AssetBuilder Inc. - Registered Investment Advisor

Adapting to the Future, Whatever It Is

admin — Wed, 08 Jul 2009 20:00:00 GMT

By Scott Burns

Q. When is it safe to discard the various computer-based income projections often used in financial planning, such as the commonly used Monte Carlo studies? When can you use real countable dollar amounts for living in retirement? My wife is 56. I’m 60. So we are in the retirement "red zone." We have $3 million in tax-free bonds and $1 million in taxable equities. We hope to draw $250,000 a year. How can we protect ourselves against future "black swans"? ---D.I. by email

A. With a joint life expectancy (meaning one of you will live at least this long) of 25 or more years, there really is no way to be certain about the future. If your savings were all in tax-deferred accounts, you could invest in Treasury Inflation Protected Securities (TIPS) that matured at regular intervals during the next 30 years. This method is recommended by Zvi Bodie, a professor of finance at Boston University.

If you did this and assumed no real return, your inflation-adjusted income would be at least $133,333 a year. With a real return of 1 to 2 percent, your actual lifetime income would be somewhat higher. Either way, your income wouldn't be $250,000 a year. That amounts to a 6.3 percent return on your savings.

Another way to do this is to annuitize your assets, giving your assets to an insurance company in exchange for a promise that the company will deliver you and your spouse a lifetime income as long as one of you is still alive. Going to www.immediateannuities.com, I found that a couple your age with $4 million could get a lifetime annuity income of $21,195 a month, or $254,340 a year. Unfortunately, that income isn't adjusted for inflation, so your purchasing power would start declining immediately.

Over the last 25 years the annualized rate of inflation has been about 3 percent. If it continued at that rate, your purchasing power would be cut in half over the next 25 years.

You'd also have to trust the insurance company would be around to make the payments. Twenty-five or 30 years is a long time.

So what do you do?

Punt.

First, you accept that life is uncertain. If you've lived and adapted this long, you'll probably manage to adapt another 25 or 30 years, too. Second, you diversify as much as possible--- and diversifying means including life annuities as part of your retirement portfolio. Third, if you insist on $250,000 of income, you accept the idea that your income may decline at a later date as your withdrawals outrun your investment returns. This would not be a fate worse than death: Research supports the idea that most of us consume less after age 75 than we do when we are younger.

Q. I have been reading Harry Dent's book THE GREAT DEPRESSION AHEAD. He has some very dire predictions along with possible opportunities. I wonder how anyone can have this kind of view of future events in the economy? Do you have an opinion, and do you see any validity to his view of the future? ---S. C., by email from Corpus Christi

A. It is easier, today, to project a dismal future than at any time in the last 40 or 50 years. But demography, which is Mr. Dent's specialty, isn't always destiny. The future could be a lot brighter than the current public mood. I keep a copy of "The Great Depression of 1990" by Dr. Ravi Batra in my library. I keep it right next to "Dow 36,000," the manic 1999 book by James K. Glassman and Kevin A. Hassett asserting that stocks were massively undervalued. Dramatic predictions are as common as their inaccuracy.

We don't know the future. All we can do is cultivate flexibility, diversify our savings, and share as little of our return as possible with those who claim to know the future.

Life of Riley Index - Retiree Version

admin — Fri, 03 Jul 2009 20:00:00 GMT

By Scott Burns

It requires gobs of money to be a person of independent means when you are young.

But age changes everything.

Once you have achieved geezerhood, your personal fortune can be a small fraction of what a younger person needs, and you’ll live just as well.

There are two reasons for this--- Social Security and what might be called the Old Mortality Trick. Let’s tackle Social Security first.

While more young people believe in flying saucers than believe in Social Security, the reality is that Social Security is the largest source of retirement income for the vast majority of Americans. According to a recent study by EBRI, the Employee Benefit Research Institute, Social Security provides an average of 38.6 percent of all income for people age 65 and older. That’s more than double the 18.6 percent that comes from pension and annuity income or the 15.6 percent that comes from assets.

Even if your income puts you in the top 20 percent of all retirees, Social Security benefits are a big deal. The same EBRI study shows that top-quintile seniors still get 17.2 percent of their income from Social Security.

Impressed? You should be. Every dollar of Social Security income eliminates the need for $20 to $25 of retirement savings. As a consequence, you need a whole lot less in savings to live the Life of Riley as a retiree than you would need as a young playboy or playgirl.

How much is a whole lot less?

Well, last week I showed that you needed $3.1 million to live the sweet life with an income that put you in the top 25 percent of all American households--- an estimated $70,000 a year. Using figures from the Aon Consulting replacement rate studies, retirees can live at the same standard with a mere $490,000 if they will risk a 5 percent withdrawal rate, or $612,500 if they use a more conservative 4 percent withdrawal rate.

That’s a whole lot less than $3.1 million.

How does that happen?

Simple. The Aon Consulting studies, which I’ve cited in other columns, adjust your current earned income for employment taxes you won’t have to pay, for saving you won’t need to do anymore, for income taxes that may be lower, and for work-related expenses that are no longer necessary. At the $70,000-a-year level, they figure you need to replace only 77 percent of your income to retire and enjoy the same standard of living. Social Security will provide 42 percent, leaving 35 percent, or $24,500, to come from places like your retirement savings.

The Old Mortality Trick is equally direct. If you want to live on an independent investment income at age 25 or 30, you’ll have to live on the actual interest and dividend income produced by your portfolio. That’s now at the dismal level of 2.25 percent. You’ll need to do that because young people are going to live a really, really long time. The young can’t take little bits from their principal every year and have any certainty that their money will last as long as they do. They have to invest as though they were as immortal as they feel or as though they were close relatives of Anne Rice’s best-known vampire, Lestat.

Once you have achieved geezerhood, however, living a really, really long time isn’t a problem. You won’t. You may live a long time, but it won’t be that long. Think of it as the upside of death. It means you can dare to take 4 to 5 percent from your investments, even if they don’t produce that much income.

So between Social Security and a higher withdrawal rate, you can knock down the entry cost of the Good Life to as little as $490,000. That’s a small fraction of the $3.1 million you’d need to live the good life as an equally idle young person.

On the web:

IRS Statistics of Income

EBRI/Income of the elderly

Aon Consulting: 2008 Replacement Rate Study

February 6, 2005: Social Security Is an Important Part of Personal Finance

June 13, 2004: Estimate Your Needed Retirement Income and Nest Egg

April 30, 2002: The Life of Riley Index, Retiree Version

October 27, 1998: The Life of Riley Index, Retiree Version

The Cost of Trust

admin — Mon, 29 Jun 2009 20:00:00 GMT

By Kennon Grose

“I don’t trust the so-called financial experts anymore. I am just leaving things alone. When I claw back some of my money, I am out of there.” This comment tells us a lot about how people are feeling. First, they have realized that no one cares as much about their money as they do. Second, they are applying the homily “Fool me once, shame on you. Fool me twice, shame on me.” Millions of people have now learned enough to know the difference between quality advice and a quality sales pitch.

Trust means to have confidence or faith: “In God we trust”; “bank on your education”; “rely on your friends”. You have faith that the advisor managing your money will provide some kind of value added – usually a return advantage for you.

Mutually Rewarding Relationship

The trust you have in your advisor is grounded in a mutually rewarding relationship – you are willing to pay advisor fees to receive the value added result. Putting this in a formula might look something like this;

Value added result plus fees equals mutually rewarding relationship

Coming off one of the worst market downturns in our lifetime has brought much needed scrutiny to the financial advisory relationship. The question, which Wall Street never answers reasonably, is whether all of the fees associated with managing your money have resulted in any value added. The answer is “rarely.”

Value Added Result

A value added result doesn’t mean you should expect your account hold its value no matter what. Virtually everyone has lost significant money in the last year. It can simply mean losing less money than other portfolios that took the same level of risk. Needless to say, it’s one thing to have this idea in your head. It’s quite another to understand it when your feelings are at the panic stage. The typical measure of valued added is the amount by which advisor selections beat their appointed asset class benchmark. As you know, investors are likely to be disappointed about 70 percent of the time.

The AssetBuilder approach is different. Rather than chase index beating returns, we accept market returns knowing those allow us to do better than 70 percent of all managed portfolios. Instead, we focus on maximizing return relative to risk. Our expectation is that our portfolios will, over time, provide higher returns for the amount of risk that was taken. That’s value added.

Let me give you a concrete example. Recently we did a portfolio analysis for a prospective client. He was unusual in that he was already using a Dimensional Funds advisor. We found that our model portfolio that had a virtually identical level of risk as his provided an annualized return that was 1.69 percent higher than his current adviser over a long period¹. The advantage held short term, as well. In the first 5 months of this year his portfolio had provided a return of 9.80 percent (period return). Our comparable risk portfolio (Portfolio 9) had provided a return of 12.5 percent (period return) over the same period. That’s quite a difference.

Similarly, measured against all “moderate allocation” mutual funds in the Morningstar database, our portfolio 9 was in the top 3 percent over the same period, well ahead of the category average of 6.12 percent. This was done at a slightly higher level of risk (13.13 percent vs.11.61 percent standard deviation). This could, of course, be a statistical fluke. But we don’t think so. We think it is our value added— more return for a given level of risk. It’s something that can be seen on the upside, but it is psychologically invisible on the downside.

Fees

Since fees are guaranteed and return is not, discriminating investors are taking a hard look. Fees can take a significant bite out of an already dwindling account balance.

Financial advisor fees vary, but can be grouped by fee-only or fee-based. A Fee-only advisor is compensated entirely by the investor. A Fee-only advisor typically pays close attention to the long-term cost of what he/she is recommending. A Fee-based advisor may be partially paid by fees but is also paid commissions. These commissions are part of the food chain for the legacy investment services industry. Sometimes, the commission drives an investment strategy contrary to investors’ best interests.

AssetBuilder Difference

Guided by Nobel Prize-winning research, we offer our clients a menu of pre-constructed portfolios that make choosing and implementing a personal investment strategy relatively simple. We believe simplicity is a virtue. It’s also a powerful tool for controlling expenses. We are committed to adding value to – and subtracting cost from – your investment decisions.

As a fee-only advisor, we believe real value is delivered not in trying to outperform the market, but in constructing portfolios that capitalize on the market’s long-term returns. That’s what AssetBuilder portfolios are built to do – at lower cost than traditional financial services firms can deliver.²

Sources:

1. The return figures used are net AssetBuilder’s advisory fee and Schwab transaction fee of 70 basis points (.70%) per year. (Calculation based on average fee impact on $50,000 invested in AssetBuilder Model Portfolio 06 rebalanced annually for 5 years. Return figures calculated using Morningstar® EnCorr® software from Ibbotson Associates

2. According to the 2008 Moss-Adams survey titled Financial Performance Study of Advisory Firms.

Yes, You Can Save Too Much

admin — Wed, 24 Jun 2009 20:00:00 GMT

By Scott Burns

Q. My husband thinks we should always save the maximum amount possible in his 401(k) so we can get the tax benefits. We've been doing this since we got married, and are now 42 and 45. Our retirement accounts currently have about $350,000 in them. About $25,000 of that is in Roth IRAs. My husband will get a pension if he stays with his company.

I think we are setting ourselves up for a huge tax bill during retirement. He says he's never heard of anyone complaining about having saved too much. I think we should be saving more for the kids’ college (they are 14 and 12), a replacement vehicle when the time comes, and paying down the house. We currently owe $165,000 on the mortgage and have no other debt. I think we should reduce our 401(k) contributions to 6 percent (to get the match), keep doing the Roth, and add to our other savings. We are coming up on some years where we will need more financial flexibility. What do you think?---A.H., by email

A. There are two major tax traps in retirement. One is certain. The other is likely. The certain trap is the risk of paying high effective tax rates on your retirement plan withdrawals because they will also trigger the taxation of Social Security benefits. As a consequence, taking an additional $1,000 from a retirement plan may cause an additional $500 to $850 of Social Security benefits to be taxed. Instead of paying $150 of income taxes on $1,000, you’ll pay $225 to $277.50 in income taxes.

Many--- probably most--- retirees will find themselves in this miserable trap as inflation increases Social Security benefits while the threshold for taxation remains fixed. The (kind of) good news for you and your husband is that this high tax rate is likely to fall on his pension, but your retirement plan savings may escape it--- because you'll already have paid the full amount through his pension.

For you the greater worry is higher tax rates, with middle income workers being the most vulnerable. Here’s why. While the vast majority of retirees will face tax rates from zero to 15 percent, when your gross income exceeds about $88,000 (joint return), you're likely to find yourself in the 25 percent tax bracket. I think it's a good bet that a future tax increase will include a new tax step between 15 percent and 25 percent.

One way to increase your financial flexibility is to reduce the 401(k) contributions to 6 percent, capturing the full match, and applying the extra money to your home mortgage. You'll pay it off faster, and each dollar paid off will be a dollar you could access through a low-cost home equity line of credit. The interest (on amounts up to $100,000) on these loans is tax deductible, and the variable interest rate is often lower than the rate on a long-term mortgage.

Used intelligently, a home equity line of credit can help you finance education and other lumpy spending. The operative word here is "help"--- $100,000 of credit won't get most families through the college education expense gauntlet.

Q. I have $10,000 in a Fidelity money market fund that pays very little. I would like to take all or part of it and invest in another Fidelity fund (or any other fund) that gives a good return on its market investments. What do you suggest? ---G. F., by email from Dallas

A. You won't do better without taking some risk that you could lose money. The increase in income, however, could be substantial. Inside the Fidelity fund family you could move to Fidelity Mortgage Securities fund (ticker: FMSFX). It was recently yielding just under 5 percent. The fund requires a minimum investment of $2,500 and has an expense ratio of 0.45 percent. The only year in the last 15 that it lost money was 2007, when it lost 0.42 percent. Given the current dismal yield of all money market funds, the risk may well be worth it.

One of the best funds in this category will require a commission to purchase in a Fidelity account. It is Vanguard GNMA (ticker: VFIIX), with a $3,000 minimum purchase, and an annual expense ratio of 0.21 percent. Over the last 15 years it has provided an annualized return of 6.69 percent while the Fidelity fund has provided a return of 5.84 percent.

Life of Riley Index Reaches New Record: $3.1 Million

admin — Fri, 19 Jun 2009 20:00:00 GMT

By Scott Burns

If you want to be rich, you’ll need a lot of money.

You didn’t need to be told that, did you? But the real question is exactly how much? Try $3.1 million as the entry level for 2009.

That’s more than three times the amount required only 15 years ago. It’s double what you needed in the crazy days of 1999. This is the amount you’ll need in financial assets to be a “person of independent means,” capable of living better than 75 percent of your fellow Americans without suffering the indignity or inconvenience of work. If you are hoping to get rich the old-fashioned way--- by marrying well--- you’ll have to find a mate with a lot more money than just a few years ago.

The $3.1 million figure comes from my Life of Riley Index, an irregular exercise I do to find out how much money we need to be independently upper middle class. Note that this isn’t genuinely rich. It’s just middling comfortable. It means you won’t be hungry, but you won’t gargle with champagne, either. It means you’ll own a car, but it won’t be a Ferrari. It means your home will never be photographed for Architectural Digest, and you’ll never buy a watch that is advertised in The New Yorker magazine or fashions advertised in Vogue.

But $3.1 million is, well, a good start. And it is way more money than most people have.

Here’s how I get the figure. Our friends at the Internal Revenue Service, always eager to be useful, compile lots of statistics about tax returns and income. One set is a time series that shows how the distribution of income (and taxes) has changed over time. It tells us that if you wanted to be in the top 25 percent of all households in America by income, you needed to have an income of $64,702 in 2006. (To be in the top 1 percent you needed $388,806, and to be in the top 10 percent you needed $108,904.) That’s the last published data, so I take an educated guess at 2007, 2008 and 2009 by using wage increase figures from the Economic Indicators, a monthly government publication. That provides the income figure.

To get the wealth figure I use the average dividend yield on the S&P 500 and the yield on a 5-year Treasury obligation. Then I assume the portfolio is invested 50/50 in stocks and 5-year Treasuries to calculate the average yield from the portfolio. Finally, I divide the needed income by the average portfolio yield to learn the required wealth (see table below).

Needless to say, that $3.1 million isn’t written on clay tablets. The amount can be changed by using assets with different yields such as value stocks, relatively high yield REITs or government-backed mortgage securities. That may reduce the amount you need well below $3 million, but the growth of required wealth is likely to be very similar to the figures presented here.

Basically, you need a lot more financial assets these days to replace the income from working your day job. For all the attention to the growth of wealth and the number of people investing, a life of leisure based on dividends and coupon clipping is a lot more elusive than it was 5, 10, or 20 years ago.

Can it be said that life is getting harder?

Yes, it probably is---catching the big brass ring of luxury and leisure requires a bigger stretch than ever.

The Life of Riley Index— (or, how much money you need to be independently upper middle class)

This table shows how much you need in financial assets to produce an income at the 25th percentile of all American households. The actual amount could be changed by substituting investments with different yields than the S&P 500 index and 5 year Treasury note that are used in this example.

Year	S&P500 Yield	5Yr Treasury Yield	50/50 Portfolio Yield	Top 25% AGI Threshold	Portfolio Required
1986	3.49%	7.30%	5.40%	$32,242	$597,627
1987	3.08%	7.94%	5.51%	$33,983	$616,751
1988	3.64%	8.47%	6.06%	$35,398	$584,608
1989	3.45%	8.50%	5.98%	$36,839	$616,552
1990	3.61%	8.37%	5.99%	$38,080	$635,726
1991	3.24%	7.37%	5.31%	$38,929	$733,817
1992	2.99%	6.19%	4.59%	$40,378	$879,695
1993	2.78%	5.87%	4.33%	$41,210	$952,832
1994	2.82%	6.68%	4.75%	$42,742	$899,832
1995	2.56%	6.77%	4.67%	$44,207	$947,631
1996	2.19%	6.07%	4.13%	$45,757	$1,107,918
1997	1.77%	5.77%	3.77%	$48,173	$1,277,798
1998	1.49%	5.15%	3.32%	$50,607	$1,524,307
1999	1.25%	5.54%	3.40%	$52,965	$1,560,088
2000	1.15%	6.15%	3.65%	$55,225	$1,513,014
2001	1.32%	4.55%	2.94%	$56,085	$1,910,903
2002	1.61%	3.82%	2.72%	$56,401	$2,077,385
2003	1.77%	2.97%	2.37%	$57,343	$2,419,536
2004	1.72%	3.43%	2.58%	$ 60,041	$2,331,689
2005	1.83%	4.05%	2.94%	$62,068	$2,111,156
2006	1.87%	4.75%	3.31%	$64,702	$1,954,743
2007e	1.86%	4.43%	3.15%	$67,225	$2,137,520
2008e	2.37%	2.80%	2.59%	$69,242	$2,678,607
2009e	2.36%	2.13%	2.25%	$70,142	$3,124,365
Sources: IRS, Economic Indicators, Author Calculations

Next Sunday: The Life of Riley Index, Retiree Version

On the web:

IRS Tax Statistics

February 29, 2004: Wealth Inflation

April 28, 2002: The Life of Riley Index Hits a New High

October 13, 1998: The Life of Riley Index

How Older People Benefit from Mortgage Payoff

admin — Wed, 17 Jun 2009 20:00:00 GMT

By Scott Burns

It’s always good to have readers who pay attention. Last week, asked how a young Army lieutenant should invest, I focused on finding a low-cost fund that invested in a broad portfolio. I suggested three such funds. Readers quickly pointed out that I had overlooked the same federal Thrift Savings Plan (TSP) that I have often praised.

Bottom line: If you are in the military, check out the Thrift Savings Plan. Have deductions taken straight from your paycheck.

Q. I’m not sure I understand your advice to pay off a home mortgage. So, help me with this: I calculate about 7 years to pay off my mortgage. But I really want to pay off this loan by applying an extra annual amount from my IRA.

You wrote that “the older a loan is, the more you benefit from paying it off."

Would you explain how I can benefit? I have a monthly payment of $538 on a mortgage balance of $40,000 at 5.875 percent. --- N. C., by email

A. You benefit from paying off an older home mortgage from the change in cash flow. Here is how it would work in your case. You're currently paying interest at 5.875 percent. You can't earn that in short-term Treasury obligations or bank CDs. According to www.bankrate.com, for instance, 5-year CDs, were recently yielding an average of 3.1 percent.

So if you have $40,000 in 5-year CDs you would earn about $1,240 a year in interest, before taxes. That’s way short of the $2,350 a year you're currently paying in mortgage interest that probably isn't tax-deductible because your total deductions may be less than the standard deduction.

But there's more! With a monthly payment of $538 on your mortgage, you are paying out $6,456 a year. A large portion of that is principal, of course, but the main issue for most retirees isn't saving for the future. It is spending for the present. So taking $40,000 out of your savings to pay off the mortgage would eliminate that payment. As a percentage of the payoff, that's 16.1 percent a year--- a major change in your cash flow requirements.

It's also an opportunity to reduce your income taxes. Suppose you need to take that $6,456 a year out of a retirement fund. That means you need to create a $6,456 a year "taxable event" just to make your mortgage payment. Eliminate the payment and you eliminate the tax bill.

All these factors are why I generally urge older people to pay off as much debt as possible and try to live debt-free.

Q. Recently you suggested that owning TIPS is one of the things we can employ against any upcoming inflation spike. But Warren Buffett has warned about a bubble in the Treasury bond market. What is your opinion about his observation? Are you recommending that we buy directly from the Treasury rather than investing in bond funds? ----R.J., by email

A. I believe Mr. Buffett is simply looking at the unnatural yield spread between Treasury issues and private issues. Actions by the Federal Reserve have, until recently, worked to artificially reduce the yield on Treasury obligations. Recently, for instance, yields on tax-free- AAA-rated 30-year municipal bonds were actually higher than yields on same maturity Treasury bonds. (You can follow this on www.bloomberg.com.) This has been done to influence the interest rates on home mortgage loans. If home mortgage rates are low, home buying will be encouraged because monthly payments will be lower.

The recent global rise in interest rates may be an indication that the "bond vigilantes" aren't interested in buying the $2 trillion in new issues the Treasury plans to sell at artificially low yields.

The only connection to Treasury Inflation Protected Securities here is that they will provide some protection against rising interest rates IF the rise in interest rates is driven by inflation. If the rise in interest rates is driven by perceptions of increased credit risk, TIPS won't help. Since governments around the world are floating trillions of new bond issues, there is increased worry that governments will have a tough time supporting their rising debt levels.

On the web:

Thursday, June 3, 2009

Sunday, May 22, 2009: The Payoff for Low Cost Index Investing

Coping With Required Minimum Distributions

admin — Fri, 12 Jun 2009 20:00:00 GMT

By Scott Burns

Overheard in a restaurant.

First man: “I don’t have to take a Required Minimum Distribution this year. Isn’t that a nice break?”

Second man: “It sure is--- as long as you can get over the inconvenience of not eating all year.”

The immediate topic here is an odd tax break given to those at least 70 years of age by our ever-thoughtful friends in Washington. This year, 2009, it is not required to take a Required Minimum Distribution (RMD) from IRA accounts. The one-year suspension means that older retirees won’t be forced to sell stocks at depressed prices and then pay taxes on the distributed proceeds.

Of course, many retirees won’t have a choice. If they want to eat and pay the cable bill, they’ll need more money than they get from Social Security. The cash will have to come from their retirement accounts. Basically, most oldsters have their own RMD from necessity, not Congress.

While required distributions are small at age 70--- about 3.65 percent--- the amount rises each year. By age 80 the RMD is 5.35 percent. By age 90 the RMD is 8.77 percent. Ultimately, the amount you must distribute may force the sale of securities at depressed prices. That, in turn, can damage your retirement security.

Young readers take note. This is not an academic problem. Contrary to popular belief, most Americans do not have one foot in the grave by age 70. The fastest growing population group in America isn’t the young. It is people at least 100 years old. According to the Life Expectancy Table for the U.S. population, 7 of every 10 people who reach age 70 will also reach age 80. And nearly 3 in 10 will reach age 90.

So unless you intend to take the poetic path and die a tragic premature death from one of our favored excesses, there is a very good chance you’ll be trying to remain solvent into your late 80s, or longer.

How can we help our savings survive as long as we do?

Here are three simple steps. Please note the complete absence of Wall Street magic.

Construct basic retirement portfolios that produce dividend and interest income that is at least the size of your RMD. This means a portfolio that yields at least 3.65 percent at age 70 and 5.35 percent by age 80. This isn’t a slam dunk, but it can be done. Among moderate allocation mutual funds, according to Morningstar data, Vanguard Wellington (ticker: VWELX) was recently yielding 4.31 percent. That would produce enough income to meet RMDs until around age 75. American Funds Income Fund of America, A shares (ticker: AMECX) was recently yielding an impressive 6.47 percent. That would produce enough income to meet RMDs until around age 84.
Leaven your portfolio yield with REIT dividends. Real estate investment trusts must distribute the bulk of their income to shareholders. One result is relatively high yields. The iShares FTSE Residential REIT exchange-traded fund (ticker: REZ), which tracks an index of apartment-owning REITs, was recently yielding 7.54 percent. Putting 20 percent of a portfolio yielding 3.65 percent into a REIT index fund would raise the overall portfolio yield to 4.4 percent--- providing current income for RMDs to age 75 instead of age 70. (Full disclosure: I own shares of this ETF.)
Avoid forced equity sales by having a near-cash cushion. Eventually, probably in your early 80s, it will be impossible to produce enough current investment income to meet your RMD. You can still avoid forced sales of equities by keeping a portion of your portfolio in near-cash. Then you add some cash to your distribution. If your portfolio was earning about 6 percent, for instance, you could keep about 10 percent in near-cash. Adding near-cash to the 6 percent yield could stave off forced sales of equities. Adding 2.5 percent a year, for instance, could sustain an 8.5 percent distribution for nearly 4 years. This could take you to about age 90.

What do you do after age 90?

Well, that’s a problem that kind of takes care of itself. By then the odds of dying have begun to exceed the odds of running out of money because of high withdrawals. About 13 percent of all those who survive to age 90 won’t survive to age 91. Basically, the rate of dying--- 13.3 percent, rising each year--- is far higher than the RMD, 8.8 percent, rising each year.

On the web:

United States Life Tables, 2004

Retirement Plans FAQs Regarding Required Minimum Distributions

The Uniform Lifetime Table in IRS publication 590

IRS Publication 590: Individual Retirement Arrangements (IRAs)

Yes, You Can Find an Expense-Sensitive Broker

admin — Wed, 10 Jun 2009 20:00:00 GMT

By Scott Burns

Q. We have been reading your recent columns about 401(k) plans and managed funds. In 2007 my husband and I were advised by our broker to invest a portion of inherited money in managed funds. These funds charged annual fees of 1.98 percent. Within two months the market began to decline.

Like most investments, these funds have lost 40 percent of their value. My husband is two years away from retirement. While we may not need this money right away, if it takes 5 years for the market to recover, we will have paid over $20,000 in fees just hoping to recoup our initial investment.

What would be the downside to cashing out of these funds at a loss and reinvesting the proceeds in index funds at Vanguard and/or Fidelity? We feel like it's time to make a move. ---B.A., by email from Dallas

A. There isn’t a downside. If you think your asset allocation--- the percentage of your money in each asset class--- was appropriate, you can change from the funds you have to an essentially identical asset allocation. You won't lose any upside opportunity by switching to index funds, or much lower-cost funds, than the ones you now own.

But many people feel differently about risk today than they did two years ago or ten years ago. While it is easy to tolerate market risk when the risk is expressed in rising stock prices, it's a lot more difficult when the risk is expressed in declining stock prices. As a consequence, people who once were happy with 90 percent of their savings in equities now feel better with 60 or 70 percent of their money in equities.

The hard part is finding the courage to make the change. Many people--- probably most--- simply don't feel they are qualified to do it. They want and need help.

If you are in this category, you have a difficult choice. You can grit your teeth and select a single low-cost fund that seems to have the right risk level for you. Or you can find a broker/adviser who will create a portfolio of low-cost load funds for you. Getting financial advice doesn't have to cost 2 percent a year plus commissions. There are brokers out there who have built their entire careers on getting people into low-cost funds such as the American Funds group. They get paid a commission up front for the service they provide. The customer gets funds that have relatively low annual expense ratios.

Here's an example. Suppose you wanted to build a balanced portfolio that was a mixture of equities and fixed-income securities. If you were a self-directed investor, you might have invested in no-load, low-cost funds like Vanguard Wellington or Vanguard Balanced Index fund. These funds have expense ratios of 0.23 percent and 0.15 percent for their Admiral shares, which require a $100,000 initial investment. Over the last 10 years both those funds were in the top 20 percent of all funds categorized as "moderate allocation" by Morningstar, returning an annualized 3.81 percent and 1.31 percent, respectively, over the period.

An adviser who watched out for long-term expenses would be likely to recommend American Funds Balanced fund A shares or American Funds Income Fund of America A shares. These funds have annual expense ratios of 0.61 percent and 0.55 percent, respectively. Over the last 10 years they were in the top 20 percent of all "moderate allocation" funds, returning 2.55 percent and 2.32 percent, respectively, after adjustment for the maximum front-end commission, according to Morningstar. While the front-end commission is 5.75 percent on all purchases up to $25,000, it is reduced to 3.5 percent for purchases over $100,000 but less than $250,000. There is no commission on investments of $1 million or more.

While a no-commission, self-directed choice would have done slightly better (Wellington) or slightly worse (Balanced Index) than a cost-minded adviser choice, the most important fact is that all four choices resulted in superior performance for moderate allocation funds. The majority of the highest expense ratio load funds, on the other hand, lost money after adjustment for commissions over the same time period.

Expenses matter. They always matter. So if you need advice, find an adviser who pays attention to the long-term cost of what he is recommending.

Second Anniversary

admin — Mon, 08 Jun 2009 20:00:00 GMT

By Kennon Grose

I would like to offer my personal thanks to those of you who have become AssetBuilder clients during the past year. We reached our second anniversary at the end of May, and we continue to grow. Even during these tough economic times. Thanks to you and your referrals, we have attracted more than 500 clients across 34 states, representing $173 million in invested assets.

The secret to our success continues to be YOU!

We believe the current global financial crisis will reshape the financial services industry in terms of competition, government regulation and investors’ taste for financial products. Now more than ever, you understand the only guaranteed part of the return is the fees you pay.

If you’re like most AssetBuilder clients, you came to us because you were tired of doing business with Wall Street brokers, their high-risk stock pickers and overpriced middlemen. You told us you didn’t want to invest based on fear, uncertainty and doubt. And we listened.

We stripped out the unnecessary costs and risks and built an investment firm that puts you first. We offered a science-based system of diversified index investing designed to capitalize on the market’s long-term growth, rather than playing stock-picking games. We cleared away Wall Street’s smoke and mirrors in favor of an open and honest relationship with our clients – one that respects your intelligence.

The question we ask ourselves every day. Do we have the right investment strategy? Are the models performing the way we expected them to?

All of our model portfolios are recovering from the current market low set March 9, 2009 – measured by the S&P 500 total return. The science of investing is holding up STRONG against the fear, uncertainty and doubt of the market. While we focus on diversification, it is nice when our investment strategy is holding two of the best performing Dimensional Fund Advisors (DFA) funds YTD. Both emerging markets; DEMSX 45.66% and DFEVX 43.13%.

Word is certainly spreading. AssetBuilder’s Web site – a wealth of valuable information and a repository for Scott’s writings – is averaging more than 1,600 visitors per day. Recently, we have seen as much viewer interest in information about AssetBuilder as we have seen with Scott’s Couch Potato information. The AssetBuilder “our portfolios” page is the third most viewed page on our site.

We were recently featured in a NY Times article “Stirring Up the Right Investment Mix” by Ron Liber. Mr. Liber focused on our use of DFA funds – available only through registered investment advisors. He further notes, “AssetBuilder, in Plano, Tex., is charging its clients less in management fees (and allowing portfolios of much smaller sizes) than just about anyone else offering DFA funds.”

Thank you again for making all of this possible, through your confidence in us, your loyalty and your referrals. Empowered by your trust, AssetBuilder will continue this journey to make our clients’ investing simple – and their futures smart.

High Debt Means Deflation, Not Inflation

admin — Fri, 05 Jun 2009 20:00:00 GMT

By Scott Burns

AUSTIN, TEXAS. Future inflation is a given. You can’t have a government borrowing $2 trillion and not have significant inflation follow. That’s what everyone believes.

Well, just about everyone. As I’ve reported before, economist Lacy Hunt and portfolio manager Van Hoisington beg to differ. That’s why I’ve flown to Austin--- to get a good dose of contrarian view.

“Irving Fisher saw it first. The man who may have been the greatest American economist wrote about the debt-deflation theory of the Great Depression in 1933. He saw that excess debt controls nearly all the economic variables,” Hunt said in a recent interview.

“Think about that for a minute. It’s a very powerful statement--- excess debt controls nearly all the economic variables.”

It means, he explained, that government stimulus won’t do much. Basically, you can’t borrow your way out of excess debt. “The only thing that will allow recovery is the passage of time,” he said.

An economic historian by inclination, Hunt sees a broad sweep. “Our periods of debt all start with great ideas. Growth in 1818, for instance, started with the building of the Erie Canal.

“But good ideas are always taken too far.” He pointed to a pattern all of us have seen--- the first innovator brings change and great productivity, but the second and third wave don’t do as well. The “Me-too” investors never do. After that, further expansion goes into what he calls “Ponzi finance,” an eager investment boom in which large sums of money will be lost, not made.

Our economic history, Hunt points out, is filled with periods of change and overinvestment--- canals, railroads, steamships, electrification, automobiles. Not to mention personal computers, the World Wide Web and optical cables for the Internet.

“Today there are no unleveraged components in our economy. The banks don’t have the capacity to take further risks,” he observes. He tells me that just growing the supply of money doesn’t create economic activity. The money has to be in motion, too. Pointing to the basic equation for economic activity--- GDP equals Money times Velocity of Money--- he says that unless we keep the money moving (velocity), the economy can shrink even as the supply of money increases. And if the economy can shrink, so can prices.

That is exactly what has been happening in the last 18 months--- the supply of money is growing, but the velocity of money has decreased and deflation fear is back.

When I ask him to explain why we won’t see future inflation he lists the factors.

“When you have major debt events, it changes our behavior for a long time. We’ve had a record decline in wealth. But the income effects are far larger. Payrolls have seen the largest drop since 1948. We’re at a six-decade low in factory utilization. The output gap (the difference between what we could produce and what we are actually producing) is the largest in history.”

That means rising demand, if it occurs, won’t cause rising prices.

What does it mean for the future?

“In the aftermath of a period of extreme overindebtedness, you don’t get paid for taking risk. The more significant the fiscal policy intervention, the more negative the risk premium (for equities). The more government borrows, the worse it is for the private sector. You can’t see this up close. You get false springs.

“Basically, we’re in a prolonged period of (economic) underperformance,” he said. “I think we’ll see the low in interest rates five or ten years down the road. It will essentially be a lost decade.”

Could anything change that dim forecast?

“Yes. A major technological breakthrough could do it. I don’t know what it would be, but we can’t go back to subprime loans.

“We will recover, but the operative factor will be time, not actions. That’s not something people want to hear.”

One implication is that bonds may continue to provide higher returns than stocks--- just as they have for the last 15- and 20-year periods.

Sidebar:

Owning Bonds May Not Be Bad for Your Financial Health

While investing over very long time periods shows that stocks provide higher returns than bonds, there are also long periods during which bonds provide higher returns than stocks. We are in such a period now. Over the last 20 years, a broad index of bonds has run neck and neck with a broad index of stocks. Over the last 15 years, bond investors have actually done better.

Will this continue?

Economist Lacy Hunt thinks so, at least for another five years.

Others argue that you can’t drive a car by looking in the rearview mirror, that the long period of good bond performance relative to stocks is simply the reflection of a long secular decline in interest rates, a decline that will soon end.

Revenge of the Bond Holders

This table compares the 15- and 20-year performance of the legendary and largest bond fund, PIMCO Total Return, with the performance of both the Vanguard 500 Index fund and Wasatch-Hoisington U.S. Treasury fund. Note that both bond funds beat the broad index of common stocks over both time periods. Hoisington Investment Management manages fixed income investments for major institutions.

Fund	Asset Class	15-year annualized return	20-year annualized return	Assets in fund
Wasatch-Hoisington U.S. Treasury	Fixed Income Long Government	8.11percent	8.28 percent	$147 million
PIMCO Total Return	Fixed Income Intermediate Government	7.26	8.23	$150 billion
Vanguard 500 Index	Large Blend Domestic Equity	6.38	7.53	$73.3 billion
Source: Morningstar Principia, 4/30/09 data

On the web:

Earlier column interviews with Lacy Hunt & archive of Hoisington Management Quarterly Reviews

November 25, 2006: Expect Lower Interest Rates

May 29, 2005: Different Drummer Investing

March 4, 2003: Another Nail in the Equity Coffin

February 23, 2003: A Future of Low Growth and Lower Interest Rates

February 19, 2002: A Somber View to a Longer Recession

Archive of Hoisington Management Quarterly Reviews

How a Young Soldier Should Invest: Simply

admin — Wed, 03 Jun 2009 20:00:00 GMT

By Scott Burns

Q. I am writing for my son, who is a first lieutenant in the U.S. Army. He just turned 24 and is ready to start his retirement investing. His car is paid for. He has no credit card or college debt. He has about $6,000 in savings with plans to increase it to $10,000. He is planning to invest the maximum for 2009 in a Roth IRA, but has no idea where to put it. Can you please offer suggestions for a simple way for a young person to start saving for retirement? Even if he makes a career of the military and has a government pension, he wants to have other sources of retirement income. ---S. P., by email

A. The most basic thing to do is to put the money in a single fund and forget about it. As you probably know, I prefer index funds and look for the lowest possible cost to manage investments. Here are three good funds that would fill the bill:

Fidelity Four-in-One Index fund (ticker: FFNOX). This fund has a current expense ratio of 0.08 percent and is a relatively aggressive mix of domestic and international equities, with about 20 percent fixed-income.
iShares S&P Growth Allocation fund (ticker: AOR) is a more diversified alternative. This new exchange-traded fund has an expense ratio of 0.33 percent and will require paying a brokerage commission (about $12 at most discount firms), but it will get him a portfolio that is 70 percent equities. Some of the equities are international.
Vanguard Balanced Index fund (ticker: VBINX). It will require a minimum investment of $3,000, has no commission cost, has expenses of only 0.19 percent a year, and has done better than 75 percent of its managed competitors over most time periods. The limitation of this fund is its lack of international diversification. It is 60 percent domestic equities.

Q. I was a little confused by a recent column about 401(k) investing and how you came up with the costs if I use exchange-traded funds (ETFs). I put money into my 401(k) every payday. My company buys my mutual funds either every payday or monthly, along with their matching funds. From what you said in your article, my understanding is that there is a transaction cost each time I buy or sell an ETF. Wouldn't this make the cost of purchasing ETFs in a 401(k) plan extremely high?

From your column, it appears that you were talking about buying each of the ETFs once per year and rebalancing as needed. If so, doesn't this take away the advantage of dollar-cost averaging? I would like clarification on how to keep the costs at 0.75 percent, or less, by using ETFs. ----N. J., by email

A. Yes, ETFs are expensive for relatively small accounts. But the greater the account value, the lower the burden of commissions as a percent of assets in the account. Suppose, for instance, that your account is worth $10,000 at the beginning of the year and you can do transactions at $12.50 each. Then you can do 4 transactions a year--- one a quarter--- and commissions will absorb only 0.5 percent of account assets.

That means you can buy exchange-traded index funds that cost an average of 0.25 percent and still keep your costs to 0.75 percent. That's well below typical industry figures.

As your account value rises, you can have more and more transactions and remain within a total transaction cost of 0.5 percent of assets. A $20,000 account can have 8 transactions--- two a quarter. A $40,000 account can have 16 transactions. By the time you get to the heavy saving years--- the late 40s and 50s--- the cost of transactions as a percentage of account value will inevitably decline.

Does this mean ETFs are what everyone should be investing in? No. Traditional index mutual funds are the most efficient vehicles for younger people with relatively small accounts. The reason I started to write about ETFs in 401(k) plans is that the combination of ETFs and a 401(k) plan with a "brokerage window" was a good way to do an end run on the choice and expense limitations of typical plans. You can read more about this on my website.

On the web:

Earlier columns in this series:

Part 1: They Don’t Call Them 201(k) s for Nothing

Part 2:: It’s Time for Plan B

Part 3: Building Inflation Tilt Into Your Retirement

Part 4: How to Build a Low Cost Inflation Hedged Retirement Portfolio

Part 5: The Payoff for Low-Cost Index Investing

How Can Government Help?

admin — Fri, 29 May 2009 20:00:00 GMT

By Scott Burns

Can government do anything to solve the coming retirement income famine?

Yes, and it won’t cost a dime. Simple steps could increase the retirement security of millions of workers.

These steps won’t be popular with the financial services industry because it will cut their income--- the billions of dollars every year that they take from our collective savings. In fact, the financial services industry has demonstrated that it is part of the problem as much as it is part of the solution.

As I have shown in earlier columns, the high cost of some 401(k) and 403(b) plans can cut a worker’s lifetime accumulation by one-third--- as much as a major market decline. Worse, when those high fees continue in retirement, the probability that workers will run out of money nearly doubles.

But that dismal reality has a big upside. If worker retirement incomes are reduced by as much as one-third by excessive fees, reducing those fees means retirement incomes could be increased by as much as 50 percent. Similarly, reducing fees could also mean that the risk of running out of money could be cut in half.

That makes investment fee reduction a high-stakes opportunity.

So how can government make it happen?

One notion is very simple: Open enrollment in the federal Thrift Savings Plan to all workers anywhere. This program has annual costs of only 0.03 percent. It provides workers with simple choices of ultra-low-cost index funds or portfolios of same. Workers could then choose between the plan, if any, offered by their employer and the low-cost plan offered by the federal government.

A 30-year-old worker could choose between accumulating as many as 11.5 years of final wages in the Thrift Savings Plan or as few as 7.7 years of final wages in his or her employer’s plan. I doubt that it would be a difficult choice.

Better still, employers could save money. Rather than wasting up to 3 percent of payroll to provide matching contributions that are consumed by fees, employers could create efficient plans. Or they could encourage workers to join the federal Thrift Savings Plan. Either way, employers could save up to 3 percent of payroll.

Think about this a bit and you see that workers and employers would both benefit. Only the financial services industry would be unhappy. But, as they say, “Two out of three ain’t bad.”

Could something this simple actually get done, since it would benefit millions of workers?

Get real. This is America, the land of the lobbyist and home of the vested interest. A proposal this simple would be attacked as anti-free enterprise by the Investment Company Institute, the entire insurance industry, the Employee Benefit Research Institute (EBRI), and benefit consultants of all shapes and sizes who make their livings off the complexity and expense of the current system. Some would say such a change would be ruinous to an already damaged financial services industry--- the same industry that workers are supporting with hundreds of billions of taxpayer dollars.

OK, so the easiest and most beneficial plan can’t happen. We’ll have to move on to another easy step.

I call it the Unified Savings Account (USA). It would not cost a dime of federal money. Congress would simply declare that all our retirement tools were created equal. Rather than have a $5,000 contribution limit for IRAs and a $16,500 contribution limit for 401(k) and 403(b) plans, the Unified Savings Account (USA) would allow any saver to put the same amount of money in an IRA as in a 401(k).

This simple step would allow teachers in expensive 403(b) plans and workers in expensive 401(k) plans to view all plans as equivalent. They could then find and use the low-cost alternatives that are readily available.

Today, for instance, you can contribute to a diversified mutual fund that costs only 0.08 percent and has a minimum initial IRA investment of $2,500. It is Fidelity Four-in-One Index fund (ticker: FFNOX). It could also be done with a more diversified fund such as one of the 237 life-cycle funds that have expense ratios between 0.18 percent and 0.75 percent. That last figure, 0.75 percent a year, has been identified as the maximum fair expense by an industry expert.

By providing a level playing field for contribution limits, this simple change would increase competition. It wouldn’t solve the expense problem overnight. Nor would it empty the fountains of disinformation that come from the financial services industry.

But it would open the door for better results through lower expenses. Money would move.

On the web:

Earlier columns in this series:

Part 1: They Don’t Call Them 201(k) s for Nothing

Part 2:: It’s Time for Plan B

Part 3: Building Inflation Tilt Into Your Retirement

Part 4: How to Build a Low Cost Inflation Hedged Retirement Portfolio

Part 5: The Payoff for Low-Cost Index Investing

Extra Principal Payments on Small Mortgages Are a Good Use of Extra Cash

admin — Wed, 27 May 2009 20:00:00 GMT

By Scott Burns

Q. My monthly mortgage payment is slightly over $500 a month. It varies yearly with cost of taxes and insurance. I pay an extra $100 each month on the principal. Is this a good idea? ---P.M., by email

A. Yes, it is a very good idea. It is extremely likely that your mortgage brings no tax benefits. The combined total of your real estate taxes, mortgage interest and other deductions is probably less than the standard deduction. So you may be earning 2 or 3 percent on your savings and paying taxes on that interest. At the same time, you are probably paying nearly 6 percent interest on your mortgage, but getting no tax deductions. Basically, any extra principal payment will do two or three times as much for you as putting the same money into new savings.

Q. I will be 59 1/2 in June. My wife passed away at age 65 last year. I’m concerned about tax liabilities and growth of assets. I have little debt--- a $75,000 mortgage on a Texas home with tax and insurance expenses of $5,000 a year and a $20,000 note on a one-year-old car. No other debts or obligations other than a Southern California timeshare that costs $1,600 a year. The children and grandchildren are doing very well. I’m in very good health and have medical insurance. My credit score is 800. My work position is very stable as long as I want to continue working.

Current assets include my late wife’s TIAA-CREF retirement fund, $400,000; my retirement fund, $100,000 (each account split 60/40 stocks/bonds, modified Couch Potato). My income is $40,000, savings $25,000. My wife’s life insurance proceeds are currently split between two FDIC-insured accounts of $225,000 each at 2.25 percent APR.

My wife was receiving $1,764 a month in terminal disability Social Security payments prior to her death. I currently qualify for $1,223 a month at age 62. Should I increase my salary to increase future Social Security benefits? We have always enjoyed Southern California, and I am considering purchasing a second home there. This would require a 30-year fixed mortgage at 4.875 percent, a $210,000 loan, and about $200,000 down. Is that a wise option for enjoyment and tax deductions? Should I put more down for a larger unit even closer to the ocean? ----JC, by email

A. It may be time for someone to start buying California real estate, but it's not clear that it should be you. According to your figures, you've got about $975,000 in financial assets, a house with a small mortgage in Texas, $40,000 of current work income and about $15,000 of future Social Security income if you retire at age 62. The question is whether you can afford to buy a second home, financing $210,000 after a down payment of $200,000.

The big problem with money is that you can spend the same dollar only once. Most of us want to spend it at least twice. That's what you may be doing when you think about buying a second house. Here's why. While you are still working, and without having bought the second home, your income looks pretty powerful--- about $80,000, divided evenly between work income and investment income. That makes it easy to support your house in Texas. You might even be able to support a second home in California, provided you don't spend much on food, clothing, transportation or healthcare.

Your two mortgages would absorb about $23,000 of your income, and you'd have to reduce your investment income by about $8,000 because you would have committed $200,000 for a down payment. So $23,000 comes off the top of $72,000 of income. As a single man, you can probably do that, as long as the operating expenses on the two houses aren't too high.

The problem comes when you retire. That could be in as little as 3 years. Then you'll have about $46,000 of income (investment income plus Social Security) to support the ongoing $23,000 in mortgage debt plus operating expenses for two houses. Not too likely.

Unless you work a long time--- like until you are 70--- increasing your salary will have only a small impact on your Social Security benefits.

Don’t Leave Your 401(k) Behind

admin — Mon, 25 May 2009 20:00:00 GMT

By Kennon Grose

You got the call in the morning. By noon everyone in your unit had been laid off, including you. After years of good work, you are suddenly unemployed.

What do you do?

First, you remind yourself that your most valuable asset is yourself— your human capital. It’s the stock of knowledge and skills that you built through years of study and work. Job One is to re-engage that human capital.

After that, you make a list with the title “Important Details.”

Some of your human capital has already been converted into financial assets— the investments that have accumulated in the 401(k) plan of your former employer. Networking with others, you are surprised to learn many left their 401(k) behind. In fact, some left a trail of 401(k) s, like bread crumbs that matched their resume entries.

Being passive about your financial assets isn’t a good idea. For many former 401(k) plan participants leaving a company is a major opportunity to reduce investment fees and share less of your return with the financial services industry. Remember, fees are the only guaranteed part of your plan.

What do these companies have in common?

When we think about ultimate 401(k) plans, we think about household names like Bechtel, Boeing, Caterpillar, Deere & Co., Excelon, Fidelity, General Dynamics, International Paper, Principal Life Insurance, Wal-Mart. These are just a few of the companies being litigated right now. The lawsuits claim the fee structure imposed by third-party administrators, record keepers, investment managers, and other 401(k) service providers ( the food chain servicing the 401k) is excessive, undisclosed, illegal and may contain prohibited transactions.

Fidelity, the largest 401(k) provider, is facing litigation on a number of fronts: Alleged excessive fees, indirect fees hidden in the plan structure, undisclosed revenue sharing and failure to inform participants of a “long-standing agreement” with Fidelity to only choose Fidelity funds.

USA Today reports: “The fees charged 401(k) plans are all but invisible to investors who don’t know where to look. Making matters more confusing are complex fee arrangements – common in retirement plans – that often lump together administrative and fund-management fees.”

Recent Congressional hearings examined requiring 401(k) plans to be more transparent on fees. Plan costs were broken down into four categories: administrative, investment management, transaction, and “other”. The real win, however, is a requirement to offer plan participants at least one inexpensive index fund.

Roll Your 401(k)

Now that you are no longer with your former employer, there is no match to help cover plan costs. So you bear all the fees. A little time and energy spent to move your 401(k) to an individual retirement account (IRA) can dramatically reduce the fees you pay and, in turn, allow your retirement savings to grow faster, possibly a lot faster.

A 401(k) Rollover Checklist

A 401(k) rollover is the process of moving your 401(k) plan from a former employer into an IRA – individual retirement account – or another qualified plan. The reason to take advantage of the rollover is simple: Reduce the fees and expenses that can take a significant bite out of your future value. The following is a list of things to think about in the transition;

Do you have any of your employer stock in your 401(k) account? If so, you’ll want to seek the assistance of a tax professional who can determine if you should to take advantage of net unrealized appreciation – NUA. NUA allows you to pay current income tax on the average cost of the shares – cost basis. The shares are then held in a taxable account. When the shares are sold, the difference between the cost basis and the market value (also called NUA) is taxed at the long-term capital gains rate. This can result in significant tax savings. It gets still more interesting if you pass the stock along to your heirs. Their tax liability is based on the appreciation of the stock while it was held in the employee’s 401(k) account.
An IRA Rollover is a tax-free transfer from a 401(k) plan, to a traditional IRA. Tactically, there are two ways this is accomplished; Direct Rollover and Indirect Rollover.x
1. In a direct rollover – also called a “plan-to-plan transfer,” – the eligible rollover distribution is transferred directly by the 401(k) plan administrator to the individual IRA rollover account.
2. Under the indirect rollover, the 401(k) plan administrator writes a distribution check to the individual. You then have 60 days to transfer the entire amount received to an IRA rollover account. The distribution is not taxable if the transfer occurs within 60 days. A direct rollover is preferred.

How to Invest Your IRA Rollover

You can use the do-it-yourself Couch Potato plan for investing. Or you can use AssetBuilder to manage your IRA Rollover for you. At AssetBuilder, we construct portfolios to provide the highest return with a defined level of risk. We use a technique called mean variance optimization and a broad mix of asset classes to maximize diversification and minimize risk relative to expected return.

The Payoff for Low Cost Index Investing

admin — Fri, 22 May 2009 20:00:00 GMT

By Scott Burns

Ten years ago Fidelity Magellan fund was riding high. Topping $100 billion in assets under management, it was the largest fund in the industry. Indeed, Magellan was larger than many entire mutual fund firms. The fund generated more than $600 million in fees for Fidelity Investments.

As you might expect, the continued success of the fund was a matter of the highest importance for Fidelity as a firm--- Magellan was the mother lode. As a firm, Fidelity was also an incredible brain trust. The best and the brightest already worked at Fidelity. It had the resources to hire anyone it chose, if that was deemed the best decision.

With so much at stake, so much talent and such abundant resources, you would think that Magellan fund would easily have remained a top-performing fund.

But it didn’t.

Today, according to Morningstar data, Magellan is a slender shadow of its past. It now has only $17 billion under management. It ranks 29th in size, 44th if you include money market funds. More important, over the last 10 years, 62 percent of its competitors have provided higher returns. Over the last 12 months, 3 years and 5 years, it has ranked below 95 percent, 89 percent, and 88 percent, respectively, of its large growth fund competition, according to Morningstar data. As a consequence, today it brings in about $500 million a year less in fees than it did 10 years ago.

I tell you this for a reason. If Fidelity, with all its savvy and resources, can’t pick a winning manager, just what do you think the chances are of you or me doing it? What do you think are the chances that the average investment adviser can do it?

In fact, the odds are poor, whoever does it.

Worse, picking a fund manager isn’t a once-in-a-lifetime decision. It’s a decision that has to be made again and again. Fund managers, on average, don’t stay at the same fund very long. According to the Morningstar database, for instance, the average duration of all fund managers at a particular fund is only 4.5 years. Restrict your sample to the largest funds--- those with at least $1 billion under management--- and the average tenure rises to 6.6 years.

This means a 30-year-old worker will need to make a fund decision 6 times before retirement and another 3 times after retirement. Each time he makes that decision--- or pays a professional to make the decision---the probability of doing better than an index fund is about 30 percent.

Those aren’t very good odds.

In fact, the odds are dismal. The probability of making two good decisions in a row is only 9 percent. Try to make three good decisions in a row and the probability of success is only 2.7 percent. By the fourth decision, the probability of making a winning choice each time is less than 1 percent.

Meanwhile, the fee meters are running, transferring billions of dollars from the return on our investments to the financial services industry. This happens year in and year out. The financial services fee machine does incredible damage to retirement security.

Fortunately, there are signs that we’re beginning to understand this is a no-win game. Today, 8 of the 28 funds that are larger than Magellan are index funds. Money follows performance--- and low-expense index funds routinely trump the expensive pride of our fee-bloated financial services industry.

During 2008, balanced funds--- an asset allocation that is close to the holdings of the average 401(k) plan investor--- lost a stunning 28 percent of their value. It was one of the worst declines in history. If you calculate the cost of additional expenses, however, you’ll find that a 30-year-old worker in a 401(k) plan with average expenses of 1.25 percent will lose 22.4 percent of what he might have accumulated in the low-cost index fund-based federal Thrift Savings Plan.

In a more expensive plan that cost an average of 2 percent a year (as many insurance-based 403(b) plans do), the same worker would lose a whopping 33 percent of his potential accumulation.

Excessive fees, in other words, can do as much damage as a major bear market. Worse, while the 28 percent lost in a bad market may eventually be recovered in a rising market, the money lost to a lifetime of excessive expenses is gone forever.

The Long-Term Cost of High Expense Investing

This table compares the 37-year accumulation of a 30-year-old worker who saves 10 percent of income each year, receives a 5 percent annual raise and works during a period when inflation averages 4 percent. He also invests in a 60/40 mixture of domestic stocks and long-term government bonds to achieve a pre-expense annualized return of 8.72 percent. The greater the annual expenses paid, the greater the long-term reduction in retirement resources.

Avg. Annual Expense	0.03 percent	0.24 percent	0.75 percent	1.25 percent	2.00 percent
Accumulation in years of final salary	11.49 years	10.99 years	9.88 years	8.92 years	7.68 years
Years of income lost to additional expenses	Na	(0.50) years	(1.61) years	(2.57) years	(3.81) years
Percent lost to additional expenses	Na	(4.35) percent	(14.0) percent	(22.37) percent	(33.16) percent
Source: Author calculations using Ibbotson annualized returns for a 60/40 balanced portfolio

Next week: Can Government Help?

On the web:

First Column in this series: They Don’t Call Them 201(k) s for Nothing

Second Column in this series: It’s Time for Plan B

Third Column in this series: Building Inflation Tilt Into Your Retirement

Fourth Column in this series: How to Build a Low Cost Inflation Hedged Retirement Portfolio

Other related columns:

Sunday, March 20, 2009: Is Your Employer Match Being Wasted?

Sunday, November 7, 2008: Workers Unite! (Magellan as poster child)

Sunday, August 2, 2005: TSP--- A Model Government Plan

Sunday, February 22, 2005: An Interview with Mr. Fund Alarm

Sunday, February 17, 2004: Fidelity Magellan--- A Strong Candidate for Sale

Sunday, November 3, 2002: The Lessons of Really Long Term Investing

The Burden of Commission Based Advice

admin — Wed, 20 May 2009 20:00:00 GMT

By Scott Burns

Q. My husband's financial adviser has made a suggestion for action. We can't decide if it's a good idea. My husband is 70, retired, and drawing from his account.

The account includes 39,427 shares of Franklin income fund class A, 4,351 shares of SunAmerica Focused Balanced Strategy A; and 4,138 shares of SunAmerica Focused Balanced Strategy B. His account manager suggests that we move half of the Franklin Income fund into Franklin Rising Dividends A shares and half of each of the SunAmerica accounts into SunAmerica Focused Dividend Strategy A. He says it might make the recovery of my husband’s account happen faster.

We do not have a happy history of good advice from this adviser. Under his management, the account has lost almost 80 percent of its value over the last 8 or so years. The value of the account is about $150,000.

Should we take the adviser's advice? ---S.J.M., by email

A. In fairness, you should remember that some portion of that decline is due to withdrawals. Your adviser is proposing is to move from three balanced funds (mixtures of stocks and bonds) to two equity funds. The portion of your total portfolio in fixed-income will be smaller than it is today. So you’ll have more risk.

Yes, the change might help recover losses faster. But it also means more ups and downs. It means that your regular withdrawals may have a larger negative effect on future growth--- because they may occur when values are down.

The selections, all load funds, indicate that your adviser's primary source of income is commissions. This limits his choices to funds with sales loads and tends to increase what you pay in annual expenses. This is the burden of commission-based advice.

The SunAmerica funds are the same fund, but you have paid for them in two ways, as front-load A shares and deferred-load B shares. The A shares cost 1.68 percent a year. The B shares cost 2.33 percent a year. The average expense ratio of funds in this category is 1.36 percent a year, according to Morningstar data. The Advisor could have put you in American Funds Balanced A shares. Your expenses would have been 0.58 percent a year. He would have earned a commission and served you, rather than putting his firm first. That’s why you don’t need this adviser.

A person in your situation should visit a no-load firm such as Fidelity or Charles Schwab. There, you will have a chance at reducing your investment expenses and improving your investment results.

You could also move your account to Vanguard and reduce expenses dramatically. As I have pointed out many times, its Balanced Index fund, Admiral shares (ticker: VBINX), has provided a better return than at least 75 percent of all competing moderate allocation funds. It has annual expenses, with a $100,000 minimum investment, of only 0.07 percent.

That's a tiny fraction of what you are now paying for commission-driven advice.

Q. What are the pros and cons of I Savings bonds, TIPS, and TIPS funds? ---K.S., by email

A. I Savings Bonds come in denominations as small as $50. All income is accumulated, tax-deferred, until you redeem the bonds. This makes them a very convenient investment. Sadly, individuals are now limited to $5,000 a year in purchases of these bonds. Fortunately, you can have both an electronic account and a paper securities account, so you can actually invest $10,000 a year. You can learn all the particulars by visiting the Treasury website.

Bonds purchased in the last 6 month period (November 1 to April 31) are earning 0.70 percent plus the trailing inflation rate. The new rate for bonds purchased between May 1 and October 31 is zero percent. That’s not very attractive since you’ll be stuck with that rate, plus inflation, for the life of the bond.

TIPS, whether purchased as individual securities or as holdings in a mutual fund or exchange-traded fund, are best held in a tax-deferred retirement plan because they create "phantom income"--- the inflation adjustment on the value of the bond is deemed taxable income even though you don't receive it in cash. While the value of these securities fluctuates with the market, these securities usually offer a higher premium over inflation than I Savings Bonds. Also, there is no limit on the amount you may purchase. According to Bloomberg.com, for instance, the recent premium over inflation was 2.35 percent on 20-year TIPS.

