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.

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Paying Off Your Mortgage is Worthwhile Despite Low Interest Rates

I often get asked whether you should pay off your mortgage early. In these times of low interest rates it doesn’t seem like you gain much when you do. For a number of reasons, paying down your mortgage shouldn’t be your first priority, but if you are otherwise out of debt, and you are meeting your retirement and other savings goals, paying off your mortgage should be next on the list.

Mortgage debt is the lowest cost form of consumer debt. Today a thirty year fixed rate mortgage will cost you about 4.3 percent and the 15 year mortgage will cost you about 3.5 percent. If you happened to buy your home when rates were at their lowest, your interest rate could be as low as 3.3 percent. When you tack on the mortgage interest tax deduction the rate is even lower. The following table shows before and after tax mortgage interest rates.

mortgage-rates

With rates this low, paying off all other forms of debt is your top priority. And even though holding this debt on your home is costing you money, earnings on your retirement savings out weigh the benefits of paying off your mortgage early. But if you are on track for saving for retirement, and don’t have any other debt, paying down your mortgage is a good next step.

Mortgage vs Investing

Paying down debt is a form of saving, and it provides a guaranteed rate of return. Every dollar you pay, you reduce the amount of interest you pay. Even though mortgage rates are low, they still offer a relatively high rate of return for risk free investments. One year Treasury bonds yield less than 1.0 percent. CDs offer similar returns. Slightly riskier fixed income investments, like one year corporate bonds, only pay a little more than 1.0 percent. But on every dollar of mortgage interest you avoid you earn your mortgage interest rate.

Yes there are riskier investments that have higher expected returns. Historically, the average stock market return has been 10 percent. Wouldn’t that be a better place for your money than paying down your mortgage? For your retirement savings goals yes. Those are very long term goals. But if you are meeting those goals, it’s worth considering the relative risk of investing in the stock market versus paying down your mortgage.

If you choose to invest in the stock market with your next savings dollar, rather than pay down your mortgage, you are essentially borrowing money to make the investment, all be it at a very attractive interest rate. Your net return is the market return minus your mortgage interest rate. That would be an average return of less than 6 percent at today’s mortgage rates. Not much more than the guaranteed return of paying down your mortgage, but with a lot more risk. Your actual return in the stock market fluctuates widely from year to year. It only has to dip down to 4.0 percent to give you a negative return after your mortgage interest. That has happened in about four of every ten years.

Mortgage vs Security

While we can quibble about the attractiveness of a higher risky return versus a lower, but attractive, risk free return, one thing is certain. Eliminating all forms of debt makes you more financially secure. That is particularly important when you aren’t getting a paycheck. If your scheduled mortgage payments would have you continuing to make payments beyond your retirement date, it is important that you find a way to eliminate your mortgage before you stop working.

According the Consumer Financial Protection Bureau, in 2011, those over the age of 65 who owned their home and still had a mortgage were paying nearly three times what those without a mortgage were paying for housing. With no mortgage payments, your draw on your savings will be smaller, making them last longer. If your savings have suffered from an investment market downturn, you will be better able to weather it, because your overall expenses will be lower.

Compare two women, Valerie and Jocelyn. Both are single and recently retired. Valerie has a pension from her government job, while Jocelyn has retirement savings. Both women will have about the same amount to live on, around $4,000 per month.

Valerie, due to a recent divorce, will have to take on a mortgage of around $100,000. Her payments will be at least $500 per month excluding taxes and insurance.  With the new mortgage payment, Valerie’s expenses will consume all of her income. As other expenses increase with inflation, Valerie may find herself pinched and need to find ways to cut back on her lifestyle. Jocelyn’s home is paid off, and as a result she has much more financial flexibility. Her cost of living is low and has plenty of room to grow if inflation forces it up. Jocelyn is much more financially secure than Valerie.

We are lucky to live in an era of low mortgage interest rates. It makes the cost of housing more affordable. So paying off your mortgage, unlike other forms of debt, doesn’t need to be a priority. But when you run out of other savings goals to fulfill, paying off your mortgage is well worth it. It’s hard to find a better guaranteed rate of return and getting rid of your mortgage payment before you stop working for pay will make you more financially secure.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Robo-Advisers Can be Better than Human Advisers for Small Accounts

Do you work with an investment adviser?

How often do you meet with your adviser?

What do you talk about beyond the investments?

What are you paying for your advice?

Unfortunately, for too many people who answer yes to the first question, particularly those with small balances (less than $1 million), the remaining answers are never, nothing and I don’t know.

Over the last several months I’ve reviewed a number of investment portfolios for people who work with advisers. Sometimes it’s good to get an unbiased second opinion, especially if it is free and not given with the intention of winning business. In general, the investment strategies have been just fine, but what has caused me concern is the high fees combined with a lack of service.

