5 Things To Demand From Your Financial Adviser

What do you do when you’re eighty-two and run out of money? It’s a frightening thing to be looking down the barrel of an empty bank account. It’s worse when the decline in your funds was due to the actions of a financial adviser that you trusted.

Gerry had been relying on her adviser for a long time. She and her husband, John, were in their mid-sixties when John passed away unexpectedly almost twenty years ago. Gerry was heart broken. John was her life.

Their’s was a traditional relationship for their time. Gerry raised their four boys, while John managed his business and their money. When John passed, Gerry put her faith in the financial adviser John had used for years. She didn’t know anything about investments, nor did she care. John had provided well for her, so she didn’t worry about money.

Gerry lived her life, enjoying her friends and a bit of travel. Her financial adviser was busy doing his thing. She didn’t know what. When the financial crisis hit, she was concerned that her account value declined so much, but what could she do?

While the investment markets recovered, Gerry’s account did not. She saw what should have been enough money to last her life dwindle to an alarmingly low level. She finally asked me to have a look.

What I saw was shocking. Her account had declined to just enough to cover a few remaining years of expenses. What’s worse, the investments were all wrong for someone living on their savings, with little savings left.

All of her money was invested in less than a dozen stocks, mostly in the energy field. There was no diversification and no pool of conservatively invested money to cover her monthly withdrawals. Amid a strong stock market, her holdings steadily declined in value. Every month the adviser sold some of her holdings to generate the cash for her monthly expenses. Because the value of the stocks he sold was down, the sales were doing more and more damage to the viability of her portfolio.

I was shocked. I naively believed that nearly all advisers had their clients best interests at heart. I never thought I’d see investment management this egregiously bad. This guy was simply trying to generate commissions on Gerry’s account. His behavior was serving no one but himself and was in fact illegal. His activity is known as prohibited conduct. In the financial services industry, investments must be prudent and suitable for the account owner.

Gerry didn’t want to take legal action, though she certainly had a very good case. She did sell her holdings to salvage what little money she had left. She’ll have to sell her beautiful house in the next year or so. She needs the equity to live on. Fortunately the equity will be enough for her to maintain her lifestyle for the rest of her life, but she’s devastated that she’ll have to leave her home that she loves so much.

You can’t just give your money to someone and assume they’ll do what’s right. While most financial advisers are good people, this story illustrates that it’s not true for all. Even an adviser with your best interests in mind, can’t know whether their strategy is still good for you unless you engage with them. Here are the things you should be discussing with your adviser on a regular basis:

  1. Update your financial information beyond the investments your adviser is managing. This should include total savings, total debt, and income.
  2. Reiterate or update your financial goals.
  3. Discuss whether you are saving enough, or if you’re closer to retirement, a plan for withdrawals that will help your money last and minimize your tax burden.
  4. Discuss how the investment strategy aligns with your goals, and how you can expect it to change over time.
  5. Ask to be educated on any concepts you don’t understand.

If your adviser isn’t willing to talk with you about these topics, find another one. Seriously consider someone with a Certified Financial Planner (CFP) designation. These professionals must demonstrate their skills before a governing board and practice for at least three years before they can use the designation. You can find CFP professionals in your area at letsmakeaplan.org or napfa.org.

Advisers gain a great deal of control over your savings. That can relieve you of making decisions you’re neither qualified nor comfortable in making. But you can’t just walk away. Review your monthly statements to make sure your adviser is doing what she said she would. And to make sure she is working toward the same goals as you, demand a detailed discussion with her at least annually.


SaveYourself-front-cover-thumbnail-1
For a comprehensive, step-by-step guide to building your own financial plan, pick up my book, Save Yourself; Your Guide to Saving for Retirement and Building Financial Security. It is now available on Amazon.

It’s Here!

Thank you to everyone who has followed my posts for the last few years. I am extremely excited to announce that my book is now available on Amazon!

Save Yourself is a comprehensive guide to saving for retirement and shoring up your financial security so you can do whatever it is you want. Through the stories of real people, it shows you exactly how you can make the changes that will allow you to save for a long and secure retirement so that you don’t need to work for pay. In addition, it covers other aspects of true financial security, giving you peace of mind throughout your life.

