Should you invest in Target Date Funds?

Posted on February 24, 2012February 24, 2012 by Danielle

LONDON, ENGLAND - OCTOBER 04: A generic view ...

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Do you know what box you checked when you signed up for your 401k or 403b or 529 plan? Pick something that sounded good, like “fixed income” or “cash max” or whatever? Guess what?

Wrong. You should give some serious thought to how you’re allocating that retirement fund, because for many people it will be the biggest investment you’ll ever make, except for your house, and we all know there have been a few problems with that investment, no?

Many of these plans have a terrible set of choices. I don’t know how employees let companies get away with offering them only Lord Putheimer funds or some other combo crap of high commission, low performance load mutual funds. I mean, pick up any newspaper and you’ll see an infinite number of recommendations to avoid these turkeys. But then, nobody reads anymore. If this describes the offerings of your company, it’s time to start “encouraging” a better choice of funds. It’s your money and your future, not the company’s.

But, let’s say your 401-403-529 does indeed offer some decent companies—Fidelity maybe, or T. Rowe Price, or if you’re really working at the right place, maybe they’ll even offer Vanguard. Should you pick the Target Date fund that most closely resembles when you hope to retire (or when your kid starts college), or should you hand pick specific funds? Here’s what you should consider:

What’s in the proposed fund? What mix of stocks, bonds, and other investments does it offer? Mostly active funds or passive funds? Are you comfortable with 90% stocks, or would you sleep better with a 60/40 mix? You have to be comfortable with the risk, no matter what your actual age. On the other hand, I see many young people who watched their parents’ retirement funds evaporate and are more conservative than is reasonable.
How much money do you have in it? If you are just starting out, investing in something diversified is important, and maybe difficult to achieve with a small amount of money. However, if there are six figures in that account, you may want to choose, or get help choosing your own diversification.
How much time and knowledge do you have? Will you take the time to compare the target fund’s results to your own proposed portfolio selection? This can be difficult because many target funds don’t have a really long track record. Of course, historical performance is no guarantee of future results, but what else do we have?
Is there a management premium? Check out how management fees are charged—does the fund charge an extra management fee on top of all the management fees in the individual funds? Is it reasonable? Could you invest in a reasonable selection of stock/bond/alternative funds individually for less total management costs? Ask for a Morningstar sheet on the target date fund and take a look at it compared to individual funds (individual bond funds and stock funds should be very low; international funds somewhat higher). Note that management fees are different from commissions or loads—management fees are what keep the lights on at Fidelity, Vanguard or whatever. They are deducted from the return you actually see deposited in your account. You’ll never actually see them, except as to how they affect your returns. Which can be a lot of leakage, depending on the fund and the fund company—another reason for passively managed funds with no “star” managers.
How does it fit in with the rest of your portfolio? If you have a “rest of…” that is. It is quite difficult to do an accurate asset allocation profile with a target date fund in the mix. As an estimate, you or your financial planner can break the fund into percent categories, but it’s not easy. Also, if you have significant investment assets, you should be considering asset “location” as well—things that generate interest in non-tax accounts, things that generate capital gains in taxable accounts, internationals in taxable accounts, as a ROUGH guide—your own investment picture may vary. Target date funds give you less control.

Now, don’t use any of this as an excuse to stop contributing. If you get an employer match, you’ve probably already gotten a better “return” than the market is offering. Then, there’s the tax benefit of salary reduction. As with all wealth building, first HOLD ON to your money, then figure out the best way to invest. If your 401k forces you to save, that may be the best investment of all.

Financial lessons for anyone, from college financial aid

Posted on February 15, 2012February 15, 2012 by Danielle

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I’m really in the trenches this year. After being a know-it-all for some time about the college financial aid process, I’ve finally had to do it close to home. While the process itself included all the forms I expected, I did learn a few tricks which are relevant to your money management even if you don’t have a college-age child.

