Retirement planning has become a very much a trick or treat landscape to navigate. Numerous products will be found in your 401(k) plans in the near future that might not prove to be the best solution for the investment dilemma your retirement accounts are in. And with Halloween just around the corner, perhaps we should look at some of the treats in your bag.
Inside Your 401(k)
Let's start with the easiest one to talk about, the index fund. This investment offering is in your 401(k) account and offers low fees, which is good, they offer of low volatility, which is attractive after last year, and the promise of steady returns. They mimic a published index and they follow those stocks to meet or beat that index all while providing you with enough of a risk return relationship that will get you to retirement. They are not your favorite trick or treat sweet; the one you will eat after the good stuff is gone kind of investment.
Fees can vary widely in 401(k)s and some of them are hidden from view for good reason. It is one thing to be charged fees in a fund, it is wholly another matter to charge them for managing the plan. So many plan sponsors are finding funds for their participants that charge lower fees but at the cost of returns.
But wait, index funds are created equal. After all, there is the index they must follow. Not quite follow. Only about 75% of the stocks in the index are actually held in a S&P 500 index fund, and a third of the available companies are in a fund that tracks the Russell 2000. That leaves room for besting the index. And some do, particularly in the small-cap space where index funds can beat the index by eight to ten percentage points and do it with fees that are the same as some popular S&P 500 funds.
And fees in those funds can be all over the map. Why? Perhaps tracking error as they trade and research more than a similar fund. Perhaps because your index fund may be wishing it were an actively traded one. Reasons vary and so do the fees.
As Good As They Are
Index funds, as good as they are, should be kept outside of tax deferred retirement plans. This will allow you to control the fees and potential returns/risk those funds are taking much better. And in the current tax environment, it might well be worth paying for them now. Consider the three years worth of losses you would have been able to write-off after the downturn.
In 2010, tax rates will change for dividends (to that of ordinary income rates) and capital gains (to 20%) which is still a good deal - at least for the next couple of years. Dividend payouts are down and not likely to begin to increase soon making that tax reasonable. Twenty percent is not 15% but still not a bad deal.
(I realize that this sounds as if I'm advocating for the more expensive actively managed funds in 401(k)s. I am although I am just looking at it from a time frame point of view. Without a doubt, early investing is best. But many folks have entered the fray of 401(k) management with less than fifteen years until they would like to retire. Even if this group maxed out their contributions, it would take a solid 8% return year over year to get even close to enough to draw $15,000 a annually from the account and not run out of money. Risk inside a tax deferred account. Less risk outside. Your 401(k) plan unfortunately is your "mad money account"!)
Some Confusion Remains
People still confuse savings with investing too often and that, I believe, is one of the real problems with how folks recently readjusted their retirement accounts. Savings is not investing. As a result of this misdirected thinking about what those accounts really were, they have assumed so little risk, they put their "planning for retirement" at too long term a pace.
Retirement planning has become a very new and tricky landscape. People switched, sold or borrowed from their 401(k)s at the exact time they should have been rebuilding them. Had they stayed put and if they were fortunate enough to be able to continue their contributions, the vast majority of them would have seen balances in those accounts close to what they were at the 2007 year-end. What scares me now, is that there are new products on the shelf to add even less risk (at least in the sales pitch of loss) that investor/consumers might find attractive.
The Next Disaster
Disaster planning, which may comes as a shock to almost no one, can effectively derail any well-laid out plan. Kids, parents, jobs and a host of other problems can make deciding which move is best to for you doubly hard as you try to construct their plan.
Building a retirement that is financially predictable, growing savings that is stable and accessible and using your 401(k) plans to guide your future is no easy task. You will be assailed in the coming months and years with products that promise to protect your gains with products that are essentially insurance. Compared to index funds, these are like the neighbor who gives you a toothbrush. Good idea but the wrong treat
Retirement planning needs to be earthquake proof. That means considering new and innovative ways to get the 50 year old investor back in position to retire while s/he can. Less risk is not the path.
Paul Petillo is the Managing Editor of BlueCollarDollar.com and a fellow Boomer.
Further reading on index funds in your 401(k)