldn’t have been in there in the first place.

Should You Invest In A REIT Or A Rental Property Directly?

October 11, 2018

I recently wrote a blog post about my decision to sell a rental property. What if you want to invest in real estate without all the risks and hassles of being a landlord? Another option is to invest in a REIT (real estate investment trust), which is kind of like a mutual fund for rental properties (although there are mutual funds of REITs too).  Let’s look at some things to consider when deciding between the two:

How easily might you need access to your money?

This is one of the biggest differences. You can sell a publicly traded REIT immediately like a stock. (There are also non-traded REITs that come with their own rules.) On the other hand, a directly owned rental property can take months to sell and can cost thousands of dollars in transaction costs. The advantage here clearly goes to REITs.

How important is diversification for you?

A single REIT can invest in a range of commercial and residential properties. As if that wasn’t enough, you can also buy multiple REITs individually or through a real estate fund. You need a lot more money to buy enough individual properties to even approach that level of diversification. Otherwise, you’re taking more risk with less diversification and it’s a risk that doesn’t necessarily come with higher returns.

How involved do you want to be?

With a REIT, your only involvement is whether to buy the REIT and when to sell. With a rental property, you have a lot more control over the type of property you own and how it’s managed. If you know the real estate market well and/or are good at property management (or choosing good property managers), this can be a huge advantage.

For example, many real estate investors are able to keep their maintenance costs low by doing their own repairs or having a network of contractors who they trust to deliver value. If you don’t want to be that active, you might want to delegate those decisions to a REIT.

Which provides a better tax benefit?

REITs can easily be held in tax-advantaged accounts like a 401(k), IRA, and HSA. While rental properties can be held in a self-directed IRA, that can be quite complex. However, a rental property can allow you to write-off depreciation, potentially benefit from the new 20% pass through deduction, and have the basis stepped up at death. That could make it preferable from a tax standpoint if you’ve already maxed out your tax-advantaged accounts and are looking to invest in a taxable account.

At the end of the day, the decision is a personal one. If you’ve maxed out your tax-advantaged accounts and want to be actively involved in your investing, you might prefer owning a rental property directly. If you’re investing in a tax-advantaged account or prefer having easy access to your money and being more diversified, you might choose to invest in one or more REITs.

Worried About A Market Bubble? Here’s What To Do

October 04, 2018

When market returns have been positive for a while (like the reasonable, respectable year-to-date return just north of 8% on the S&P500 as of 9/24/2018 shown below), I’ve noticed that not too many people are complaining about earning “only” 4% back in mid-June (or 1.5% at the end of June – yikes!).

Instead, we stop worrying about not making money (when the markets are down or sideways) and we begin to worry about losing the gains we have made. I’ve had more than a few people ask me lately if the next stock market “bubble” is here. It seems we are never quite satisfied unless we can worry about something, even when things are going well.

Source: https://www.macrotrends.net/2490/sp-500-ytd-performance, accessed 09/25/18

Loss aversion

Psychologists and behavioral finance specialists have a term for this sinking feeling: loss aversion. When our minds begin to flirt with loss aversion, our thoughts and discussions focus on words like “bubbles” and we begin to deliberate over the various negative outcomes that could happen (but haven’t) and what we should do about them.

Mostly we worry. Sometimes we panic. The reactive lizard portion of our brains then kicks in and we make bad financial decisions (like moving 100% of our investments to cash). Why? Because our reference point has shifted – we don’t want to “lose” that additional 4% we made from June to September.

There’s just no way to know

While it can feel right to protect ourselves from these potential losses, it is almost always the wrong move to make. Why? The easy answer is, none of us has a crystal ball. Not me. Not you. Not Warren Buffett. No one. Looking back at the stock performance chart, which way will the line move next? No one knows. It is simply unknowable. The market giveth, and the market taketh away. But in the long run, the market generally giveth, does it not?

I’m not always so sure about that, either, but history is a pretty good indicator. Let’s go all the way back to 1926 and look at what arguably represents a (long) lifetime of investing. Looking at this next chart, there have certainly been some lengthy periods where investing in the stock market surely was not much fun. The mid-sixties through the mid-eighties come to mind; as does the so-called “lost decade” between 1998 and 2008. Ten or more years can be a long time to invest and feel like you might have been better off stuffing cash into your mattress.

Source: https://www.macrotrends.net/2324/sp-500-historical-chart-data, accessed 09/25/2018

What’s the alternative?

Despite some ugly short term performance (remember, stock investing is a long term game), stocks are still the best producing asset around. Better than bonds. Better than real estate. And yes, better than gold. (Don’t get me started on cryptocurrencies). However, I wouldn’t suggest keeping all of my money in stocks, either. When those inevitable dips do take place, those other asset classes (bonds, cash, real estate, etc.) are exactly the performance buffers you will need to offset the temporary stock dips.

How to manage stock risk

If the mantra for real estate is location, location, location, for investing it is diversify, diversity, diversity. Timing the market doesn’t work. Even the experts fail at that strategy. A successful investment approach is also generally a dull, boring approach:

  • Spread your money across different investment types – stocks, bonds, some cash, and even real estate if you are so inclined. Asset allocation is your friend.
  • Measure your risk tolerance from time to time and rebalance only when necessary.
  • Be very, very patient.
  • Ride out the next stock market dip; your (wealthier) future self will thank you.

When all else fails, do this

You’ve done it. You took steps to get in touch with your individual tolerance for risk, diversified your investments accordingly, and promised yourself to leave your investments alone and let them do their work for you. However, the news, noise, and chatter about the latest market “bubble,” “crash,” or “nosedive” is causing the inner recesses of your brain to twitch and second guess yourself. You really feel like you should be doing something – anything – because doing nothing feels like the wrong thing to do.

I couldn’t agree more. Doing nothing can feel like helplessness. When the market gets frothy and investors (including me) get nervous, here’s what I do:

  • Turn off the news (radio, TV, Internet, smartphone – all of it).
  • Go for a run (or a walk on the beach).
  • Take my sweetie out to dinner.
  • Paddle my kayak (or standup paddle board).
  • Go fishing.
  • Keep investing.

You and I can’t change the financial markets. They are going to do what they are supposed to do. We can choose to change how we react to them, however.

NUA – One Overlooked Benefit Of Employer Stock In Your 401(k)

October 03, 2018

Should you own stock in your current or former employer? There are mixed opinions out there regarding the risk of holding too much stock in the same company that provides your paycheck, but before you liquidate a large holding in your 401(k), keep reading.

One little known benefit of holding company stock in a 401(k) plan is the ability to have the “net unrealized appreciation” of the stock or “NUA” taxed at a lower tax rate. Normally, when you take money out of a traditional 401(k), it’s taxed at your ordinary income tax rate. However, the gain in employer stock can be taxed at the lower long term capital gains rate if you meet several conditions:

Here’s how NUA works

1) You have to reach a triggering event. This can be death, disability, separation from service, or reaching age 59 ½. You can’t take advantage of this at any time. Most people take advantage of it upon retirement or after.

2) You have to take a lump sum distribution of the entire account. You can’t just withdraw the shares of stock. However, you can choose to roll the rest of the money into an IRA or another retirement account, while moving the company stock shares to a regular brokerage account.

3) The employer stock has to be distributed “in kind.” Basically, this means you can’t sell the shares and then withdraw the cash as you would typically withdraw money from a 401(k). Instead, you have to transfer the shares of stock into a brokerage firm.

If you meet the criteria above, then when you do a withdrawal of the company stock, you would pay ordinary income taxes on the cost basis of the stock (essentially the value of the stock when you purchased or received it) at that time. You may choose to hold the stock or liquidate some or all of it at that point. When you do so, you’ll pay taxes at the lower long term capital gains rate on any growth in the value of the shares beyond what you paid for them (regardless of how long you actually held them).

Be aware that withdrawing a large amount of stock could push you into a higher tax bracket for that year, so you’ll want to be strategic about when you make this move. However, removing the stock from your retirement account would also reduce the amount of required minimum distributions you’d have to take starting at age 70 ½. (Incidentally, the capital gain would not be subject to the 3.8% Medicare surtax on investment income, but the stock would not benefit from a step-up in basis when you pass away.)

It’s about more than just the taxes

As I always like to say, don’t let the tax tail wag the dog though. This is not a reason to load up on company stock. After all, individual stocks are always a lot riskier than diversified mutual funds since an individual stock can go to zero and never recover. This is even more true when it’s the company that your job is tied to. A good rule of thumb is to never have more than 10-15% of your portfolio in any one stock, especially your employer’s.

That being said, it could be a good reason to keep some money in company stock, especially if you already have shares that have appreciated quite a bit. In fact, this is one of the main reasons I would suggest someone not roll a former employer’s retirement plan into an IRA or a new retirement plan while they are still working.

How to decide whether NUA is right for you

You can calculate the value of doing an NUA distribution vs an IRA rollover here. If you’re still not sure whether this makes sense for you, see if your employer offers access to an unbiased financial planner who can help you with what can be a complex decision, or consult your own financial advisor if not.

How To Decide Whether It’s Time To Sell An Investment Property

September 12, 2018

A few years ago, I wrote a blog post about why I started investing in direct rental real estate. I recently decided to sell the first property I bought. This was prompted by my property management company letting me know that they were exiting the business and suggesting that I sell the property rather than find a new property manager because they felt the neighborhood was in decline.

In addition, I saw this article about rising foreclosures, which could indicate a downturn in the real estate market. For me, it’s time to get out of this investment. Here are the things I considered in this decision.

How much is the property earning?

One way to measure this is cash flow (rental income minus expenses) and a second is total return (cash flow plus growth in equity from a declining mortgage balance and real estate appreciation). The bad news for me is that vacancies and expenses were higher than I estimated with this property, so my cash flow was much lower than expected and ended up being slightly negative overall.

The good news is that appreciation was much higher than expected (at least according to the valuations on sites like Zillow, Trulia, and Redfin) so the total return might end up being pretty good. If the property continues earning at the same rate but appreciates at a more normal 2-3% a year, my future total return would be about 6-8%.

That’s not terrible, but it’s also not great, especially given the risks of a potentially declining neighborhood and a weak real estate market if interest rates continue climbing or the economy weakens. For me, the property isn’t earning enough by either measure to justify continuing to hold it.

What are the tax implications of selling?

The ability to write off depreciation in addition to the expenses has helped reduce my overall tax burden throughout the years I’ve owned. However, all that depreciation will hurt me when it comes to paying the capital gains tax by reducing my cost basis.

I can minimize capital gains taxes by waiting until the capital gains tax is lower to sell, selling when I’m in a lower (possibly even zero) capital gains tax bracket in retirement or just holding it until I pass away and allow my heir(s) to inherit it at a stepped-up cost basis, avoiding capital gains taxes altogether. Neither of those options appeal to me, so I will just pay the taxes and move on.

While taxes are important, don’t let the tax tail wag the dog. If your goal was only to minimize taxes, you could easily do that by minimizing your income and investment earnings. Instead, make your goal to maximize your after-tax return.

What else would you do with the money?

Once you know the rate of return, you need to compare it with what you could earn with that money instead. Many investment experts expect even lower future stock and bond returns in the future, given relatively high stock market valuations and low interest rates today. However, it’s generally a good idea to invest in what you know and I know stocks and bonds better than I know real estate.

What non-financial factors should you consider?

In the end, part of me wants to sell simply because I prefer having more liquidity, one less property to worry about, and one less state to file a state income tax form in. Remember, money is just a means. Happiness is the end.

 

Is Investing In Just The S&P 500 Enough?

September 05, 2018

One thing I often hear out in the world is that in order to grow your money, all you really need to do is just invest in an S&P 500 Index fund. This is a typically low cost mutual fund that invests in the stocks of 500 of the largest companies in the US, in proportion to how their stock price performs.

Like most index funds, it has outperformed the majority of actively managed funds that invest in similar companies, and this one fund strategy has also been promoted by Warren Buffett. It’s certainly better than trying to time the market, pick a few individual stocks, invest in high-fee funds, or stay in cash over long time periods. So what’s not to like?