Early reviews are very positive. Here’s one that a reader was kind enough to post on Amazon.

The Save Yourself guide to retirement planning justifies the need to take control of your financial security with meticulous statistical research and lays out the step-by-step plan to reduce debt, budget and achieve financial independence. If you are putting planning off, author Grandstaff’s remark that “The monthly savings requirement more than doubles for every ten years you delay” is a sobering statement to prompt action to read her work and get started today.”

Happy reading! Reviews are very important to help other readers find the book, so please post one back at the same Amazon page. Again thank you for your kind attention, and have a wonderful holiday season.

What You Should Do When the Stock Market Swoons

Nothing.

Now, what would be really great is if we could invest more money in the stock markets when they are going up and get out of the stock markets when they are going down. Our return would be much better if we could avoid those nasty market downturns. Many attempt to do just that, but few are any good at it.

The trouble is if you missed just the months with the top 5 percent of returns in the market since 1950, you would have cut your returns almost in half. Of course, if you were able to avoid the bottom 5 percent of months in the process, you would perform just about as well as the market. But given the uncertainty of when those occur, that doesn’t seem like a good trade-off.

To illustrate, take a look at what happened during and after the financial crisis. The following chart shows the total return for the S&P 500 and cash flows in (bars going up) and out (bars going down) of equity mutual funds during the crisis and through the recovery to 2012.

S&P chart

The peak in value for the S&P 500 prior to the crisis came in September of 2007. From there the stock market began a gradual decline, with some investors selling sporadically. However, in September of 2008, the floodgates opened, and mutual fund investors began pouring out of equity funds. The S&P 500 had already lost more than 36 percent of its value.

The bottom of the market came in February of 2009, just four months and 16 percent later. But money kept leaving the stock markets. Even as the stock market crested its prior peak, equity funds saw growing withdrawals through the end of 2012.

If you had perfect foresight, you would have sold in September of 2007 at the peak. You would have avoided the following drop in value of 51 percent. Then you would have bought back your investment at the low in February of 2009. If you had done that, then ten years later—by September 2017—your investment would have risen by almost four times, or 14.2 percent per year.

But be realistic. You only have perfect hindsight. You know nothing about the future. You can’t tell whether the market is at a peak or just a nice viewpoint along the way. And you certainly can’t tell when the market has hit bottom.

The biggest monthly net sale of equity funds was in October of 2008, and the biggest monthly net buy following that was January of 2013. If you had sold and bought back in those months, as many other market participants did, your return for the ten years ending in September 2017 would have been just 10 percent, or about 1 percent per year.

What if you had done nothing? If you had not touched your stock market investments, in the following ten years your money would have more than doubled for an annualized return of 7.3 percent. Doing nothing is certainly easier than picking both the top and bottom of the stock market. Steadily adding to your investments, as you would in your retirement account, would have been even better.

Timing the market is a fool’s game. Seeing your nest egg shrink is no fun for anyone, but if you don’t have to spend your money right away, it can recover. So, as the market is adjusting, your task is simply to do nothing.

Photo by Chris Liverani on Unsplash

When Your Money Makes More Money Than You Put In

Saving money is hard. As human beings we are naturally wired to place our immediate needs (or wants) ahead of our future needs. Long term goals, like retirement, seem particularly daunting. The numbers are large, and the payoff is a long way off. Would it help to know that it gets easier the longer you do it?

Yes, the more consistently you set money aside the easier it becomes, because you are developing a habit of saving money. If you save through your company retirement savings plan, it’s even easier, because the money is whisked away before you get it.

But that isn’t what I’m talking about. The more money you save, the more your money works for you. Your money starts making money through the magic – actually the math- of compounding. Here’s what you could look forward to if you were to save the same amount of money each year, and earn an annual investment return of 7 percent.

  • In eleven years, the earnings on your total savings will match your contribution in that year.
  • In about six more years, the earnings on your total savings will be double your contribution in that year.
  • In about three more years after that, the earnings on your total savings will be triple your contribution in that year.

Of course if your investment return is lower, it takes a bit longer for your investment earnings to match your savings contribution. If your return were only 5 percent per year, it would take about fifteen years for the earnings to match your contribution. But there is a similar pattern of doubling and tripling your contribution over ever shorter time frames following that.

Admittedly, I’m both a money and a math nerd. I find this half-life of time to essentially gain an extra year of savings through the earnings on what you’ve already saved exciting. Who wouldn’t appreciate their money working harder than they do?

That is why it is so important to begin saving for your long term goals as soon as possible. The more time you have, the more your money can do the heavy lifting for you. Your total contributions toward your goal can be smaller.

If you are struggling to find the motivation to save for something that is decades away, keep in mind that you don’t have to do all the work. Saving money is hard, so make it as easy as you possibly can. Take advantage of the magic of compounding. Save early and save often, and you won’t have to save as much.

Photo by Mert Guller on Unsplash

 

 

 

How to Take Advantage of the Mutual Fund Company Price Wars

Fidelity has added two zero cost funds to their line-up of low-cost index mutual funds. One fund tracks the U.S. stock market and the other tracks international markets. These new funds are the latest volley in the index fund price wars. So it’s a good time to talk about the impact of fees on your investments and at what point it makes sense to switch.

Mutual fund fees are extracted from the value of the underlying fund investments. While you never have to pay out-of-pocket for these fees, they reduce the value of your investments, and are therefore, worth paying attention to.

Average fees for funds investing in large U.S. companies are 1.25 percent per year. If you assume the stock market will return 7 percent per year, after fees, your return would be 5.75 percent.

However, there are many index funds with much lower fees. Index funds track a market index, which is a fixed list of company stocks, like the S&P 500, or the Dow Jones Industrial Average. There are hundreds of indices which slice and dice the investment markets every which way you can imagine.

Because index funds track a fixed list of companies, the investment process is largely automated. The fund companies don’t have to pay expensive research staff, and therefore the funds are cheaper to manage and less costly to you.

The following table compares investment minimums and fees among a sample of a few low-cost index funds similar to one of the new funds from Fidelity.

Index Mutual Funds Minimum Investment Annual Fees
Vanguard Total Market Index Fund Investor Share Class  $3,000 0.14%
Vanguard Total Market Index Fund Admiral Share Class  $10,000 0.04%
Schwab 1000 Index Fund  $ 1 0.05%
Fidelity Zero Total Market Index Fund  $ – 0.00%

All of these funds are substantially less expensive than the average fund investing in U.S. stocks. That is why index investing has become so popular. Over a ten year period, a $10,000 investment will be worth around $2,000 more in any one of these index funds, versus a fund with a 1.25 percent expense ratio. Give yourself thirty years and the difference will be around $20,000.

However, among these already low-cost funds, the differences are much smaller. The following table shows the difference in expenses over time on a $10,000 investment for the funds above.

Cumulative Expenses Over Time

Ten Years

Twenty Years

Thirty Years

Vanguard Total Market Index Fund Investor Share Class

$256

$1,000

$2,932

Vanguard Total Market Index Fund Admiral Share Class

$73

$288

$849

Schwab 1000 Index Fund

$92

$360

$1,060

Fidelity Total Market Index Fund

$0

$0

$0

If you are just starting out and planning to invest in index funds, going with the low cost provider is a reasonable strategy. While Fidelity has these two new zero cost funds, they also have several index funds with expenses ranging between 0.015 percent and 0.11 percent.

However, if you already have investments, there are a few things to consider when deciding whether to change fund companies for the purpose of getting a lower fee.

  1. It’s important to keep your financial life simple by holding as much of your investments as possible at one institution. If most of your investments are already with Vanguard, it probably isn’t worth it to open a Fidelity account just to take advantage of the new zero cost funds.
  2. While the fund fees may be lower, you could pay a premium to buy and sell a low- cost index fund away from the fund company that manages it. For example, if you buy the Vanguard Total Market Index fund through Charles Schwab, the trade will cost you $76. The Fidelity Zero funds aren’t available there (at least not yet).
  3. If your investments are in a taxable savings account, you will have to pay capital gains taxes on the sale of the fund you already hold to move to a lower cost fund. If you have a high expense fund, it could still be worth it, but it probably won’t pencil out among already low-cost index funds. Of course there are no tax consequences to transactions in your retirement savings accounts.

