by Suze Orman
Focus on the Cheapest Investment Offered in Your Current 401(k)
I want you to find the lowest cost mutual fund in your 401(k). As I explained in the previous chapter, every mutual fund has what is called an expense ratio. This is the annual percentage of your assets that is deducted from your investment each year to pay the mutual fund. That said, you don’t really see the expense ratio as a line-item expense in your annual statement. It’s levied in a somewhat invisible way, as it is deducted from each fund’s gross return before the net return is credited to your account. For example, let’s say a stock mutual fund has a 1% annual expense ratio and its gross return is 6%. That means your account will be credited 5% after the 1% expense ratio is siphoned off to pay the fund’s fees.
I know this is a bit dry to think about, but it is very profitable. The expense ratio you pay can have a huge impact on your retirement security. As I noted in the previous chapter, I think it is prudent to set our expectations for future returns in the vicinity of an annualized 6%. As some of you may remember, that’s one-third the rate of return for stocks during the 1990s, when in fact the S&P 500 grew at an annualized 18% rate for the decade. Let’s imagine you owned shares in a mutual fund in the 1990s that had an annualized gross return of 18%, and the fund charged a 1% expense ratio, so your net return was 17%. Now let’s assume you own the same mutual fund today and it still charges that 1% annualized rate of return. Today’s truth suggests that future returns might be more like 6%. So that would mean your net return would drop from 6% to 5%. That 1% now eats up a bigger portion of your return; it is about 16% of the 6% return, whereas a 1% fee represents just 5% or so of an 18% return. Fees are always important, but you can see how they become even more important when your expectations for future returns are lower. You can’t afford to waste any money paying a higher expense ratio than necessary. And mutual funds offered within 401(k)s can have wildly different expense ratios; some stock mutual funds may charge 1.5%, while others might charge just 0.20%, or even less. One of the best ways you can make money in the coming years is to reduce the amount you are paying in that fee.
That is why I want you to locate the fund in your current 401(k) plan with the lowest annual expense ratio. If that fund owns securities that you want to own, I would consider pouring the bulk of your money into that one fund. Remember, you don’t need this specific 401(k) to have a mix of investments; all that matters is that your overall portfolio—of all your various retirement accounts—makes one cohesive pie.
Here’s an example: Let’s say you have a total of $250,000 in all your retirement accounts, and the 401(k) at your current employer accounts for $100,000 of that total. Now let’s assume that you want to keep 50% of your money in stocks and 50% in bonds/cash. So that’s $125,000 you have earmarked for stocks. If your 401(k) has a great low-cost stock mutual fund, you could put all of your account in that one fund. Then with the remaining $150,000 in your consolidated accounts (you will likely have more than one, since traditional and Roth accounts must be kept separate) you will want to put another $25,000 in a stock mutual fund or ETF. That brings your total stock investment to your target of $125,000. The rest can be invested in cash and bonds. Your total pie adds up to 50% stocks and 50% bonds, but you are strategically taking advantage of the lowest-cost fund within your 401(k).
I really like this approach because it is a great way to avoid ever having to invest in bond funds in your 401(k). I do not like bond funds at all—see this page to get my reasoning—and prefer that you invest directly in individual bonds, such as Treasuries. This strategy makes it easy to steer clear of bond funds in your current 401(k).
I want to be very clear here: If the majority of your retirement savings is in this 401(k) account, you obviously should not shift all of it into one fund. If your 401(k) is in fact your whole pie, then this must be a diversified pie. For your stock portion I recommend you keep 85% in U.S. stock funds. If your plan offers a fund with the name Total Stock Fund, that can be a great option, as it invests in a mix of large established firms, mid-size firms, and small firms. So-called large cap stocks tend to offer steadier returns—and often dividends—while stocks of smaller companies typically offer more growth potential. If your plan offers an index fund with “500” in its name, that means it focuses on the large company stocks in the Standard & Poor’s 500 stock index. That’s a find choice as well, and you can also invest in a mid-cap and small cap fund offered in your plan. As a guide for how to split that money among the different funds, you might follow how a Total Stock index fund allocates money: about 70 percent is in large caps, 20 percent in mid-caps, and 10 percent in small caps.
The remaining 15% of your stock portfolio should be earmarked for international stocks. There are two broad ways to invest in international markets: developed countries, such as Japan and most of Europe, and emerging markets, such as China and India. My recommendation is to have most of your international stock money invested in developed markets and reserve just 5% of this 15% slug for emerging markets. Fast-growing emerging markets are more volatile. So you don’t want to overload your portfolio with exposure to them. And keep in mind that those those big multinational blue-chip U.S. stocks that make up 85% of your 401(k) stock allocation do a lot of business selling their goods and services into the emerging markets. So your 401(k) will be tied to the fortunes of emerging markets through those U.S. firms.
Locate the international fund offerings within your 401(k). If your plan has one fund, well, you’re good to go. But if you see two (or more) international funds, that means one of them focuses on developed markets; it will often have EAFE in its name. That’s a tip-off that it is a fund focusing on developed markets in Europe, Australasia, and the Far East. The other offering probably focuses on emerging international markets.
Before you put 10% of your stock portion in the developed fund and 5% in the emerging markets fund, I recommend you take a look at the portfolio of the developed fund. While the bulk of its assets will be in developed markets, you may find that a fund has 10% or 20% invested in emerging markets. If that’s the case, then you can just invest in that fund and forget about adding the emerging markets fund as well. Your 401(k) plan should provide you easy access—online or over the phone—to the latest available portfolio mix of each fund. If not, go to morningstar.com. Type the ticker symbol for your fund into the search box (it is a five-letter string of letters ending in X that will be listed alongside a fund’s name in your 401(k) material). Then click on the portfolio tab, scroll down, and you will see a breakdown of how much of that fund is invested in developed markets and how much is in emerging markets.
BEST INVESTMENTS OUTSIDE YOUR CURRENT 401(K)
Let’s talk about the right investments for your rollover accounts as well as any regular taxable accounts. The advice here is exactly the same advice I gave to younger investors in the previous class. For retirement assets outside your 401(k), you have the freedom to choose among the thousands of investments offered by the discount brokerage you use. That includes mutual funds, individual stocks, and individual bonds, as well as exchange-traded funds (ETFs). Please go to this page–this page for my investment advice.
BOND INVESTMENTS
For the bond portion of your IRAs and any taxable accounts, I recommend you invest in individual Treasury bonds. Because the U.S. government backs these you do not have to worry about default risk. If you were to invest in corporate bonds you would need to build a diversified portfolio of 10 or more issues, and unless you have $100,000 or more to devote to bonds, the commission you would end up paying would be too expensive.
The discount brokerage where you keep your IRA should offer the ability to buy Treasury securities. Just remember to stick with shorter-term issues—maturities of five years or less.
• No Target Funds Allowed
At this stage of your life I am going to put my foot down and insist that you do not rely on target retirement funds. It’s for the very reason I mentioned earlier: I do
not like bond funds in any way, shape, or form. And a target retirement fund when you are in your late 40s and 50s will in fact have plenty invested in bond funds. It varies by each different fund company but it might be 30% to 60% or more of the target fund’s assets. In the previous class I told younger adults that if they didn’t think they had the discipline to create their own portfolio of mutual funds among the offerings in their 401(k), I would allow them to opt for a target retirement fund because at a young age a target fund wouldn’t have much invested in bond funds. But as you age, a target fund’s glide path—that’s the term used to describe how its mix of different types of investments changes over time from higher risk to lower risk—will naturally shift into more bond funds.
You do not have my permission to stay in a target-date retirement fund once you are in your 50s. Nor do I want you using a target retirement fund for your rollover and taxable accounts. Time to stand in your truth. You are here in this class because you have a dream to retire. And to retire knowing you will be financially secure. That is your children’s dream as well. The more you can build true financial security for your later years, the less likely you will need your children to step in with financial support.
No matter how unfocused you may have been on making the smartest retirement investing choices in the past, you have reached a crossroads moment. You are standing at an important intersection: You can continue down the same road of not paying much attention; if you choose that path, there is no way to say whether you will in fact realize your retirement dreams. Or you can choose to become actively engaged in managing your retirement accounts and take control of steering your retirement to success. The choice is yours; which way will you go?
I understand that some of you may feel too overwhelmed to handle all the decisions on your own. There is nothing wrong with wanting to hire help. But I ask you to think of a financial advisor as a coach who is there to offer expert advice and help devise a strategic game plan. But you must be an active participant in the process as well. Hiring a financial advisor is not the end of your work. There is no end here. This is your retirement we are talking about, this is your money, not anyone else’s money. As I have said so many times: What happens to your money in the coming years affects you and you alone. So no matter how talented and smart an advisor is, if you blindly hand over your money and the decision making to someone else, that is a failure to stand in your truth. Hire a financial advisor to help you make the right choices for your future.
In previous books I have offered detailed advice on how to identify a solid financial advisor. At my website you can read the steps I recommend you take when interviewing possible fee-only advisors. But I do want to be very clear here: Fee-only advisors are in fact the only financial advisors you are to ever work with. Fee-only advisors charge a flat hourly fee, or if they oversee your investments, they will charge a small percentage of your total assets. But they do not make any money through sales commissions on the investments you buy, sell, and own.
An advisor who is reliant on commissions has an inherent conflict of interest. To get paid, an advisor who relies on commissions or trade-based fees needs you to buy certain investments to get paid. So that raises a question: Are you being advised to make an investment or trade because it is the right and smart move for your future, or because it generates a commission for the advisor? You should never put yourself in a situation where you have to ask yourself that. Working with a fee-based advisor is the way to go.
I hope what I am about to say will be ridiculously obvious to all of you, but history tells me this is an age-old problem: A referral from a friend or family member is not all you need to find a financial advisor. Bernie Madoff had great word of mouth for decades. Gather leads from people you admire and trust, and then do your own legwork to verify that the advisor is not only legit, but is someone you feel understands you and your financial situation. In the second class of this book I discussed my belief in trusting your gut—if something does not feel right to you, you must honor that. You are never to take a leap of faith, particularly when it comes to choosing someone who will be instrumental in the handling of your finances, simply on the basis of what someone else says. You have to get in there face-to-face and assess the situation for yourself.
LESSON 6. PLAN FOR LONG-TERM CARE COSTS
One of the most important decisions to make in your 50s, one that can have a huge effect on your retirement years, is whether to purchase a long-term care (LTC) insurance policy. Long-term care insurance helps pay for your care if you can no longer take care of yourself without assistance. LTC insurance can pay for someone to help within your home and it can also be used to help with nursing home costs. I think buying an LTC policy now is a seriously smart move to make because the policy will be much more affordable. However, you will once again have to factor the cost into your annual expenses for years to come—possibly all the way to age 84. Why 84? That is the age when people typically need this type of care. It will do you no good to purchase a policy now, pay for it for ten years, and then have to give it up in retirement because you can’t afford it. No one wins in that situation except the insurance company. But if you can afford it, I would urge you to buy it. I remember suggesting to my mother that she buy a long-term care policy about twenty years ago. I even told her I would pay for the premiums, but she refused. She said she would never need such a thing. She even refused to sit for an exam. This year my mother, God bless her, turns 96. Her expenses in an assisted living facility are approximately $20,000 a month. If my mom did not have my help in covering these costs, I cannot imagine the life she would be living right now. So know that this is a subject I take very seriously—and so should you.
WHEN TO BUY
In the past I have recommended you wait until age 59 to purchase an LTC policy. Given recent changes to these policies, I now say that is the latest you should consider making a purchase. Your age at time of purchase and your health status determine your premium cost. If you purchase a policy before age 61 you will likely pay a premium of less than $2,500 a year. Furthermore, what you want to avoid is being turned down outright because of a health issue; the older you are when you apply, the more likely you are to have a preexisting condition that could impact whether you are able to buy a policy, or the cost of that policy. It’s just a fact of life that medical issues increase as we age. That is why I recommend you make your LTC decision no later than 59.
Go to The Classroom at www.suzeorman.com:
I have more information on how health issues can impact your ability to qualify for LTC insurance.
THE FINANCIAL CASE FOR BUYING LONG-TERM CARE INSURANCE
The fact that on average we are all living longer creates a bit of a good news/bad news situation for your retirement planning. A longer life span increases the likelihood that at some point you may no longer be able to take care of yourself.
Some of us may need nursing home care. The median daily rate for a private room in a skilled nursing home in 2010 was $206, according to Genworth Financial’s comprehensive survey of long-term care costs. A semiprivate room at a private nursing home carried a median daily rate of $185. And that’s just today’s cost. Like most of our healthcare system, long-term care costs have been rising more than the general inflation rate, about 5% a year. At that pace, the cost in 20 years could easily be $470 a day for a private room, or more than $170,000 a year.
What’s really eye-opening, though, is the cost of at-home care, something that many more of us will likely require. At some point we may well need to hire people to come into our homes to help us manage the daily rhythms of life as we age. And that can end up being even more expensive than nursing home care. The median hourly salary in 2010 for a home health-care aide, according to Genworth, was $19; that adds up to more than $450 a day for round-the-clock care. Moreover, assisted living facilities carry a median monthly rate of about $3,200. Even adult day care is around $60 a day. It’s all expensive and something you must plan for if
you are going to live a long life without outliving your money.
HEALTH INSURANCE, MEDICARE, AND MEDICAID
Please know that your current health insurance policies and Medicare do not cover your long-term care needs. Medicare offers limited financial assistance for short-term recovery periods of less than three months. If you have been hospitalized (for at least three days) and then move to a Medicare-approved skilled nursing home facility, Medicare will only pick up the full tab for 20 days. For days 21–100 you must contribute to the cost of your care—called a copay. Beyond 100 days there is no coverage. Medicare coverage for at-home care is also limited. The bottom line is that Medicare will provide limited help in covering your long-term care needs. At Medicare.gov you can download a free booklet that explains Medicare coverage.
A Promising Development: A Partnership Between LTC Insurance and Medicaid
In the past, Medicaid (MediCal in California) has paid for long-term care only after people have spent down most of their own money. As I have said many times, if you think choices where you can receive care when you are on Medicaid are as good as when you are a private-pay patient, I am here to tell you that you are wrong.
But a promising program called the Partnership for Long-Term Care makes it possible to hold on to more of your assets if you were to ever need to apply for long-term care coverage that is provided within the Medicaid program. Under partnership plans, states allow consumers who purchase a state-approved LTC policy to be able to keep assets equal to the benefits paid out by your policy. The idea is that you buy as much private insurance as you can afford from an insurance company that participates in the Partnership program and if it isn’t enough, you can then use Medicaid as a safety net to help pay for your care for the rest of your life without spending most of your hard-earned money first.