A lack of diversity in the companies

The main problem is that the S&P 500 index isn’t as diversified as it may seem to be. While it does include 500 companies, it doesn’t include international or small cap stocks, both of which have had long periods of time where they’ve outperformed the S&P 500. It also doesn’t include any bonds or cash, which can help reduce risk, or real assets, which tend to do well during inflationary periods.

If you’re going to invest in an S&P 500 index fund, consider adding in funds that invest in other asset classes like international and small cap stocks too. You might also want to include bonds and cash, depending on your time frame and risk tolerance, and even some real assets. If you’re not sure how much to put in each asset class, here are some options to consider:

Alternatives to give you more diversification

Target date funds composed of index funds: Since they’re composed of index funds (typically including the S&P 500), these funds are low cost. But as target date funds, they’re also much more diversified and are designed to be a “one stop shop” that automatically become more conservative as you approach the target retirement date. All you need to do is pick one fund (generally the one with the year closest to when you plan to retire). Then “set it and forget it.”

Total market index fund: If you want to stick with all stocks, a total market index fund allows you to invest in just about all the stocks in the world. Just be aware that these funds tend to weight the stocks based on market capitalization so small cap stocks will make up a very small percentage of the fund. They also tend to be slightly more expensive than buying index funds that focus on each area of the market (large US, small US, and international).

Use a robo-advisor or model portfolio: If you want to diversify beyond stocks but want something more customized to you, you may want to consider a robo-advisor that recommends a portfolio for you based on your time horizon and risk tolerance. These programs generally use low cost index funds and are often available at no additional cost in employer-sponsored retirement plans or for a low fee outside such plans. If you want to avoid those fees, you can choose a model portfolio like one of these “lazy portfolios”, but it won’t be customized to you.

Doing simple slightly better

When it comes to investing, simpler is often better, but it’s not always the best approach. In this case, you could certainly do a lot worse than just investing in an S&P 500 index fund. But you can also do a lot better in terms of diversification with just slightly more effort.

How To Approach Investing As Retirement Draws Closer

August 15, 2018

One of the things I discuss quite a bit with employees that are approaching retirement is how they should structure their investments as retirement draws closer. Many times, they are considering becoming more aggressive over their last few years in the workforce to try and boost returns and maximize account values. This can be a recipe for delayed retirement if the timing is wrong.

The fundamentals

While the fundamentals of investing – being mindful of how long until you need the money and your risk tolerance – do not change as you approach (or enter) retirement, conventional wisdom says you should really want to take less risk as you approach retirement. The idea being you have less time to recover from market losses than you did earlier in your career.

It’s a (hopefully) long road ahead

But, you don’t want to just plow everything into a stable value fund or cash either. Retirement can last upwards of 30 years or more, so you want some aggressive investments to help that money grow and last. You may be thinking, “OK you’re telling me to be more conservative, but stay aggressive – which one is it?”

Well, like many things in financial planning, it depends. Let’s look at some strategies to help you decide how to best manage your own nest egg as you approach retirement.

Exploring the fundamentals

At any point in your financial life, sticking to the fundamentals is the best way to be a successful investor.

  • When do you need the money? Money you know you will need to spend in the next 5 years should be invested conservatively. Investments like a CD, money market mutual fund, or a stable value fund protect those funds from dramatic market movements.
  • What is your risk tolerance? Knowing how you feel about risk is crucial in setting up your investment allocation. There are investors in their 20s or 30s that are very conservative by nature, just like there are investors in their 70s and 80s that are aggressive. Staying true to your risk tolerance allows you to be comfortable with the risk you are taking, which makes you much more likely to stay with your strategy when markets are down.
  • Don’t react to market moves. This one is easier said than done because it contradicts our human nature. For most of us, the pain of losing value in our accounts is stronger than the joy we feel when our accounts are growing. Selling stock investments at low points locks in losses as we are often selling low after buying high. It’s best to resist watching the market on a day-to-day basis.
  • Rebalance regularly. At least once per year, make sure your allocation reflects your original strategy. If your goal is to have 60% in stocks, 30% in bonds, and 10% in cash, check to make sure that is how your funds are set up. In a year when stocks have done well, you may find yourself with 70% in stocks and 20% in bonds. It can be tempting to keep riding the wave of a bull market, but it’s better in the long run to lock in the gains and stick to your original mix. Rebalance by selling enough of the stock investments (sell high) to get back to your target, then buying enough of the bond investments (buy low) to get back to your target there.

The bucketing strategy

When it comes to making investment changes as you approach retirement, one popular strategy is to think of putting your money in hypothetical buckets.

  1. The first bucket is your short-term funds – money you know you will spend in the next 5 years. This bucket can be thought of almost as a savings account and be very conservatively invested.
  2. The second bucket is your intermediate bucket and should be invested in things that generate income, like bond funds. This is money you’d anticipate withdrawing after 5 years, but before 10 years. This bucket is used to refill your short-term bucket as you spend from it.
  3. The third bucket is your long-term bucket and holds your aggressive investments (think stock funds) and is designed to drive growth. This is the bucket that can help your savings to last those 30+ years you’ll hopefully have in retirement.

Rule of thumb

Another way to look at it is by using a common rule of thumb that says the best balance is investing a percentage in stocks equal to 120 minus your age. So if you are 58, then 62% of your funds would be in stock funds. You may try this rule of thumb, along with the 5-year bucket if you find that simpler.

Final thoughts

As you approach retirement, it is a wonderful time to revisit your retirement accounts and make sure you are in line with your risk tolerance and following good fundamentals. Take some time to review your budget and spending needs over the next couple years, which will help you to clarify how much goes into each bucket. Having your money split into the different buckets can help make sure you have the right balance of safety, income, and growth. This will help your money last as your enjoy your retirement!

How To Find A New Advisor

August 01, 2018

If after evaluating your financial advisor, you find that you are no longer comfortable working with him or her, then what? I’m convinced that one of the reasons so many people stay with someone they aren’t crazy about is simply because they don’t know what else to do. (kind of like the reason you might put off certain home maintenance needs if you don’t know who to call)

The good news is that there are lots of different options out there. The bad news is that it will take time and some extra energy. However, if we’re talking about preserving your hard-earned savings and possibly your retirement, wouldn’t you say it’s worth it?

Options for finding a new financial advisor

Hire a new financial planner who aligns better with your goals

  • Ask your friends or colleagues for referrals.
  • If you’re looking for a CFP® professional, consult letsmakeaplan.org and search for planners in your area.
  • If you’re looking for someone who may also offer tax services, consider a CPA/PFS, which is a certified public account who has also demonstrated expertise in personal finance.
  • Interview 2 or 3. Don’t be afraid to ask the right questions.
  • Use the questions here as a guide to your interviews.

Do it yourself

Depending on your free time and interest in following the markets, you may find it to be worthwhile to take it on yourself.

  • If you’re a “hands-on” investor who likes to pick your own investments, make trades and re-balance as necessary, there are several online brokerage firms that offer platforms. Most have very low trading costs and little to no incidental fees.
  • If you’re not hands-on, there are still platforms that provide hands-off people with allocated portfolios according to risk tolerance and time horizon. Some of these come with a personal online advisor for an additional cost, so make sure you understand this cost.

Go hybrid with a robo-advisor

While these types of investing platforms haven’t really been tested yet by a bear market, they are increasingly popular with people who want some advice toward how to allocate their funds, but don’t feel like they need customized guidance from an actual human. Make sure you understand the pros and cons. These are a few of the more-established robo platforms out there, although this is not an exhaustive list by any stretch (nor is this a recommendation of a specific platform):

Contact your employer’s financial wellness partner for guidance

Lastly, if you have access to an unbiased financial wellness coach, take advantage by running your ideas past a coach. At Financial Finesse, we don’t make specific recommendations nor do we have any type of ties to any companies that could profit from your choice, but we are always happy to talk employees through their choices and help them to find the best fit for them.

There are lots of different ways out there to manage your money — there isn’t really a right or wrong one, just the one that’s best for your personal situation. Finding that takes time, but it’s worth it.