Vanguard’s New Self-Employed 401(k) Plan – Roth Option Included

Posted on November 16, 2008 // 22 Comments

Vanguard has recently announced the details of their Individual 401(k) plan – otherwise known as Solo 401k or Self-Employed 401k. Although you can’t apply yet it seems, many of us passive investors have been waiting for Vanguard to offer this for a long time.

The Vanguard® Individual 401(k) plan is a retirement plan for self-employed individuals. This plan is available only to sole proprietors or partners in business who have no common-law employees. The only other participant allowed in this plan would be a spouse of the business owner if he or she works for the business. Business owners should not establish this plan if they have common-law employees, including their children.

There is some confusion as to whether this includes the sole owners of an S-Corporation, but I’m betting it does as it is a passthrough entity and we are essentially self-employed. Here are some more Vanguard-specific details, along with some comparison with the Fidelity Self-Employed 401(k) which I currently have:

  • Seems like you can buy any Vanguard fund with no commissions, and there is “no minimum initial investment required to open most funds” (emphasis mine). It doesn’t seem like you have the option to buy ETFs through their brokerage service. At Fidelity, the Fidelity funds are also free, but I am subject to minimum initial investments. However, I do have the ability to buy any ETF with a $12-$20 commission, as well as buy individual bonds.
  • The Vanguard Individual 401(k) will accept three types of employer and employee contribution sources: individual employee salary deferral contributions (pre-tax money), traditional employer contributions (pre-tax money), and Roth salary deferral contributions (post-tax money). Roth is available! Fidelity does not have this.
  • Employees can move money between different Vanguard funds by phone or in writing only. This is kind of a pain. I can manage my Fidelity Self-Employed 401(k) online like a regular brokerage account, with limit trades and everything.
  • There are no set-up fees charged to the employer for a Vanguard Individual 401(k) plan. Vanguard charges employees a $20 annual account service fee for each mutual fund held in an account within the Vanguard Individual 401(k). If you like to own multipole funds, that can add up quickly! (Note: If at least one participant in a Vanguard Individual 401(k) plan qualifies for Flagship™, Voyager Select™, or Voyager™ Services, the account service fee will be waived for all participants in the plan.) Fidelity has no setup fees, and no annual account fees at all.
  • Rollovers are permitted out of the Vanguard Individual 401(k), but not into it. Not sure why this is the case.

This is only a superficial review, but so far I’m not planning to try and open one. It turns out that I am quite happy with my Fidelity Solo 401k, as it provides a lot of flexibility, great customer service, and reasonable costs. Vanguard has a wider array of index funds, but I can also buy the equivalent Vanguard ETFs at Fidelity. If I buy in large enough chunks, the commission is balanced out by the lower annual expense ratios. Besides, if you are at not at least Voyager ($50k in assets), the $20 fee per fund from Vanguard costs as much as two trades anyway.

The main thing going for Vanguard is the Roth option, which I must admit should be very attractive for most people. But for us, our current tax bracket is high enough that I prefer pre-tax contributions.

Via Guzzo the Contrarian and Bogleheads.

Filed Under: Investing, Retirement //

Shorter Full-Retirement vs. Longer Semi-Retirement?

Posted on November 11, 2008 // 38 Comments

Which would you rather do:

A) Work 40 hours/week for 15 years, and then not work at all for the next 15 years, or

B) Work 20 hours/week for 30 years?

If you were to ask me a few years ago, I would have picked A. Now, I’d much rather have B. Of course, it’s not as simple as just picking one or the other. Some sample considerations:

  • At most jobs, you can’t simply decide to work less hours and get pro-rated pay. A job change or some clever negotiations with management might be necessary. Self-employment may be better suited to option B.
  • Even if you can work half-time, often you lose your healthcare benefits. This might be reasonable if you are single, but for a family with kids the costs can be pretty high. Might need to investigate alternative ways to get group coverage (professional association, creating your own small business insurance group).
  • For option B, you have less money coming early on, but you have more time for compound interest to occur before taking withdrawals. The opposite is true for option A – more money upfront, but you’ll need to start spending sooner.
  • The (historically) optimal investing asset allocation might be different for both situations.
  • With option B, depending on timing and desire, you would have more ability to spend time with your children when they are young. Is time upfront worth more than time later? Quite possibly.
  • I think it would be hard for me not to work at all. For one, there is the stress of trying to live off a finite amount of money. Second, one would need to find another purpose in life to fill all the hours. Others might find it really easy…
  • Option A gives you a bit of leeway if investment returns don’t pan out as you’d like. Maybe you’ll work a bit longer than 15 years. Trying to make up lost savings when you are older may be more difficult (ageism) and/or tiresome (just age).
  • Lower annual income with option B might leave you with lower overall tax hit.
  • Behaviorally and psychologically, it may be easier to spend less if you force yourself to make less.

I need a better name than “semi-retirement”. Downshifting? Half-retirement? Half-working? Working 9-1?

Filed Under: Retirement //

Got Enough To Retire? Frugal Spenders Just Might

Posted on October 30, 2008 // 18 Comments

In a CNN Money article titled “Got enough to retire? Think again”, I actually found the opposite.

The main point of the article is that you may need to replace a lot more than just 70-80% of your pre-retirement income after you stop working.
Here’s the chart of average replacement rates from an Aon study:

However, I am agreeing with the authors of Spend Til The End on this one – using replacement rates and averages for this sort of thing is dangerous. One should always look at their own unique situation. It’s you, isn’t it? For example, I don’t see why a household earning $100k or even $500k a year can’t get by on spending $40k per year, especially if their mortgage is paid off.

But after looking at the chart some more, something else caught my eye.

Let’s just say that your spending in retirement requires income of $40,000 per year. This is the same as assumed for a household earning $50,000 pre-retirement according to the study. Even though we earn more than that, I know that we can easily run on $40k per year outside of housing costs.

The graphic suggest that 50% of that, or $25,000 per year, will be covered by Social Security. That only leaves $15,000 per year to be covered by your pension or investment portfolio. Assuming no pension and a 4% withdrawal rate, that means you would need a nest egg of $375,000 in today’s dollars. That is much less than the multi-million dollar figures usually being thrown around.

Now, how much would you need to save to get that $375k? If you save $5,000 inflation-adjusted dollars per year, and they earn a 4% annual real (above inflation) return, every year for 35 years – you’d end up with a little over $380,000. In essence, you’d just have to max out your Roth IRA each year and call it a day. (The contribution limit is $5,000 this year, but the cap rises with inflation.)

Of course, this is all rough numbers and you’ll still have to work until the full Social Security retirement age. Most young people like myself are skeptical of Social Security, but I have come to believe that SS will be with us for a long time – it is just too critical a piece of the retirement puzzle for much of America. And hey, the solution to any underfunding – as always – is simple: tax the high-income earners more!

Filed Under: Retirement //

Exploring Consumption Smoothing: An Alternative Path To Retirement Planning

Posted on October 22, 2008 // 11 Comments

I just finished reading the book Spend ‘Til the End: The Revolutionary Guide to Raising Your Living Standard–Today and When You Retire by Burns and Kotlikoff. One of the main themes of the book is consumption smoothing, which is an economic theory where the primary goal of financial planning is to avoid abrupt changes in one’s standard of living.

This can actually be a very controversial goal, because it may ask you to borrow money or even stop saving at times, in order to maintain a constant standard of living. Here is an illustration of this idea taken from the website for ESPlanner, which is a financial planning software package made by Kotlikoff.

Note that consumption smoothing can be very different from what other traditional methods propose. For example, one traditional goal is to replace 75-100% of your current income in retirement. Another generic rule of thumb (which they call “rules of dumb”) might be to simply save 10-15% of your annual income. The authors argue that these one-size-fits-all approaches can greatly overestimate or underestimate the amount of saving one’s family needs to do, leading to the dreaded “standard of living disruption”:

As far as they are concerned, both scenarios are equally bad. Undersavers might die broke. Oversavers are misers and compared to the mentally insane.

Replacement Rates Are Stupid, But Is Smoothing Better?
Now, I would agree that those 5-minute retirement calculators like Fidelity’s MyPlan Calculator or T. Rowe Price’s Retirement Income Calculator can be really off.

For example, Fidelity’s calculator assumes I will need 85% of my pre-retirement income in retirement. But what if my kids are grown up and we’ve already paid for college tuition? What if our house is paid off? What if it isn’t? All these things change what income we need. Look at us – I’ve already calculated that our total non-housing expenses are around $30,000 year – this is less than 15% of our current combined income. An 85% replacement rate would inflate our nest egg target by millions of dollars!!

So yes, inflexible replacement rates are stupid, but I don’t know if consumption smoothing is that much better. I would use ESPlanner, but it costs $200. It is plugged so much in the book that I feel like book buyers should have gotten a free 30-day trial at least to play with it. But I’m betting that even with the smoothing approach, the software will simply say something like “you can maintain a maximum spending standard of $80,000 every year.” Still much more than I need to spend to be content.

I would rather have each household try to estimate their own spending needs from the ground up, and not just spend what some software program tells you to spend. What makes you happy? What are your priorities? What is enough? Then, find a way to create that income.

Predicting The Future
Here’s the problem with all these future calculators. Any time you extrapolate 30 years into the future, any slight change in inputs can throw things way off. Let’s say you think your investments will average 8% returns annually. What happens if it’s only 6%? You estimate inflation at 3%. What if it’s 4%? What if you are 60% stocks/40% bonds, nearing retirement, and your stocks drop 40% in less than a year (*ahem*)? Finally – what about jobs? People switch jobs, careers, geographic locations. Income isn’t so predictable either.

With all this uncertainty, having a calculator tell me I can spend $68,644.55 this year and every year after that just doesn’t seem right.

I don’t know about you, but I see running out of money as a lot worse than ending up with too much. Accordingly, I simply view retirement (financial independence, whatever) as a goal to be reached as soon as possible, while still enjoying life along the way.

Positive Consumption Slope?
Just a thought, but I don’t know if I would want a constant standard of living anyway. I would rather having a slowly improving standard of living, so that life is (supposedly) getting a little better as I go.

Still, consumption smoothing is an neat concept, and the book goes on to extend it into a number of other interesting examples. More to come…

Filed Under: Frugal Living, Retirement //

Portfolio Changes: Buying More TIPS Inflation-Protected Bonds

Posted on October 19, 2008 // 13 Comments

This past week, I made some minor tweaks to my investments. No, I didn’t go all cash! Previously, I had set the bond portion of my portfolio to be 50% short-term Treasury bonds and 50% Treasury inflation-protected bonds (TIPS). I use the mutual funds VFISX and VIPSX. However, this week I shifted my allocation to be 25% short-term Treasury bonds and 75% Treasury inflation-protected bonds (TIPS).

Comparing Yields to Find Expected Inflation
You can compare the nominal yield of the Treasury bonds and the real yield of TIPS and find the implicit expected inflation. For example, if a 20-year Treasury bond yields 5%, and TIPS yield 2% real, then the expected inflation is the difference, or 3%. (If inflation is 3%, then the nominal yield of TIPS becomes 2% + 3% = 5%.)

This week, the expected inflation over the next 10 years has been hovering around 1%, some of the lowest in a long time. On Monday, the 10-year Treasury yield was 4.08% and the TIPS real yield was 3.05% (source: US Treasury), for an expected inflation of 1.03%. As of Friday, the gap was 1.02%. For the 20-year bonds, the gap predicted inflation of a about 1.6-1.8%. If the actual inflation rate turns out to be greater than these values, then holding TIPS will result in a higher yield over time.

Here is a chart of annual CPI-U changes over time (source: BLS.gov). The red line is the 10-year moving average:

Yes, there are deflation worries in the near future, but you can see the only decade that inflation has averaged below 1% was during the Great Depression. Not only that, but our currency was still on the gold standard then.

Currently High Real Yields
As mentioned earlier, the current real yields offered by TIPS of around 3% are also the highest in many years:

Since real yields are rising, the value of existing TIPS have actually dropped. So I’m buying low. 🙂 If real yields rise any higher, I’d buy even more.

Making The Change
There are many things to consider out out there, like global demand and the infamous $700 Billion bailout package (where do you think this money comes from?), but I only see more spending and borrowing down the road. With the printing presses available to go full blast, and lots of future promises made, I just can’t see inflation being this low for a decade.

Combine this with the fact that TIPS have a historically high real yield, it would seem like the market is overreacting. Although I usually don’t make such changes, I decided to go for it. So far, I have chosen not to go with 100% TIPS because I wanted to maintain some of the benefits of short-term treasuries, like lower volatility and low correlations with other assets. It’s kind of tough though, as the yields are horribly low right now due to the flight-to-quality.

I haven’t increased the target amount of total bonds in my portfolio, although due to the current drift and limitations due to juggling separate accounts, they are now 18% instead of 15%. I still believe in stocks as well due to their low valuations, and have also made equities purchases this week to re-balance that side of my portfolio. I am expecting to invest another $10,000+ before the year ends.

Filed Under: Investing, Retirement //

October 2008 Financial Status / Net Worth Update

Posted on October 6, 2008 // 33 Comments
Net Worth Chart 2008

Credit Card Debt
If you’re a new reader, let me start out as usual by explaining the credit card debt. I’m actually taking money from 0% APR balance transfer offers and instead of spending it, I am placing it in high-yield savings accounts that actually earn 3-4% interest or more, and keeping the difference as profit. Along with other deals that I blog about, this helps me earn extra side income of thousands of dollars a year. Recently I put together a series of step-by-step posts on how I do this. Please check it out first if you have any questions. This is why, although I have the ability to pay the credit card balances off, I choose not to.

Retirement and Brokerage accounts
Whew! Ignoring new investments, the value of my holdings lost nearly $12,000. I won’t go into why, I think most people have heard the overall reasons. I did a portfolio update in mid-September to better understand what happened specifically. Accordingly, I am directing future contributions as I can to help rebalance my portfolio back towards the target asset allocations (mainly international developed and emerging markets stocks).

I did make an $5,000 contribution to my self-employed 401k, although I am still left in negative territory for the month. I do hope to contribute at least the $15,500 maximum salary deferral in 2008, as this has been my only contribution so far this year. My wife has already maxed out her 401(k).

Cash Savings and Emergency Funds
Last month, we achieved our mid-term goal of six months of expenses ($30,000) in net cash put aside for emergencies. Once my retirement accounts are funded, I may try to increase this cushion. An alternate reason for increasing cash is for potential real estate opportunities (way) down the road.

Home Mortgage
Another ~$500 of loan principal paid off. According to Zillow, the estimate of the value of my house is still higher than what I originally paid for it, but has also dropped 3% in the last month alone.

Big Expenses
We are taking a trip to Spain in November, which will cost us about $1,000 each. I wrote earlier about how we tried to save money on travel and how we manage cash and credit cards abroad. The airfare has already been paid for (charged on the credit cards to earn rewards, of course).

Basically, I still consider myself doing well, but I guess it is hard to avoid what everyone else is experiencing. Shrinking 401(k). Dropping house value. Rumors of potential layoffs for part-time employees at work (who’s next?). Lots of red in my net worth chart. 🙁 Fun times, eh?

You can see our previous net worth updates here.

Filed Under: Goals, Investing, Retirement //

Planning For Early Retirement Makes Me Happy

Posted on October 3, 2008 // 15 Comments

In a recent issue of Money magazine, Walter Updegrave shared the results of a recent survey by insurer Northwestern Mutual and health education company LLuminari. It showed that people who perform financial planning tend to feel happier than those who don’t. The article is also online here – Save for tomorrow, be happy today.

You have to be a little careful in reading the diagram provided, and realize that there are separate components going on (the colors help):

Economists, psychologists and others who study happiness find that people who have a sense of control over their lives cope better with stress and live more happily, while those who feel powerless are more likely to be depressed.

Now correlation doesn’t necessarily mean causation. It could be that those who are happy are more likely to budget. But in general, I agree that consciously choosing how I spend and invest my money makes me feel in control of my future, which makes me happy. Realizing the abundance of choices and alternatives out there is one of the best things I’ve learned from blogging.

(It also helps keep my mind off of all the things I can’t control, like a bailout bill with $150 billion of pork attached. Wooden arrows? Nascar race tracks? How is this related at all???)

Filed Under: Retirement //

September 2008 Investment Portfolio Update

Posted on September 18, 2008 // 24 Comments

Given recent events, I suppose I should take a look at how my investments are doing. I am also planning to make some large-ish 401k contributions and need to figure out which asset classes to buy in order to rebalance my portfolio.

9/08 Portfolio Breakdown
 
Retirement Portfolio Actual Target
Asset Class / Fund % %
Broad US Stock Market 38.8% 34%
VTSMX – Vanguard Total Stock Market Index Fund
DISFX – Diversified Stock Index Institutional Fund*
DODGX – Dodge & Cox Stock Fund*
US Small-Cap Value 9% 8.5%
VISVX – Vanguard Small Cap Value Index Fund
Real Estate (REITs) 8.4% 8.5%
VGSIX – Vanguard REIT Index Fund
Broad International Developed 21% 25.5%
FSIIX – Fidelity Spartan International Index Fund*
VDMIX – Vanguard Developed Markets Index Fund
International Emerging Markets 6.5% 8.5%
VEIEX – Vanguard Emerging Markets Stock Index Fund
Bonds – Short-Term 9% 7.5%
VFISX – Vanguard Short-Term Treasury Fund
Bonds – Inflation-Indexed 8% 8.5%
VIPSX – Vanguard Inflation-Protected Securities Fund
Total Portfolio Value $105,654
 

* denotes 401(k) holding given limited investment options

Contribution Details
Throughout 2008, my wife has been making regular salary deferrals to her 401k, and has recently reached the annual $15,500 limit. I plan to start contributing to my Self-Employed 401k plan shortly.

YTD Performance
The 2008 year-to-date time-weighted performance of my personal portfolio is -27.9% as of 9/18/08. In fact, despite sizable additional contributions, my portfolio is down over $10,000 since my last update in April. Today might have been a bad day to run these numbers… 🙂

Although not necessarily a benchmark, the Vanguard S&P 500 Fund has returned -20.07% YTD, their FTSE All World Ex-US fund has returned –29.74% YTD, and their Total Bond Index fund is up 2.71% YTD as of 9/18/08. (My emerging markets fund is down nearly 40%!)

Rebalancing Details
First of all, I am not changing my asset allocation or moving into safer investments. In fact, I am doing the exact opposite and buying what has been dropping the most…

I am still following the general asset allocation plan outlined here, with a 85% stocks/15% bonds split [115-Age]. Here is an example of how we implemented the asset allocation across multiple accounts, although I’ve since moved some funds around.

So, it looks like I need to buy more Emerging Market and Broad International. I am now a bit overweight in Bonds and Broad US, so I need to sell those. Due to the limited index fund choices in my Fidelity Solo 401k account, I may start buying ETFs if I can justify the $10.95 commissions.

You can view all my previous portfolio snapshots here.

Filed Under: Investing, Retirement //

September 2008 Financial Status / Net Worth Update

Posted on September 8, 2008 // 24 Comments

Finally got around to adding up the numbers for the last month:

Net Worth Chart July 2008

Credit Card Debt
If you’re a new reader, let me start out as usual by explaining the credit card debt. I’m actually taking money from 0% APR balance transfer offers and instead of spending it, I am placing it in high-yield savings accounts that actually earn 3-4% interest or more, and keeping the difference as profit. Along with other deals that I blog about, this helps me earn extra side income of thousands of dollars a year. Recently I put together a series of step-by-step posts on how I do this. Please check it out first if you have any questions. This is why, although I have the ability to pay the credit card balances off, I choose not to.

Retirement and Brokerage accounts
The bad news is that the market value of our investments went down over $3,500. And this is despite my wife being able to finally max out her 401k for 2008 (total of $15,500 as of this month). At least I don’t own much Fannie Mae stock…

The good news is that I am finally ready to make some big contributions to my Fidelity Self-Employed 401k, at the same time that the markets are near their 2008 lows. Buy low, sell high! Why now? I like to wait because my income fluctuates and this way I have a clearer idea of what my contribution limits will be, as they are based on gross income.

Cash Savings and Emergency Funds
Our mid-term goal was to have six months of expenses ($30,000) in net cash put aside for emergencies. This is now done. As mentioned, future cashflow will be put towards retirement accounts. Speaking of emergencies, with all these hurricanes, I have been checking out portable generators as well.

Home Mortgage
Another ~$500 of loan principal paid off. Housing prices are still dropping in my area. I will probably have to adjust my home value estimate in the future, a short-term goal might be to pick a simple benchmark to follow. After a few other financial priorities are taken care of, perhaps I’ll start a DIY biweekly mortgage plan.

We had some visitors and took a tiny bit of vacation this month, so it was a nice end to the summer. You can see our previous net worth updates here.

Filed Under: Goals, Retirement //

Helping Mom Transfer Old 401(k) To Vanguard IRA

Posted on August 27, 2008 // 20 Comments

My mom is trying to organize and simplify her financial accounts, which I applaud. A major part of this is to finally move her orphaned 401(k)s and IRAs into one location. I recommended Vanguard, since that’s where all my IRAs are. She was okay with sticking with low-cost and passive index funds, which is Vanguard’s specialty. They are also known to be investor-oriented and have high client loyalty.

If you intend to buy individual stocks or ETFs, I wouldn’t go with Vanguard Brokerage Services because they are relatively expensive. Open an account elsewhere – check out Zecco, TradeKing, or Sharebuilder.

Make A Phone Call To Old Administrator
There are a variety of ways these rollovers can happen. They may want to know the name of the company you’re going with, and also have some various paperwork to fill out. With some companies, you can request everything be done online. Even so, I think the easiest way is to simply call them and ask them the easiest way to do it (my mom didn’t like having to deal with the old company “Why are you leaving us? You can simply rollover to an IRA here…”).

You have to ask for a “direct rollover”, because otherwise you may be subject to a 20% automatic withholding, taxes, and also penalties. If the transfer can’t be done electronically, the old company will liquidate your account and send you a paper check made out to your new company. Be sure to send the check to your new company within 60 days.

Open An Account At Vanguard
Just go to Vanguard.com, click on “Open an account” at the top-right, and follow the guide. We went with “Invest for retirement” > “Roll over a 401(k) or other employer-sponsored plan” and then “Vanguard® mutual funds”.

Choosing Initial Investments
If you don’t know what to buy yet, just choose a conservative money market fund to get started. One popular option is the Prime Money Market Fund (VMMXX). You can switch into other mutual funds later easily as there are no transaction fees.

If you have over $100,000 in assets at Vanguard, you reach their Voyager level which includes a discounted financial plan. The pitch: “Pay just $250 for a plan developed by a Certified Financial Planner™ from Vanguard—a $1,000 value.” I haven’t actually paid for this myself, so I don’t know how customized it is.

Avoiding Fees
Don’t want mom getting hit with crazy fees! Vanguard charges a $20 annual fee for each Vanguard mutual fund in which your balance is under $10,000. Again, if you are at the Voyager level ($100,000+ in total assets at Vanguard) these are all waived. After that, the easiest way to avoid this fee is to sign up for electronic delivery of documents. Most people are willing to save a potential $20-$100 a year by printing out their own statements.

So now she has a funded Vanguard IRA. Next task is to provide her some investment options which fit within her overall portfolio.

Filed Under: Family, Investing, Retirement //

Choosing Between Multiple Investment Options For 401k or 403b Plans

Posted on August 11, 2008 // 15 Comments

My mom has been asking me to look over her 401k plan, as she has been worried about its performance and suitability recently. In fact, she changed all the future contributions to 100% bonds a while back. As her 401(k) had somewhat limited choices (although they could definitely be worse), I had to make do with what was available. Usual disclaimer applies: I am not a financial professional.

1. Decide on an asset allocation.
This can be a complex topic, but I put most of my research in this series of posts on asset allocation. Given my mom’s age, years until retirement, other existing investments, and and risk preferences, I recommended an overall asset allocation of 60% stocks and 40% bonds. Currently, she is at 68%/32%. I would definitely like to have at least a broad US stock fund, a broad international stock fund, and a broad US bond fund. It might be nice to have Large-cap Value, Small-cap Value, Emerging Markets, Real Estate, or Inflation-protected Bond funds. The final ratios will be similar to the asset allocation breakdown here.

2. Make a list of fund options and characteristics
First up, you’ll want to gather a list of all your available investment options. Usually this includes about 5-30 mutual funds. If the fund details are not well organized, just ask for the ticker symbol and pull up their Morningstar.com snapshot. Put them in a spreadsheet, and include the each fund’s asset class, any front- or back-end loads, and annual expense ratio. Here are the 15 options in my mom’s 401(k) plan:

Now, I am completely ignoring Morningstar “star” ratings. They are based primarily on past recent performance, which have been shown to be a poor indicator of future long-term performance. You could buy a 5-star fund and have it end up a 1-star fund a few years later. Fund managers change all the time as well. I want to create a low maintenance portfolio that doesn’t involve chasing hot managers or performance.

3. Narrow down the options by cost and asset class.
If I don’t need the asset class, then I cross it out. If there are two similar funds, then pick the cheaper one with lower loads. In my “nice to have list”, if it is too expensive, then it becomes less useful as a diversifier and I cross it out as well. An example is the AIM Real Estate fund, with the 5.5% front load. The 6 bolded funds above are the ones that I am left with.

4. Decide if you are going to do a full asset allocation or cherry pick
It is often recommended that you implement your asset allocation across all your investment accounts (401ks, IRAs, brokerage) as one pie. For example, you might hold all your bond funds in tax-sheltered accounts for optimal tax efficiency. Or your 401k might only have one really good fund, and you can buy the other asset classes elsewhere. If this is the case, then you might want to cherry pick the funds you want for your 401k.

For other reasons, you might just want to implement your entire asset allocation as best you can within the 401k. I’m going to go ahead with this latter route for now.

5. Consider Target-date Funds or Pre-Set Model Portfolios
Many 401(k)s include an even simpler option, either all-in-one Target-dated funds or pre-set portfolio mixes. But all target-date funds are not made the same. Look at the prospectus and see what funds are included within them, and if they charge you an extra layer of management fees on top of the fees of the underlying funds. Many are crap, and you could do much better with your own custom mix. My mom’s 401k has no such option.

She does however, have a few options for pre-set model portfolios. These are basically a set ratio of selected funds (the pink and blue highlighted items above), which are are automatically rebalanced once a year. Shown above is the breakdown the “balanced model” option. However, I don’t like them because they include several expensive funds and exclude some of what I think are the best funds. Not including the large front-end loads of two of the funds, the average weighted expense ratio of the model portfolio was 0.59%.

6. Construct Your Custom Portfolio
In the end, I chose the 5 funds below. I decided to leave out Windsor II (Large Value fund) for the sake of simplicity. I calculated the averaged weighted expense ratio to be 0.48%.

7. Explain and Implement
Now, I have to explain to my mom why I picked these funds, and how they may perform in the future. If she wants, I may shift it to 50% stocks/50% bonds. I’ll check in on it again after a year to show her how to rebalance. This is not the perfect portfolio, but it will be better than her previous hodgepodge, and also be easier to manage.

Filed Under: Investing, Retirement //

Comparison Of Different Ways To Generate Income In Early Retirement

Posted on August 6, 2008 // 29 Comments

As outlined in this previous post about One Way To Track Your Progress Towards Financial Independence, you can say you’ve reached financial independence when your “passive” investment income equals your monthly expenses (“crossover point”):

The above chart was taken from the Your Money or Your Life, which also says the best way to generate income is by purchasing 30-year Treasury Bonds. But there are a variety of other ways that retirees generate income for retirement. Each one has their own pros and cons.

High-Grade Bonds or Certificates
U.S. Treasury bonds are a very safe and reliable way to generate regular income, as it is guaranteed by the U.S. government and they are very liquid. A similar situation results you invest in bank CDs or other investment-grade corporate or municipal bonds. The primary drawbacks are lower returns, especially relative to inflation. The 30-year bond is currently yielding somewhere around 4.5%. The current real (above inflation) yield for a 20-year TIPS (inflation-indexed bond) is only about 2.20%.

This means that if you want both the highest safety and you wish to only live off the interest of your money without ever touching the principal, you can only withdraw about 2.2% each year. That’s only $183 per month for each $100,000.

60/40 Asset Allocation with 4% Safe Withdrawal Rate
Although there is still much ongoing debate, the “4% rule” is based on on research by William Bergen:

William Bengen, a U.S. researcher, has back-tested a 4% withdrawal rate with a balanced portfolio of U.S. stocks and government bonds earning overall market returns and found that you would have been able to safely withdraw 4% of your portfolio over any 30-year period since 1926. [source]

The general idea is that if you have a portfolio with an asset allocation of 60% stocks/40% bonds, you can withdraw 4% of the portfolio each year with only a small chance of running out of money somewhere down the line. A 4% withdrawal rate would be $333/month for each $100,000. However, your portfolio will experience wilder swings, and this rigid method is very sensitive to the returns in the first years of retirement. If you have a bad decade upfront, your chance of going broke rises quickly.

Income-Focused Mutual Funds
These are mutual funds who primary objective is not growth, but to create a stable income stream from a combination of stock dividends and bond interest. The secondary objective is some capital appreciation, which ideally will help the income stream to keep up with inflation.

A passive index fund example is the Vanguard Target Retirement Income Fund (VTINX), which is currently yielding 4.05%. A popular actively-managed example is the Vanguard Wellesley Income Fund (VWINX), which is currently yielding 4.71%. Both of these funds hold roughly 35% in stocks/65% in bonds. Wellesley has been around since 1929, and many retirees swear by the reliable income it produces.

Managed Payout Mutual Funds
A new breed of mutual funds actually adjusts to help you spend your money as fast as you like. You choose how fast you wish to withdraw your money (3%? 5%? 7%?), and the fund does it’s best to accommodate that without going broke. Vanguard has their Managed Payout Funds, and Fidelity has their Income Replacement Funds.

These funds help you create regular monthly payments like an annuity, but still include risk from the stock market. They are also very new and could be seen as unproven.

Individual Dividend Stocks
I know of several retirees who manage their own portfolios of individual stocks. These people accumulate shares in companies with a history of reliable stock dividends, like General Electric and Coca-Cola, and live off the dividends. An ETF of top dividend producers, DVY, currently yields 5.14%.

I would be wary though that the share value of these stocks can vary widely without the cushion of bonds. DVY has dropped by over 20% so far this year, which is indicative of many similar dividend stocks.

Income Annuity
With a simple version of an immediate annuity, you hand over a lump-sum upfront in return for fixed income payments for life. Of course, if you die early then you don’t get your lump sum back. However, you could live until 110. It’s almost like life insurance in reverse. A special risk here is that your insurance company must stay solvent the entire time, so you must check credit ratings.

I went to ImmediateAnnuities.com and looked into a Joint Annuity, where the income payments keep coming as long as one of us are alive. A rough quote for a 40-year old says that each $100,000 paid will get me about $450 a month. That is the same as saying I can earn 5.4% interest forever, but remember that I lose the principal. Of course, this value goes up with age. For a 60-year old couple, you can get 6.4% forever. At age 70, you can get 7.5% forever.

How much income will a million bucks get you?
Based on these numbers, with $1,000,000 one could get anywhere from $1,830 a month (very little risk, no principal loss) to $5,833 per month (fixed annuity at age 65, all principal is given up). I’d probably end up going with something in between, but it is food for thought.

Filed Under: Investing, Retirement //
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