SuperCharge Your 401k How to add 1% or more to your annual returns without adding risk Annual Savings 7.0% 8.0% Dale P Beals Spring 2014 1
What Not To Do Don t Use the Target Date or Strategy Fund Selections A Penny Saved is a Penny Earned and then some - Benjamin Franklin If you have bought this book, I assume you are, or soon will be, investing in a 401k. If so, this book is definitely for you. 401k and 403b plans have been under a lot of fire over the last decade, and much of that has been deserved. Still, 401k and 403b plans are used by more working Americans than just about any other retirement savings vehicle. (For simplicity, during the rest of this book, you can assume the terms 401k and 403b are interchangeable unless I say otherwise.) In response to the critics, many changes and improvements have been made to reduce costs, improve investor education and provide broader investment alternatives for 401k investors. Early in the life of 401k s, most plans offered only seven or eight index funds (I ll call them the Basic Funds), each investing in a different asset class like US large company stocks, US small company stocks or bonds. Now, your plan probably offers many specialty funds managed by various well-known money managers. One interesting enhancement to 401k s in recent years has been the advent of so-called Target Date or Retirement Date funds, such as a 2035 Fund. Another improvement has been the introduction of Blended or Strategic Funds, such as Balanced Portfolio, Growth Portfolio or Conservative Portfolio. The stated benefit of these funds is to simplify the life of the investor, letting them set it and forget it by choosing just one fund and letting it ride. For the rest of this book, I ll call these funds, Combo Funds. Don t ever choose these funds. Here s why: 1. Your annual overhead in fund expenses immediately doubles or worse when you use these Combo Funds; jumping from an estimated average of 0.6%/year to 1.6%/year for a Balanced Allocation. The long-term performance of these Combo Funds is almost never good enough to justify that huge jump in your 2
annual costs. You may ask Hey, wait a minute, what choice do I have?, and that s a great question. What most investors do not know is that, for almost all 401k s, the Combo Funds are just a pre-set combination of the more basic funds already provided in your plan. This means that you can save 1%/year or more, simply by allocating your 401k among the basic funds yourself. This one change will make a difference of potentially tens of thousands of dollars at retirement time without adding to your investment risk Later in this book, we ll cover how you can do this for yourself as well or better than your friendly 401k provider in just a few minutes each month or each quarter. 2. The methodologies used to allocate the Combo Funds between the underlying Basic Funds are badly flawed, as many investors found out in 2008, and earlier, back in 2001-2002. In the following chapter, we will cover, in more detail, how these Combo funds are constructed and show you why these methodology flaws can devastate your retirement savings. Later on in this book, we ll show you a couple of ways to pick your own mix of Basic Funds, using an approach that avoids the pitfalls and the high expenses of the Combo Funds. Are you ready? 3
Why Combo Fund Methodologies are Flawed They are Based on False Assumptions about the Markets It s not what you don t know that will kill you. It s what you know that ain t so. The eternal search for the best way to balance risk and return in investing gave birth to Modern Portfolio Theory back in the 1950 s and 1960 s. Several people won Nobel Prizes for their work during that remarkable period. Some basic ideas, now commonly accepted, that came out of that time include: Diversification - Putting your investment eggs in multiple baskets is safer than putting everything in one investment or asset class. Risk is Related to Reward - The more volatile (risky) asset classes like stocks will produce better long-term returns than the less volatile (risky) asset classes like bonds. Efficient Frontier - Based on the known properties of those investment asset classes, an investor can carefully construct a portfolio that maximizes the return for the risk (volatility) he is willing to take; or conversely, she can construct a portfolio that minimizes the risk necessary to achieve a desired long-term return. Is that cool or what? Almost all financial advisors and 401k plans make use of these concepts in helping you, the investor, determine your risk tolerance and allocate your investments accordingly. Here s the problem remember this line from the Efficient Frontier discussion above? Based on the known properties of those investment asset classes The Nobel Prize winner, Dr. Samuelson documented the assumptions that served as the foundation for Modern Portfolio Theory. In laymen's terms, the mathematical models which determine the asset allocation mix appropriate to each level of risk assume that assets will behave the 4
same way in the future that they have over the prior 15-20 years in terms of: Volatility - Stocks historically have a higher volatility (risk) than real estate which has a higher volatility than bonds. Gold historically has a higher volatility than bonds and real estate, but a lower volatility than stocks. Correlation - Stocks, Bonds, Gold, Real Estate and other asset classes historically do not all go up and down (in price) together. So by mixing asset classes that all go up over time, but don t move together in the short term, the investor can construct a portfolio that is much less risky (volatile) than pure stocks, but get maybe 80% of the long-term returns a pretty good tradeoff. Long-Term Return - Stocks historically have the highest return with the other asset classes falling behind. For example, in Modern Portfolio Theory, stocks are expected to stay about as volatile as they were, maintain their approximate correlation to other assets, and gain more in the long run than other asset classes. Guess what happened in September 2008? 1. Volatility - Stocks fell off a cliff after declining much of 2008. Stock volatility (and daily risk to your portfolio) quadrupled. Instead of a daily movement of, say 2% from high to low, the S&P500 was moving 8% from high to low. Bond volatility went crazy too, when the crisis in mortgage-backed securities heated up. Scratch the volatility assumption. 2. Correlation - Bonds historically would move up when stocks moved down, cushioning the portfolio losses, and initially that happened again, but Oh No there was a liquidity crisis and mortgage-backed securities became worthless almost overnight. People began selling anything to raise cash, including the ultra-safe US Treasuries. Almost all asset classes that could be sold, were sold, and fell together. So much for the correlation assumption. 3. Long-Term Return - This assumption has held up the best of the three major assumptions, now that we can look at this seven years later, but here s the lesson. When you are prepared to withstand a 10-15% dip in your portfolio but then watch a 55% drop in stocks and a 30% drop in your portfolio in less than 5
a year, long-term average returns don t matter What you care about is what your 401k will be worth when you retire. Many investors sold out of stocks in their 401k s or 403b s somewhere near the bottom in late 2008 and early 2009 because they couldn t take it anymore. Many of them had been led to believe that they were diversified and safe from that big a hit to their life savings. Why? Many, if not most, of the people who constructed the Combo Funds for the 401k plans, or the people who provided the education about investing did not emphasize the foundational assumptions to Modern Portfolio Theory and how to respond when market behavior changes. Later in this book, we ll cover how to recognize when the basic assumptions begin to break down (as they will again someday), and how to respond to protect your nest egg. Unfortunately, there are still other serious problems with the methodologies used in the construction of the Combo Funds. Let s take a look 6
As Market Cycles Change, Combo Funds Swing Between Too Risky and Too Safe The sun don t shine on the same dog s ass all the time - Jim Catfish Hunter The biggest Combo Fund culprits (but not the only ones), in my opinion, are the Target Date funds. Let s take a look at how they work to see why. The Target Date concept seems to make a lot of sense at first. It is based on this idea Younger investors should have a more aggressive (risky or volatile) portfolio because that portfolio will produce better long-term returns, and younger investors have a lot more time to ride out the ups and downs. In general, that makes perfect sense. So, Target Date funds allocate their portfolios based on the amount of time remaining before the Target Date. Initially, they are heavily weighted toward stocks maybe even 100% stocks. As time passes and the Target Date draws closer, these funds begin allocating more and more to bonds, or less volatile (risky) assets. In the last few years before the Target Date, almost all of the portfolio is in bonds, based on the idea that the investor should be taking very little risk this late in the game. So far, so good now lets look at how this worked in the real world. Let s take a look at an investor at age 33 in December of 2007, who has her 401k invested in a 2040 Target Date Fund. Let s call her Susy. Since she graduated from college at 21, she has been working at Baylor Hospital in Dallas, and investing $6,000/year in her 401k. After 12 years, including her employer matching funds and the growth of her Target Date Fund, she has an account balance of $120,000. Although she is unaware of the specifics, her allocation started out as 100% stocks, and is now still 80% stocks, since she is a good 32 years from retirement. She is also unaware that the annual management expenses for her portfolio starts out at 0.75% for the Basic Funds (mostly stocks), adds another 1% for the Aggressive Growth Fund and Growth Fund Combo funds (which are made up of the Basic 7
Funds), plus another 0.5% for the 2040 Target Date Fund (which is made up of the other Combo Funds). So, in this example, she is already paying $2,700/year in fund management expenses (2.25% times $120,000) She could be improving her annual return by 1.25%/annually by picking the Basic Funds herself Run that math out for the 32 years until her retirement and you will probably start to get angry on her behalf. I got angry enough to write this book for you. Okay, now comes 2008. As we know, stocks trended down most of the year until September, when they fell off a cliff. Volatility in stocks climbed sharply, and stocks finally hit bottom in March 2009 after a 55% loss on the S&P 500. So, Susy s 401k fell around 40%, or $48,000 from the top in 2007 to March 2009. This would be very hard for Susy to take, even though she has 32 more years until retirement and she can keep dollar cost averaging into her 401k as the market falls. She might not even be able to hang on. All of this would happen because the 2040 Target Date fund pays no attention to current market behavior, so it is far more risky (volatile) than it should be for the existing market conditions, or than she expected it to be. Common sense would tell us that when stocks are in a long downtrend, like they were before September 2008, or when market volatility begins to rise sharply, like it did in July and August of 2008, something should be done to reduce risk Sadly, the 2040 Target Date Fund makes no adjustments, and Susy, or her counterparts make a fearful decision that severely damages their retirement. They sell at the bottom. We ve seen how damaging a Combo Fund that gets too risky can be. Its ironic that it gets too risky by making no changes, but when the markets change, that s exactly what happens to investors in those Target Date Combo funds, and they don t have anyone telling them to sit up, pay attention and manage their risk before they get financially hurt. Let s look at another case. Susy has an uncle named John, who has worked at IBM for 30 years. John is 60 in December of 2007, and plans to retire in 2012, so his $700,000 401k is invested in the 2010 Target Date Fund. As before his annual fees 8
are stacked, with about 0.5%/year in his Basic Funds (mostly bonds), 0.85%/year in his Total Return Fund and his Blue Chip Stock Fund, with 0.5%/year as icing on the cake of the 2010 Target Date Fund. Let s see, $700,000 times 1.85% is Oh My Goodness $12,950/year And he could be paying as little as 0.5%, or $3,500/year. Ouch Okay, let s pretend that John doesn t know how badly he s getting clipped. His allocation is probably 85-90% bonds, since he is so close to retirement. As 2008 begins, he actually sees his account gain until September, so he is up 5%, or $35,000 before the bottom drops out. Correlations fall apart and his bonds begin to drop rapidly along with the stocks. This is very uncomfortable to watch, because he thought he was safe from big fluctuations like this. By the end of 2008, he has gone from up 5% to down 10%, or $70,000. Ouch. The good news is that this drop, percentage-wise is not very bad. When stocks bottom in March of 2009, he is still hanging in there at $630,000 only down 10% from the market top in 2007. He has about 45 months to go before retirement. Many might go to cash here, but John will stick it out. What happens for the rest of 2009? His bonds stabilize. Volatility quickly drops back down close to normal, stocks begin a rally that will show a 30% plus gain by the end of 2009. Does the 2010 target date fund take advantage of the bargains after a 55% drop in stocks? The lower volatility and risk? The uptrend in stocks? No. The 2010 Target Date fund makes no provision for the market environment and the once in a generation opportunity to increase the allocation to stocks. John can use the money, he ll probably live to 90. You get the idea. In the case of Uncle John, the Combo Fund, in addition to being incredibly expensive, does a fairly good job in 2007 and 2008, but is far too conservative for the market environment in 2009 and 2010 and 2011 and 2012 when he retires. In retrospect, the flaws of the Combo Funds, their costs and their inflexibility have become obvious. That leaves us with a burning question; So what can we do short 9
of quitting our jobs and becoming professional investors? 401k investors are rightfully told that you can t time the markets you can t pick the tops and the bottoms. Lots of education is provided to the 401k investor, but none wants the liability that goes with giving individual advice when they are not reaping those annual fees from the investments. I am aware of big brokerage firms whose legal departments have specifically instructed their Financial Advisors NOT to give recommendations on 401k and 403b plans not sold by their own firm. Good News In the Next Chapter, we ll cover several different ways to pick your funds for yourself, using the Basic Funds that carry the lowest costs, without giving up the benefits of Modern Portfolio Theory and good risk management. 10
Three Easy Ways to Intelligently Pick Your Funds Solution 1 - Copy the Allocations used by Your Combo Funds Every 401k website is different, but almost all of them will allow you to click on the Combo Fund name or symbol and see a breakdown of the asset classes included in the fund. Additionally, you may actually see the specific Basic Funds from your 401k plan, that are included in the Combo Fund Yes They have to tell you what they are investing in So, with just a little common sense, you can use the tools provided by your 401k to: 1. Assess your risk tolerance, 2. Identify the Combo Fund they suggest for you, 3. Read the data sheet or fund disclosure sheet of the Combo Fund, and 4. Use the allocation of Basic Funds from the disclosure, thus saving the extra overhead (perhaps 1% or more) of investing in the Combo Fund How easy it that? They say the truth shall set you free. In this case, the facts can save you a ton of money between now and your retirement. As I promised in the title of this book, those savings immediately increase your annual return without adding any risk. Caveat: While this approach saves you money and improves your returns, it still depends on Combo Fund Methodologies, which have the short-comings we covered in the last Chapter of this book. Nevertheless, just taking this one step can make a huge difference to your retirement. 11
Solution 2 - Use Free Planning Tools From the Internet to Determine Your 401k Allocations For those who like doing a little more research rather than depending on only one source of input, this approach should work quite nicely. If you Google asset allocation advice you will see pages of websites offering tools and calculators that help you do everything from assess your risk tolerance to actually recommending asset allocations for you. I ll list a few that seemed useful at the time I wrote this book: www.bankrate.com www.401k-checkup.com www.finance.yahoo.com/calculator/retirement/inv01/ www.cgi.money.cnn.com/tools/assetallocwizard/assetallocwizard Once you have used these various tools to determine your general allocations, then you need to map those allocations to the Basic Funds offered in your 401k. The steps might look like this: 1. Use the various internet tools to assess your risk tolerance, 2. Use the various internet tools to determine your desired asset allocation, 3. Map your desired allocation to the Basic Funds actually available in your 401k, and 4. Select your 401k Basic Funds This approach takes just a little more time, and you may need to adjust your desired allocation to fit the funds you actually have to choose from, but you can still save those extra expenses and improve your 401k returns without adding risk. Caveat: Some of these online tools may do a better job of dealing with the Combo Fund Methodology flaws inherent in your 401k s Strategic Funds or Target Date Funds. Possibly, though, you may still need to be alert to times the markets behave irrationally. 12
Solution 3 - Find a Better Asset Allocation Methodology While Still Using the Basic Funds in Your 401k Where can I find a better methodology? You may ask. Well, I asked the same question back in the 1990 s when I worked for IBM Global Services and invested in our 401k plan. Years later, when I had changed careers and started my own investment management firm, Portfolio Wisdom LLC, I finally got around to developing that methodology. It took over two years to develop, test, and implement that methodology and the mathematical models needed to recalculate those allocations each month, but that work was essentially completed in 2011. If you go to www.portofoliowisdom.com and click on the menu option for free 401k assistance, you will see the results of my work, updated monthly. Even better, I have created a 401k/403b Asset Allocation newsletter, and have customized my allocation methodology to the fund choices available to my newsletter subscribers. So, for my subscribers, at $5/month, here is the simple monthly process you would follow: 1. Read the PortfolioWisdom Asset Allocation Newsletter when it arrives by email, 2. Click on the link to the Asset Allocation Matrix for Your Individual 401k, 3. Check to see if the Allocation Matrix recommendations are more than 2% different from your current allocations. If necessary, update your 401k allocations, if not, sit tight, and 4. Relax Knowing that you are saving as much as 1% or more annually, while following a better, less risky asset allocation methodology. For more information about the methodology I developed and how it works, check out the website at www.portfoliowisdom.com Whichever of the three Solutions to Supercharging Your 401k you choose, I wish you good health, happiness, and successful investing 13