Sunday, April 15

Week 41 - Personal Savings Modules

Situation: Many of us who have retirement benefits through our jobs tend to not fully fund our plan, thus not receiving the full tax advantage of the retirement benefits, even though it would reduce our annual tax bill. And it gets worse! Some of us do fully fund our workplace retirement plan and that can STILL leave us with too few dollars for our sunset years. Is there a solution? Yes,we need to mimic our neighbors who don’t have a workplace retirement plan but instead use IRAs (including Roth IRAs), and US Savings Bonds to build Personal Savings Modules (PSMs).

This week’s blog assumes that IRAs are understood and in common use by our readers. In reality, fewer than 25% of job holders contribute to an IRA; fewer than half of those contributors are not paying the full amount allowed by law per year (for a related story click here). Since you’re reading this blog, we will assume you want a fully funded IRA at $5000/yr (in DRIPs) balanced with $5000/yr in Savings Bonds (which have the same tax benefits as an IRA). And let’s face another tough fact--chances are that if you are in the early stages of your career, you don’t have enough income to do this. This means we need a way to decide how much of your income can safely be siphoned off into retirement savings as you age.

We recommend investing 5% of gross income at age 25 and increasing this up to 20% by age 70. In other words, every 3 years add another 1% to your savings plan. If you’re 25 years old and making $20,000/yr, set aside $1000/yr (5%). By age 50, 14% needs to be diverted to your workplace retirement plan and PSMs. By retirement age (71), those savings plus Social Security will need to replace at least 70% of the income you were receiving through work.

The simplest and cheapest way to start a PSM is to go online and set up automatic monthly withdrawals from your bank account. A balanced mutual fund would be just the ticket--a “starter home” for your savings! The problem we immediately encounter is that all of them have irritatingly high costs, take on too much risk, or don’t invest enough in bonds. The only balanced fund that roughly mimics what we call a “Goldilocks Allocation” (see Week 3) is the Vanguard Wellesley Fund (VWINX). It has a very low expense ratio (0.25%) and no fees or commissions but it requires an initial purchase of $3000. For many of us, that is a stretch. The second best choice for a hybrid investment is to buy stock in a regulated public utility. ITR’s Master List (Week 39) suggests two: NextEra Energy (NEE) and Wisconsin Electric (WEC). Investing in either of these companies would give you a DRIP with rock bottom costs that can be managed by you from the website. For tax purposes, that DRIP then needs to be designated as part of your IRA.

For a follow-on PSM, we suggest that you stretch beyond relying on a single-asset and balance it with regular purchases of a Lifeboat Stock DRIP balanced by purchases of US Savings Bonds. The accompanying Table lists all the Lifeboat Stocks that are also on our Master List (Week 39). For your Savings Bonds, we recommend choosing traditional (EESB) Savings Bonds because those are guaranteed to pay at least 3.5%/yr if you hold them for 20 yrs. (Prior to that anniversary date, each EESB purchased pays approximately the same interest as a 5-yr Treasury Note that was purchased on that same date.) As an example, I constructed a PSM using a JNJ DRIP started 12 yrs ago using $100/mo, and balanced it with EESBs I started purchasing 20 yrs ago (~$50/mo). By 4/2/2012, the $12,200 paid into EESBs had grown to $27,068.44 (a 6.3%/yr increase) and the $14,200 that went to JNJ had grown to $18,867.80 (a 4.2%/yr increase). That’s an increase of 4.6%/yr for both together, which beats inflation by 2.1%/yr.

Should you be one of the lucky few who has a workplace retirement plan, contribute as much as you are allowed by law but avoid the exciting/expensive choices: emerging market mutual funds, high-yield bond funds or small capitalization stock funds. If you’re offered hedge funds, don’t take the bait (for fun, do a Google search on the terms “Warren Buffett” & “Hedge Funds”). Stick with “plain vanilla” choices: large-capitalization US stock funds and intermediate-term investment-grade bond funds. If your company wants you to stuff your retirement savings plan full of its own stock, don’t go there! No company is immune from bankruptcy. For example, Johns-Manville and over 10,000 other companies were bankrupted in the 1980s by asbestos-related lawsuits. Even though many of the lawsuits were later declared to be criminally fraudulent, by that time the companies were gone. Enron is another example with 6000 of its employees putting all of their retirement savings into its stock and losing every penny when the company collapsed. If you do choose to purchase company stock, limit those holdings to 5% of your total assets--the same limit you would place on any other single company’s stock.

What kind of assets, overall, are good for your retirement savings? To ride out the last market crash defensively with Lifeboat Stocks (see attached Table) as measured by the drop in each of those stocks between 10/1/07 and 4/1/09, the best DRIPs to have were: WEC, JNJ, ABT, BDX, WMT, HRL, and MKC. Those went down less than 20% (vs. 46% for VFINX, the Vanguard S&P 500 Index Fund). Wal*Mart stock even went up 19% (Table). Did your portfolio have any of those stocks going into the crash? Mine had only two (JNJ and MKC). A market crash of that magnitude usually means one thing: Investors are afraid of deflation. There are only two types of assets that do well then: 10-30 yr US Treasury Notes & Bonds, and stock in companies that sell food very cheap: McDonald’s and Wal*Mart. Unless you had those assets and some of the more resilient Lifeboat Stocks noted above, your portfolio probably took a beating. Even the most resilient balanced fund (VWINX) went down 24% over that 18-month period.

Bottom Line: If a crash occurred one month after you retired, would your portfolio be able to ride it out relatively unscathed??

Post questions and comments in the box below or send email to:

No comments:

Post a Comment

Thanks for visiting our blog! Leave comments and feedback here: