What’s inflation got to do with this? Well, if you do live into your 70s and 80s the price of things you need and want to buy—from groceries to medications—will be higher. If your investments haven’t grown at a pace that keeps up with inflation you will have to use more of your savings just to maintain your standard of living, and that raises the risk of running out of money too fast. The solution is to keep a portion of your money invested in stocks, which over the long term have the best potential for producing gains that beat the rate of inflation.
Have the Right Mix of Stocks and Bonds
So what’s the right mix in your 50s? Well, I will be the last person to tell you there is any single right formula. You must decide for yourself. If you have so much money saved up that you are confident that you could keep 100% of your money in CDs and bonds and still be able to pay for everything in your 80s and beyond, then that is a wonderful truth! But the reality is that for most of you, you must think about the rising cost of things 20, 30, or 40 years from now. And that makes it wise to keep some of your money in stocks. A rule of thumb that is actually very sound is to subtract your age from 100. So at age 55 you might have 45% invested in stocks. At age 65 you might have 35% invested in stocks. (Every few years you should be rebalancing your retirement portfolios so you have less in stocks and more in bonds.) This rule of thumb is a guideline you can tweak to fit your emotional truth. If you want a little more or a little less in stocks, that is for you to decide. I just ask you to avoid any extreme allocation: 100% in stocks is way too risky. And unless you know for sure that you have ample savings so you don’t have to worry about inflation, 100% in bonds and cash is too risky as well.
MAKING THE MOST OF WHAT YOU HAVE
A critical step in building your new retirement dream is to focus on how to maximize the money you have in all your retirement accounts. And if you have changed jobs through the years and have left behind old 401(k)s at former jobs, you are likely dropping the ball here. What you need to focus on is that once you leave a job, whether voluntarily or not, you no longer have to keep the money invested in your former employer’s 401(k). You have the option to move your money out of the 401(k) and into what is called a rollover IRA, where your money will continue to grow tax-deferred. I believe that is often the smartest move you can make. I discussed IRA rollovers in the previous chapter about planning for retirement, so if the concept is new to you, I would encourage you to go back and reread that section. There you will learn where to open an IRA rollover account and whether to choose a traditional IRA or a Roth IRA.
One of the reasons I recommend rolling over old 401(k)s into one account at a single brokerage, and consolidating your IRAs as well, is so you have an easier time looking at the entire retirement pie you have. It will be infinitely easier for you to make sure your overall allocation of stocks and bonds/cash makes sense if you have everything under one roof; most discount brokerages and no-load mutual funds have free online tools that will produce easy-to-grasp pie charts that can show you what you’ve got. And if you are indeed rolling over old 401(k)s you will also benefit from the wider array of investment choices you have with an IRA at a discount brokerage, including investments in individual bonds and all sorts of specialty ETFs, such as precious metal and other commodity-based sectors.
And the reality is that by the time you are in your late 40s or have segued into your 50s, you—and your spouse or partner—no doubt have a mix of different accounts. I bet there are a few traditional IRA accounts, maybe a Roth IRA or two, a handful of “old” 401(k)s from past jobs, along with the retirement plan from your current employer.
Note:
If you have old 401(k)s that include company stock, I recommend you work with a fee-only financial advisor before you roll over any of your 401(k)s into an IRA. There is a special way to handle your company stock that is in a retirement account—referred to as net unrealized appreciation (NUA)—that can help you boost your after-tax return on that stock. At my website I have more information about the NUA rules for handling company stock in an old 401(k).
A trusted financial advisor can also help you sort through whether it makes sense for you to convert some of your retirement savings into a Roth IRA rollover. Beginning in 2010, anyone, regardless of income, can do a Roth conversion on all or part of their IRA accounts, including money being rolled over from old 401(k) accounts. You will owe income tax at the time you convert the money, and the tax bill is based on a convoluted formula that includes more than simply the amount of money that is being converted.
That’s why you want to work with a financial advisor or tax advisor who has experience with all of this. An added complication is that the amount you convert in any given year is added to your taxable income for that year, and that could bump you into a higher tax bracket. So one consideration is spreading out your conversion over a few years to make sure that no single-year conversion pushes you into a higher tax bracket. Again, that’s why you want to have a pro run the numbers and walk through your options with you.
The advantage of doing the conversion today is that once your money is in a Roth you will be able to use it in retirement without owing any tax whatsoever. Moreover, you will not have to take a required minimum distribution from a Roth account (explained in greater depth in the next chapter); so if you don’t need to tap that money for living expenses it can stay growing for your heirs.
After you consolidate your accounts (other than your current 401(k)s) under one roof, you can more easily consider a few strategic moves:
Focus on the Entire Pie
Your goal is to make sure that the sum of all your retirement assets is invested in a way that matches your long-term allocation strategy. So, for example, if your goal is to have 60% in stocks and 40% in bonds/cash, then your focus should be for all the various accounts in the aggregate to give you that 60/40 split. But that does not mean every single account must have the same split between stocks and bonds. You don’t need your Roth IRA to be 60/40 and your 401(k) that you have at your current job to be 60/40. All that matters is that the total sum of all your money divided between stocks and bonds/cash lands at 60/40 (or whatever you have decided is the right truthful mix for you).
And one smart move to consider is how you are investing the money in your current employer 401(k). Of course you are limited to the investment choices offered in the plan, but because you are taking a holistic approach to your overall retirement pie, a smart move can be to pile your 401(k) savings into the least expensive option. I explain this in the next step.