How to Build a Low-Cost Inflation-Hedged Retirement Portfolio

admin — Fri, 15 May 2009 20:00:00 GMT

By Scott Burns

April was a scary month for the big dogs in the financial services industry. After decades of hiding the true cost of 401(k) plans, Congressman George Miller got some movement for H.R. 1984. Otherwise known as the 401(k) Fair Disclosure for Retirement Security Act of 2009, the bill would set new standards for expense disclosure. In the same month, “60 Minutes” correspondent Steve Kroft brought home the devastation the market crash has brought to millions of near-retirees. He also made it clear that many who piously call for improving 401(k) plans are really lobbyists--- shills for the industry.

The industry thinks things are just fine, thank you.

But they aren’t.

We may focus on the market losses of the last year, but the greater danger isn’t the ups and downs of markets. It is the unrelenting high costs of many plans. As I pointed out in my previous column “Is Your Employer Match Being Wasted?” some plans would require a 50 percent employer match just to overcome the high costs of the plan.

How much should a 401(k) plan cost? Investment manager David B. Loeper believes that anything over 0.75 percent a year is excessive. Indeed, he calls 0.75 percent the “maximum fair total expense.” In his book “Stop the Retirement Rip-Off: How to Avoid Hidden Fees and Keep More of Your Money” (John Wiley & Sons, $19.95), he shows exactly how much the ongoing rip-off means with a menu of consequences.

By his calculations, a 30-year-old worker with an 80/20 (equity/fixed-income) portfolio who saves $2,500 a year in a plan that costs 1.75 percent a year can compensate for the additional cost by:

Increasing annual savings by $1,600 a year, or
Delaying retirement by 6 years, or
Reducing annual retirement income by $4,100.

Those are major consequences. Do you really want to work another six years just to feed the financial services industry? The same higher cost also increases the risk of outliving the money accumulated by a whopping 91 percent, Loeper estimates.

In fact, it is possible to manage 401(k) plans for well under 0.75 percent. I’ve written about it for years. It can be done by any worker who invests in index mutual funds or exchange-traded index funds. It can be done following William Bernstein’s directions for “the coward’s portfolio,” Bill Schultheis’ instructions for his “coffee house portfolio” or by building my Couch Potato Building Block portfolios. (You can read about them, their trailing time period performance, and their history at www.assetbuilder.com.)

You can, for instance, build the most basic Couch Potato portfolio (50/50 total domestic equity market/TIPs) using Vanguard mutual funds with a starting investment of $6,000. Its annual expense ratio will be less than 0.20 percent. And there will be no commissions to pay.

But suppose you want more inflation protection? Is there a simple, low-cost way to build such a portfolio--- a way you can use an account at Fidelity, Schwab, TDAmeritrade, E-Trade, Bank of America, USAA, or any other discount brokerage platform?

Yes. Use low-cost exchange-traded funds. Buy equal amounts in each of six categories. Here’s the recipe. Note that three parts--- TIPS, REITs and energy--- are recognized inflation hedges.

Combine equal parts:

Vanguard Total Stock Market ETF (ticker: VTI), expense ratio 0.07 percent. This fund allows you to buy the entire domestic stock market.
iShares TIPS ETF (ticker: TIP), expense ratio 0.20 percent. This fund gives you ownership of an inflation-protected portfolio of U.S. government securities.
iShares MSCI EAFE ETF (ticker: EFA), expense ratio 0.34 percent. This fund allows you to buy the entire equity market of the developed economies.
SPDR Barclays International Trust Bond ETF (ticker: BWX), expense ratio 0.50 percent. This fund gives you broad ownership of international government bonds.
Vanguard REIT ETF (ticker: VNQ), expense ratio 0.10 percent. This fund tracks a broad index in domestic real estate investment trusts.
SPDR Energy ETF (ticker: XLE), expense ratio 0.21 percent. This fund tracks an index of major energy companies.

Put more in the pot each year. Rebalance as necessary. Simmer for as long as possible.

The average expense ratio of this portfolio is 0.24 percent. With 6 transactions a year at $20 each, your all-in expense would be 0.75 percent for a portfolio of $24,000. With commissions of $12, your all-in expense would be 0.75 percent for a portfolio of only $14,000. The more you have put away, the lower your average expense--- with 0.24 percent being your lowest limit.

The difference is money in your pocket and your retirement.

Next week: Part 5--- Measuring the Difference Fees Make

On the web:

Stop the Retirement Rip-Off on Amazon.com

60 Minutes, April 17, 2009: Retirement Dreams Disappear with 401(k) s

The Coward’s Portfolio

The Coffee House Investor website

The New Coffee House Investor on Amazon.com

Columns on Couch Potato Investing and Results for Couch Potato Portfolios

Sunday, June 19, 2001: Location, Location, Location---REIT in Your Portfolio

Sunday, December 14, 2007: The Art and Benefit of the Steady Eddy Portfolio

Sunday, January 11, 2008: Making Commodities Part of Your Portfolio

March, 2009: Craig Israelson on “A Better Balanced Benchmark”

First Column in this series: They Don’t Call Them 201(k) s for Nothing

Second Column in this series: It’s Time for Plan B

Third Column in this series: Building Inflation Tilt Into Your Retirement

Sunday, March 20, 2009: Is Your Employer Match Being Wasted?

To Do Well Over 50 Years, Reduce Costs

admin — Wed, 13 May 2009 20:00:00 GMT

By Scott Burns

Q. I am a 26-year-old man, looking into starting a Roth IRA. I have been investing in my government 457 plan for the past three years but am unhappy that I will be taxed on my gains at retirement. I am one of the few people left in the world who will receive a pension and regular pay increases. When I retire, this will make my retirement tax bracket higher than what it is now. I am thinking of starting a Roth IRA to avoid higher taxes later.

Can you give me any advice on what is a fair fee for a Roth IRA account? I would have a managed account. Most companies charge 1.6 percent to 1.9 percent for the management of your mutual funds. My insurance company wants to charge an additional 3 percent for having the account through its name brand. I don't feel this is a good investment strategy. ---C.W., by email from Buffalo, NY

A. A Roth IRA, like a traditional IRA, SEP or other retirement account, is just a legal wrapper for a pool of assets. So it isn't appropriate to talk about what the right fee on the account should be. The amount you pay in fees should relate to what you pay for management of the assets themselves plus how much you might pay in additional fees for contractual guarantees from an insurance company.

In my view the 1.6 percent to 1.9 percent range you mention is simply too high. It may be "normal," but that doesn't make it right or good for you. I suggest that you consider filling your Roth IRA account with low-cost no-load mutual funds. At firms like Fidelity and T. Rowe Price you can get funds with annual expenses well under 1 percent a year.

Go to Vanguard and you can get your money managed for still less. Vanguard Wellington (Ticker: VWELX), a moderate allocation (or balanced) managed fund, has beaten 95 percent of its competitors over the last 15 years, according to Morningstar data, yet its annual expense ratio is only 0.27 percent. Similarly, Vanguard Wellesley (Ticker: VWINX) has beaten 99 percent of its competitors over the last 15 years, yet its annual expense ratio is only 0.33 percent. That's very clear evidence that paying up for management does little for you, but lots for your manager.

The insurance products you are considering probably come in at just over 3 percent a year. That's fairly typical for a variable annuity contract with "living benefits" provisions. There is no reason on earth for you or anyone else to subject hard-earned money to such high fees.

When you are talking about investing for 50 years, managers come and go, as do the firms for which they work. The best long-term investment strategy is cost reduction.

Q. I am a retired Texas teacher who will also be eligible for Social Security benefits. But because I retired from a school district that did not withhold Social Security, my payments will be reduced because of the WEP rule. I plan to begin receiving my Social Security benefits when I turn 62. I also have a fixed annuity, and I plan to begin a five-year distribution plan when I turn 61. Since my Teacher Retirement System income distributions reduce my Social Security payments, will those fixed annuity distributions further reduce my Social Security payments? ---R.E. – Austin

A. Talk about adding insult to injury. While the annuity income won’t reduce your Social Security benefits directly, they may be reduced beyond what the Windfall Elimination Provision (WEP) does if the combination of your remaining Social Security benefits and income from other sources triggers the taxation of a portion of your Social Security benefits. Here's an example. Suppose you are single, have Social Security benefits of $10,000 a year after the WEP, and your other sources of income add another $40,000 a year to your income. Then the first $20,000 of other income would not trigger any Social Security benefit taxation. The next $10,000 of income, however, would cause $5,000 of Social Security benefits to be added to your taxable income. You would have to pay federal income taxes on that $5,000.

Building Inflation Tilt Into Your Retirement

admin — Fri, 08 May 2009 20:00:00 GMT

By Scott Burns

Prices dropped last year. But we still need to invest to protect ourselves from inflation. That’s why our retirement plan investing needs an inflation “tilt.” You’ll understand why in a few paragraphs.

How bad will future inflation be? I don’t know. Neither does anyone else. It could be a “normal” inflation of 3 to 4 percent a year. It could also be a banana republic 10 percent a month.

What we know is that all governments make promises they can’t fulfill. Our government certainly has. Under both political parties, it has taken promise-making to a high art. This is not hyperbole. The figures can be found in regularly published government reports.

The figures exist, but they are ignored. News reports regularly inform us of the growing federal deficit--- projected at a stunning $1.75 trillion for fiscal 2009 and $1.17 trillion for 2010. But regularly reported, less-visible government obligations have been growing much faster.

In the four years between January 2004 and January 2008, the Medicare trustees reported that the unfunded liabilities of Social Security and Medicare grew by a stunning $10.4 trillion. The average annual growth was $2.8 trillion.

That’s well over the expected formal deficit of $1.75 trillion this year.

In the 2008 trustees’ report, the unfunded liabilities of Social Security and Medicare--- promises of future retirement and health care benefits--- total $42.9 trillion. In a few days we should be able to read the 2009 report. It’s a good bet that the unfunded liabilities will increase by $3 trillion in the new report.

Ironically, payroll tax payments are still large enough that the Social Security and Medicare programs don’t need every dime. The extra money goes into the program trust funds as Treasury debt. The actual cash is spent elsewhere. Basically, the employment tax has been subsidizing other federal spending. This has been going on since the 1983 reform of Social Security--- another disaster chaired by former Federal Reserve Chairman Alan Greenspan.

Last year’s Social Security trustee report estimates that OASDI (Social Security retirement and disability) and HI (Hospital Insurance), excluding book entry interest for the Trust funds, will have more revenue than expenses until 2015. If higher cost assumptions prevail, however, the last year of positive flow will be 2010.

That’s next year.

I am not making this up. It is public record. You can see for yourself by examining table VI.F9 on page 191 of the 2008 trustees’ report.

When Social Security and Medicare costs exceed their revenues, the Treasury will have to borrow still more money to cover the shortfall. When that happens, today’s stunning deficits will look small.

That’s why our future contains inflation, not deflation.

There is another way to see how serious our situation is: Compare the unfunded liabilities of Social Security and Medicare to the net worth of every household in America.

According to the Federal Reserve flow of funds figures for year-end 2007, our collective net worth as consumers was $62.7 trillion. By the end of 2008 the same figure had fallen to $51.5 trillion. Another year of growth for Social Security and Medicare liabilities would bring total unfunded government promises to $46 trillion. That’s nearly 90 percent of our net worth.

Going for Broke: How Unfunded Government Liabilities Stack Up Against Consumer Net Worth

This table compares the unfunded liabilities of Social Security and Medicare over the next 75 years, which is the standard measure, with the current net worth of all households in America.

Program	1/2004	1/2008	Change	Projected 1/2009
Social Security and Disability: OASDI	$ 3.7 trillion	$ 6.6 trillion	$2.9 trillion	NA
Hospital Insurance: HI	$ 8.5	$12.7	$4.2	NA
Supplemental Medical Insurance: SMI-Part B, doctors expenses, etc.	$11.4	$15.7	$4.3	NA
Supplemental Medical Insurance: SMI- Part D, prescription drugs	8.1	7.9	($0.2)	NA
Total Unfunded Liabilities	$31.7	$42.9	$11.2	$46.0 est.
Consumer Net Worth	$51.9	$62.7	$10.8	$51.5
Unfunded Liabilities as % Consumer Net Worth	61.1 percent	68.4 percent	NA	89.3
Sources: Social Security and Medicare trustees’ reports, Federal Reserve, author estimate

If consumer net worth fell another $5 trillion--- the same amount it fell in the last three months of 2008--- we’d be broke.

Yes, you read that right.

Government obligations for basic programs would exceed the net worth of every household and nonprofit organization in America.

We’d be Upside-Down Nation.

The only way out of this is to print more money, inflating the value of assets relative to the amount of debt.

Cutting the expense of investing through index funds alone won’t solve the inflation problem. In addition to cutting expenses, we have to invest a portion of our money in assets that give us a hedge against inflation: Treasury Inflation Protected Securities (TIPS), real estate investment trusts (REITs), and energy companies.

Will this be perfect protection? No way. It will only give our savings a fighting chance.

Next week: Exactly How to Build a Couch Potato Portfolio in Your 401(k)

On the web:

Federal Reserve Consumer Balance Sheet for 12/31/2008

Sunday, May 14, 2006: This Year, a $3 Trillion Lump under the Rug

2008 Annual Trustees Report for Medicare

Trustee estimates of OASDI and HI cash flow, ex trust fund interest, 2008 Social Security Report:

Economic Indicators: Times series on Federal revenue, spending and debt 1992-2010

Sunday, November 16, 2007: Government, the Big Magician

No Magic in Biweekly Mortgage Payments

admin — Wed, 06 May 2009 20:00:00 GMT

By Scott Burns

Q. I have a new mortgage loan of $328,000 at 5.25 percent. Recently a direct mail offer said that if I pay the mortgage biweekly, I can save about $100,000 during the loan repayment period. Can I pay one additional installment every year directly to the mortgage company and have the same advantage as biweekly installments? What is your recommendation for this?

I am also getting letters for mortgage insurance. The companies say that in case of my death, the remaining loan would be paid off by a life insurance policy I can buy.

Please let me know how to decide whether to go for such things or not. ----P.R., by email

A. If you followed this plan, you would save less than $100,000. My calculator puts the savings at about $71,429. If we also considered the purchasing power of the money repaid and some loss in tax savings (because you’ll pay $71,429 less in tax-deductible interest), the saving in real purchasing power would be still less.

That doesn’t mean you should not work on paying your mortgage off early. It just means some of those dollars are apples and others are oranges.

There is no reason for you to pay a third party to help you pay your mortgage off early. You can do it for free, in your spare time at home. Offers like the biweekly offer you received come with virtually every new mortgage or refinancing. The offer makes it sound as though there was great magic in making biweekly payments. That’s simply untrue.

The magic is in paying extra principal each year.

Here’s how it works. When you make biweekly payments, you make 26 payments a year for one-half of your stated mortgage payment. That means you make the equivalent of 13 normal mortgage payments a year, not 12. That single extra payment accelerates the pay down of principal. Over time, it reduces the number of payments you will make.

If you read the fine print carefully, you’ll find that while YOU will make 26 payments a year, this third party won’t. They’ll make your normal payments and, in the course of each year, they will make a single additional payment.

So calling it a biweekly mortgage plan is simply a marketing gimmick.

If you would like to pay your mortgage off early, try this. Divide your $1,811 monthly mortgage payment by 12. Add that amount ($151) to your regular payment. Your new payment will be $1,962 each month. At the end of a year you will have made the equivalent of 13 regular payments, just like the magical biweekly mortgage. Instead of paying $652,042 over the life of the loan, including $334,042 in interest, you’ll be paying $590,613 over the life of the loan, including $262,613 in interest. You’ll be on your way to saving $71,429 in interest over the 301-month life of the mortgage.

Want to shorten the life of the mortgage still more? Make the equivalent of two extra monthly payments a year by paying $2,013 a month. You’ll have your mortgage paid off in 286 payments. The real magic is in additional payments of principal.

Before buying mortgage insurance, shop for a term life insurance policy. It is likely to provide you with greater benefits for a smaller premium outlay.

Q. In 2010, I will be taking monthly distributions from my federal Thrift Savings Plan and annual distributions from my Vanguard Long-Term Treasury Fund. I want to reinvest these distributions for emergency purposes or as an inheritance for my son. What are some good investment options?---W.R.

A. Try this two-step plan. Build an emergency fund, limiting it to three to six months of current spending. Step two would be to use additional money to build a portfolio that both you and your son would like, probably a balanced fund that would be about 60/40 equities/fixed-income. You’ll be close to that with most of the Couch Potato Building Block portfolios that you can learn about on my website (www.assetbuilder.com). Alternatively, you could invest in one of the many no-load, low-expense balanced funds that I regularly mention in this column--- such as Vanguard Balanced Index (ticker:VBINX).

It’s Time for Plan B

admin — Fri, 01 May 2009 20:00:00 GMT

By Scott Burns

Call it the Automated Monkey Project. More than 30 years ago, a Richmond, Va.-based company, Media General, started an unusual project. Their Portfolios Without Management was intended as a performance-measuring tool for Wall Street.

Media General programmed a mainframe computer to randomly select thousands of stock portfolios, calculate the performance results and then rank order the portfolios, in percentiles, from the best performer to the hindmost. They automated the old joke about having monkeys pick stocks by throwing darts at the financial page.

The result was embarrassing for professional money managers.

A majority of the randomly selected portfolios delivered higher returns than the pros. Like the earlier studies of institutional portfolios that led to the first institutional index fund, about 70 percent of the automated monkeys beat the pros.

Sometimes the pros did a little better. Sometimes they did a little worse. But the performance gap has existed for more than 40 years of research by multiple researchers. It was part of the 1980s. It was part of the 1990s. And it is alive and well this century.

Today, if you visit the Standard & Poor’s website and check its SPIVA (Standard & Poor’s Indices Versus Active funds scorecard) page, you’ll find a list of reports going back to the third quarter of 2002. That report, in turn, measures performance from the third quarter of 1997.

The SPIVA report corrects performance measures for “survivorship bias”--- the tendency of average trailing returns to be higher than what most investors actually experienced. This happens because the funds with low returns disappear, like early cuts from a football squad.

And what is left? Only the better-performing funds.

Although few in financial services talk about this, one out of every four funds is likely to disappear over a five-year period. As a consequence, the five-year average performance figures are really averages of the “best three out of four” when 5 year performances are discussed. The other funds, like names on Gilbert and Sullivan’s Lord High Executioner list, “won’t be missed.”

Morningstar, now the standard in mutual fund performance reporting, doesn’t correct for survivorship bias. Its figures show the relative performance of the surviving funds for any time period. Even so, the Morningstar rankings consistently show that index funds regularly beat the majority of their managed competitors.

What’s true for equity funds is true in spades for fixed-income funds. The most recent SPIVA report shows that managed funds in only one of 13 fixed-income categories--- emerging market debt funds--- did better than the appointed index over the trailing five-year period. For the other 12 categories, the managed funds trailed their indexes from 64.7 percent of the time (global income funds) to a whopping 98.39 percent of the time (long-term government funds).

The Texas phrase “ain’t worth shooting” comes to mind.

Mix stocks and bonds, and the record is still terrible. Vanguard’s Balanced Index fund (ticker: VBALX) has done better than 85, 82, 77, 66 and 75 percent of its managed balanced fund competitors over the last 12 months, 3 years, 5 years, 10 years and 15 years, respectively, while charging investors only 0.19 percent a year.

Its long and dismal history notwithstanding, the mutual fund industry skims off billions of dollars in fees each year. According to a recent Investment Co. Institute study, for instance, 80 percent of all 401(k) plans have average expenses that range from 1.72 down to 0.35 percent. Workers in 403(b) plans often suffer far higher expenses.

Where does this money go?

It goes to feed the managers and the distribution system. It does not go to building more secure retirements for American workers. The difference in fees goes to build houses in the Hamptons, Nantucket, Jackson Hole and a few other spots favored by the very rich.

It doesn’t have to be this way.

The future of working people can be solved with a simple step: I call it plan B.

And what is plan B?

Cut the middleman’s take. Switch to index investing in 401(k) plans. The annual cost difference, which can be as much as 2 percentage points a year, will make a profound difference in your retirement security.

Next Sunday: Part 3--- Building an inflation tilt into your retirement investments.

On the web:

Standard & Poor’s Indices Versus Active Funds Scorecards

Part 1 of this series:

Sunday, April 26, 2009: They Don’t Call Them 201(k)s for Nothing

Smooth your Income for the Long Haul

admin — Wed, 29 Apr 2009 20:00:00 GMT

By Scott Burns

Q. My wife and I are 60. We own our town home, worth $400,000 in this market. She has $167,000 in her IRA. I have $400,000 in my IRA. She also has a $2,000-a-month pension from one of the remaining airlines. We have no debt. I generate $50,000 in any given year consulting.

We are trying to figure out where to put our money to generate the largest income. We are ready to sell the town home and either downsize or rent. We like to travel economically. We plan on taking Social Security as soon as we qualify--- while it still lasts. Any suggestions or direction would be greatly appreciated. ---G. G., by email from Dallas

A. Putting a major emphasis on current cash generation will result in a rapidly falling standard of living as you age. At age 62 your life expectancy will be about 19 years. At the same age, your wife has an expectancy of about 22 years. When two 62-year-olds live together, however, one of them can be expected to live 29 years.

However you cut it, retiring at 62 means you're planning on surviving on something other than work for a really long time.

That's why most people should be thinking about retiring later--- at age 65, 66 or 70 rather than ASAP. So don't focus on the highest possible income you can generate at this moment. Instead, I suggest that you play with ESPlanner/basic. This is the financial planning software I have written about in many columns and in "Spend 'til the End" (Simon & Schuster, 2008) with economist Laurence J. Kotlikoff. A simplified version is now available, free, online at http://basic.esplanner.com

Using it and the data you provided, I found that you and your wife may be able to sustain annual spending after taxes, Medicare, and current shelter of nearly $40,000 a year--- if you can earn a return of 3 percent a year over a 3 percent average rate of inflation. That’s a conservative total return of 6 percent.

This took about 10 minutes. The output included tables of constant dollar expenses, state and federal income taxes, rising Medicare premiums and changes in net worth until death at age 100. (Just to be on the safe side.)

You may want to play "what if" and fine-tune things. One exercise would be to see what happens to your lifetime $40,000 of spending power if you sell your house and rent. I hope you and other readers will start thinking about smoothing your living standard over your (long) remaining years of life.

It's easy--- now you can become your own financial planner online. (Collection of columns on ESPlanner)

Q. My husband, age 66, just signed up and started receiving his Social Security benefits. He assures me that because of his age, he can work and earn income without his benefits being taxed or affected in any way. I assume he will pay taxes on any work-related income. Is this correct?----M. C., by email

A. Your husband is in for a surprise. If he was born in 1943, his "full retirement age" is 66. All those born between 1943 and 1954 have 66 as their full retirement age. Since he took his benefits when he reached full retirement age, he doesn't face what many early retirees face--- the possibility of having to return a portion of his benefits if he earns too much wage income.

Unfortunately, that has nothing to do with the taxation of Social Security benefits. If your household income from any source--- wages, dividends, interest, pensions, rents, capital gains, or even tax-free bonds--- exceeds certain limits, up to 85 percent of your combined Social Security benefits can be added to your taxable income. As a result, your income tax bill in retirement can be a lot larger than you thought it would be.

Suppose, for instance, that your combined Social Security income is $30,000. If your other income sources exceed certain amounts, you may have to pay income taxes on as much as $25,500 of benefits that would not be taxed if your other income was lower. It is little complexities like this that make using software like ESPlanner (mentioned above) essential. The software knows the tax law and calculates accordingly.

On the web:

Free ESPLanner online:

Scott Burns’s columns on ESPlanner

Spend ‘til the End on Amazon

They Don’t Call Them 201(k) s for Nothing

admin — Fri, 24 Apr 2009 20:00:00 GMT

By Scott Burns

It’s time for a declaration: Enough of not enough.

Only one event could make the market crash of last year worse, and it is happening. Many employers are choosing to eliminate their contributions to 401(k) plans. According to Hewitt Associates, a one-year suspension will cost a young, $50,000-a-year worker $16,000 in future retirement money. It will cost $48,000 if the employee also suspends contributions for that year.

This follows the worst peak-to-trough decline in U.S. equities since the Great Depression, a period where many workers have seen their 401(k) accounts shrink further than the gallows humor “201(k)” to the near-death experience of a 101(k).