It doesn’t get any better if you avoid it. If something has a deadline (for example, choosing your 401K investment mix, assembling records for taxes, or choosing the right options for your flex-spending account) your ability to think this through and get adequate information decreases as the deadline gets closer.
With any important financial move, follow up. It’s hard to believe, but two of the schools my daughter applied to lost significant parts of her application, which had to be re-sent.
The more complicated the transaction, the more follow up needed. Financial systems are set up to have lots of checks and fail-safes. Why? Because, guess what, they fail. If you are making a transfer of accounts, for example, you or your financial advisor needs to be watching it like a dieter looking at pizza.
Don’t ignore your accounts for long periods. I once had a major brokerage transfer someone else’s $250,000 account into one I was managing. The actual owner never noticed, and you can bet his broker never told him.
Get names or follow-up is hopeless. Dear daughter has been trying to send some supplementary materials (recent awards, extra recommendations) and, at one school, has been given five different names on who is actually reviewing her admissions. Turns out two students with her name are applying this year to the same school. Belongs in Ripley’s Believe It or Not. I wouldn’t believe it but it’s happened before—two people with the exact same name had a checking account at the same local bank and one of them became, temporarily, $10,000 richer. This was only discovered after the rightful owner’s checks began bouncing all over town. Straightening out these snafus required quite a bit of contact with one person who could keep the details straight and be accountable for fixing the problems.
Things you dread turn out to be easy, and things that are hard you never see coming. Everybody worries about filling out the FAFSA, but this year’s version takes about 10 minutes if you have your tax return. On the other hand, the CSS/Profile (for private schools), took hours, lots of extra explanations and several calls to the organization about what I still believe are errors in this year’s form.
Good records are important. Having to reconstruct or unearth financial records in a time of stress makes everything worse. Really, it’s worth spending an hour on the weekend entering spending and investments in Quicken or Mint.com, filing those papers or creating a decent file system on your computer, and reading an article or two on something financial. You’ll be so grateful when you fill out those college apps, try to do taxes, or retire; you’ll have a better idea of whether you can retire and how much money you really need; you’ll have some check on runaway spending; and your heirs will thank you. Put in that spade work. It’s all good.
You can go broke saving. It’s important to analyze whether an action really puts you ahead. Sometimes people get so focused on getting financial aid that they make poor investments (often, annuities) that reduce their assets for aid, but are also high cost and hard to get out of. People justify bigger houses for the mortgage interest tax deduction, not realizing that they are spending much more to save just a little. Is it worth your time? Is it worth the cost?
Most authorities are already hip to your little tricks. College financial aid officers and the IRS generally clue in to the most “creative” strategies pretty quickly. In the case of the IRS, just how much money and time do you want to spend in an audit? (see #8 above!)
On the other hand, you are entitled to what’s due. There’s no reason not to apply for financial aid if you’re on the borderline. In the larger scheme of things, spending a day filling out forms could have a pretty big payday. If you really do work out of your home, you’re entitled to home office deductions just the same as any business deducts its expenses.

In college applications as in life, the more complex the system gets, the more “controls” are introduced, the more money at stake, the more that can go wrong. Good luck, and keep on top of it!

What’s a reasonable emergency fund?

Posted on February 8, 2012February 8, 2012 by Danielle

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Sure we all know we should have some rainy-day savings, but for too many of us that’s spelled C-R-E-D-I-T C-A-R-D. Unfortunately, it’s very easy to lurch from crisis to crisis, racking up ever larger charges until the credit card bill itself becomes the emergency. Every time I see an article on how much the fund should be, it’s usually a breathtaking amount. But really, how much is enough?

The standard CFP® exam question’s correct answer is usually some variant of three months if you’re married with a working spouse, have a trust fund, or a second job; and six months if you’re single, or married with a stay at home spouse. However, I would add to that six months’ recommendation a few other considerations: if you work in an industry or place where it would require major effort or relocation to get another job; if you have any health problems; if you’re over about 45; if you have no retirement savings; or if the economy remains in the toilet for much longer. In fact, some people are starting to recommend that you look at the current unemployment rate and save the equivalent number of months—9% unemployment, 9 months’ worth of savings.

Now that your heart has skipped a beat, let me tell you that you can safely reduce that amount somewhat by a few subtractions. Let’s say your gross is $100,000. That puts you in the 28% tax bracket if you’re single. With no other deductions your tax bite is going to be around $22K. I’m sure you have other deductions, but let’s just use this as an illustration. If you don’t have any income you’re not going to be paying any taxes, so take that off your gross. So, single person, we’re down to $77,878. Now, let’s say you were putting 5% in your 401K. No job, no 401K contribution–$72,878. I’m not going to tell you to reduce your grocery estimate, because if you’re unemployed for six months you’re going to need significant chocolate. However, being terrified, you probably will decide to eat out less and maybe not replace your entire wardrobe this year—let’s take another $1,500 off the total: $71,378: your six months’ emergency fund needs to be $35,689, not the $50,000 you thought I was saying at first gulp.

A general example never works for the specific. The emergency fund goal goes up or down depending on how you live your life now. If you’re already contributing the max to a 401K or other retirement plan, if you regularly fund a Roth, dump all your quarters into a mad money jar, in short, if you’re a big saver, replacing your necessities is a smaller number. If you would need to pay child support, buy your own health insurance, or your car is about to crap out, you need to adjust upward. If you’re self-employed, it’s six months at least plus GO GET DISABILITY INSURANCE.

I generally recommend you have an emergency fund of at least three months’ expenses BEFORE you start paying more than the minimum on any credit card debt repayment program. It’s better to pay the minimum balances and fund an emergency fund rather than have no or inadequate emergency funds and send a big payoff to the card. Why? Because without an emergency stash you’ll never get out of debt—something will inevitable come up, and back it goes onto the card. Pay cash and you’ve still got the same credit card debt; no cash and the debt just revolves–no matter how much you send, new stuff keeps getting added.

Where to put this cash? You need immediate access to it, so it needs to be in a checking account, a bank savings account, or a money market fund that you can write checks on. When you do manage to build it up to six months, you might consider putting 3 months’ worth in a 3 month CD at the highest rate you can scavenge locally or through an internet bank. Just in case you might need all the money at once, make sure the CD seller would only ding you on interest, not penalties or principal loss.

Saving six months’ worth of expenses isn’t an instant achievement—if you’re just starting out, it can take you three years or more at a 10% savings rate. I’d propose that any found money also go into this account: here’s where your tax refund (which you shouldn’t be getting), your bonus check, the computer rebates you actually remembered to collect, or the $200 you got for writing an article or making a presentation should go. I’d even suggest that it’s worth some kind of second job or seasonal or short term gig to build that fund. You can blow that stuff later when you have the fund funded. Right now, it’s the best thing you can do for your future security.