The mutual fund company price wars are making investing cheaper and more accessible to all investors. Mutual fund fees take a bite out of your returns, so the lower the better. But if you are already invested in a low-cost fund, there can be drawbacks to switching to a new fund, even if it costs less. It may not be worth it to chase the fund companies to save a few bucks.

Image courtesy of sheelamohan at FreeDigitalPhotos.net

How to Lose Money with Every Dollar You Invest

Recently I was helping my daughter with her bank account and noticed a $1 withdrawal labeled “Stash Fee”. It was a fee to robo-adviser, Stash. Normally I would be thrilled by the good news that my daughter was saving and investing. But in this case I wasn’t.

I had a couple of concerns, but the biggest one was that $1 fee which would be coming out of her account monthly as long as she maintained her account with Stash. It doesn’t seem like a lot, $12 per year, but she had only invested $50 so far. That’s an investment expense of two percent per month! It would be really hard for her investment to make money with that expense load.

I’m a fan of robo-advisers. They offer a great service for savers with both small balances and big ones. They generally use low cost exchange traded funds to build a well diversified portfolio, and their management fees are also low. For more details on robo-advisers, check out the post I did a little over a year ago.

The Stash service allows investors to invest as little as $5.00. You can set up an automatic regular transfer from your bank account. In fact, you are required to link your bank account to your Stash account, so they can automatically withdraw your fees every month.

Most robo-advisers subtract your fees from your investment account, and even with small balances, the fees are lower. Betterment, and Wealthfront two other robo-advisers, offer investment management for 0.25 percent per year. Betterment has no minimum balance, but Wealthfront does require an initial $500 investment.

Stash bills itself as a way for young investors to learn more about investments while building their portfolio. They offer lots of information on investing as well as help selecting investments. But they seem to leave out the bit about how high fees eat into your savings.

Stash’s fees do become more reasonable as a percent of your investments the more you invest. Once your balance hits $5,000, the fee converts to 0.25 percent per year, which is about $12.50 on that amount of money. That is in line with Betterment and Wealthfront, but both those advisers will build your portfolio for you, as opposed to offering to help you build your own.

This experience highlights the importance of understanding what you are getting into. Never hand over your money to any adviser without investigating how they work, what they offer and how they compare to other alternatives. There are many low cost ways to have your money invested for you.

Robo-advisers are a good way to go, particularly if you don’t have much to invest right away. However, Stash’s fee structure makes them a poor choice for balances less than a few thousand dollars. There are other options with much lower fees. If you like what Stash has to offer, wait until you’ve saved up the $5,000 to make the fees competitive before you invest with them. Whatever investment adviser you choose, make sure that you understand what they offer and what they charge before you hand over your money.

The Stock Market is at Record Highs. Should You Get Out?

Both the Dow Jones Industrial Average and the S&P 500, the venerable U.S. stock market indices, closed near record highs on Friday, October 13th. Both indices have been steadily climbing all year. The Dow, including dividends, is up 17.92 percent and the S&P, also including dividends, is up 15.86 percent just this year.

The run up has investors waiting for the other shoe to drop. Surely the next move can only be down. Every week there are articles discussing whether we are on the verge of another stock market bubble bursting. You’ve worked hard for your savings, and nothing is worse than seeing a big hole in the value of your nest egg. So should you sell your stock market investments to avoid that?

To see how it might turn out, look at what happened following the last stock market peak, in September of 2007, just before the financial crisis. If you had perfect foresight you would have sold then, and avoided the following drop in value of 51 percent. Then you would have bought back your investment at the low in February of 2009. By now your investment would have more than tripled.

But let’s be realistic. We only have perfect hindsight. We know nothing about the future. We can’t tell whether we are at a peak or just a nice view point along the way. And we certainly won’t be able to tell when the market has hit bottom.

To get a sense of what most investors did following the stock market peak in 2007, we can look at investor net buys or sales of mutual funds and exchange traded funds investing in the stock market during the time period. In the following chart, fund net buys (actually sales because they are negative) are in blue and the S&P 500 Total Return Index is in orange.

Funds flows and performance

Yes, investors began taking money out of the stock market as it began to decline from it’s highs. But they continued to take money out even as it rebounded. As the market surpassed it’s previous peak investors were still withdrawing money. It wasn’t until the end of 2012 that stock funds began to see steady net buys.

The biggest monthly net sale was in October of 2008 and the biggest monthly net buy following that was January of 2013. If you had sold and bought back in those months your return from September of 2007 through October 13, 2017 would have been just 11.89 percent, or about 1.3 percent per year.

Even being off by a few months would have cost your returns. If you didn’t sell until December 2007 and didn’t buy until May 2009, your money would have only doubled instead of tripled. If you had waited another six months on both ends, your money would be only 1.5 times more than at the 2007 peak.

What if you had done nothing? If you had not touched your stock market investments, by now your money would have more than doubled. Doing nothing is certainly easier than picking both the top and bottom of the stock market. Steadily adding to your investments, as you would in your retirement account, would have been even better.

Where stock market declines become devastating is when you have to withdraw your money during the decline to meet expenses.  To avoid that, don’t invest any money you will need to spend in the next ten years there. Anything that you won’t need for more than ten years can stay invested in the stock market. Historically, the S&P 500 has finished higher than it started in 26 out of every 27 ten-year periods.

Of course there will be another market down-turn. But no one knows when or how severe it will be. In the mean time you need your savings to grow for your long term goals, like retirement. So no, don’t get out of your stock market investments now and in fact keep adding to them. If you have more than ten years before you need to spend your money, you have plenty of time for your savings to recover from the next down-turn, whenever that is.

Sources: Yahoo Finance S&P 500 Total Return Index and Data Hub US Investor Flow of Funds

Image courtesy of Idea go at FreeDigitalPhotos.net

There are Only Three Investment Categories

Investing your hard earned savings can be daunting. There are so many options it can be hard to figure out what to do. You likely have several investment options in your 401(k). And what about all the other options? Are IRAs or ETFs right for you?

You can untangle the mess of terminology and options if you understand that at the root of things, there are only three types of investments. Everything else is simply a container to hold those investments. The three categories are:

  1. Stocks: Also known as equities. When you invest in stock you own a small piece of a company. As an owner you share in the company’s earnings with other owners. Your earnings may be sent to you in the form of a dividend, or the company might reinvest them in the business. Growth in earnings and dividends drives the long-term value of the shares you own, though many things influence the daily prices of stock in a publicly traded company. Because the future earnings are uncertain, stocks are risky investments.
  2. Bonds: Also known as fixed income. When you invest in a bond, you own a piece of a loan made to a company or government entity. There are even bonds that bundle together mortgage loans to individuals known as mortgage backed securities.  As the owner of a bond you are entitled to interest and the return of principal (your piece of the amount loaned). The daily value of a bond is driven by changes in interest rates and the time remaining until the loan must be paid back, but if you hold the bond to maturity you will simply get the interest and principal. Because the interest and principal payments are contractual obligations, bonds are less risky than stocks.
  3. Hard Assets: Hard assets are things you can touch, like precious metals, agricultural products, oil and gas or real estate. The value of most hard assets is driven by supply and demand. Real estate is the exception. Real estate can also generate income through rent. Supply and demand is unpredictable, so hard assets are also risky investments.

Within each of these broad categories is a host of sub-categories. They include US and international stocks in large, mid or small sizes, US and international corporate and government bonds and many more. There are thousands of companies and bond issues, and you can hold any of them directly. All other investments are indirect ways, or containers, for holding one or more of these three investment categories. Here are a few of the common forms of holding investments indirectly.

  1. Mutual Funds: Mutual funds can hold any or all of the three investment categories. There are single category mutual funds that invest in only one of the three, and there are multi-category funds that invest in two or more categories.
  2. Exchange Traded Funds (ETFs): ETFs are a special type of mutual fund. Mutual funds are valued at the end of each day and sold through the fund company that manages them. ETFs are sold on the stock market like a company stock. The value fluctuates throughout the day. Because the ETF must have a value at any given moment, most invest to mimic an index, which is a fixed group of investments, like the S&P 500.
  3. Target Date Mutual Funds: Target date funds are also a special form of mutual fund. They were designed for retirement savings investments and invest in at least stocks and bonds, if not hard assets too. They usually have a year in their name, like 2035 or 2050. When the target date is far in the future, these funds invest most of their holdings in stocks, and as the target date approaches their holding of bonds become larger.