In one account, the adviser was charging what seemed to be a relatively low annual fee of 0.60 percent of assets under management (about $6 per $1,000), but he was investing the money in class A shares, which not only had high internal expense ratios, but also had a front end load of 3.50 percent. The internal expense ratio is what the mutual fund manager gets paid to manage the mutual fund. The front end load is paid to the adviser for selling the mutual fund to you. The investor was depositing $1,000 per month, and every month’s deposits were being hit with the 3.50 percent load. That was in addition to the management fee. Average expenses were nearly 2.0 percent per year on the account.

What was the adviser doing for this compensation? Nothing. The owner had never met the guy. He had taken over the account from the previous adviser who no longer worked for the firm.

In another case, a friend left one adviser because he didn’t think his investments were doing as well as they should have been. He moved his investments to an adviser at his credit union. The new adviser charged a 1.0 percent per year management fee and invested the money in a variety of mutual funds. All of the mutual funds had above average internal expenses, making total expenses close to 2.0 percent again. At least in this case, my friend had met with the adviser. But only once. There was no financial planning. There was no assessment of estate planning needs. There was not even any subsequent review of the investments.

Below is a table showing the average investment advisory fee charged by a sample of advisers nationwide from a survey conducted by Advisory HQ.  If your portfolio is less than $1 million it is pretty typical to pay an adviser at least 1.0 percent. These fees don’t include any investment expenses, which could increase total expenses a little or a lot depending on whether the adviser uses cheap index funds or expensive actively managed funds.

asset-management-fees

Advisers need to make a living and smaller accounts just don’t pay for themselves. Some advisers work on an hourly fee, but most don’t like to do that. There is no leverage in that fee model. The adviser can only make as much as she has hours in the day. Most advisers work on a percent of assets under management structure, where their income can grow with the amount of assets they manage. But that means advisers have an incentive to work with larger accounts. An adviser can make almost as much money with one $1 million account as she can with ten $100,000 accounts.

In order to make small accounts work for advisers, they often streamline the service model. If your account is small, you may see your adviser less often than larger accounts do. Your service may be limited to investment management, which will include creating a portfolio of mutual funds. The adviser will review your investments regularly and maintain the portfolio structure over time, though they may not speak with you very often. If that is all you are getting, you can do just as well for a lot less money.

Enter robo-advisers. The very name seems derogatory. However they are a great solution for people who aren’t getting much service from their current human adviser. Robo-advisers use automated systems to create an investment portfolio for you based on your investment objectives, time to meet those objectives and other information designed to gauge how much investment risk you can take without running for the exits.

These advisers generally use low cost exchange traded index funds or index mutual funds, so the investment expenses are low. Because the investments are maintained automatically, there is no human to pay, and therefore the fees charged by the advisers are low too (some are even free). That leaves more of your investment return for you.

Two of the top rated robo-advisers are Betterment and Wealthfront. Betterment offers investment management using exchange traded funds from 12 different investment categories. Fees for service are tiered and range between 0.15 percent for accounts with more than $100,000 invested and 0.35 percent for accounts with less than $10,000 invested. There is no account minimum. Average investment expenses are just 0.13 percent. For a $100,000 account, you would pay just $380 per year all in. That is $210 less than the average human investment adviser’s fees alone, without taking the investment expenses into account.

Wealthfront offers a similar service. They use exchanged traded funds from 11 different investment categories. They charge no fee for the first $10,000 and then charge 0.25 percent for higher balances. Their investment expenses are about 0.12 percent per year. Annual expenses on a $100,000 account would be about $345. Nerd Wallet has done a good review of several different robo-advisers that is worth checking out.

Robo-advisers are registered investment advisers that take fiduciary responsibility for their clients’ accounts. Fiduciary responsibility means they are required to invest in their clients’ best interest. However they have been criticised. The main concerns are that they can’t offer advice on money they aren’t managing, because the systems simply can’t see it, and the information gathered by questionaires may be too shallow.

If you aren’t getting a lot of service from your adviser, he isn’t in any better shape than a robo-adviser. If you have an account he doesn’t manage, like your 401(k), your investments with your adviser and your 401(k) investments may not come together in a cohesive investment strategy. Human advisers tend to tout the advantages of their customized approaches, but unless your advisor is meeting with you regularly, his investment strategy will be based on limited information too.

The primary driver of investment strategies in general is your time horizon. Your time horizon dictates how much risk you can reasonably take, and therefore how much of your investments should be in risky stock market investments versus lower risk income oriented investments. Time horizon is something that can reasonably be collected through an electronic questionaire. I’ll bet your adviser had you fill in that information on a form when you opened your acount.

A good adviser is worth the money that you pay. A good adviser will help you with saving as well as investing. She will meet with you regularly and take into account all of your investments, even the ones she doesn’t manage. She will advise you on how to put an estate plan in place, how much insurance you should own and how to manage your tax burden effectively. She’ll help you understand what you need to retire, and how long it will take you to get there. If you are getting this kind of service, 1.0 percent of assets under management is a reasonable fee. It is low if your account is less than $1 million.

If you are not getting this kind of service, 1.0 percent is way too expensive. If your adviser isn’t going to do more than put together a few expensive mutual funds for you and send you a statement once a quarter, you shouldn’t be paying him so much. All you are getting is a faceless automated solution. A robo-adviser will do the same thing for a lot less money.

Image courtesy of iosphere at FreeDigitalPhotos.net

 

 

Rental Property – Good Investment or Money Pit?

I’ve been asked more than a few times whether rental property was a good investment. Many people feel more comfortable with an investment they can go and visit than with the stock market which seems so out of our direct control. When a duplex went up for sale near us, it seemed like a good time to do an analysis.

A good investment is one that provides you a good return for the risk that you take. Of course good and risk may be in the eye of the beholder and depends to some degree on how long you expect to hold the investment. For comparison, we’ll use the return on the S&P 500 and it’s range of historical returns over ten year periods to gauge the return on this rental property.

What should be included in our analysis? Well of course we’ll include our annual rent and an estimation of the increase in the value of the property. But we’ll also need to subtract the costs involved in owning the property. Those include property taxes, insurance and maintenance. If we take out a mortgage to buy the property, we’ll also need to include the interest on the loan. Finally we’ll need to make an assumption for inflation on both the income and expense side.

The duplex that is for sale has two 1,000  square foot, two bedroom, one bath units. Here are the reasonable expectations for this property here in Portland.

rental-assumptions

There are two rules of thumb about what to assume for maintenance costs. One suggests using 1.0 percent of the purchase price, and the other suggests using $1 per square foot. The property for sale was built in 1957 and likely could use some tender loving care. So I’ll take the higher of the two and use $4,950 per year as an average maintenance cost estimate. That puts our net annual rent, after expected expenses at $14,449. If we were to take out a 30 year mortgage to buy the property*, deducting the interest cost would leave $710 in annual rent. That’s not much, but property values tend to increase over the long run. Will the increase in value provide our return?

Using data from the Federal Housing Finance Agency the following chart provides the average annualized rate of increase in home prices over different periods within the 1991 to 2016 time frame. The Portland market data is from Zillow.

home-price-increases

As you can see, the Portland market has been hot, but the increases in prices over the last five years here are not sustainable. The best ten years nationally, at 6.8 percent, ended in 2006 and there is not another period with price increases of that magnitude. So we’ll exclude those two data points. The last ten years were also an anomaly. The price declines from 2006 to 2011 were the worst in the 1991 to 2016 time frame. A reasonable assumption for the increase in the future value of our property would be the longer term national average annual increase of 3.4 percent.

A few other assumptions can go into our analysis. Rents and property taxes go up more or less with inflation, so I’ll include an annual 2.0 percent increase in these values as well as the cost of insurance and maintenance. With all of this information what is our expected investment return?

While the price of the property is $495,000, if we mortgage the purchase with a 20 percent down payment, our investment is only $99,000. The mortgage leverages our return, so our net rent and price increases would be judged on that basis, not $495,000. As we make mortgage payments the base does grow, however. Given these assumptions the expected average annualized return over a ten year holding period would be 9.9 percent. That is comparable to the historical averages for the S&P 500.The NYU Stern School of Business data set has the average annualized return for the S&P 500 from 1991 through 2015 at 9.7 percent with similar returns for the full data set which goes from 1928 to 2015.

What could go wrong? Well it’s not likely that we’ll be able to rent the property all of the time, but we’ll have to make loan payments every month. If we assumed that we average ten months of rent per year the return drops to 8.6 percent.

It’s possible that we’ll have to put more into the house than our down payment in order to make the rental units comparable to similarly priced apartments in the neighborhood. If we had to put in an extra $50,000, our return would drop to 7.0 percent. Or alternatively we could rent the units for less; say $750 per month. That would drop our return down to 4.9 percent.

Finally our return is sensitive to the gain in the value of the property. If the next ten years were like the worst ten years for residential real estate prices, our return would be 1.8 percent. If everything works against us, we need to put more money in, rents aren’t as high as we expected and real estate values don’t rise, then we would lose 2.7 percent per year. But if everything works in our favor, we could gain more than 14 percent per year.

The worst ten year period for the S&P 500, ending in 2009, had a loss of 1.3 percent. The best ten year period, ending in 1999, had an annual return of over 19 percent. The same numbers for the full series were also similar.

