2. Avoid stable-value funds unless you’re close to retirement. There are worse investments than stable-value funds, but there’s no reason anyone should ever put a dime of their retirement savings into one, and there’s certainly no reason why these things should be the second-most popular 401(k) investment. I’m sure people like them because of the name, but when you look at what they actually are, there’s no reason to own a stable-value fund rather than a short-term to intermediate-term highly rated bond fund.
I can’t believe that most people truly understand what a stable-value fund is, so my best guess is that 401(k) investors are attracted to the conservative sound of the name. When I say that capital preservation is more important than capital appreciation, I don’t mean that you should invest in a fund that sounds like it can’t lose you money. So what is a stable-value fund? These are funds that invest in money markets, highly rated short-and medium-term bonds, and insurance contracts. To make sure the value of your investment is “stable,” these funds will buy what are called “wrapped bonds.” Take an old high-quality bond, and then get an insurance company to give it a “wrapper,” or “wrap contract,” which is basically an insurance policy on your investment. These wrappers are, in my opinion, really bad deals. Here’s how it works: a wrap contract has a set rate of return. If the stable-value fund is forced to sell a wrapped bond for a loss, the insurance company will pay it the difference between the insured price and what your fund actually got when it sold the wrapped bond. Maybe that seems like a good way to minimize your downside. If you think so, keep reading. Wrappers don’t just minimize the downside, they also prevent the possibility of an upside. If your stable-value fund sells a wrapped bond, or anything else with a wrap contract, for a profit, it gives the profit to the insurance company too. These funds have truly stable values: they don’t go down, but they also don’t go up.
Typically, a stable-value fund will give you a slightly higher return than a money market fund (different from a money market account) and a lower return than a high-quality bond fund. That really breaks it for me. Why on earth would anyone invest in a complex fund that they probably don’t understand when that fund has a lower yield than a straightforward, simple bond fund? Even if you’re enthralled by the idea of wrappers, shouldn’t the fact that on average you will make less money in a stable-value fund be enough to discourage you from contributing to it? It’s not as though high-rated bonds are very risky. In fact, they’re quite stable and reliable. As I said before, people invest in these funds because the name is comforting. You don’t want your 401(k) to comfort you during the thirty to forty years you’re contributing to it; you want it to comfort you in retirement, and it won’t do a good job of that if you invested in lower-yielding funds, producing less money for your retirement, because it felt safe at the time.
In the old days, stable-value funds relied on guaranteed investment contracts, or GICs, and you can still find and invest in these too, but again I don’t see any reason to. A GIC is a contract between an insurer and a retirement plan that guarantees investors a fixed rate of return. The GICs fell out of favor in the 1980s after several insurance companies used low-quality debt to finance the contracts that they’d sold to various retirement plans and then went bankrupt. If your insurance company goes bankrupt, it can’t pay off that guaranteed contract.
The difference between the risk you take on putting your money in a high-quality short-term bond fund and the risk you take on investing in a stable-value fund is tremendously small, and in my opinion not consequential. A bond fund should have a higher yield and slightly lower fees. Plus, stable-value funds tend to charge high redemption fees, meaning they could take 1 percent or 2 percent of your investment when you take your money out. There’s no world in which going with stable-value funds over bonds makes sense.
3. Don’t be confused by your 401(k)’s offerings. Stick to my bedrock principles and you’ll be fine. People view the options offered by their 401(k) plan as though they represent the rest of the markets. What do I mean? If your 401(k) offers you ten funds, let’s say five stock funds and five bond funds, you’re more likely to believe that a 50-50 split between stocks and bonds is the correct allocation of your capital. (This is the gist of what Jeffrey R. Brown, Nellie Liang, and Scott Weisbenner found when they surveyed investors for their 2007 article for the National Bureau of Economic Reserarch, “Individual Account Investment Options and Portfolio Choice: Behavioral Lessons from 401(k) Plans.”) It’s not. Don’t mistake being diversified among the handful of funds your 401(k) allows you to invest in with being genuinely diversified among different sectors of the world economy. The only thing the list of funds your 401(k) offers tells you about is the list of funds your 401(k) offers. You might learn a thing or two about the quality of the people selecting the investment options for your 401(k) plan, but you won’t learn squat about diversification.
4. When you leave your job, be sure to roll over your 401(k) into an IRA. This is extremely important. The average worker in the United States will switch jobs eleven times over the course of his or her working life. That statistic probably vastly overstates the number of times the average American will move from job to job by including things like the summer jobs you had as a kid, but you get the idea. Today’s workforce isn’t committed to staying at one company to build an entire career, and young people especially have very little problem moving from employer to employer.
There’s nothing wrong with that, except that when many of us switch jobs, we really screw up our 401(k) plans. When you leave your job, you’re given thirty days, mandated by law, to decide what to do with your 401(k) from that job. You have four options: you can cash out your 401(k) plan; you can leave it with your old employer; you can roll it over into the 401(k) at your next job, if you have one; or you can roll it over into an IRA, which I’ll explain in more depth later in this chapter. Something like 45 percent of people who lose their job choose to cash out of their 401(k) plans. This is the worst possible thing you can do. First of all, when you cash out, you pay the taxes. The whole point of a 401(k) is that your investments can compound over time and you won’t have to pay any taxes on gains until you withdraw the money and it’s taxed like ordinary income. Well, you’re withdrawing the money when you cash out. Your employer is required to withhold 20 percent of the money in your 401(k) to pay the taxes, and you also pay a 10 percent penalty for pulling your money out of a retirement account early. Again: this is a retirement account. It’s for retirement. If you intend to pull out your money well before you retire, there’s really very little reason for you to contribute. If you don’t have a lot of money, there are other options. You don’t have to fund your 401(k) if you’re barely making ends meet, but what you absolutely cannot do is invest in a 401(k) and then cash out the plan when you get fired, because that’s just a waste of your money and your time.
If you lose your job, you will probably feel upset, helpless, and resentful. That’s natural, and even healthy, but it’s not conducive to making smart decisions about how to fund your retirement. I’d bet that many of the people who cash out their 401(k) plan after they lose their job do so because they think they’ll need the money between jobs. That’s rarely going to be true. You can apply for unemployment benefits from your state’s department of labor and get half of your weekly wages, up to a cap that varies from state to state, for six months, although you’ll have to wait a week before collecting the benefits. It’s much better to go on the dole than break into your 401(k) and pay a huge penalty and all those taxes. Every penny that goes to Uncle Sam when you cash out is another penny that won’t be compounding when you get a new job and decide it’s time to start investing for the future again.
I’m sure some people are unclear about what their 401(k) options are after they lose their job. For some people, thirty days isn’t a whole lot of time if you’re struggling to find a new job and live within your reduced means. But if you don’t make a decision, your former employer will cas
h you out, and that’s one of the things that will absolutely ruin your ability to retire and make the whole exercise in 401(k) investing pointless.
So why do I think you should roll over your 401(k) into an IRA, rather than leaving it with your old employer or rolling it over into a new employer’s 401(k)? If you leave your 401(k) with your old employer—and by the way, they don’t have to let you do this—they are allowed to charge you higher fees. And it can be impossible to reallocate your assets, meaning your former employer basically freezes the account as it was when you got fired, and you can’t rearrange your investments to your liking. Leaving your 401(k) with your old employer is like a more expensive, less-free version of your 401(k) before you got fired, and if you remember, I was none too thrilled about the lack of control and the high fees before. It’s that much worse when you have less control and bigger fees.
What if you want to roll over your 401(k) into an IRA and not your new 401(k) because you believe an IRA is better than a 401(k) plan? Here is what you should know. An individual retirement account is quite similar to a 401(k) in that it’s a tax-deferred account, meaning you contribute to it with pretax income and don’t pay any taxes on gains until you cash out, at which point all your distributions are taxed as regular income. The difference is that you open an IRA with a bank or a broker or a mutual fund company, not through your employer, so there are no matching funds. It’s better to contribute new money to a 401(k) plan than an IRA as long as you haven’t maxed out the company match. But once your money’s in one of these plans, you’d much rather have it in an IRA. Why? Well, there’s the other difference: you actually get to run an IRA yourself. There’s no choosing from different approved offerings as with a 401(k). You get to decide to invest almost any way you want once your money is in an IRA. I’ll talk about these accounts in more depth later, but you can see why rolling over into an IRA is more appealing than putting that money in a new 401(k). Unfortunately, you can do this kind of rollover only once every twelve months.
There’s a right way and a wrong way to do this as well. Call the bank or broker where you set up your IRA to get specific instructions from them, and then call your old 401(k) administrator and ask to have your 401(k) funds transferred directly into your new IRA. The IRS gives you sixty days to complete the process, but if you do it right you won’t be pressed for time. How could you screw this up? Often, your 401(k) administrator will try to give you a check. Many people who don’t understand the process take the check and try to fund their new IRA with it. Here’s the problem: if your 401(k) administrator gives you a check, they have to withhold 20 percent of it for tax purposes, just as they do when you cash out. It gets worse. You’ll have to make up that 20 percent withholding from your own money when starting up the IRA. Otherwise the IRS will decide that the 20 percent the old administrator withheld was actually a payment to you, and they’ll then tax and penalize it accordingly. You can avoid this as long as you’re careful and make sure the money goes straight from your old 401(k) to your new IRA.
5. Pay attention to where your money’s going, and allocate your assets yourself. Most of the people who write about 401(k) plans assume that ordinary people are dolts who can’t take care of themselves or make good decisions. I’ve read way too many columns blasting workers for failing to contribute, or contribute enough, to their 401(k). I have plenty of issues with how these plans are structured, but the complainers finally came up with a 401(k) solution that manages to be worse than the problem. The solution is called the Pension Protection Act of 2006, and one of its provisions makes it a great deal easier for companies to enroll you automatically in their 401(k) program. Every personal finance writer and his mother loves the idea of automatic enrollment. Not me. I can understand their thinking, though. Most people who are automatically enrolled in a 401(k) choose not to take themselves out of the plan, so the people researching this stuff concluded that the majority of workers don’t care whether they’re enrolled or not. And since investing in a 401(k) is supposed to be an easy, slam-dunk decision, automatically enrolling workers is the best thing a company can do. At least, that’s how the advocates of automatic enrollment put it.
I have a wholesale distaste for anything involving your money that can be described as automatic. Everyone is capable of making sound financial decisions. When you take away the need to decide, people stop caring, and people who don’t care about how their money is managed don’t manage their money well. But entirely aside from that fundamental objection, automatic enrollment in 401(k) plans has far bigger problems. Everyone who advocates increasing automatic enrollment has his heart in the right place; these people just want to make sure you can retire comfortably. Unfortunately, their heads are not in the right place. What’s wrong with automatic enrollment? Most of you are probably familiar with Murphy’s Law: whatever can go wrong, will go wrong. If you’ve seen me on TV or read Confessions of a Street Addict, my memoir, you know that I’m an anxious guy. It’s probably one of the reasons I was such a good money manager. If you’re good at running money, you fret constantly about the downside, about what can go wrong and lose you money. Obsessing over what can go right will cloud your judgment, but obsessing over what can go wrong will make you cautious and concerned about everything you should be concerned about.
So let’s take that logic and apply it to automatic enrollment in 401(k) plans. If your enrollment is automatic, you get hired and the company you work for invests some chunk of your salary in its 401(k) plan unless you check the box telling them not to. How do you think they’re going to allocate your retirement capital? The great thing about the 401(k)—the reason these plans far surpass old-fashioned defined-benefit pension funds, which are becoming increasingly rare—is that with a 401(k) you control how your retirement funds are invested. Your future isn’t in the hands of some pension fund manager you don’t know, who in the old days often legally or illegally robbed you blind and could not care less about your retirement. It’s in your hands. When your employer automatically diverts a part of your paycheck into a 401(k), you lose some of that control. You don’t actually lose the ability to control where your 401(k) money gets invested—you can still decide where that money goes—but remember, the whole reason for automatic enrollment is that a lot of people don’t pay attention to this stuff. Those people will get hurt.
Why? Because when your employer automatically enrolls you in its 401(k), it doesn’t invest your money in the best possible mix of assets available through the plan. It doesn’t find the lowest-cost index fund for stocks so that you have the right amount of equity exposure in your retirement account. No, it invests your 401(k) money in the worst possible way. That’s why I believe automatic enrollment will really damage your retirement funds if you don’t pay attention and know what you’re doing. The two most popular default options for automatic 401(k) enrollment are company stock and what are known as target-date funds. You already know why company stock is the worst thing you can have in your 401(k). Plus, doesn’t it seem a little fishy that your employer can automatically enroll you in a 401(k) plan whose default option is to invest your money in the company’s own stock? Call me cynical, but that doesn’t seem right. And then there are the target-date funds.
According to Vanguard, the fabulous investment management company that created the index fund, two-thirds of companies that automatically enroll their employees in 401(k) plans have target-date funds as their default investments. So if you’re automatically enrolled and don’t specify where you want your 401(k) money to go, the odds are good that it will end up in one of these funds. And that would be pretty bad for you. I’ll go into much more detail about target-date funds, which are also called life-cycle funds, in the next chapter when I explain the ups and downs of every kind of investment, but these target-date funds warrant special attention in this chapter about funding your retirement because they’ve become such a popular and incredibly well-marketed type of fund. The idea behind target-date funds, or at least the way
they’re sold to regular investors, is that they’re the only fund you’ll ever need. It’s clever, even insidious, but it just isn’t true. Let’s say you plan on retiring within five years of 2025. You could put your money in a 2025 target-date fund now, and the fund would automatically adjust its asset allocation as you get closer to retirement. Actually, the guiding principle of these funds is the same as the guiding principle of this book: to be the only product of its kind that is totally comprehensive and effective for your entire life. The difference is that this book does contain everything you need to know, but target-date funds aren’t the only fund you ever need to invest in.
As you get closer to retirement, the conventional wisdom says you should keep less and less of your money in stocks and more and more of it in fixed-income investments, meaning bonds. I can’t quibble with that advice in general, because bonds are much less risky than stocks, and as people get older they should shift their focus away from capital appreciation (remember that term: growing your money) and toward capital preservation (making sure you don’t lose your money while staying ahead of inflation). A target-date fund will reallocate your assets for you as you get closer to retirement, so if you put your money in one of these, it will automatically sell stocks and beef up on bonds to keep up with the conventional wisdom. You allegedly benefit, according to the people who promote these funds, because you don’t have to worry about making the switch yourself.
There’s so much buzz surrounding target-date funds as the ideal investment for inexperienced, incompetent, and indifferent investors that I feel I have a responsibility to warn you away from them. At the end of 2002, there were only forty-five of these funds, but there were 209 by the end of 2006. They are on the march, and if they haven’t invaded your 401(k) yet, the odds are good that they’ll invade it soon. If you’re auto-enrolled in your 401(k) there’s a good chance your money will end up invested in one of them. You don’t want that, and you need to correct it if it does happen to you.
Jim Cramer's Stay Mad for Life Page 9
