Archives for August 2015

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Should I Still Contribute to a 401(k) if I Plan to Retire Early?

A reader writes in, asking:

“If I plan to retire well before age 59.5, should I still be contributing to my 401-K? In case it matters, I am in my late 20’s and the goal is to retire around age 40.”

For a few reasons, even if you plan to prior to age 59.5, it is still probably a good idea to contribute to a 401(k) account.

First, in order to retire very early, you’re probably going to have to save more per year than your maximum 401(k) contribution limit, so you will probably also have money in a Roth IRA and in taxable brokerage accounts, each of which can be accessed prior to age 59.5 without penalty. (At least, contributions made to the Roth IRA can be accessed prior to age 59.5 without penalty. For earnings, one of several exceptions to the penalty would have to be met.)

Second, there are several ways to get money out of a 401(k) account prior to age 59.5 without having to pay a penalty. For example, there is an exception to the 10% penalty for any distributions that are part of a “series of substantially equal periodic payments” taken over your life expectancy. The rules are complicated, and I would urge you to work with a tax professional if you plan to take advantage of this option. But if you follow the rules correctly, you can get access to (some of) the money as early as you want.

Finally, even if you retire at age 40, there will still (most likely) be many years after 59.5 for which you will need savings. According to the Social Security Administration, the average total life expectancy for a 40-year-old is approximately 80.5 years. In other words, on average, there would still be more than two decades of post-age-59.5 spending that must be funded.

In short, the 10% additional tax that applies to certain early distributions from 401(k) accounts shouldn’t necessarily be a big problem, even for somebody who plans to retire early. And it is unlikely that that drawback overwhelms the benefits of contributing to a 401(k) account (i.e., tax-deferred growth, potential for shifting income from high-tax-rate years to low-tax-rate years, and potentially an employer match).

Investing Blog Roundup: Responding to Stock Market Volatility

On Monday, I shared my thoughts on how to respond to a bad day or week in the stock market. Naturally, countless other financial publications have written about similar topics over the last couple of weeks. Here are a few of my favorite such articles:

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What to Do about a Bad Day (or Week) in the Stock Market

On Thursday the U.S. stock market (as measured by Vanguard’s Total Stock Market ETF) went down by 2.17%. And on Friday it went down by 2.88%. The week’s market performance (down approximately 5.5% in total) has received quite a bit of news coverage, and if my email inbox and Facebook feed are any indication, many people are nervous — or even downright scared.

This Could Be No Big Deal

According to Yahoo Finance, in the last 5 years (i.e., during a roaring bull market) there have been 8 other days worse than Friday and 28 days worse than Thursday.

You might say, but this was two bad days in a row, surely this is a problem! Well, those 8 days worse than Friday? Two of them were in a row as well (9/21/11 and 9/22/11). In fact, all 8 of the days that were worse than Friday occurred within the August-November window of 2011. Perhaps, like me, you have already forgotten about that brief little period of not-so-great returns. Until looking at the data just now, I had forgotten about that period because it turned out to be no big deal. The market continued to climb for another (so far) nearly 4 years after that.

In other words, this sort of thing is normal, and it can even happen right in the middle of a period of great market returns. It doesn’t necessarily mean the bull market is over.

But Maybe We Are in for a Crash

On the other hand, maybe this is the beginning of the next bear market. We could be in for a much greater decline. In the 2007-2009 decline, for instance, the market fell by more than 50%.

If last week’s not-that-big-of-a-deal performance has you in near panic mode already, you have learned an important lesson. Specifically, you have learned that you overestimated your risk tolerance and chose a portfolio that is probably too risky for you. If a decline of less than 10% has you scared, imagine how you’d feel if the market fell another 40%.

The point of strategic asset allocation is to give up on guessing where the market is going next and instead craft a portfolio that will allow you to sleep well at night, regardless of whether we’re in for another 4 years of great returns (as we were after that little blip in late 2011) or a further decline of 40% or more.

What to Do Now?

Evaluate. How are you feeling about your portfolio and its risk level right now?

If you’re feeling perfectly comfortable, this week could be a great time to rebalance your portfolio back to its target allocation, which likely means buying more stocks. (It may also be an opportunity to tax-loss harvest.)