There are many other vehicles that allow you to indirectly invest in the three main categories. Whether you are investing directly or indirectly to get a truly diversified portfolio, you should spread your investment money among different categories. Diversification reduces the risk of your holdings, because their values aren’t influenced by the same drivers, and therefore they will perform differently in any given circumstance.  The biggest reduction in risk comes from adding investments in the lower risk bond category to your other holdings. Different investments in the same category offer some diversification, but not as much as investments across categories.

The next container up is the account. The different forms of accounts are merely ways of titling your holdings, similar to the way you would title an account in both you and your spouse’s name or the name of a business. The different titles designate how the account is to be used. Theoretically an account can hold any kind of investment, but the institution or the provider may limit what they offer you.

  1. 401(k): You may have a 401(k) or its cousin the 403(b) account through work. Your employer has picked a list of several mutual funds for you to choose from and will include some in both the stock and bond categories as well as at least one or two investing in multiple categories.
  2. IRA: IRA accounts are available through most financial institutions. Common places to open an IRA are through a full service brokerage firm, like Merrill Lynch, through a discount brokerage firm, like Charles Schwab or directly through a mutual fund company, like Vanguard. There are many more investment options available in an IRA. You can hold stocks, bonds and hard assets¹ directly, or you can hold any of hundreds of mutual funds and ETFs.
  3. 529 Plan: 529 plans are college savings plans offered through your state of residence. The state will offer a limited line-up of investment options that will usually include a fund paying guaranteed interest, funds investing in single categories and age based funds, that like target date funds are designed to become less risky as the date of college attendance approaches.
  4. Taxable Account: Taxable accounts are simply titled in your name or jointly in you and your spouses name or the name of a business. They don’t have any tax advantages, and the title simply designates who has the authority to use the account. You can use the money in the account for any purpose including retirement and college. Like with IRAs, the investments you can hold in a taxable account are wide open.

401(k)s, IRAs and 529 plans have tax advantages. If you use them as intended your investments can grow tax free. It is still your money, and you can use it however you like. But the government will want the taxes that you didn’t pay along the way if the money isn’t used as intended, and in some cases there may be a penalty in the form of additional taxes.

Investing is a process of matching the account type with the intention you have for the money, deciding whether to invest indirectly through mutual funds, ETFs, and other vehicles or directly depending on what is available to you and how much work you want to put into managing your money, and diversifying your investments among the different categories according to the amount of risk you are willing to take. What the money is for may be the only straight forward decision here, but understanding this framework will help you know what questions to ask.

  1. Hard assets are held through futures and forward contracts to buy or sell the product, or in the case of real estate, through real estate investment trusts. There are a few specialty institutions that can hold title to real property.

Image courtesy of Teerapun at FreeDigitalPhotos.net

Home or Retirement?

The housing market in many areas of the country has seen dramatic increases in prices over the last five years. Home prices in coastal metro areas, like Portland, seem to be on fire. If you don’t already own a home, your hopes of buying one may be dimming as each month brings higher prices. It takes time to save up for a down payment, especially with today’s housing prices. Should you take the money you’ve stashed in your retirement savings and use it to buy a home?

Using the S&P/Case Shiller 20 City Composite Home Price Index, home prices have risen, on average, nearly 8.0 percent per year since the bottom of the housing market in 2012. The fast pace of price increases was at least partially due to the depths of the decline in the market. Since the last peak in housing prices in 2006, nationwide home values are still down. Longer term, home price appreciation has been much more modest. Nationwide, since 1980, home values have only increased 3.6 percent per year. Even in trendy Portland, prices are up just 4.7 percent per year. So values are unlikely to continue to run at the pace of the recent past.

Still it’s hard to not want to jump in for fear of being priced out of the market altogether, especially if you have enough money for a down payment sitting in your retirement account. But raiding that account is not the answer.

Depending on the account type there are limitations to what you can do. If you withdraw your money from a traditional 401(k) or IRA, you will have to pay taxes on the balance you take out, and you may also pay a tax penalty.  You could borrow money from your 401(k), but you can only borrow the lower of $50,000 or half of your balance.

