Archives for retirement category
28
Dec
Posted in retirement by Roger |
One of the most basic tenets when you are saving for retirement is to dollar cost average your investments by contributing the same amount of money each month (or quarterly or weekly, depending on your preferred investment schedule). By doing so, you’ll end up purchasing more shares of the (usually) mutual funds when the price is lower, and fewer when the price is high. The end result is that you end up purchasing more shares at a lower average cost, than by purchasing the same number of shares each month. For an example, let’s check out the following table:
Dollar Cost Averaging in Action
If you wanted to invest $100 in the Vanguard 500 index fund (the first and probably most popular index fund) on the fifteenth of each month (or the last business day before the fifteenth, for months when the fifteenth falls on a weekend or other holiday), this shows you an example of how dollar cost averaging will lower your expenses. If you take a straight average of the share price, you come up with a share price average of $87.56.
But, you didn’t purchase the same number of shares each month, did you? Nope, because you put in the same amount of money each month, you ended up buying a total of 13.913 shares; dividing the total you spent ($1200) by this number of shares, and you’ll see that you bought your shares for an average price of $86.25. Because of your dollar cost averaging, your per share cost is a bit lower than the average share cost of the year. If you’re in the process of buying sharing to build up your investments, this is a good thing; more shares for less money!
But let’s reverse the money flow; imagine you’re a retiree who is selling your investments in order to generate additional funds in retirement. Now, you are selling enough shares of your Vanguard 500 index fund to generate $100 each month. You’ll have to sell more shares when the price is low, and fewer when the price is high. The end result is that you’ll get less money for selling more shares; not the sort of situation in which you want to find yourself.
This is known as negative dollar cost averaging (DCA); where the process of dollar cost averaging, when thrown into reverse, ends up increasing the number of shares you need to sell in order to keep your cash flow the same. (It was mentioned as part of Yes, You Can Still Retire Comfortably!, which recommended a version of market timing to counter the problem.) How can you prevent negative DCA from taking its toll on your investments? There are a few possible methods:
1) Sell a constant number of shares: Negative DCA results when you sell different numbers of shares at different prices in order to generate constant cash flow. You can break up this problem by selling a constant number of shares instead. If you sell one share each month (for our example), you know that by the end of the year, you’ll have sold 12 shares, regardless of the changing share price over the year. The problem is, you’ll have to accept a fluctuating income stream from your sales; if the share prices drop in half, your income from selling these shares drops in half, as well.
2) Rebalance your portfolio regularly: Assuming you have more than one type of investment in your portfolio (and you should, unless you have a target-date fund, which will rebalance automatically), you should make an effort to rebalance your portfolio on a regular basis. (At least yearly, although quarterly or even monthly rebalancing can work provided you are working in a retirement account and don’t have to worry about taxable events when buying and selling mutual funds.)
When you rebalance, you sell the portion of your portfolio that has risen above your desired allocation and use the proceeds to buy the under-performing funds. You’ll be putting the ‘buy low, sell high’ formula back to work for you, and won’t have to worry about negative DCA working against your progress. Alternatively, you could…
3) Sell from the best performing funds: A poor (or tax-adverse) man’s version of rebalancing, you can sell from the funds that are performing the best (the ones that represent a larger portion of your portfolio than you originally intended). The result is that you’ll bring your portfolio more into line with your desired portfolio, and you’ll avoid having quite so many taxable events (since you won’t be selling large portions of your portfolio to shift them around at once). While not completely relieving the need for occasionally rebalancing your portfolio when things get really off kilter, it’s not a bad way to generate needed funds without causing any negative DCA problems.
Hopefully, you now have a better idea about negative DCA, and what it will do when you start to draw down your retirement income.
Has anyone else given any thought to negative dollar cost averaging (or dollar cost averaging in general, for that matter)? Are there any other methods of avoiding negative dollar cost averaging that I missed? Aren’t mathematics just a load of fun?
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24
Aug
Posted in retirement by Roger |
I’ve been thinking lately about cashing out lately. For those of you who’ve never heard the term, the concept is basically to build up your money so that you are able to effectively retire early, usually in your forties to fifties, and do whatever you want with your new found free time. Depending on your personality, that might be taking on new hobbies, expanding the time you devote to your existing hobbies, simply spend more time with your family, or even start working a job you really enjoy, regardless of the pay rate.
So far, cashing out sounds pretty good; what could be better than calling it quits on your job a decade or two ahead of schedule and being able to live every day like it was a vacation? Well, unfortunately, there are some downsides: because you’re trying to retire so early, you’re pretty much going to be on your own as far as saving for retirement. Retiring before the age of 62 means you aren’t entitled to even partial Social Security benefits, and pensions (for those lucky few who still work at companies that have them) are likely going to unavailable to someone who’s only been on the job for fifteen or twenty years.
“No problem,” you say, “I’ll just depend on my own retirement savings to carry me through.” Well, that’s fine, except early retirement means you’re not giving your best friend as an investor, compound interest, much time to work. This means, if you want to get to the amount of money you need in a much shorter time frame, you need to add much more money to your investments. How much more? Well, let’s say that you crunch some numbers and decide that taking out $40,000 of your money each year will allow you to enjoy your early retirement. If we assume this amount will represent no more than 4% of your total portfolio, that means you need one million dollars in your account on the day you retire in order to make your whole plan work. If you’re saving for 40 years, no problem; according to my ‘back of the napkin’ calculations, an annual contribution of $2100 more than gets you to your goal. (We’re setting aside inflation at the moment, to make the calculations a bit easier; don’t worry, we’ll cover how inflation affects the amount you need to invest soon.)
The problem starts if you try to cut down that amount of time until retirement. If you want to retire in 30 years, expect to contribute $5600 a year to reach one million; more than twice as much, but still a workable amount for someone who requires about $40,000 a year to meet their needs. To retire in twenty years, you’re looking at a contribution of about $16,000 a year, nearly tripling your savings requirement. Finally, to reach a one million dollar nest egg in ten years, you will need to contribute $58,000 a year, nearly fifty percent more than you intend to spend each year in retirement. If you are not making a six figure salary, you’re going to be hard pressed to come up with nearly sixty grand year; and if you are making that much, are you really going to be satisfied only spending forty thousand dollars each year after you retire?
If that hasn’t shattered your dream about retiring to a tropical paradise in just a few more years, let’s note that this is an oversimplification. For one thing, we haven’t talked about inflation at all. This is one area where the early retirees have a bit of an edge; less time until retirement means less time for inflation to eat away at the real value of your money. Unfortunately, it also means you’re have to increase the figures we just gave for the yearly contributions; even ten years from now, a million dollars just won’t be worth as much. To get an inflation-adjusted million after forty years (with a 3.5% assumed rate of inflation), you’ll have to increase your yearly contribution four-fold, to $8400 dollars; in order to retire in ten years with an adjusted million, you’ll need to put in $82,000, a nearly ten-fold increase in your contribution amount from a forty year horizon.
After hearing all this, are you sad, depressed, and ready to just give up on your dreams of early retirement? No? Good; if you realize the enormity of the task ahead of you and still are determined to retire early, you might just have the resolve and determination in order to make your dream come true. To help you out, let’s end this column on a higher note and go over a few steps for anyone who shares my dream of leaving the rat race and retiring early:
1) Plan carefully, and conservatively - Your first step should be to sit down, crunch some numbers, and see (a) where you currently are, financially, (b) where you hope to be when you retire, and (c) what path you need to travel to get from (a) to (b). Decide just how much you will need when you retire (adjusted for inflation), the amount to invest each year, and whether it will be possible for you to pull that much from your budget to add to your future plans. If it’s simply not mathematically possible to retire at the time you want (without working two more jobs or simply never eating), try to shift your desired retirement date a bit; aiming to retire in twenty years rather than ten cuts the (inflation-adjusted) amount you need to save down more than fifty percent (to $32,000, if you are curious), and going from a twenty to thirty year time frame (which could still lead to retirement before the AARP decides to add you to their ranks) cuts the needed amount in half again (to $16,000). Of course, all these figures assume you’re shooting for an inflation adjusted one million dollars at retirement; you’ll have to adjust them to meet you own particular situation.
2) Cut down on your spending – There are two advantages to this course of action. First, if you’re spending less each month, you have more money to put towards your early retirement, making it easier for you to meet your investment goal. Second, if you find you’re able to live a good, full life spending only thirty thousand a year rather than forty thousand, you can probably adjust your final goal downward, requiring less in contributions (or netting a quicker time to reach the needed amount with the same contributions).
3) Invest More – If you’re trying to retire years, if not decades, ahead of the rest of your office mates, you can’t invest the same amount that they do. Putting 10% of your paycheck into a 401(k) every year might (and I stress, MIGHT) provide you with enough of a return in order to retire at 65, but it won’t be enough to give you a ‘Get of Work…Forever’ card by the time you turn 50, to say nothing of when you’re even younger. Shoot for 20-30% of your gross income, and try to ramp it up a bit more, if possible.
You should also look carefully at the rules governing retirement plans, to determine if, should you invest in a 401(k), IRA, or Roth, whether you will be able to get the money out when you need it and how much it will cost you in penalties and other fees when you do. If they look like they will benefit you, feel free to take advantage of their tax advantaged nature for a portion of your retirement savings; if not, simply use taxable accounts. (A complete guide to all the subtleties of retirement accounts as they pertain to early retirees is bit more than we’re going for right now; just be aware that usually, taxable accounts will be better when you’re trying to retire early, but not always.)
And most importantly…
4) Make sure to have fun along the way – It might be tempting to take every spare cent you have and put it into your retirement savings (and you might argue that I just told you to do as much in my last point), but if you do so at the cost of your current enjoyment, you’re going to spend some of the best years of your life doing an impression of Scrooge while your friends, coworkers and classmates are having the times of their lives. Furthermore, if you spend the first twenty years of your adult life depriving yourself, you’re going to be that much more likely to live it up when you do retire, and possibly blow through all the money you worked to accumulate. Neither of these events is something I want to happen to you.
A much better strategy is to be conscious of your financial goals and how much you are trying to save, but not to let it stop you from having a life. Go on, attend parties, go on dates, spoil your significant other every now and then, and perhaps even spoil yourself occasionally. Just try not to go over the top when you do so; be frugal in your day to day life as well as your celebrations, and you can have your fun AND save your desired amount for an early retirement.
Here’s looking at good luck to you in your attempt to retire early; I hope I’ll have the chance to join you!
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29
May
Posted in Great Debates, retirement by Roger |
Welcome once again to the little corner of the blog where we discuss some of the greatest arguments in the personal finance world. Today, we’ll discuss which is better when planning for your retirement, a traditional IRA or a Roth IRA. (There are also traditional and Roth flavors of 401(k)s, as well, but since that choice will be made by your company and its human resources department, you’ll have less control over which variety you will have.)
The big difference between the two types of IRAs is when the the money you invest in them is taxed. In traditional IRAs, the money you invest is taken from your taxable income, allowing you pay fewer taxes now, but the withdrawals when you retire are taxed at your regular tax rate. Roth IRAs are funded with after-tax money and the withdrawals are tax-free. The decision then becomes when you want to be taxed, now or when you retire.
Therefore, there’s a simple way to determine which type of IRA will be better for you: hop into your time machine, travel forward to the time you retire, and see what tax rates you will be paying. If the rates are higher in the future than they are now, you’ll do best financially with a Roth; if the rates are lower (or if the Fair Tax has been enacted), than a traditional IRA is the way to go. Then, come back to the present and open that style of IRA; easy as pie!
What’s that? You don’t have a time machine? That complicates matters a bit. You can still choose the style of IRA you open based on what you think the future will hold for tax rates. Personally, given the rising national debt and rather low current tax rates, I would imagine that tax rates are only going to rise in the future (although, again, the Fair Tax or other non-income taxes could drastically change the tax landscape), making Roth accounts more attractive. Some other questions to ask yourself:
Will I need more or less money in retirement? – As a consequence of our graduated tax system, the less income you have, the lower taxes you pay as a percentage of your income. Thus, since different IRAs allow you to be taxed at different times, you can attempt to determine how much money you will need to spend in retirement. If you intend to cut down your spending when you retire, even just to the 70-80% of your final income that many experts say that you need, traditional IRAs should be beneficial; if you intend to maintain or increase your current level of spending, a Roth IRA will help you dodge the tax burden.
Do you want to lock in your tax rate? – One of the biggest advantages of a Roth is that you know what tax rate you are paying now (or at least, should be able to figure it out), and therefore know exactly what you are paying in taxes. As we’ve already discussed, though, tax rates in the future are a big unknown. If you prefer to pay your current tax rate and not have to worry about tax increases in the future, a Roth provides you with that opportunity. On the other hand, if you are currently in a high tax bracket, taking a tax break now for your traditional IRA may make the most sense.
(If your taxable income is high enough, you may not even have the option of using a Roth. For single filers, you can put in the maximum ($5000) if you earn less than $105,000 in 2009, with partial contributions allowed up to an income of $120,000; married couples filing jointly can donate up the max if they earn less than $166,000, and partial donations up to $176,000. A complete matrix comparing income limits and other factors affecting traditional versus Roth IRAs and 401(k)s can be found here.)
Am I diversified? – Diversification isn’t just about holding a variety of investments, it also involves ensuring that your portfolio is prepared for whatever the tax rates do in the future. If you have a traditional 401(k) at your work place, having a Roth IRA to help in case of rising taxes is a good way to diversify. Similarly, if you are one of the lucky ones who has a Roth 401(k), having a traditional IRA can help to lower you current tax burden and help to minimize the taxes you will pay overall.
These questions, as well as your thoughts about how taxes will change in the future, will help you to decide which type of IRA will be best for you. As is frequently the case, there is no easy answer to which type of account is better that applies to everyone equally, but hopefully, asking yourself questions about your tax rate, future spending, and the types of other accounts you hold will help you to make some good decisions. Happy retirement planning!
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13
Feb
Posted in retirement by Roger |
Trying to decide whether you should invest in a 401(k) (or equivalent retirement plan)? It’s one of the most commonly suggested first steps for people trying to get their financial house in order; many financial advisers will tell you to contribute to your company retirement plan (at least, up to the maximum of any company provided matching contribution) before anything else, even paying down credit cards or building an emergency fund. But, is the decision really that clean-cut? Here are some considerations I’d make before asking Human Resources to add me to the plan:
Does my company provide a 401(k) to which I am eligible to contribute? This one’s pretty easy; if you don’t have a 401(k) plan at work (or you aren’t eligible for an account), you won’t be able to contribute. You might want to write to your HR representative or talk to your manager about adding it to your benefits, but until that happens, you’re just out of luck.
Does the company add matching funds to my contribution? The main incentive to invest through a retirement plan at work, rather than through an IRA, is that many companies will match your the amount of money you contribute with some portion of their own funds. So, if your company offers a 100% match on contributions up to 5% of your salary, then if you put 5% of your salary in the 401(k) plan, your company will add an equal amount of their own money to your account (in effect, you’ve doubled your money, without even trying).
It’s this employer match that drive the aforementioned financial advisers wild with desire for 401(k)s; they refer to it as ‘free money’, and admonish you for not contributing enough to your company plan in order to get the maximum amount possible. And, with few exceptions (which we’ll get to in a minute), they’re absolutely right.
Is the amount of money added by my company dependent on my contribution? This one’s based on my own experiences; my old company used to give all its employees a flat contribution each month ($200, half in funds according to our asset allocation, half in company stock). It didn’t matter if you contributed 3% or 30%, everyone still get the same amount of added company money. In this situation, the ‘free money’ afforded by 401(k) plans is given to you regardless, so you can focus on other priorities before your company plan.
If the answer to any of the above questions is no, you can put aside contributing to your 401(k), at least until you’ve done things like pay down your debt, max out a Roth IRA, and (especially if you, like me, aren’t yet in a home of your own and want to be) start saving for a house down-payment.
But these aren’t the only considerations when deciding whether (and how much) to invest in your company’s retirement plan. Here are two more issues to ponder:
Are your employer’s matching funds vested? Some companies that provide matching funds have a vesting period, where the company match is not immediately transferred to the employee. Instead, after a period of time spent with the company, the employer contributions will be transferred to the employees control. In this way, the company can hold out the promise of full vesting of the retirement contributions as an inducement for employees to stay.
If your company does vest its matching contributions, you have to ask yourself some serious questions about how long you intend to stay in the company, how long it will take for the matching funds to be fully vested, and whether it will be worth staying for several years in order to get the full amount of your company’s match. Depending on your personal situation, you might decide it is not worth contributing, especially if you expect to leave your position before you become fully vested.
Does your plan provide for decent investment options? Not excellent, not great, not even good; just decent. 401(k) plans are known for having higher fees and poorer selection (typically no more than a dozen investment options, if that) than IRAs or non-retirement investments. If you’re getting a good company match, that (and the tax deferment afforded to 401(k) plans) will more than compensate for the higher expenses, but you still have to have some decent investment options.
If you have a variety of mutual funds from a reputable fund family like Vanguard, Fidelity, or TIAA Cref, you should be able to find some useful funds amongst your investment options. You’ll still have to do some research in order to find the best funds for your asset allocation and fit them in along with your other investments, but at least you should the tools needed to build a decent investment plan.
If your plan doesn’t offer a decent selection of funds, if they force you to take your matching funds in company stock (and don’t provide the option of selling the shares at any time and reinvesting the proceeds) or invest in raw land, you should gather up your coworkers and DEMAND decent investment options.
For everyone else, look over your plan carefully, consider the investment options, and do what will help to maximize the money you can squeeze from your company’s tightly clenched fists.
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