Focus on the Cheapest Investment Offered in Your Current 401(k
)
I want you to find the lowest cost mutual fund in your 401(k). As I explained in the previous chapter, every mutual fund has what is called an expense ratio. This is the annual percentage of your assets that is deducted from your investment each year to pay the mutual fund. That said, you don’t really see the expense ratio as a line-item expense in your annual statement. It’s levied in a somewhat invisible way, as it is deducted from each fund’s gross return before the net return is credited to your account. For example, let’s say a stock mutual fund has a 1% annual expense ratio and its gross return is 6%. That means your account will be credited 5% after the 1% expense ratio is siphoned off to pay the fund’s fees.
I know this is a bit dry to think about, but it is very profitable. The expense ratio you pay can have a huge impact on your retirement security. As I noted in the previous chapter, I think it is prudent to set our expectations for future returns in the vicinity of an annualized 6%. As some of you may remember, that’s one-third the rate of return for stocks during the 1990s, when in fact the S&P 500 grew at an annualized 18% rate for the decade. Let’s imagine you owned shares in a mutual fund in the 1990s that had an annualized gross return of 18%, and the fund charged a 1% expense ratio, so your net return was 17%. Now let’s assume you own the same mutual fund today and it still charges that 1% annualized rate of return. Today’s truth suggests that future returns might be more like 6%. So that would mean your net return would drop from 6% to 5%. That 1% now eats up a bigger portion of your return; it is about 16% of the 6% return, whereas a 1% fee represents just 5% or so of an 18% return. Fees are always important, but you can see how they become even more important when your expectations for future returns are lower. You can’t afford to waste any money paying a higher expense ratio than necessary. And mutual funds offered within 401(k)s can have wildly different expense ratios; some stock mutual funds may charge 1.5%, while others might charge just 0.20%, or even less. One of the best ways you can make money in the coming years is to reduce the amount you are paying in that fee.
That is why I want you to locate the fund in your current 401(k) plan with the lowest annual expense ratio. If that fund owns securities that you want to own, I would consider pouring the bulk of your money into that one fund. Remember, you don’t need this specific 401(k) to have a mix of investments; all that matters is that your overall portfolio—of all your various retirement accounts—makes one cohesive pie.
Here’s an example: Let’s say you have a total of $250,000 in all your retirement accounts, and the 401(k) at your current employer accounts for $100,000 of that total. Now let’s assume that you want to keep 50% of your money in stocks and 50% in bonds/cash. So that’s $125,000 you have earmarked for stocks. If your 401(k) has a great low-cost stock mutual fund, you could put all of your account in that one fund. Then with the remaining $150,000 in your consolidated accounts (you will likely have more than one, since traditional and Roth accounts must be kept separate) you will want to put another $25,000 in a stock mutual fund or ETF. That brings your total stock investment to your target of $125,000. The rest can be invested in cash and bonds. Your total pie adds up to 50% stocks and 50% bonds, but you are strategically taking advantage of the lowest-cost fund within your 401(k).
I really like this approach because it is a great way to avoid ever having to invest in bond funds in your 401(k). I do not like bond funds at all—see
this page
to get my reasoning—and prefer that you invest directly in individual bonds, such as Treasuries. This strategy makes it easy to steer clear of bond funds in your current 401(k).
I want to be very clear here: If the majority of your retirement savings is in this 401(k) account, you obviously should not shift all of it into one fund. If your 401(k) is in fact your whole pie, then this must be a diversified pie. For your stock portion I recommend you keep 85% in U.S. stock funds. If your plan offers a fund with the name Total Stock Fund, that can be a great option, as it invests in a mix of large established firms, mid-size firms, and small firms. So-called large cap stocks tend to offer steadier returns—and often dividends—while stocks of smaller companies typically offer more growth potential. If your plan offers an index fund with “500” in its name, that means it focuses on the large company stocks in the Standard & Poor’s 500 stock index. That’s a find choice as well, and you can also invest in a mid-cap and small cap fund offered in your plan. As a guide for how to split that money among the different funds, you might follow how a Total Stock index fund allocates money: about 70 percent is in large caps, 20 percent in mid-caps, and 10 percent in small caps.
The remaining 15% of your stock portfolio should be earmarked for international stocks. There are two broad ways to invest in international markets: developed countries, such as Japan and most of Europe, and emerging markets, such as China and India. My recommendation is to have most of your international stock money invested in developed markets and reserve just 5% of this 15% slug for emerging markets. Fast-growing emerging markets are more volatile. So you don’t want to overload your portfolio with exposure to them. And keep in mind that those those big multinational blue-chip U.S. stocks that make up 85% of your 401(k) stock allocation do a lot of business selling their goods and services into the emerging markets. So your 401(k) will be tied to the fortunes of emerging markets through those U.S. firms.
Locate the international fund offerings within your 401(k). If your plan has one fund, well, you’re good to go. But if you see two (or more) international funds, that means one of them focuses on developed markets; it will often have
EAFE
in its name. That’s a tip-off that it is a fund focusing on developed markets in Europe, Australasia, and the Far East. The other offering probably focuses on emerging international markets.
Before you put 10% of your stock portion in the developed fund and 5% in the emerging markets fund, I recommend you take a look at the portfolio of the developed fund. While the bulk of its assets will be in developed markets, you may find that a fund has 10% or 20% invested in emerging markets. If that’s the case, then you can just invest in that fund and forget about adding the emerging markets fund as well. Your 401(k) plan should provide you easy access—online or over the phone—to the latest available portfolio mix of each fund. If not, go to
morningstar.com
. