The worst aspect of target-date funds is how they’re advertised. The idea that a target-date fund is an easy, one-size-fits-all investment for people without much financial savvy, that it’s the only fund you’ll ever need, is deceptive and untrue. Packaged into this marketing ploy is the notion that if you put your money in a target-date fund, you won’t need to do any homework. You won’t need to think about your investments, you won’t need to worry about them, and you won’t need to actively manage them, because the target-date fund supposedly takes care of everything for you. Wrong, wrong, and wrong. Every investment requires homework, period. You need to do less research to own mutual funds or index funds than you do to own stocks, but you’re being completely reckless and irresponsible if you leave your money with someone and don’t spend at least one hour per week per investment—be it a stock or a fund—to check on the performance of your capital and decide whether you need to put it somewhere else. That’s no less true if you invest in a target-date fund that allegedly obviates the need for paying attention to your retirement capital. You still need to do the homework, if only for the basic reason that not all target-date funds are built the same way. For example, if you’re twenty years away from retirement and buy into the appropriate target-date fund, depending on who offers it, it could have anywhere from an 80-20 mix of stocks and bonds to a 50-50 mix of stocks and bonds. The whole point of these funds is that they’re supposed to have the right mix of equities and fixed income, but there’s a wide variety of mixes even for funds that are supposed to cater to people retiring at the same time. At the very least, if you want to invest in one of these funds, you have to figure out what the mix of stocks and bonds is and whether that’s the right mix for you. Since they aren’t all the same—far from it—you’re going to have to first learn what the mix is, and then keep track of your target-date fund to make sure that it continues to give you the right mix as you get older. Does that sound like a hassle-free, homework-free investment to you? It doesn’t sound like that to me, but the advocates of these funds seem to think otherwise. These target-date funds cause you to take your eye off the ball, and the companies that offer them make more money off of you. These one-size-fits-all solutions are good only for them, not for you. You’re not the same size as the next guy or the guy after that. You are your size, and target-date funds don’t address that. And worse, even if their funds fits you, it’s still overpriced and made of low-quality material, to keep extending the metaphor.
Then there’s the question of the mix. Though target-date funds vary wildly in terms of the mix of stocks and bonds they offer, it’s rare to find one that offers the right mix. I’m not the only guy making this point, but it’s right on the money: target-date funds are way, way too conservative. I have a more aggressive perspective on investing, even retirement investing, than most people in this business (I’ll go into more detail on that in another chapter), so take the numerous other critics as a sign that the average asset mix in target-date funds, and not yours truly, is wrong. Basically, these funds own too many bonds. If you’re aiming to retire in forty years—if you’re 25 and plan to retire at 65—there’s no reason for you to own bonds. At that age, you should be 100 percent in equities, meaning stocks, which time and again have proven to be the single best investment over any twenty-year stretch. Fixed-income securities are for older investors who are on the cusp of retirement and can’t afford to take serious risks with their capital. But if you invest in a target-date fund that’s tailored for those seeking to retire within five years of 2045, you’re going to own many bonds—anywhere from 8 percent to 15 percent of your investments will be in bonds. That’s no good.
In sum: target-date funds require as much maintenance homework as any other type of fund, despite how they’re pitched; they’re way too conservative; and to top it all off, their fees are way too high. You might disagree with me on the first two points; I think you’d be wrong, but at the end of the day, we’re talking opinions, not numbers. But the third point is irrefutable. The most recent data I’ve seen, from an article in Pensions and Investments by Susan Kelly on February 5, 2007, found that the expense ratio of the average target-date fund was 1.29 percent, but the expense ratio of the average fund offered in 401(k) plans is only .75 percent. That means if you put $1,000 into a target-date fund, they’ll take $12.90 in fees a year, while that same $1,000 in the average 401(k) fund would charge you only $7.50 a year. It may not look like much, but over time, with compounding, those extra fees really devour your capital. Let’s do the math. If you contribute $5,000 a year every year to your 401(k) and you put it into the average fund offered by 401(k) plans, assuming the returns for this fund average 10 percent every year, after thirty years you would end up with $809,918.07 after paying .75 percent in annual fees. If, however, you contributed to the target-date fund, where fees eat up 1.29 percent of your investment every year, and we assume that before fees this fund produced the same 10 percent return as the 401(k), then you will have only $723,456.06 when you hit retirement. It’s only slightly more than half a percentage point difference in fees, but over time it adds up to more than $86,000. You might not feel the little bite of the large fees every year when you have to pay them, but don’t try to tell me they don’t add up, because $86,000 is a lot of money.
So if you have been automatically enrolled in a 401(k) by your employer—something that will happen increasingly now that the Pension Protection Act of 2006 has kicked in—you still have to take control of your investment. If the 401(k) plan is invested in company stock and target-date funds, pull it out and reinvest that money in a superior fund so that you don’t end up with your money in bad investments.
Now you know how to avoid the worst, and the most common, 401(k) mistakes that have already done so much damage to so many people. It’s time to build up your retirement capital. Once you know what pitfalls to avoid, how can you get the most out of your 401(k)? I have four more rules that will help you become a successful 401(k) investor, not just someone who doesn’t make the worst mistakes everyone else makes.
Four Ways to Exploit Your 401(k) Plan
1. Set up your 401(k) so that every month you contribute one-twelfth of what you expect to contribute during the entire year. Whenever the stock market falls dramatically, double your investment the next time you’re allowed to contribute. With your typical 401(k) you don’t have much control over when you invest or how much you invest. You can rebalance your assets or change the amount of money you’re contributing every month with most plans, but only every three months at a sizable minority of plans. When you start your job and set up your 401(k), usually you’ll designate a percentage of your income that you want the company to withhold and contribute to your 401(k). Because most 401(k)s operate on a monthly schedule, your contributions are split up among all twelve months, and every month you automatically add the same amount of money as you did the month before into the same mix of funds. I’ll explain the thought behind this later in the book when I get into more detailed advice about investing, but the basic 401(k) rule is this: you should double down when the market (and when I say “the market” I’m talking about the S&P 500 or the Dow Jones Industrial Average) declines by 10 percent from the peak, the top, to what’s called the trough, or the bottom. It may not actually be the bottom; you’re just looking for a 10 percent decline. When you see that decline, you need to talk to your 401(k) administrator or whoever is charge of the plan for your company’s human resources department and tell them that you want to double down the next time you can contribute.
Look at it like this: in a whole year you expect to make twelve contributions, each one the same size, month after month. What I’ve always done is make a double-size contribution after a 10 percent decline in the market in order to take advantage of the weakness by spending more money than I usually would on stocks that have become especially cheap. So if we experience a 10 percent decline—or a 10 percent correction, as they call it in industry gibberish—in June,
then come the beginning of July you want to make sure you contribute not one-twelfth of your annual 401(k) contribution, but one-sixth of it. It’s true that if you catch the decline in December you’re not well poised to take advantage of it, but you can always contribute more money. Once you stop receiving the company match, however, there’s really no good reason to invest in a 401(k) if you haven’t yet contributed the maximum to your IRA.
2. Recognize that stocks are still king, and invest with the right mix of stocks and bonds, which means tilt heavily toward stocks. Even as you approach and enter retirement, your retirement fund should still have a healthy amount of stock exposure, about 30 percent to 40 percent. This is a pretty radical position; most of the people who give out retirement advice insist that in the years immediately preceding retirement, and certainly during retirement, you should completely or almost completely divest yourself of stocks. People who say you should have all of your retirement capital in fixed income by the time you retire simply refuse to acknowledge that for most people, relying 100 percent on bonds won’t be sufficient. We’re living longer than we used to thanks to modern medicine; that’s terrific from every perspective except that of your retirement fund, which needs more money to support you for a longer period of time. The best way to do that is by continuing to invest in stocks—not risky stocks, but large-cap, conservative, dividend-paying stocks. Only with a sizable chunk of your portfolio in equities or equity funds as you approach and reach retirement can you be sure you’ll have enough money to retire wealthy or even retire comfortably. Of course, if you have enough money in your retirement fund to support yourself for thirty years on bonds alone, then bonds alone it is. Most people won’t have that much, and I believe it’s better to play on the safe, responsible side by investing heavily in riskier securities with the upside you need, like stocks.
Your 401(k) portfolio does not need any bond exposure when you’re in your 20s, and I think that anything over 10 percent to 20 percent bonds when you are in your 30s is downright irresponsible. To get the right mix of stocks and bonds in your retirement account, increase this range by 10 percent with each decade. So in your 40s, a good allocation would be 20 percent to 30 percent bonds; in your 50s, we’re looking for 30 percent to 40 percent bonds; in your 60s, 40 percent to 50 percent bonds; and once you retire, no more than 60 percent to 70 percent bonds. This last is a bigger increase in bond allocation, but that’s because you don’t want to have to come out of retirement and start working again after taking big losses in stocks. I’m not just saying that you will make more money if you keep about one-third of your retirement fund in stocks after you stop working; I’m saying this is the responsible thing to do.
How can that be true? In what universe are stocks ever a more responsible investment than bonds? Here’s how I like to look at it: if you retire at 60, which is early for most people, and thus also more desirable, you need to plan to support yourself for the next thirty years. It’s true, you may not live to the age of 90, but remember, when we plan for the long term we always prepare for the worst, and in a perverse way, from a financial perspective “the worst” means living longer, because it’s more costly. It certainly won’t feel like the worst-case scenario if you’re lucky enough to live to be 90 years old, but when you’re saving for retirement at close to 60, you might feel it’s the worst that can happen because you’re so desperate to declare you’ve got enough money to retire, and every extra year you expect to live is more money you need to save.
Since I’m a conservative investor, I assume that everyone lives for thirty years after they retire, and my plan requires you to have wiggle room to be able to afford to live even longer. If you’re planning to support yourself without working for three decades, putting all of your retirement fund into bonds when you retire probably won’t take you far enough. Put two-thirds into bonds. Those two-thirds can pay for the first two decades of your retirement safely and securely. Then, to finance the third decade of retirement, because inflation should make your cost of living higher than it’s ever been before, you’ll want that last decade in stocks until you get a few years away from turning 80 or thereabouts. We leave this money in stocks longer simply because I want you to have more money. High-quality, dividend-paying stocks have been proven to be the best way to make money over any twenty-year stretch of time. Use bonds to pay for the first twenty years of retirement, but after that you can be almost certain that owning stocks will make you a lot more money without requiring you to take on that much more risk, because we’re looking at a twenty-year period, and over lengthier periods of time the risk of owning stocks diminishes.
3. Invest in index funds or the lowest-cost mutual funds offered by your 401(k) plan. This is the conventional wisdom on Wall Street, but it’s advice that most people fail to take. People always want to know which mutual fund will give them the best return, but it turns out that’s a bad question. Even before you add up the fees, actively managed funds fail to beat the market 80 percent to 90 percent of the time. That means that at least in your 401(k), you’re better off investing in an index fund with low costs that simply tries to mirror the performance of the entire market than in a mutual fund that tries to beat the market. I’ll explain the difference between actively and passively managed funds in greater depth in the next chapter. For now, let’s just say that an index fund has no head. It’s designed to follow a certain stock index, and that’s all it does. Aside from your annual fees, which should be substantially lower for an index fund than an actively managed fund, your index fund will simply track the performance of an important index like the S&P 500 or the Wilshire 5000 Total Market Index. An actively managed fund has professionals at the helm trying to beat these benchmark indexes. Some of them can do it consistently, and later I’ll talk about the best of these consistent winners. But for the most part, it’s fair to generalize and say that mutual funds seldom beat the market. Your 401(k) plan might offer a dozen different stock funds, but the odds of finding just one that can outperform a simple S&P 500 index fund two years in a row are slim. The odds of finding an actively managed stock fund that can beat an S&P 500 index three years in a row are even slimmer. And that’s not even taking into account the higher fees charged by actively managed funds.
You already know that a small difference in the fees that two different funds charge could add up to tens or even hundreds of thousands of dollars over thirty to forty years. It’s always important to pay close attention to the fees that any type of fund charges you, but it’s never more important than in your 401(k). Why? Because in a 401(k) plan, despite the fact that it’s supposed to let you manage your own money, the truth is that you don’t have very many choices. You’ll be offered only so many funds to invest in, and though most 401(k) plans offer at least one stock index fund, some don’t even do that.
In general, I advocate hunting down a mutual fund that can consistently beat the market, but there’s little point in doing that for your 401(k), because you can invest only in the offerings they give you. You could successfully convince your plan administrator to allow you to invest in a really great mutual fund, but often you’ll fail, no matter how persuasive you are and how many other employees agree with you. It’s rarely worth the effort. You’re not going to get to invest in the best funds in your 401(k), but that’s fine. A 401(k) plan is for the tax savings and the company match, and you can afford to invest in a less-than-perfect fund as long as those two things are going for you. Just remember to exercise the little control you have over your 401(k) by investing in index funds, and, if you have no index options, by finding the actively managed funds with the lowest fees.
4. Never mind what the so-called experts say: don’t contribute the maximum allowable amount of money to your 401(k) plan every year. You want to contribute the maximum amount of money that’s eligible for your employer match, but that shouldn’t come near the annual ceiling on tax-deferred 401(k) contributions. Starting in 2008, the maximum contribution is $16,000 a year. Cont
ributing that much money to your 401(k) is just nuts. Anyone who’s making enough money to comfortably contribute $16,000 a year to a 401(k) plan is what’s called a highly compensated employee, or HCE (which also stands for “hateful cultured elite” and “hostile class enemy”). If you make more than $100,000, you’re an HCE and there’s a different kind of limit on the amount you can contribute. In any given company, the amount HCEs can contribute is limited by the average percentage contribution of normal employees at the company. If regular employees on average contribute 3 percent of their income, an HCE will be allowed to contribute only 5 percent. In any company, HCEs can always contribute 2 percentage points more than the average employee, but no more than that.
For those making less than $100,000, what about that limit? If you make $90,000 and decide to contribute the maximum $16,000 in 2008 to your 401(k), you’ll be diverting 17.7 percent of your pretax income into the plan. Few people have enough control of their finances to actually pull that off. Remember, your retirement funds should make up only about half of your investments. It’s the most important half, but you have to leave room for your discretionary investments too, just in case you want to use your capital to pay for anything before you reach retirement age.
You can’t seriously consider maxing out your 401(k) contributions, because of the way the rules are set up. As soon as you exhaust the company match for the year, stop funding your 401(k). Why? Some of you might not like the idea of passing up the opportunity to save as much as you possibly can tax-free, but there’s a good reason not to. The only thing about a 401(k) plan that’s better than an individual retirement account is the employer match. As soon as the match runs out, your next step should be to fully fund your IRA. Your 401(k) plan probably has sky-high hidden fees, and it won’t let you actually manage your money. The fact that your 401(k) gives you a crummy menu of possible investments makes it a really bad place to invest. An IRA gives you the same tax savings as a 401(k), but you’re not limited to investing in the handful of offerings that your plan administrator has deemed worthwhile. With an IRA, you’ve got the whole market to choose from, and that makes a big difference. So contribute just enough money to your 401(k) to get the full company match, and not a penny more. Your next step is to max out your IRA. Starting in 2008, you’ll have a $5,000 cap on the amount of money you can invest in an IRA every year.
Jim Cramer's Stay Mad for Life Page 10