Skeptical? Just consider the impact of employer stock. In the 12 months ending Feb. 28, only 12 companies in the Standard & Poor’s 500 provided a positive return. Over 200 companies lost at least half their value. Entire industries virtually disappeared.

If you worked at Bank of America, Citicorp, AIG or General Motors, the value of your company stock fell to virtually nothing. Ditto, if you worked almost anywhere in the newspaper industry. Shares of Gannett, the largest publisher of newspapers in America, fell 88 percent. Shares of McClatchy, Media General, Lee Enterprises, and Sun Times Media fell 89 to 95 percent. Although employer stock as a percentage of 401(k) plan assets has dropped over the last 5 years, it still looms large in some plans. And it still represents a major hazard to retirement security.

In spite of this, 401(k) plans are the primary instrument, other than Social Security, for providing retirement income. They surpassed defined benefit pension plans in assets and number of workers covered long ago.

That’s part of the problem. A generation ago, an employer contributed about 7 percent of pay to fund worker pension plans. Basically, the employer had 100 percent of the responsibility for both saving and managing retirement funds. Before this recession, the cost of the employer contribution had been cut in half— to about 3 percent of pay. If more employers drop their 401(k) match, workers will be responsible for 100 percent of the saving and managing. Employers will be responsible for zero percent. It’s not a pretty picture.

Plans have improved in some respects:

The automatic enrollment that ERISA attorney Brooks Hamilton and I advocated through a paper written for the National Center for Policy Analysis in 2001 is now common.
The default choice is likely to be a balanced fund rather than a money market fund.
More plans offer low-cost index funds.
At some plans, expenses have declined.

Unfortunately, there is also bad news:

Most workers remain totally unprepared for the task of managing their retirement assets.
Just as executives at firms that have taken government bailouts continue to feel bonus- entitled, those in financial services continue to believe that high expenses are justified--- in spite of their failure to add value.
The majority of professionally managed funds still trail their appointed index, a reality that has been a consistent feature of investment management for decades.

Plans that were created to help workers build savings for retirement continue to be expensive, risky and complicated. Because of their legacy connection to retail mutual funds, many 401(k) plans carry an unneeded expense burden. As I pointed out in an earlier column, every dime contributed by some employers is absorbed by the high costs of some plans. They also carry an unneeded burden of risk--- fund manager risk and company stock risk.

All other things being equal--- gross return and career contributions --- a federal government worker with a virtually cost-free plan who starts saving 6 percent of income at age 30 will accumulate about 10.5 years of final income by age 67.

A private-sector worker with a typical plan will accumulate only 8.5 years of final income by the same age, if the plan has costs of 1 percent a year.

A worker with a plan that costs 2 percent a year will accumulate only 7 years of final income by age 67.

Those are big differences. Put another way, 2 to 3.5 years of income are siphoned off by the costs of typical plans.

We can’t do anything about market ups and downs--- including the horrors of the last year. But there are concrete things we can do to increase what most workers accumulate.

In the next five columns I’ll show how we can do it.

Next Sunday: Starting Plan B.

On the web:

Sunday, March 20, 2009: Is Your Employer Match Being Wasted?

Hewitt Study of 401(k) Match

Hamilton and Burns: Reinventing Retirement Income in America

Playing in the Casino of Life and Death

admin — Wed, 22 Apr 2009 20:00:00 GMT

By Scott Burns

Q. I’m a 62-year-old black man, eligible for early Social Security. After working 42 years I was recently downsized. I currently have roughly $140,000 in my 401(k) account. We have no mortgage on our home. My wife receives $8,000 a year in early Social Security benefits. I have an additional $15,000 to $18,000 in income, after taxes, from a pension plan. This amount will change based on the amount I pay for health insurance. I am currently in good health and feel I could work another 4 to 6 years--- if I could find a job in today’s environment. All the charts seem to suggest that my life expectancy is 2 to 4 years less than others my age. Would it be wise for me to start drawing my Social Security benefit at 63? ---W. J., by email, from Austin

A. According to the U. S. Life Tables, black men have a significant life expectancy disadvantage at any age when compared to white men, white women or black women. At age 62, for instance, a black man has an expectancy of 16.9 years. That's 2.4 years, or 12.4 percent, less than the 19.3 -year life expectancy of a white man at that age.

But the news isn't all bad.

First, the longer you live, the smaller the expectancy gap in both years and percent. By age 70, for instance, a black man can expect to live an additional 12.4 years. That's 1.3 years, or 9.5 percent less than the 13.7-year expectancy of a white man at that age.

Second, even though your life expectancy is lower than others, it is still long enough that you can benefit from deferring Social Security benefits. The benefit gain isn't as much of a slam dunk as it is for, say, white women, but as long as your life expectancy is equal to, or greater than, the 12- to 13- year payback period, you will increase your lifetime income.

At 62 with a 16.9-year expectancy, deferral is a good bet for you. At 66 with a 14.6-year expectancy, it is still a good bet because you're likely to exceed the payback period by about 2 years. Only at age 70, with a 12.4-year expectancy, does it become an even bet.

There may be another reason for you to defer taking benefits. If your earnings record shows more earnings than your wife's and your wife is younger than you are, she will benefit from your deferral even if you don't live as long because her retirement benefit will be adjusted upward upon your death.

Your decision, of course, will always be a gamble--- you could be hit by a bus the day after you start taking benefits. But if deferring Social Security benefits were a table game in a casino, it would be one of the better games to play because you've got a good chance of "beating the house." In your shoes, I'd definitely defer until full retirement age---66--- but I probably wouldn't defer until age 70.

Many readers argue about this idea. They say, "Take the money and run." They like to assume that they will die young rather than old. They also assume that they will enjoy spending the money much more at age 62 than at age 70 or age 80. Since I am not 70 or 80, I can't argue from experience. But at age 68 I have yet to notice the decline in pleasure of living that I assumed was inevitable when I was 20, 30, and 40. Trust me: It’s still fun to spend money.

Q. Recently, you had an article on closed-end mutual funds and discounts. How is the discount on a mutual fund determined?---G.M., by email from Dallas

A. Closed-end funds issue a fixed number of shares that trade on an exchange. If you multiply the number of shares by the share price, you know what the total market capitalization of the fund is. That number can be smaller than, or greater than, the market value of the securities in the actual portfolio. One easy way to learn the size of the discount or premium on a fund is to visit www.etfconnect.com. There, you can examine the discounts or premiums on both traditional closed-end funds and ETFs--- exchange-traded index funds.

Buy a Home, Save America, Become a Citizen

admin — Fri, 17 Apr 2009 20:00:00 GMT

By Scott Burns

Our friends in Washington continue to reward witless members of the financial sector. Meanwhile, those of us who don’t fly Bonus Class think about importing guillotines from France.

Thankfully, we may not need to place the order.

All we have to do is to get Washington to listen to the best idea I’ve heard to end the decline of housing prices and, thereby, restore our confidence in the most important asset most Americans ever own. The idea comes from economist A. Gary Shilling and real estate developer Richard S. Lefrak.

Their suggestion: Don’t think about artificially low mortgage interest rates and other stop-gaps. Instead, eliminate the oversupply of houses. Too many were built during our speculative bubble. And, by the way, don’t spend a dime of taxpayer money doing it.

How can this be done? Simple: Open our borders to immigrants who can buy a home in the USA. Let a million immigrants a year do this for two years and the entire oversupply of homes and condos will be absorbed. Supply will no longer dwarf demand. Prices will stabilize. The most important asset owned by the vast majority of Americans will, once again, be a source of pride and security.

While there has been much attention to the incredible decline of equity markets around the world, the reality is that the vast majority of Americans have far more at risk in the housing market than in any financial asset. Indeed, many Americans have more at risk in the used car market than in the stock market.

According to the 2007 Survey of Consumer Finances done by the Federal Reserve, households at every level of income had more at risk in the value of their home than in financial assets. Those in the top 10 percent, for instance, owned homes with a median value of $500,000, compared to median financial assets (of any kind) of $404,500.

Households in the middle of the income distribution owned a primary home worth a median of $150,000--- but had median financial assets of only $18,600. Middle-income Americans, in other words, have about 8 times as much to lose in the home resale market as in all of the financial markets.

As you can see from the table below, 80 percent of all households in America have at least 3 times as much at risk in the housing market as in our financial markets.

The Risk of Home Value Versus The Risk in Financial Assets

This table compares median home values to the median value of all financial assets across income groups based on the 2007 Survey of Consumer Finances

Percentile of Income	Median Primary Home Value	Median Value of All Financial Assets	Ratio of Home Value to All Financial Assets
Bottom Quintile	$100,000	$ 1,700	58.82x
Second Quintile	$120,000	$ 7,000	17.14
Middle Quintile	$150,000	$ 18,600	8.06
Fourth Quintile	$215,000	$ 58,300	3.69
Second 10 Percent	$300,000	$129,900	2.31
Top 10 Percent	$500,000	$404,500	1.24
Source: http://www.federalreserve.gov/pubs/oss/oss2/2007/bull09_SCF_nobkgdscreen.pdf

Economist Shilling estimates that we built 6.7 million excess houses during the 1996-2005 boom. Of that number 3.9 million was to make up for underbuilding during the 1987-1991 S&L collapse. That leaves an excess of 2.8 million homes. That’s about two years of building. He estimates that lower building in 2007 and 2008 reduced the surplus to about 2.4 million houses for which there is no need.

Reducing interest rates or resetting mortgage payments won’t reduce that surplus. The only way it will disappear is if new customers appear and buy those homes. The fastest way to do this is to offer citizenship to immigrants as a reward for buying a home in America.

Here’s the formula: Buy a home. Save America. Become a citizen. Admirably direct when compared to the expensive and complex programs Congress has already funded.

Shilling writes: “If the current excess of 2.4 million houses were purchased at today’s median home price of about $184,000, the inflow from foreigners would be $88 billion, assuming they put 20 percent down and borrowed the rest in this country. If they paid cash, the inflow would be $442 billion. Besides stimulating the domestic economy, this would vastly help the U.S. foreign accounts and support the dollar. The mere announcement of this program would probably go a long way toward stabilizing house prices.”

And stabilizing house prices is very important. It may be the whole ball game. Without productive action, economist Shilling estimates that home prices will fall another 20 percent by the end of 2010. That would leave nearly 25 million homeowners “upside-down”--- owing more on their homes than they are worth.

This is something worth writing about to your representative or senator.

AssetBuilder Inc. - Registered Investment Advisor

Adapting to the Future, Whatever It Is

Life of Riley Index - Retiree Version

On the web:

The Cost of Trust

Mutually Rewarding Relationship

Value Added Result

Fees

AssetBuilder Difference

Yes, You Can Save Too Much

Life of Riley Index Reaches New Record: $3.1 Million

The Life of Riley Index— (or, how much money you need to be independently upper middle class)

On the web:

How Older People Benefit from Mortgage Payoff

On the web:

Coping With Required Minimum Distributions

On the web:

Yes, You Can Find an Expense-Sensitive Broker

Second Anniversary

High Debt Means Deflation, Not Inflation

Revenge of the Bond Holders

On the web:

How a Young Soldier Should Invest: Simply

On the web:

How Can Government Help?

On the web:

Extra Principal Payments on Small Mortgages Are a Good Use of Extra Cash

Don’t Leave Your 401(k) Behind

What do these companies have in common?

Roll Your 401(k)

A 401(k) Rollover Checklist

How to Invest Your IRA Rollover

The Payoff for Low Cost Index Investing

The Long-Term Cost of High Expense Investing

On the web:

Other related columns:

The Burden of Commission Based Advice

How to Build a Low-Cost Inflation-Hedged Retirement Portfolio

On the web:

To Do Well Over 50 Years, Reduce Costs

Building Inflation Tilt Into Your Retirement

Going for Broke: How Unfunded Government Liabilities Stack Up Against Consumer Net Worth

On the web:

No Magic in Biweekly Mortgage Payments

It’s Time for Plan B

On the web:

Part 1 of this series:

Smooth your Income for the Long Haul

On the web:

They Don’t Call Them 201(k) s for Nothing

On the web:

Playing in the Casino of Life and Death

Buy a Home, Save America, Become a Citizen

The Risk of Home Value Versus The Risk in Financial Assets

On the web:

Earlier Scott Burns Columns on the Foreclosure/Financial Crisis:

Earlier Burns and Kotlikoff columns: