New 401(k) plan fee disclosure requirements from the US Department of Labor are coming soon. This includes defined benefit, 401(k), 403(b), profit sharing, and other retirement plans. I was getting confused myself, so I wanted to summarize some of the basic deadlines. First, there are three main parties involved:

1. Plan service providers. For example Vanguard, Fidelity, or numerous smaller local providers.
2. Retirement plan fiduciaries. Basically, your employer.
3. Plan participant. The employee.

First, there is a new requirement for fee disclosure by service providers to the fiduciaries (i.e. from Fidelity to the employer). These regulations become effective on July 1, 2012. The idea is to get fiduciaries to understand the services received from providers and to determine the reasonableness of the costs incurred. You’d think that your employer would already demand to know what they’ve been paying for all these years. Why don’t they? All too often, you, the employee are the one paying for it out of your investment balances and earnings!

Which brings up the next stage, the fee disclosure requirement from plan fiduciaries to participants (i.e. from employer to employee), which becomes effective August 30, 2012. Now, your employer is legally required to tell you what fees you’re paying, including both investment management fees and administrative fees for things like record keeping, accounting, and legal services. However, this is likely be wrapped up into just an overall percentage for each investment option, or worded as dollars charged per $1,000 invested.

The basic problem remains. Employers choose 401k plans with high fees often because they it doesn’t affect their bottom line – most are smaller companies with plans that shift the cost burden onto the employees. However, by simply shining a brighter light on these fees and allowing easy comparison between employer plans, it lets employees have more information to affect change. Indeed, it appears this forced transparency is working already, as the WSJ reports:

Employers “have been polishing up their plans in anticipation of fee disclosure, making sure the fees are appropriate,” says David Wray, president of the Plan Sponsor Council of America. He says nearly two-thirds of 401(k) plans changed their investment lineup last year, and 57% did so the year before, compared with a “normal number” of about 10%.

More reading: Department of Labor, NY Times, Employee Benefits Law Report

What happens when you finally want to live off of your portfolio? Most withdrawal methods call for a combination of spending dividends and selling shares to cover the rest. But what if you wanted to live only off of dividends from your stocks and the interest from bonds? I was curious to see how this would have worked out historically.

Let’s say you had $100,000 invested in a mutual fund, and you had to live off the dividend income produced from those shares without any additional buying or selling. I found historical price data and dividend distributions for select funds from Yahoo Finance that went back to 1987-1990, and added up the trailing 12 months of dividends to see how much money they would have generated over a year’s time.

The Vanguard Wellesley Income Fund (VWINX) is a low-cost, actively-managed fund which has been around since 1970. It is composed of approximately 35% dividend-oriented stocks and 65% bonds (mostly corporate for higher yields). This conservative allocation is designed to create a steady income stream with less focus on capital appreciation. Let’s see how $100,000 invested in 1988 would have done in terms of income:

In 1988, interest rates were relatively high and $100,000 of Wellesley shares would have created nearly $9,000 of annual income. In 2012, that same set of shares would be worth $156,000 and your income would be about $5,400 annually. The income produced had some swings, but overall did not seem to track with inflation although the share price did better. According to the CPI, $100,000 in 1988 would buy as much stuff as $180,000 today.

The Vanguard 500 Index Fund was the first index fund available to the public and is now one of the largest funds in the world, passively following the S&P 500 index of large US companies since 1976 and thus always 100% stocks. Even though this is not a dividend-focused fund, it still does produce a regular stream of dividends from the companies it tracks:

In contrast, $100,000 of the Vanguard 500 Fund would have only created about $2,700 of income in 1988, but that income has grown over the next 24 years to about $8,800 today in 2012. Also of high significance is that the value of your $100,000 worth of shares from 1988 would be worth around $500,000 today.

This is just a limited snapshot of two funds, but it would suggest that you can’t just buy an income-oriented fund that has a large chunk of bonds and expect to sit back and spend whatever dividends are spit out. However, things would have turned out much better if one was reinvesting a big chunk of those Wellesley dividends when the overall yield was high. I can still envision a income-oriented portfolio, but I will have to set a reasonable withdrawal rate that isn’t too high and have the discipline to plow the rest back into buying more shares.

Just as theorized by a previously-mentioned academic paper about target funds, a new Bloomberg article talks about how some mutual fund providers like PIMCO and Invesco are now adding things like commodities futures, options, and currency swaps into these all-in-one funds. Will all these bells and whistles be worth the added cost? I doubt it, but differentiation is important in marketing. The article also included some interesting stats about these funds:

Investments in the [target date retirement] funds have swelled more than 380 percent since 2005 to about $343 billion as of September, according to the Investment Company Institute, a Washington- based trade group for the mutual-fund industry. […]

The majority, or 53 percent, of plan sponsors that automatically enroll participants in 401(k)s use target-date funds as the default investment, according to a 2011 report by the Plan Sponsor Council of America, a Chicago-based trade group.

There are more than 40 target-date mutual fund families employers may choose from and some sellers also offer them in collective trusts or customized versions, said Jeremy Stempien, director of investments for the retirement solutions group at Morningstar Investment Management. “We can see tremendous discrepancy, tremendous differences among asset managers,” said Harvard’s Pozen, who’s also a senior fellow at the Brookings Institution. “I don’t think most people understand what they’re getting.”

Fidelity, Vanguard and T. Rowe Price Group Inc. controlled about 75 percent of the target-date assets in 2011, according to Morningstar. The average fee for a target-date mutual fund last year was about 1.1 percent, according to Morningstar, which included all share classes and retirement years such as the 2030 or 2040 funds.

Fees for the funds at Pimco and Invesco averaged about 1.2 percent. Vanguard, which mainly uses three broad-market index funds in its series, had the lowest expenses at about 19 basis points, or 84 percent less than the more expensive funds. A basis point is 0.01 percentage point.

Vanguard reported yesterday that in 2011 about 64 percent of new enrollees in 401(k) plans administered by the company invested solely in a target-date fund. The Valley Forge, Pennsylvania-based firm managed about $100 billion in the funds as of Feb. 29, according to spokeswoman Linda Wolohan.

I don’t invest in any of these funds, but I keep track of them because they are where the industry is heading. I have recommended Vanguard Target Retirement 20XX funds to family members, but have adjusted the “date” to match their own situations.

If you have a 401(k) plan or similar, then you most likely have a target-date mutual fund (TDF) as the default option. This is a direct result of the Pension Protection Act of 2006 (PPA). These funds contain some mix of stocks and bonds, and the asset allocation changes according to a “glide path” as you reach your “target date” of retirement, and were designed as a stupid-proof, low-maintenance option for investors. But did this turn out to be a good thing or a bad thing?

The Freakonomics blog notes a new academic paper Heterogeneity in Target-Date Funds and the Pension Protection Act of 2006 [pdf] by Balduzzi and Reuter. Heterogeneity is just a fancy word for they tend to be very different from each other even though the yearly dating system can make them seem similar. For example, the WashingtonRock 2020 Fund could be completely different than the LincolnStone 2020 Fund. Why? Their theory is that because every 401(k) now would have a target date fund inside, then every fund provider would have to create a target date fund. However, you wouldn’t want your TDF to be the same as the other guys’ TDF, so you’d make yours slightly different, right?

Here is a glide path comparison done by State Farm showing the paths of the major providers Fidelity, Vanguard, and T. Rowe Price:

(click to enlarge)

[Read more…]

I took some time this weekend to check on my investment portfolio, including employer 401(k) plans, self-employed plans, IRAs, and taxable brokerage holdings.

Asset Allocation & Holdings

You can view my target asset allocation here, along with links to other model asset allocations. Despite the headlines, I still like to buy, hold, and rebalance primary in low-cost index funds. Here is my current asset allocation:

I continue to rebalance continuously with new cashflow. Everything looks okay; stocks have been on a pretty good run recently for whatever reason and bond yields are still kept low by central bank policy. My personal outlook for the world economy is still uneasy. My current ratio is about 75% stocks and 25% bonds, but my goal is to get closer to a 60% stocks and 40% bonds setup, the classic balanced fund ratio within the next 5-7 years.

The main change since last time is that I dropped the stock funds in my 401k plan and moved them all to my taxable accounts for tax-efficiency reasons. I needed for space for bonds. I also stopped buying shares of the stable value fund in my 401k because new purchases only earn 1.25% interest. Instead, I am buying the only other bond option which is the behemoth PIMCO Total Return (PTTRX) which has a relatively low 0.46% expense ratio due to it being an institutional share class. This fund is actively managed and includes various types of bonds, but since the portion is so low, I’m still classifying it under my short-term nominal bond asset class.

Stock Holdings
Vanguard Total Stock Market ETF (VTI)
Vanguard Small-Cap Value Index Fund (VISVX)
Vanguard FTSE All-World ex-US ETF (VEU)
Vanguard MSCI Emerging Markets ETF (VWO)
Vanguard REIT Index Fund (VGSIX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX)
PIMCO Total Return Institutional* (PTTRX)
Stable Value Fund* (3% & 1.8% yield on existing balances, no longer contributing)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities

* Denotes 401k holdings due to limited choice.

The overall expense ratio for this portfolio is in the neighborhood of .20% annually, or 20 basis points, which is much lower hurdle to overcome than the average mutual fund expense ratio of over 1% annually. This is all self-directed inside accounts held at Vanguard (IRAs, taxable), Fidelity (401k, Solo 401k), and a small retirement plan provider. I have some “play money” assets at other discount brokers that is invested in individual stocks, but the total is less than 2% of our net worth and not included here.

Goal Progress

Due to our goals to achieve financial independence early, I use a 3% theoretical safe withdrawal rate on my portfolio for the purposes of my tracking. This means that I expect every $100,000 that I save will provide me an inflation-adjusted $3,000 in expenses forever. However, in reality we will probably adjust our withdrawals based on our personal inflation, continuing income, and market returns.

With portfolio increases and additional contributions, at a 3% withdrawal rate our current portfolio would now cover 50% of our expected non-mortgage expenses. If you recall, I also plan to have the house paid off, and I will be making a lump sum payment shortly to bring our home equity past 50% as well. Hopefully as we cross the 50% hump, things will accelerate as portfolio growth will benefit from compounding returns and our mortgage balance will shrink faster from the opposite effect as more of our monthly payment goes towards principal as opposed to interest!

I recently started subscribing to Consumer Reports magazine again, and the February 2012 issue included an article about the major financial brokerage companies (subscription required, press release). The first part was an investigation about the big firms (ex. Citibank, Fidelity, Schwab, T. Rowe Price) and their pre-packaged investment plan advice, and the second part was a survey on the quality of service from discount brokerage firms (ex. E-Trade, Ameritrade, Scottrade).

Consumer Reports is always unique because they don’t take any advertisement money at all, and so they sent in their own staffers anonymously (by this I mean they didn’t disclose they were writing this article) and then had the resulting advice analyzed by independent financial planners. Here were my takeaway notes:

• Many firms will offer some level of “free advice” if you have a certain level of assets with them, usually $100,000+.
• Good news: In general, the free advice is okay, but not surprisingly it tends to be boilerplate stuff.
• Bad news: Most people you talk to won’t provide you fiduciary duty. Most of them avoided disclosing how they were paid, and one researcher got pitched a complicated variable annuity after just a brief initial consultation.

I think fiduciary duty is a big deal, as I see no point in paying even a penny for financial advice if they won’t even promise it is in your best interest. Just seems like common sense to me. I don’t think I would bother to take them up on this free advice unless they were fiduciaries.

Self-Service Brokerage Firm Reviews

The Consumer Reports survey revealed that readers were “very satisfied” with 10 of 13 major brokerages, but it also left out a lot of the cheaper guys like OptionsHouse ($3.95) and TradeKing ($4.95). They seem to run this survey every few years, so here are the publicly-available May 2009 ratings:

One new change was that they separated out the “full-service” brokerage firms like Ameriprise, Edward Jones, and Morgan Stanley. In comparing the remaining “discount/online” brokerage firms, it’s noteworthy that the top 4 stayed the same for both 2009 and 2012, although the order changed slightly:

• USAA Brokerage – $8.95 trades at basic tier. Also offer banking and insurance products, although insurance is limited to the military-affiliated. Good all-in-one choice for military-affiliated.
• Scottrade – $7 trades, limited free ETF trade list. Large physical branch network. Has more active-trader tools than others on this list.
• Vanguard Brokerage – $7 trades at basic tier, all Vanguard ETFs trade free. Best known for low-cost index mutual funds.
• Schwab – $8.95 trades, limited free ETF trade list. One of the original “discount” brokers, also expanding into banking.