Michael's Blog: Money Matters

OK, I'll admit it - I'm a risk freak.  

It's not that I love to take a ton of risk in my life (though some wonder whether surfing, downhill skiing, hang gliding and scuba diving are appropriate activities for someone in his 50s); it's that I contemplate the concepts of risk. A lot.  

That is not a typo. It's the concepts of risk, plural. There are at least three facets of risk that merit consideration: need, ability and willingness.

With the Fed's current zero interest rate policy, almost all of us need to take risk to accomplish our retirement objectives. The so-called "risk-free rate of return" is 2.4% per year (fully taxable), which is what the US government gives you for lending it money for 10 years. After taxes, you are probably guaranteed to lose only a little purchasing power over that decade after inflation in factored in. [Yes, that's right: risk-free means almost certain guarantee of losing real value in your investment!] All other things being equal, you'd need to take more risk. 

To fully understand your own need, think about what you want your money to do for you, and when you want it done. Want to retire at 65 with $10,000 a month in living expenses? Fine, that requires a certain amount of risk. Retire at 52 with $20,000 a month? No problem - as long as you have $15 million or want to assume a risk profile that makes climbing Mt. Everest look like a walk in the park.  

The ability to take risks reflects where you are in life. If you're 28 and starting a job, you have all the ability in the world to take as much risk as you would like. But if you're nearing retirement, or facing health challenges, or are living paycheck to paycheck, you simply do not have an ability to take much risk.

Need and ability are fairly quantifiable and objective. The challenge comes in assessing one's willingness to take risks, and this is where most uncertainty lies. Your nest egg, at its most bare, is there to give you peace of mind that you are able to do what you want when you want. But if there's so much risk in the portfolio that you're stressed when the Dow drops a few hundred points... well, that kind of defeats the purpose of peace of mind! [I'm reminded of the investor during the crash of '08 who told me he slept like a baby: woke up crying every few hours curled up in a corner.] 

Ask someone their long term risk tolerance when the market has been down six months in a row and you'll get a markedly different answer than you would when the market is roaring ahead (recency bias). Or notice reticence to change? That's status quo bias. Oh, there are plenty more, but here's the takeaway: understanding risk requires time and patience, and a recognition that it's a dynamic concept.   

The riskiest approach? Not knowing how much risk you need to take, you're able to take and that you're willing to take!

We have all been told since our first job that saving for retirement through the workplace makes sense. By deferring a portion of your salary while you are working, you can not only make solid and notable strides toward funding your future, you can save on your taxes today.

That's because 401(k) plans - and their less well-known sister, 403(b) plans - are "pre-tax" plans. If you made $140,000 and deferred $15,000 to your company retirement plan, you would be taxed as though your salary was $125,000. Any gains in the plan are not taxed until you begin to withdraw funds, presumably later in life when you are retired. Chock that one up to the "no brainer" category, right?

Well, yes and no. [There are no yes or no answers in this field; it's why economics is called the "dismal science."] Nine times out of ten you will want to take advantage of this type of tax-deferred savings. At an absolute minimum, if you work for a company that matches any of your own contributions, by all means you should participate - failing to do so, at least to the maximum of the company match if you can, is equivalent to throwing away free money.

Let's talk about two of the times (there are others) when you may want to reconsider using your 401(k) as a primary retirement funding vehicle (if you work in the Pentagon, we'll call this your PRFV). The second is more prevalent, so skip ahead if you're time constrained. 

The first instance where it makes sense to forgo a 401k is if you are nearing retirement and you expect your marginal tax rates to stay the same or increase in retirement. Remember, long-term capital gains and qualified dividends are generally taxed at lower rates than income, so if your salary is lower (or maybe you've gone part-time), and your tax rates will increase in retirement because of Social Security, a pension or other income, take the tax hit now and pay lower rates than you would later, in retirement. Remember, all funds (whether original contributions or gains) withdrawn from a 401k or 403b and non-Roth IRAs are subject to ordinary income taxes at the state and federal level at the time of distribution.

The second and more likely reason why you might hesitate to fully participate in your company's 401k plan is fees. A long-time client of mine just switched jobs, so we were reviewing his new plan and found that the annual expense ratio for the "right" investment portfolio was at least 2.28%. That is utterly outrageous; although sadly, it is not uncommon. [There's a ditty in here somewhere:  "If your plan costs start with two, you, my friend, are screwed!"]

So how much is "too much"?  The first thing to know is that small plans - those with total assets of less than $10 million - are more expensive, simply because the plan maintenance costs are spread over fewer employees. A recent Deloitte Consulting study for the Investment Company Institute found that the typical annual fee is 0.67%, but for small companies the average cost is 1.27%. A similar study by the trade magazine Plan Sponsor showed the average plan cost for a plan with 50 participants and $2.5 million in assets was 1.46%. 

The good news is that the figures are declining, mostly because of regulations that now require making information on expenses available. The bad news is that a whole lot of smaller companies have not taken the time to look at their plans to see what they and their employees are paying. Two types of folks are happy about that: (1) the insurance companies and large brokerage houses, which are often the ones who are charging the usurious fees; and (2) plaintiffs' attorneys, who are seeing this employer breach of fiduciary duty as ripe pickings for class action lawsuits. [If you own a company with a 401k plan, then you are a fiduciary, and that's a high standard! This email address is being protected from spambots. You need JavaScript enabled to view it. to see if you are at risk!]

Mark my words: there will be a spate of lawsuits in the coming years that relate to exorbitant fees in 401k plans. If you are a fiduciary, please take a look at your plan - for your own sake and for the sake of your employees. The 401k world is changing, don't be left behind!

If you are not an employer fiduciary, but you're interested in reviewing your 401k holdings (and expense ratios) or consider other retirement planning, call me. I'd be happy to take an objective look and let you know if you are doing all you can to prepare for a successful retirement.