On the other hand, if you’ve been stressing about this modest decline, you may want to scale back your stock allocation somewhat. Yes, that means selling immediately after a decline, which isn’t ideal. But chalk it up as a lesson — one that could have been much more expensive.

And take note of the stress you’ve been feeling. Literally. Make a note of it. Record how you are feeling right now. Then sign and date that document. You want something that you can refer back to the next time things are looking rosy and you are tempted to bump up the risk level of your portfolio (to a level that you have already proven is too risky for you).

Investing Blog Roundup: Fund Investors Are Making Better Decisions

This week, I particularly enjoyed a piece from Morningstar’s John Rektenthaler discussing some positive, investor-driven changes that have occurred in the mutual fund industry over the last few decades.

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Why Use Actively Managed Bond Funds?

A reader writes in, asking:

“I saw an article on your blog about passive funds beating active ones. But then why do Jack Bogle and Rick Ferri use the actively managed Vanguard funds? For example, wouldn’t a muni ETF be a better option if it beats the active manager 95% of the time? I’m a full time indexer but I don’t understand why these legends use active bond funds. Can the same be said for corporate bond funds?”

The key point about indexing isn’t that there’s anything magical about the indexing itself but rather that it is a very low-cost way to run a diversified mutual fund. Or, to look at it from the other direction, most actively managed funds have a very difficult time overcoming their much higher costs.

In some cases, however, the actively managed funds have costs that are approximately as low as (or sometimes even lower than) the costs of index funds (or ETFs) in the same category. This is especially common with Vanguard’s bond funds. Many of them are not technically index funds, because they do not specifically track an index. But they have low expense ratios because the fund’s investment strategy is still very passive. That is, the fund isn’t trying to do any of the (expensive) things that many actively managed funds do in their attempts to outperform their benchmarks.

For example, Vanguard’s Intermediate-Term Investment-Grade Fund is technically actively managed. But the Vanguard website describes the fund’s investment strategy as follows: “This fund provides diversified exposure to medium- and high-quality investment-grade bonds with an average maturity of five to ten years.” Nothing about trying to pick bonds with unusually high performance. Nothing about trying to predict interest rate movements. It’s basically just, “We’re going to buy a bunch of bonds with investment-grade credit ratings and maturities of 5-10 years.” Very boring and, importantly, inexpensive to implement.

Similarly, in the muni bond category, Vanguard’s funds are technically actively managed. And their expense ratios range from 0.12% (for Admiral shares) to 0.2%. By way of comparison, if you take a look at a list of muni bond ETFs (here or here, for example), you’ll notice than none are less expensive than Admiral shares of Vanguard’s non-index muni funds.

The triumph of index funds is really a triumph of inexpensive funds over expensive funds. When an actively managed fund has very low costs (and there’s no reason to think that the manager is going to do something stupid with your money), such a fund can be a perfectly good option for inclusion in a low-cost, diversified portfolio.

Investing Blog Roundup: How Different Full Retirement Ages Affects Social Security Strategies

With regard to Monday’s article (about Social Security strategies for couples with very similar primary insurance amounts), an astute reader pointed out that I made a mistake. Specifically, I neglected to take into account how the analysis changes when the two spouses have different full retirement ages due to being born in different years. (You can see a chart with full retirement age by birth year here.)

In short, the analysis is different because, if you have an older full retirement age, your maximum possible retirement benefit is reduced relative to somebody with the same primary insurance amount and a younger full retirement age. For example, if a person with a full retirement age of 66 has a primary insurance amount of $1,000, his retirement benefit if he waits until age 70 would be $1,320 per month — because he delayed for 4 years beyond his FRA, with each year granting an increase equal to 8% of his PIA. But for a person with a $1,000 PIA and a full retirement age of 67, his retirement benefit at age 70 would be just $1,240 per month — because by age 70 he has only delayed for 3 years beyond his full retirement age.

This is actually a relevant point in the analysis for any married couple. I often write about how it is advantageous for the spouse with the higher PIA to be the one to delay (because doing so results in a higher retirement benefit as long as either spouse is still alive). It would be more precise, however, to write that it is advantageous for the spouse with the higher age-70 benefit to be the one to delay. (In most cases, this is the spouse with the higher PIA, but it could be a spouse with a slightly lower PIA and a younger full retirement age.)

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