If you have a Roth IRA, you can withdraw your contributions at any time, however if you withdraw earnings on your contributions before age 59½ you will pay both taxes and a penalty. Roth 401(k)s have similar rules, plus many employer plans limit withdrawals while you still work for your company, though loans are still an option.

If you take a loan from your 401(k), you will make monthly payments, and those payments are not considered contributions to your plan. So, unless you make a contribution and a loan payment, you will miss out on the employer match if your company offers one. Loan interest is paid to you, but the interest rate is generally lower than the return you can expect from growth oriented investments available in your plan. And if you leave your job before the loan is paid, you will have to repay the loan in full or pay taxes and penalties as if the loan were a distribution.

Let’s say you have the best situation possible. You have a Roth IRA account with a balance of $100,000, and you can withdraw enough to cover your down payment without triggering taxes. You have three choices. You can continue to save in your Roth IRA and at the same time save for a down payment for your home. You can stop making your Roth IRA contributions and use the money to add to your savings for a down payment on a home, or you could withdraw the down payment from your Roth IRA.

With option one, your retirement account will continue to grow as before. But the cost of the home you want to buy will continue to rise, and given how low interest rates are today, you will likely pay higher interest on your mortgage loan. With option two, your balance won’t grow quite as fast, because you aren’t adding money to your account. With option three, you buy today with a down payment withdrawn from your IRA. You put a big dent in your retirement savings, but your home price will appreciate and you can lock in today’s low interest rates.

To figure out which option is best, I’ve calculated the combined retirement plan balance and home equity twenty years from now using some assumptions. I’ve assumed home values will increase on average 3.6 percent per year for the next 20 years, but over the next five years they grow at a somewhat faster pace of 4.0 percent per year. Using a modest home in my neighborhood (1,100 sq ft) as an example, today’s purchase price is $390,000, but in five years, the same house would be valued at $474,000. Today’s 30 year mortgage rate is 4.25 percent, and I’ve assumed rates rise to 6.25 percent over the next five years.

I’ve also assumed that you would ordinarily save $5,500 (the maximum for 2017) per year in your IRA. The average annual return on your IRA investments over the next 20 years is 8.0 percent, because you are still young and investing primarily in stocks. The following chart shows the results.

home v retirement

In option one and two, you put off buying the home for five years while you save up the down payment. In option one you are able to save for both. In option two you opt to not add to your IRA, but you don’t take anything out either. In both cases you pay a higher price for the house and higher interest rates, because you have to wait five years. In option three, you take out enough from your IRA to cover the 20 percent down payment on the home today, leaving you with about $22,000 in retirement savings.

You do have more home equity in option three, but your retirement account has taken a nasty hit. The value is only half what it would have been if you hadn’t touched the balance and continued to make the contributions. Even if you stopped contributing to your IRA while you save for a down payment, you would be better off than if you raided it today.

To raise a down payment for the house in question, you would need to save about $19,000 per year to be able to buy it in 5 years with the assumptions I’ve made. To recover from raiding your IRA, you would need to save the same amount above your normal $5,500 contribution over nine years, or $171,000 instead of $95,000.

As tempting as it might be to use the savings you’ve already built for retirement for a down payment on a home, in the end you won’t come out ahead. You need that balance to grow for you as long as possible. Dipping into those savings takes valuable time away from growing your account. As hard as it may be, you will still be better off saving for your home, even in the face of rising prices.

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Where to Stash Your Emergency Cash

As a saver, your first priority is to build up savings for an emergency, namely the loss of your job. Most people need at least three months of expenses set aside to bridge the gap between paychecks should the unthinkable happen. But where should you put your emergency savings?

The conventional wisdom says that you should deposit your emergency savings in a “safe” investment. A safe investment could be a savings account at your bank or credit union or a money market mutual fund at your favorite brokerage firm or mutual fund company. Unfortunately, in today’s low interest rate environment, these options don’t pay much more than simply burying your money in the back yard.

The typical bank pays you a whopping 0.01 percent on a savings account. If you have $10,000 saved, that will earn you $1 in a year. Vanguard offers a Federal Money Market Fund that pays 0.38 percent per year, or $38 for ten grand, and Fidelity offers a Government Money Market Fund that pays 0.20 percent per year, or $20 on your $10,000 in savings.

Of course there are investments that can be expected to provide a better investment return over time, but the operative phrase is “over time”. They all pose risks, and could leave you with less money than you contributed if you have to spend your money too soon. Here are the options and what might happen to your savings.

Stepping out just a bit from a bank savings account, you could invest your money in a certificate of deposit (CD). A CD is an account where you commit to leaving your money for a period of time, like six months, one year or longer. These accounts have somewhat higher interest rates. The following table shows current national average rates from the Federal Deposit Insurance Corporation (FDIC). However, if you withdraw your money early, you could wind up losing the interest earned and possibly paying fees, which could cause you to end up with less money than you started with.

cd-rates

At the national average rates, a money market mutual fund is a better deal, however there are CDs available with higher rates. Another option would be to invest in a short term bond mutual fund. Short term bond mutual funds invest in bonds with a few years to maturity. Bonds are essentially loans made to whoever issues the bonds. Both companies and governments issue bonds, and the interest rates they pay depend on their credit worthiness and how long until the bond matures, or in other words when the loan has to be paid back. Bonds and bond mutual funds will pay higher interest rates than the savings options listed so far, and there is no withdrawal penalty. But the value of your investment can fluctuate on a daily basis.

Using the yield on a composite of two year corporate bonds from the Treasury Department as a proxy for short term bond funds, I’ve calculated the returns and historical incidences of losses from 1984 through 2016. The results are in the following table. The current yield on this composite is 1.83 percent. A sampling of short term bond mutual funds had yields between 1.08 percent and 1.70 percent.

st-bond-funds

If you invested your emergency savings in a short term bond mutual fund, and you had to withdraw it in a month, there is a good chance, almost one in five based on historical returns, that you would pull out less money than you contributed. The longer you hold on to your savings, though, your risk of an absolute loss declines. Since 1984, there has never been a three year period that produced a loss in the Treasury Department’s two year bond composite. For holding periods with losses, the losses on a $10,000 investment were less than $300.

You could reach for a higher return by moving to longer term bond mutual funds. The next group of bond funds are called intermediate term bonds. These funds generally invest in bonds that mature in three to ten years. The longer until a bond matures, the greater the yield (usually), but also the greater the fluctuations in prices. Using the Treasury Department’s five year corporate bond composite, the historical incidence of losses are in the following table. The current yield on the composite is 2.62 percent, and the yield on a sampling of intermediate bond mutual funds ranged between 2.50 percent and 3.00 percent.int-term-bond-funds

For the extra earnings, you do take more risk. If you have to withdraw your money within a month you stand a more than one in four chance that you will lose at least some of your contribution. Losses were bigger for this investment. In the worst case since 1984, the loss was almost 9.00 percent, or $900 on a $10,000 investment. That is starting to hurt. But as with short term bonds, these longer bonds historically have not lost money over three year holding periods.

The riskiest place to put your emergency savings is the stock market. For a one month holding period, it is virtually a gamble. The S&P 500 stock index has lost money in more than 40 percent of the months since 1950. Losses can be large, leaving you substantially short of your ability to cover your emergency. Like with the bond mutual funds, the incidences of absolute losses decline the longer you hold your stock market investments, but even ten year holding periods are not immune to losses.

A good rule of thumb is to match your investment to your holding period. If you will spend your money soon, keep it in a savings account or a money market mutual fund. If you will spend your money in the next three years, short term bonds and bond mutual funds are a good option. If you will spend your money sometime between three and ten years, intermediate bonds and bond mutual funds are reasonable. Only money that you won’t touch for ten years should be invested in the stock market.

So which holding period does your emergency savings fall into? You may never lose your job, but for most there is at least a small possibility that you could lose your job at any time. If you are just starting out and your emergency savings are all the savings you have, the conventional wisdom applies. You can’t afford to lose any of your money, so keep it in a savings account or a money market mutual fund. As you build up your savings, and you begin to save for other goals like retirement, you could get away with a bit of risk. Losses in short term bonds have been limited historically, so the extra yield may be worth the small risk.

Save the higher risk investments for your longer term goals. The whole point of having emergency savings is that it will be there when you need it. Low interest rates may be hard to accept, but they are easier to live with than having your emergency fund come up short.

Image courtesy of Tina Phillips at FreeDigitalPhotos.net

 

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