I’m a stock. You’re a bond. Target-date retirement funds are a pain.

When it comes to retirement planning, sometimes simple, no-brainer concepts take a hell of a long time to catch on. Take “human capital,” for instance. The basic idea is this: Your wealth is not only made up of the cash, stocks and bonds in your portfolio but by your future earnings potential. worker-in-suit-by-steve-woods

So, a 24-year old might be concerned that he only has $10,000 saved for retirement, but can rest easy that he has another $3 million in potential earnings over the course of his career. A 66-year old with only $10,000 in savings would be a little more worried.

“No duh,” you might say.

But let’s take a slightly different scenario. In the first case, take a 35-year old advertising salesman, making $70,000 a year (Note: this is improbably high, but possible). He has $50,000 saved for retirement. His pay is good but unpredictable. Depending on factors outside of his control, like the economy, he might have a particularly good year followed by a string of dismal years.

Next, take a 35-year old tenured professor, making $70,000 a year. He also has $50,000 saved for retirement. As long as his college merely survives, he’ll always have a job and depending on the school’s policies, will always get a moderate pay increase until he retires. He’ll get to work as long as he’d like and can pretty accurately project his income for years and years out.

The ad guy’s earnings are “stock-like” – erratic with possible good and bad years. The professor’s earnings are more like a bond – steady and easily forecast.

Now which of these guys do you think can take more risk in his portfolio? To me, it seems pretty obvious that the ad salesman should save more now and keep more of that money in bonds just in case his earnings take a dive.

But surprisingly, that concept hasn’t really caught on in retirement planning until recently, with the writing of York University professor Moshe Milevsky’s Are You a Stock or a Bond?. To see an interview Money magazine recently conducted with Milevsky, click here.

In my mind, it’s yet another blow to the idea behind target-date retirement funds. The 35-year-old ad salesman might be better advised to get into the target-date retirement 2015 fund (as if he were retiring in his 40s) than to pick the 2040 fund.

And to all you mutual fund companies, I pose this question: Why not just call them what they are? Why not call it a 90% stock/10% bond fund (or 90/10 Fund, 70/30 Fund, etc.) and let the consumer know that he’s going to have to figure out for himself what his proper allocation is or get help?

That certainly beats oversimplifying the most important investment decisions a wannabe retiree will make.

For another post on target-date retirement funds, click here.

– Joe Light

How 10 minutes made me $500

I’m irrationally afraid of overdrawing on my checking account. It’s never happened before (cross your fingers), but I’ve read plenty enough about overdraft fees to make me blanch at the slightest possibility of going below $0. For that reason, I generally keep a $2,500 buffer in the account that I try to never dip below. My cashflow management is pretty solid. So I actually don’t think I’ve ever gone below $2,700. That money just sits there, in the off chance that I go on some sort of unpredicted spending spree or hit an emergency that’s so immediate that I can’t transfer money from my emergency savings account to my checking account in time. no-brainer

Just recently, I started thinking about how much keeping that $2,500 sitting there is costing me. As with most checking accounts, my good old Bank of America account gives zero interest. What would I earn if I simply shifted all but $500 of that money (remember, I’ve never even gone below $2,700) into a money market account?

According to Bankrate, the highest yielding money market account right now pays about 3%. So I’d make an extra $60 per year if I only kept a $500 buffer.

Sixty dollars is nothing to sniff at, and nothing to get excited about either. But that 3% figure, for an FDIC-insured money market account raised my eyebrows for another reason. A 3% yield is more than double what my uninsured money market fund from Vanguard is on pace to earn this year.

I keep a much larger chunk of money with Vanguard as an emergency fund. As a writer in a struggling industry, I felt it prudent to keep a year’s worth of living expenses (that’s a lot – I live in New York City) on hand in case I lose my job. Suffice it to say that a couple percentage point difference between the yield on my money market fund and that of a money market account is costing me several hundred dollars a year. That’s for me — a single, young person with no kids and a relatively low cost of living compared to my New York peers. I imagine the cost would be thousands for someone with a family. Yes, the yield on the money market account could go down and the yield on the money market fund could go up, but nothing’s stopping me from simply moving my money around again.

It’s never a good idea to “chase yield” with money you can’t afford to lose. Emergency fund cash certainly falls into that category. But when you’re choosing between already ultrasafe investments, like between a money market fund or an (even safer) insured money market account, there’s no reason to not pick the higher yielding account.

I’d extend the same advice to any of those thousands of investors sinking their investments into Treasury bonds. If you’re going to go the safe route anyway (and that’s a bad idea, by the way), why not just deposit it into an insured money market account, in case you change your mind? You’d have to lock up your money for 10 years to get a yield that’s as high as top performing money market accounts, and your money would be protected by the very same government that backs Treasury bonds.

You should also doublecheck to make sure you have no cash from dividends or matured bonds sitting uninvested in your brokerage account. Thankfully, I didn’t suffer from that problem. Some of those so-called “sweep” accounts have interest rates as low as 0.01%.

It pays to spend a few minutes each month finding the best paying places to park your cash. In my case, it’ll be about $500 a year depending on how interest rates move. That’s a no-brainer if I’ve ever seen one.

– Joe Light

Why your fund’s expense ratio is only half the story

I just got out of an interview with Ric Edelman, a financial advisor and asset manager. The conversation was wide ranging, but he pointed out a weakness in reported mutual fund expense ratios that I hadn’t thought about until now.

When we tell people to find funds with low fees, most often, we’re talking about a fund’s expense ratio. It’s that seemingly small percentage of assets that a mutual fund company takes out of your fund to pay for things like fund manager salaries, rent for their offices, and so on. Of course, over time, just one percentage point of difference in your return can make a huge difference. (See chart, and sorry about the color issue. Needless to say, the fund with the lower expense ratio is the higher line.)

Growth of $10,000. Assuming an 8% annual return.

Growth of $10,000. Assuming an 8% annual return.

Unfortunately, that expense ratio, found so easily in the prospectus and categorized at Morningstar, only represents a fund’s ongoing costs. It doesn’t include the transaction costs that can bring down a fund’s actual return. In something like an index fund which has low turnover, that cost will be negligible. But in an actively managed fund, in which a manager is buying and selling stocks all the time, Edelman says that the fund’s total expenses can sometimes be significantly higher.

Let’s take the Dryden International Value Fund, by way of example. I’m not trying to pick on them. I just noticed that their portfolio turnover rate last year was 27%. In other words, it switched out about one in every four stocks that it owned last year. In the past, the fund’s turnover has been much higher, hitting a pinnacle of 121% in 2005.

According to the fund’s prospectus (page 53), the no-load shares’ expense ratio is 1.31%.

But let’s see how much that 27% turnover cost them last year. In the fund’s “Statement of Additional Information” on page 86. You’ll see that the fund spent $156,431 in brokerage fees last year. According to Morningstar, the fund’s Net Asset Value right now is about $136 million. That means that investors paid an additional 0.11% for those transaction costs without knowing it.

I’m not saying that 0.11% is a lot, but it seems like that kind of off-the-top fee is exactly what investors think they’re getting in an expense ratio. And according to a study by a few researchers from Boston College and Virginia Tech, the trading costs of a fund can sometimes exceed that of the expense ratio.

It took me about 30 minutes to find that Statement of Additional Information and calculate the added cost. If it’s unreasonable to do that yourself, a reasonable proxy is to just look at the turnover rate, which is pretty easy to find in the prospectus. The higher the turnover, the more you’re likely paying in hidden broker fees. But besides that, you probably want a mutual fund manager who picks stocks for the long run anyway and doesn’t have to switch around a quarter of his portfolio every year.

– Joe Light

Shocker: Treasury bonds beat stocks in the long run

Back in 1994, a Wharton professor by the name of Jeremy Siegel published a book (called Stocks for the Long Run) that helped form the basis of investing advice for the next decade. The book’s well-known conclusion: Stocks have returned on average about 7% (after inflation) for the last 200 years. Investors were almost guaranteed to get a positive return if they held on for at least 20 years.

Wharton professor Jeremy Siegel

Wharton professor Jeremy Siegel

There’s been a lot written about the “lost decade” for stocks, in which the market’s return has been zero or negative. But a new study by Rob Arnott shows that stock returns have been even worse when compared to the returns of U.S. Treasury bonds. (4/21 update: The study has come out.)

The study is running in the Journal of Indexes in their May/June issue. So I can’t yet link to it and have been asked not to quote it verbatim. But its basic conclusion is this: Starting at any time from 1980 to 2009, an investor in 20-year Treasury bonds, who rolled over their income every year, beat the S&P 500. From January 1969 through the end of this January, such a bond investor would also come out ahead (albeit by a small margin).

If you go back to 1801, stocks did beat those bonds by an average 2.5 percentage points per year (which is huge). But the Treasury bonds beat stocks during three long periods — between 1803 and 1871, between 1929 and 1949, and between 1968 and 2009.

The implications of this are pretty massive. For the most part, Treasury bond investors don’t have to worry about dramatic volatility. Stock investors do. As a result, stocks are supposed to provide a “risk premium” of a couple percentage points to pay for that chance their investment could drop. In effect, Arnott’s saying that the risk premium hasn’t been there for the last four decades. You could have chosen the absolute safest investment known to man and performed better than the guys rolling the dice on the stock market.

What does this mean to you, an investor looking to the next 40 years? It does not mean to stick all your money into Treasury bonds. Just as investors were wrong to think the stock market would roll on forever in the late 90s and early 00s, it’d be wrong to think Treasuries will beat stocks from now on.

Instead, the study reminds me of all those retirement scenarios that planners love to run. “If you invest 60% in stocks and 40% in bonds,” the scenarios say, “you’ll have a 95% chance of not running out of money in retirement.” But that means you do have a 5% chance that those assumptions don’t come true. And is a 5% chance of not making it small or big? You only get one shot at retirement.

You can’t control the market’s performance. Your job, then, is to make that outside chance of something terrible happening as small as possible. How can you do that? For me, it means saving more. I’m sticking 20% of my income into stocks and bonds every paycheck instead of 10%. I’ll have to live frugally, but that beats not making ends meet. It might seem like a big sacrifice to bring my chances from, say, 95% to 98%. All those new retirees might have thought the same thing 40 years ago.

– Joe Light

Why do mutual funds get prizes for losing money?

The 2009 Lipper Awards for the best mutual funds of last year were given out last week. Here’s the list of winners. While one of my colleagues at Money Magazine finds it pretty ironic that awards were given to funds that actually lost money in 2009, it doesn’t really bother me. money-prize-by-taroslav-b

The Intrepid Small Cap fund, for example, lost 7.1% last year. That’s pretty bad, but it’s more than 25 percentage points better than the small cap category as a whole. The bottom line is that small caps were a bad class of stocks to be in last year. The best decision you could have made (though no one could have seen this at the time) was to avoid small caps altogether. But unless you’re in an actively managed balanced fund, that seems like the kind of decision you should have made, not the fund manager. If the small cap category returns a positive 20% this year, you’d better believe that investors would be mad as hell if their small cap fund manager had moved a lot of the fund’s money to cash because he thought there were dangers in the sector. (Ironic disclosure: Intrepid has 7.5% of its money in cash, which is actually quite a lot. I wonder if that cushioned their losses last year.)

To easily see how your mutual funds are allocating their money, check out Morningstar. Most features on the site are free but might require registration.

Another useful tool whose founders I recently spoke to is Mutual Decision. Take a gander at the “Active Share” tool which will show you how active your “active” mutual fund manager really is by comparing his investments to those of his benchmark. After all, there’s no reason to pay a manager 2% a year if he’s mostly just following an index. The site (which costs money but has a free trial) was founded by a few college professors at Georgetown and Rutgers. They basically take academic studies on mutual funds and develop tools that allow investors to apply those studies to their investments. Interesting stuff, but I’d stick to the free trial until its proven that using the tools can actually save you money.

– Joe Light

Keep a debt bomb from damaging your portfolio

Stocks have fallen 2% so far today. In the context of recent volatility, that’s not a big deal. What is a big deal is that executives at GM are apparently preparing to declare bankruptcy, a move that would affect hundreds of large and small companies that do business with the automaker. general-motors-gm-logo

GM has the typical profile of a bankruptcy candidate – a large amount of debt and not enough cash flow to make those debt payments. Investors will not be surprised if GM goes bankrupt without getting more government aid.

But what some investors might not appreciate in their own stock portfolios is that even their profitable companies might run into serious trouble as long as the credit markets stay tight. In the past, if a company had a few hundred million dollars worth of bonds maturing, instead of having to write a gigantic check at once, the company would simply issue new bonds to refinance the debt. But now, both large and small companies have found it extremely difficult to “roll over” (i.e. refinance) their bonds when they mature.

Value investor Ed Maran, a portfolio manager with Thornburg Funds, told me that he checks the debt schedule of the companies he owns to make sure they don’t have large amounts of debt maturing in the next three years. If they do, they’d better have enough cash on hand to pay that debt off. Otherwise, even a company that shows a healthy profit on their income statement can be forced into bankruptcy.

If you want to see when your own stocks’ debt matures, go to the company’s annual or quarterly report and look in the footnotes of the balance sheet. I’ll have more on the subject in this month’s issue of Money Magazine.

– Joe Light

“Investing is no longer child’s play”

Bill Gross, PIMCO’s chief investment officer, published his monthly investment outlook a few days ago. PIMCO is one of the largest bond fund managers in the world, and Gross’ newsletters are widely read and respected.

PIMCO's Bill Gross

PIMCO's Bill Gross

This month, Gross made a point that all investors should heed — especially those like me who have basically spent their entire lives traveling from one asset bubble or another:

Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks…In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return.

That emphasis was Gross’ by the way (He underlined it. I bolded it.).

It’s not hard to derive what this means for me and you, if you believe what he’s saying. Stocks’ historical 8% annual return? Meaningless. The “latte factor”? Dead. (Though, one could argue that David Bach’s gross oversimplification of the benefits of compound interest was misleading in the first place.) In other words, the core assumption that personal finance advice has relied on – whether it be from writers or financial planners – could just be plain wrong.

In retrospect, there’s no question that we’ve relied too much on a simple trendline to predict how stocks will perform over long periods of time. As one of my colleagues, Pat Regnier, put it a few months ago, you wouldn’t expect Microsoft to experience the same growth over the next 20 years as it did over the last 20, so why would you expect the U.S. stock market to keep performing as it has in the past?

So what could this new landscape look like? Gross believes investors will place a renewed value on earnings that reach their pockets, like dividends and bond payments. An investor would rather that his share of Microsoft send him a $2 dividend than hope that the share would increase $2 (or maybe even $3) in value. As such, there might be a renewed emphasis on companies with high dividend payments, and until stock dividend yields catch up with bond yields, bonds could be the preferred investment.

In short, investors’ wealth will only increase as fast as actual earnings increase. No more easy rides on speculative bull markets. “There should be no doubt that the bull markets as we’ve known them are over and that the revolution is on,” Gross writes. “Investing is no longer child’s play.”

– Joe Light

Do Target-date retirement funds work? (Interview with Principal Funds)

Target-date retirement mutual funds have become hugely popular over the last five years. retiree-photo-by-ginny-austinThe concept is simple: Instead of having to constantly adjust your asset allocation between stocks and bonds as you grow older, you invest in one fund that does it for you. Invest in the Company X Target-Retirement 2020 fund this year, for example, and they might have you allocated 60% in stocks and 40% in bonds. Ten years from now, when you’re only a year from retirement, the fund might have automatically moved your money into a more conservative 50%-50% mix. It’s an easy, set-it-and-forget-it alternative to having to rebalance and reallocate your portfolio every year on your own.

Sounds good, right? Well last year, retirees found out why these funds aren’t no-brainers after all. Vanguard’s Target-Retirement 2010 fund dropped 20% in 2008. That’s quite a hit for someone who’s starting to withdraw money. According to a T Rowe Price study, if the market returns 0% to 5% in your first 5 years of retirement rather than the higher market-average, your chances of running out of money in retirement double. Unless those funds show a really strong upswing soon, holders of retirement income funds might be in serious trouble.

I interviewed David Reichart, the head of business development for Principal Funds, about the issue earlier this week. Principal’s 2010 fund dropped 31% last year. Here’s an excerpt:

Joe: Do you feel like the fund was allocated too aggressively? What went wrong?
David: You can point to a lot of sources for the negative returns, but the lion’s share just came from pure equity exposure. If you look at your equity exposure as you near retirement…let’s say you had 50% in equities. Somebody might say “Well, gee, how can you afford to have that much in the market because it may go down 40% or 50%? No wonder you were down 30%.” But people should understand that when you talk that way, you’re only talking about market risk. The biggest risk for a retiree entering retirement is longevity risk — the prospect of outliving your wealth. You’re going to run out of money if you don’t have equity exposure.

David’s point is a good one. If a retiree panicked and put all of his money in Treasury bonds right now, his money might only gain 2% a year. Depending on how much he’s saved up, while his portfolio won’t go down, he might be nearly guaranteed to run out of money before he dies.

But target-date retirement funds don’t capture the whole picture. Let’s say you’re retiring at 66 years old, need a retirement income of $40,000 a year (in addition to Social Security and inflation adjustments), and have $1,000,000 in savings. That person might very well need stock-like returns to not run out of money.

But what if a similar 66-year old lived frugally, and had saved up $4 million instead? If he still just draws down $40,000 a year, he won’t need the same level of returns as the first guy. So, to protect himself from the remote possibility that the market has a massive heart attack (as it did last year), he might only put a small fraction of his money in stocks.

Target-date retirement funds treat everyone the same. And as a result, they don’t give those super-savers the chance to whittle their risk down to the level that they’ve earned by penny pinching before they retired. They’re still better than not asset allocating at all, but they’re probably a little oversold as the end-all and be-all of mutual funds.

Update: For a more recent post on target-date retirement funds, click here.

– Joe Light

Update: Market now down for same reason it was up

I’ll have a real post coming later (on a different topic, I promise), but for anyone who missed the news this morning, the stock market was up nearly 3% in the first 15 minutes of trading because the dismal job report fell in line with expectations. About five minutes later, the market gave up all of its gains (as of this writing, it’s down about 0.5%). The reason given? That “it’s hard to put a positive spin on continued job losses.” In other words, the market is now down half a percent for the same reason it was up 3% minutes before. Yes, the stories came from the same news outlet, and no, I did not have the foresight to get a screen grab.

Insanity.

– Joe Light

The market went up today because…

The S&P 500 went up nearly 3% today, and the Dow crossed the 8,000 mark for the first time since February. Most every news outlet is attributing the rise to a change in mark-to-market accounting rules that lessen the burden of write-downs on banks. why-did-the-market-move

While I’m sure the change of the accounting rule might have helped, does anyone really know why the market moved up 3%? Shares of Time Warner, the company that owns the magazine I work for, rose FIVE percent today. That’s versus less than 0.25% for JP Morgan Chase, about 2.7% for Bank of America, and about 4% for Goldman Sachs. Does anyone think that a change in the accounting rules helped Time Warner more than it helped those companies? In fact, if the market’s huge move was due to that accounting rules change, why did some banks’ gains fall under the S&P’s gains?

The point here isn’t to rag on overworked reporters. It’s more to rag on the idea of being able to attribute a stock market move to any one event. Ok, sometimes an uber-event like the bankruptcy of Lehman Bros. is the clear driver of the market’s direction. But most days, trying to find a reason for a daily move is silly. In an interview with the Nieman Journalism Lab, NPR correspondent Adam Davidson says that business journalism needs to lose what he calls the authoritative voice of God:

So, the voice — I feel like the voice of business journalism is sort of, it’s an authoritative voice of God. “Today, the stock market rose 3.8% on news of unemployment rising and anticipation of the Fed cutting its interest rates.” And, you know, I know before I was a business journalist, as a consumer, I didn’t know much about business, and there’s a guy in a suit, who seems like he knows what he’s talking about, and he’s saying things with a very strong, authoritative voice, and what this crisis taught us is all those people were missing the most fundamental things…I mean, I think it’s a more trustworthy journalism if the journalist reveals their process of discovery. I don’t think it weakens our authority. I think it strengthens our authority ’cause it’s closer to the actual truth…They know we don’t, we’re not experts in that sense, and frankly, the expert we quote isn’t an expert in that sense — that he’s definitely right, or he can speak with objective truth about things.

But don’t worry, reporters (myself included) will continue to try to pin easy-to-digest motives for every one or two percentage point increase in the market. If we don’t have anything, we’ll resort to my personal favorite catch-all: “profit taking”.

– Joe Light