One other thing to consider is personal effort. While the expected return on a rental property could be in line with what you would expect from an investment in an S&P 500 index mutual fund, the rental property will demand time and attention. An investment in an index fund is passive and requires no effort at all.

So is a rental property a good investment? It’s not a bad investment. In any given time period the return on a rental property could be better or worse than the return on an S&P 500 index fund, a reasonable passive alternative. Over long holding periods, expected returns on a rental property are in line with historical returns on the S&P 500, given the uncertainty of the projections.

Most people will only be able to own one to a few rental properties, and those will be in a single geographic region, which increases the risk of the investment. Rental property requires time and attention. If you value your own time in line with the cost of a property manager, your return would drop further (by about 1.0 percent per year). But if you like the idea of being able to visit your investment, rental real estate might be a good alternative or addition to your stock market investments.

*30 year mortgage loan interest rate: 3.5 percent per bankrate.com.

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Do You Know Where Your Money Is?

Diversification is good right? Well yes it is, if it truly is diversification. But it doesn’t work if your idea of diversification is that you have your money in a lot of different places.

These days, it’s easy to grow the number of your investment accounts. According to The Balance, a career advice web site, the average person will change jobs twelve times during their career. That means potentially twelve different 401(k) accounts if you’re a good saver. There are also lots of opportunities for savers to open accounts outside their 401(k)s too. Maybe your neighbor sells annuities, or your brother in law is a stock broker. As long as you’re investing, how can it be bad?

Brenda and Gary are good savers, and that makes them vulnerable to AAS (account accumulation syndrome). Their accountant recommended a financial adviser who sold them a variable annuity. They had savings in a mutual fund company, and more savings with an insurance company. Gary had his company 401(k), and Brenda, as a teacher, spread her retirement savings around a few of the dozens of vendors participating in the school district’s 403(b) program.

There are several problems with this approach.

  1. It’s hard to get a good picture of how your money is invested. From how much you have in stocks versus bonds, to how much is in U.S. versus international investments, it takes digging into each provider’s information to understand your investment portfolio.
  2. It’s hard to keep track of your investment expenses. Brenda and Gary’s average investment expenses ranged from 0.65 percent at the mutual fund company to over 4.50 percent in the variable annuity.
  3. It’s hard to keep track of your investment balances. If you’ve gone paperless, you have to keep track of usernames and passwords to all of the accounts. If not, you’ll still get statements from multiple providers, and some will be quarterly, while others are monthly. Of course this can be alleviated by using an account aggregation service, like Mint, but some accounts may not be accessible through these services.
  4. It’s hard to change your investment strategy. As you get older and closer to the time when you’ll be tapping your savings for living expenses, you’ll want to reduce the risk of your investment strategy. With a large number of accounts it becomes harder to make the transactions necessary to move your investments to better meet your needs.
  5. It’s hard to manage what happens to the investments if you or your spouse dies. The more retirement accounts (company or individual) you have, the more beneficiary designations there are to manage. The more investment accounts you have, the more accounts that have to be retitled if you decide to create a family trust. At the very least there are more vendors for your family to work with as they settle your estate.

When it comes to your money, keeping things simple is your best approach. Consider choosing a single mutual fund company or discount brokerage firm to hold your savings outside your company sponsored retirement plan. If you change jobs, roll your 401(k) account into either your new employer’s retirement plan or into an individual retirement account at your fund company or brokerage firm.

An added benefit of consolidating your investments in this way is that you will get additional services as your balance grows. Jeff and I have the bulk of our savings with Vanguard. As our investments grew through savings, 401(k) rollovers and market increases we were offered access to a financial planner for free, lower cost share classes, and more free brokerage account trades than I’ll ever use in a year. Other providers offer similar perks.

The longer you wait to simplify, the more difficult it will be. Taxable accounts and annuities in particular are difficult to move. Mutual funds held with the fund company generally have to be sold if you switch companies, which creates a taxable transaction. Income on annuities is taxable upon withdrawal unless the proceeds are rolled into another annuity.

Our lives are complicated enough. There isn’t any need to add complexity with multiple investment accounts. Keeping as many of your accounts as you can in a single location  will go a long way toward simplifying your financial life.

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Don’t Let John Oliver Keep You from Investing in Your 401(k)

This past spring, John Oliver did a spot on retirement plans on his program Last Week Tonight with John Oliver. The video has been viewed over 4.4 million times on YouTube. A few friends have sent it my way asking me what I thought. Well first, it’s hilarious, so if you haven’t seen it yet, enjoy. He brings up some very serious issues in the financial services industry in general, and in the retirement plan industry specifically. He hits the nail right on the head in many ways, but he does leave the wrong impression in a few.

His first salvo was targeted at financial advisers. It is true, the term financial adviser has about as much meaning as the label “all natural”. Anyone can call themselves a financial adviser. There are very few barriers to entry for providing financial advice. For example, here in Oregon, if you have $300 and can pass the series 65 exam, which covers investment basics and regulations, you can be a state registered investment adviser. Registered investment advisers are fiduciaries by law, as Oliver recommends, but that doesn’t mean they are competent.

For most people, if you are seeking investment advice, look for someone with the Certified Financial Planner (CFP) designation. These individuals must show competency in eight topic areas, pass the comprehensive CFP exam, present a financial plan for review and have three years of related work experience before they can use the designation. These advisers can help you plan for your financial future as well as invest for it. Another group of advisers to consider are those with the Chartered Financial Analyst (CFA) designation. These individuals tend to be more focused on the investment side, but also have very rigorous testing and experience requirements.

Next Oliver took on high fees. Every cent of fees you pay is investment earnings you don’t get to keep, and high fees do take a toll on your savings. In a company sponsored retirement plan, there are two broad categories of fees. There are the fees associated with making the plan work, called administrative fees, and there are the fees charged by the mutual fund companies for managing your investment options.

The first set of fees are out of your hands. Your company selected the plan, and hopefully made the best deal possible. Unfortunately, for small plans, such as the one for the staff of Last Week Tonight, high administrative fees are difficult to avoid. Few retirement plan providers work with small and start up plans. It’s just really hard for companies to make a profit on plans that don’t already have large balances. Part of the fees typically do get paid to a middle man who acts as a sales person for the company providing the retirement plan. Unfortunately too many of these financial advisers do very little to earn their keep, but for those who do, they can be a tremendous resource for the employer and the employees participating in the plan.

If you work for a large employer, administrative fees are usually low. These companies can demand high levels of service and low fees because the retirement plan providers want to work with them. There are certain fixed costs to administering retirement plans, regardless of the size, and large plans cover these costs and more. That means the retirement plan provider makes a profit even at lower fee percentages.

The fees that you can control are those on the investments. You can minimize them by choosing low cost index mutual funds, just as Oliver recommends. Actively managed mutual funds have higher fees, and often don’t have better performance. The term active means that they are managing the fund in a way that they believe will perform better than market indices, like the S&P 500. In order to perform better, they have to invest differently, and sometimes (actually pretty often) that means they perform worse.

One exception that I make to the advice to invest in only low cost index mutual funds is when target date retirement funds are on offer. Oliver’s staff aren’t the only ones who would prefer to google tea cup pig antics over paying attention to their retirement plan investments. For most people, it’s worthwhile to get the broad diversification and automatic adjustment in portfolio risk that comes with target date retirement funds, even at the cost of higher fees. If your plan offers these, and more than 70 percent of plans do, simply pick the one with the year in the title that is closest to your most likely retirement year. For more information on target date retirement funds, see this post.

Oliver’s video closes with five things to do in order to successfully invest for retirement, and they are right on the money. Start saving early. Choose low cost index mutual funds. If you work with an adviser, choose one who is a fiduciary, and I recommend that you choose one with the CFP designation. Gradually shift your investments from stocks to bonds as you get older. In order to do this automatically, it may be worthwhile to choose a target date retirement fund, even if it is not an index mutual fund. Finally keep your fees as low as you can.

Oliver’s experience with his retirement plan wasn’t good, and it might leave the impression that you should be wary of investing in your own company’s plan. Company sponsored retirement plans offer many benefits including higher limits on tax deferred savings than on individual retirement accounts, and in many cases, a company match for your savings. If you are questioning whether you should participate in your company’s plan, the answer is simply, yes.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

To Buy or to Rent?

Recently one of our neighbors put their house up for sale.  It has roughly the same floor plan as our own. Their asking price made my jaw drop. Home prices in the Portland Metro area have been skyrocketing lately. Are you kidding me? Could we really sell our house for nearly half a million dollars? Being the analytical type, my joy at such luck usually lasts about a minute. And so it was in this case. I started thinking about all of the money we had put into the house, and wondered whether we were really ahead. For grins, my husband, Jeff, and I sat down and tallied all that we had invested. This was from memory, but I’m sure we are very close.

Before I give the gory details, I must tell you what we actually bought. I remember the day vividly. Sixteen and a half years ago, Jeff came home and told me I had to go check out this house. It wasn’t actually for sale yet, but they were having an estate sale, so I could walk through. I opened the front door of this 1972 gem to gold and beige shag carpeting in the hall so worn you could see the mesh. A quick turn through the old west bar style swinging doors into the kitchen revealed faux walnut cabinets and gold and brown foam carpeting. Through another set of swinging doors into the open dining and family rooms was more shag carpeting of the same color as the hall, formal harvest gold taffeta  drapes and the ugliest fireplace I had ever seen. In fact most of the house was in harvest gold, except for the master bathroom, which was turquoise.

