Tag Archives: investing for retirement

Understanding How Fund Performance Comparisons Overstate Returns

May 13, 2014

Every investor has, I hope, read the standard disclaimer on mutual fund and ETF performance documents that ‘past performance does not predict future performance,’ or other text to that effect. Still, when you read a fund company’s statement that ‘x% of our funds have out-performed their category average’ or that ‘x% of our funds are rated 4- and 5-star by Morningstar,’ this seems meaningful. Similarly, if you read that the average small value fund has returns ‘y’% per year over the last 10 years, this also seems significant. There is a major factor that is missing in many of these types of comparisons of fund performance, however, that tend to make active funds look better than they really are (as compared to low-cost index funds) as well as making a mutual fund family’s managers look more skillful than they might actually be.

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How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

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The Hidden Risk in Target Date Funds

Lately, Target Date Funds (TDFs) have been the subject of intense scrutiny and criticism, because investors have realized (in many cases, after the fact) that these types of funds can be very volatile. In the aftermath of the 2008 collapse of the financial markets, TDFs for investors near retirement (funds with a projected retirement data of 2010, a.k.a “2010 TDFs”) got considerable media attention because some of these funds suffered dramatic losses.

Clearly, investors nearing retirement didn’t understand the levels of risk they were taking by investing in 2010 TDFs.  It has also been widely noted that the percentage of assets invested in equities in 2010 TDFs varied dramatically among funds, which in turn meant Continue reading

How Much Does Your 401(k) Plan Really Cost You?

Ron Lieber at the New York Times recently came out with an article that explores one of the most important problems with 401(k) plans: they can be expensive and plan participants have no idea how much their plans are costing them.

There are costs associated with with running a 401(k) plan–administrative costs for the plan, for example, are distinct and in addition to the expenses associated with the individual funds within the plan.  These costs are sometimes added to the fund’s expense ratio in the creation of a share class specifically designed for retirement plans.  These are usually “R”  class shares.

The New York Timesarticle cites research by BrightScope, a firm that compiles data on 401(k) plan costs, that shows … Continue reading

The Evolution of Retirement Plans

These days, most of the news about the state of our retirement savings is bad news . But a recent study from Fidelity Investments contained two very good pieces of news.

  • The average 401(k) balance among the clients the firm surveyed, rose to $74,900 at the end of the first quarter of 2011. That’s the highest it’s been since Fidelity began tracking account balances in 1998, a 12% increase from a year ago and a 58% jump from the same time period two year earlier.
  • Nearly one in 10 participants increased his or her deferral rate during the first quarter. That’s the biggest move in that direction in the past five years.

To some extent, this good news is a triumph of applied Behavioral Finance. Since academics started parsing investor behavior in 401 (k) accounts several decades ago, it’s become clear that Americans have Continue reading

Jim Otar’s Pearls of Wisdom

Guest blog by Steve Thorpe.

Yesterday, I posted a review of Unveiling the Retirement Myth: Advanced Retirement Planning based on Market History by Jim C. Otar, a financial advisor, Certified Financial Planner, and engineer.

In this second post, I share a few quotes that epitomize the reality-based themes and critical insights woven throughout Otar’s text:

Risks

  • Proper retirement planning requires planning for the worst.
  • This book is based on my research of retirement planning involving one hundred and nine years of market history. What you read will be depressing.
  • When it comes to retirement finances, the three main risk factors are longevity risk, market risk, and inflation risk.  A retirement plan must minimize each of these three risk factors to be considered a well-designed plan.
  • Disregard any financial research, any words of wisdom, any gibberish from financial gurus in the media that “markets eventually recover in the long term.” They are not telling you the full story: Yes, markets did always recover in the past, but your distribution portfolio retained a permanent loss for the rest of your life.

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Investing Book Review: Jim Otar’s Unveiling the Retirement Myth

This is a guest blog by By Steve Thorpe.

(Part two of this review, Steve Thorpe’s compilation of the best advice and insights from Unveiling the Retirement Myth by Jim Otar, will run tomorrow.)

For individual investors planning for retirement, basing those plans on averages just doesn’t cut it. For example, one might estimate an investor’s expected life span, future investment returns for a given asset mix, inflation rates, etc. But the investor may live longer than average, the sequence of future investment returns could easily go against him or her, likewise inflation effects can be enormous over time. Bad luck in any of these areas can easily deplete a retiree’s investment portfolio to zero during his lifetime. Unfortunately we are unable to change the luck factors that can so profoundly affect a retiree’s future income stream – or lack thereof.

Jim C. Otar, a financial advisor, Certified Financial Planner, and engineer, clearly explains these topics and more in his book Unveiling the Retirement Myth: Advanced Retirement Planning based on Market History. This review contains only a sampling from this fine body of work; accordingly I’d recommend that you pick up a copy if you want to understand all the details.

Most Research and Many Strategies Are “Just Plain Garbage.”

He covers a lot of ground in the book including: diversification, rebalancing, optimum asset allocation, warning signals of potential diminishing luck, flaws of investment simulations, budgeting for retirement, determinants of a portfolio’s success, and many others. This review will focus mainly on two core insights. First, that luck plays a remarkably large part in how well any retirement plan holds up. Second, that lower withdrawal rates, not savvy asset allocation, is the best defense against bad luck. Continue reading