But there were windows everywhere and the ceilings were high. The light, even on a dark rainy Portland day, was amazing. The yard was beautiful. We seriously considered two other houses in the neighborhood, but wound up buying this one. The ugliest of the three. This, of course, is due to Jeff, who was able to see beyond all of the harvest gold. My initial response was “no way!”

Obviously there was some work to be done. We initially did a cosmetic makeover using starter materials for about $35,000. But over the years we replaced the roof, the windows, the furnace and AC. We redid some of the initial remodel and had some unexpected expenses as well. We replaced a retaining wall we didn’t even know we had, because our rear fence sat on top of it, for example. Here is the total of sixteen years of investment.

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According to Zillow our house is worth about $486,000 now. That probably is pretty close given where our neighbor listed his house and the fact that it sold quickly. So we have a gain of  $66,500. But not so fast. Over the sixteen years we also paid $59,000 in property taxes and $48,000 in mortgage interest. OK, now we’re behind by $40,500. If we had been renting we wouldn’t have spent any of the money we did on fixing up the house, nor would we have paid property taxes or mortgage interest. Was it worth it?

Our current value minus total costs works out to a monthly rent of $211. To rent a house of our size in the same condition it’s in now we would have spent, on average, $1,800 per month, or $342,000 in total. Therefore, the answer is yes. Though we have spent more than the current value, we do have a thing of value in our home. Had we been renting all along we would have no value to offset the rent we paid.

This of course is just the financial side. It says nothing about the intangibles. Our house is where we raised out daughter, and where we gather with our friends. It holds our memories and mementos. Because it has value, it gives us security. We know we never have to leave.

Following the financial crisis and housing bust, people were understandably reluctant to buy a home. So many people owed more on their house than it was worth that it didn’t seem like a good deal. Since then home prices have recovered, and Zillow estimates that only about six million, or 7 percent of owner occupied homes are worth less than the owners owe on their mortgages. It may be daunting to buy a home, particularly in frothy markets like Portland. If you plan to live in your home long term, it is worthwhile. Both the math and the sentiments are in your favor.

Image courtesy of hywards at FreeDigitalPhotos.net

 

 

Your Personal Pension Plan

Saving for the time when you can stop working for pay is hard enough. Setting aside the right amount of money and investing it in a way that will make the most of your hard earned savings is a challenge for anyone.  But there are years to work on it, and if things don’t work out as planned you can make changes. Things get trickier as you approach the day when you give up your paycheck. For most, gone are the days when your employer will send you a pension check every month.

Can you create your own pension plan? The answer is yes, and there is more than one way to do it. You can buy an income annuity, or you can invest the money yourself using a disciplined preplanned withdrawal strategy.

The simplest approach is to buy an income annuity. An income annuity is an investment that is created by an insurance company. You can buy one through a financial adviser or an insurance agent. With an income annuity, you are buying your future income. You deposit your money with an insurance company, and in return they guarantee you a monthly payment. Your monthly payment consists of the interest income the insurance company is paying and a portion of your deposit being returned to you.

You can choose from a variety of contracts. The simplest is one that pays you a monthly income for life. With this contract the insurance company guarantees to pay you the same monthly benefit every month for as long as you live, whether that is another ten years or another fifty years. Fidelity offers income annuities from a variety of insurance companies. Using their calculator, a woman turning 65 could receive $507 every month for the rest of her life, or, alternatively, $407 per month to start, with annual increases of 2.0 percent, for every $100,000 deposited. Similar to a traditional pension plan, this type of contract ends when you pass away. There is no cash value left regardless of how long you held the contract.

However, if you are married, you can buy an annuity that pays out over both you and your spouse’s lives. If our hypothetical woman deposited $100,000 in an annuity to cover both her and her husband of the same age for both their lives, they would receive a payment of $450 per month, or $357 per month to start, with a 2.0 percent annual increase. If you are worried that you will die and the insurance company will get to keep all of your money, there are also options that guarantee your payments for a minimum number of years or your lifetime, whichever is longer. The longer the minimum period, the lower the monthly payments.

These days, many people choose the DIY approach. Too many don’t know what annuities are, and there is a general lack of trust in the insurance industry. If you were to create your own retirement plan and manage your investment yourself, what kind of payment could you reasonable take each month?

In 1994, William Bengen, a financial adviser, studied thirty year time periods beginning in 1926 to determine whether there was a withdrawal rate that a retiree could take and reasonably expect that their money would last for at least thirty years. His conclusion was that a withdrawal rate starting at 4.5 percent of savings and increased by the rate of inflation for all following years worked. In a 2012 Financial Advisor Magazine article, he revisited the study, and concluded that even if concerns about difficult financial markets were to come true, the withdrawal rate remains reasonable. His work and conclusions have become known as the 4.0 percent rule. Bengen isn’t certain how the 0.5 percent got lost in translation.

If you were to invest $100,000 with about half in stocks and half in bonds, as in Bengen’s model investment strategy, you could spend about $375 per month to start, with annual increases for inflation. That is a very similar payment to the $357 you and your spouse can get with an annuity that has a 2.0 percent annual adjustment. With Bengen’s approach, you can generally maintain your purchasing power for about thirty years, but if you encounter high inflation, particularly early on, you may not be able to make your money last any longer. With the annuity, your payments are guaranteed until you die, but if inflation is high, you may not be able to maintain your lifestyle even with 2.0 percent annual increases. So neither approach is perfect. Either will require making some adjustments as life plays out.

Of course, you don’t have to go all or nothing with either option. If you are worried about outliving your money if you manage it yourself, but not comfortable with forking over all of your savings to an insurance company, consider blending the two ideas. You could use some of your savings to invest in an annuity that is large enough to cover basic monthly living expenses. The remainder of your savings could be invested in stocks and bonds. With your basic expenses covered, you can be more confident that you won’t run out of money, and you can still retain control over a portion of your savings.

An annuity is a great option for many. After all, it’s much easier to just continue getting a monthly pay check, after you stop working, than it is to manage an investment portfolio and withdrawal strategy. It is possible to manage your savings on your own, but it takes some discipline and work. And the outcome won’t necessarily be better. Even if you do decide to manage on your own, consider an annuity to provide at least a foundational level of income that won’t run short.

Image courtesy of ponsulak at FreeDigitalPhotos.net

Like It or Not, You Need Stocks

Which is better – $100 or $600? This is pretty black and white, of course $600 is better.

Would you prefer to have your paycheck reduced by $100 or $600? Again, there is little question. If your paycheck is to be reduced, the least amount possible is best.

Yet, nearly half of Americans are making exactly the opposite choice. In a recent Gallup Poll, it was found that the level of stock ownership in the U.S. is at record lows. Only 52 percent of Americans have investments in the stock markets. That is down from the peak in 2007 when nearly two in three held stocks.

The age group whose stock ownership has dropped the most is not the one that you might think. It would seem logical for older Americans to reduce their stock ownership, given that many are approaching or at the point where they are living off of their savings and therefore need a more conservative investment approach. Yet while stock ownership among those 55 and older is down by about 9 percent since 2007, the age group whose participation in the stock market has dropped the most is the 18 to 35 group. Just over half in the 18 to 35 age group reported holding stocks in 2007, and now only 38 percent hold them.

The Great Recession and the dramatic stock market losses of 2008 and early 2009 certainly left a mark on the psyche of investors. The lack of job security and uncertainty about the economy are also good explanations for the low level of enthusiasm for the stock markets since then. But avoiding the stock market, particularly for those younger than 35, is the equivalent of trading $600 for $100, or worse.

Since 1928, the average annualized return on the S&P 500 has been 9.50 percent. For the last ten years, through the end of 2015, the average annualized return has been 7.25 percent. In both cases, the stock market return is over six percent more than the return to be had on safe short term investments, such as three month U.S. Treasury Bills. Over the last ten years, the stock market return has been six times the return on T-Bills.

For young people saving for their distant retirement, the cost of sticking with safe investments is huge. Staying safe means that you will have to save six times what you would have to save if you were to invest in the stock market in order have a secure financial future. Alternatively, you will have to be willing to live on one sixth as much money when you do retire.

Yes the stock market goes down. Generally speaking it goes down one in every four years. However, it has never failed to recover. If your investment horizon is thirty years or more, you have nothing to fear from a short term decline in the value of stocks. In fact, a short term decline is an excellent time to add even more to your stock investments. Some analysts predict that future stock market returns will not be as good as in prior years. That may well be the case, however the returns are still likely to be better than T-Bill returns over long periods.

I get it. It is hard to see your savings balances go down. When I know the stock market is down, I tend to not look at my portfolio, being the buy and hold investor that I am. How can I get away with that, especially now that we’re living off our investments? I have arranged our investments so that our short term cash flow needs are met with safe investments, leaving only money that we will need ten or more years in the future in stocks.

A good approach to arranging your holdings for a good night’s sleep is to use a time based bucketing approach like this. Have your emergency fund and any money that you will need to spend in the next year, such as for big ticket purchases, property taxes or college tuition in safe cash like investments, like a money market mutual fund or a savings account. Money that you will definitely need within three years, should be invested in short term bonds or a short term bond mutual fund, which pay higher interest than money market funds. These investments can fluctuate in value, but generally the fluctuations are limited. Money that you will need in the next three to ten years should be invested in what are called intermediate bond funds or bonds maturing in three to ten years. The expected price fluctuations of these mid range fixed income investments is larger than short term bonds, but the higher income and longer horizon provide a cushion for these fluctuations. Finally money that you won’t need within ten years can reasonably be invested in the stock market.

If you are 35 years old, and plan on leaving the work force at the current full retirement age of 67, there is no reason that  your investments for retirement shouldn’t be in the stock market. Over such a long horizon your investments will grow at a faster pace than they will with a simple interest bearing account. To make the most of your savings you need the leverage the stock market provides. The alternative is to save every dollar you will need, which will have a big impact on either your current or your future lifestyle.

 

House Flipping Can Easily Turn Into A Flop

Shortly before the financial crisis and concurrent housing bust, home prices in the Portland Metro area were soaring, much as they are today. My husband, Jeff, thought it would be fun to buy a house and flip it. I did not. We both had day jobs and we have a daughter, so spending weekends and evenings working on a house we’d never live in wasn’t appealing. However, the biggest reason was that it was a very risky proposition.

Oh sure, at the time it seemed like a good bet. The prices of single family homes were rising non-stop. You heard about flippers making a mint for going into a house and putting in new carpet and paint. Where was the risk?

The risk was in taking on debt in order to make the investment. Debt exacerbates the impact of any changes in the market value of an investment on your return. Of course that is a great thing when prices are going up, but it is a terrible thing when prices are going down. Say you pay $100,000 for a house with $10,000 of your own money and a $90,000 loan. It only takes a drop in prices of 10 percent to wipe out your investment. A larger drop and the sale of the property won’t generate enough to pay what you owe your bank.

The National Association of Realtors just reported that the average price for an existing single family home was up 6.3 percent in the first quarter of 2016 from a year ago. Prices are up in nine out of ten housing markets nationwide, and flipping is back in vogue. While it may be tempting to make a quick buck in today’s hot housing market, there are a few things to keep in mind before you jump in.

Historically speaking, houses aren’t a very good investment except as a place to live. In each of the last four decades, home prices have only increased in-line with inflation, with one big exception; 1995 to 2005. In that decade, home prices increased 4.75 percent more than inflation, but of course that was followed in the next ten years by an increase of only 0.41 percent, or 1.43 percent less than inflation. Over the two decades from 1995 to 2015, home prices were only up by 1.60 percent more than inflation on an annualized basis.

House Price Chart
Source: Federal Reserve Economic Data, Case Shiller US Home Price Index, Bureau of Labor Statistics

Given how much work you have to put in and the transaction costs involved in buying and selling homes, not to mention property taxes, the historical picture just isn’t very compelling. Of course if you are lucky and time your flip well, there is profit to be had. The thing is when you insert the word “luck” into the equation, it starts to look more like gambling than investing. Had Jeff and I jumped on the band wagon of house flipping we could have very well lost our investment, or we could have wound up paying interest on the loan for years, waiting for the investment value to recover.

The average person usually only sees an opportunity when the window has been open a long time. That makes the timing of the investment precarious. There are a number of indications that the window of opportunity in the housing market may be narrowing. The first is the very fact that flipping is back in vogue. You have to worry about a market where speculators advertise their winning house flipping formula on the radio and in free seminars. In addition more markets are reporting that homes are selling above asking price. Home values are rising faster than incomes, and the average down payment for first time home buyers according to an article by Market Watch is now just 3.5 percent of the home value. All of this could lead to home prices stagnating or declining if the economy were to fall into a recession. That means the risk of making no money or losing your investment is increasing.

Successful flippers have years of experience in the residential real estate markets. They are better able to gauge the likely return relative to overall costs when they invest. They also have a reliable team of construction contractors that can get in and out of a project in a timely way. If you are considering going into a flip for the first time, you will be at a disadvantage in all of these aspects of the deal.

Real estate has a unique draw as an investment. It’s tangible, and it seems like you have greater control over the outcomes. Many people think they know more about the real estate market than they do, simply because they live in a house and are surrounded by other houses in their neighborhood. The stock market, in contrast, is esoteric. The gyrations of the S&P 500 index or the Dow Jones Industrial index seem to follow no logic, and you certainly cannot see and touch your investment. However, for most, these markets are a better place to invest.

In the stock market, transaction costs are low. You can buy an entire portfolio of stocks for a tiny fraction of a percent when you buy an index mutual fund. There is no work involved in buying an index fund, and while these markets are not for short term investments, over time the historical returns relative to inflation have been better than residential real estate. Before using your hard earned savings to invest in today’s hot housing market, carefully consider all of the costs and how much you really know about residential real estate. It’s better to leave high risk, debt funded investments like these to the pros.

 

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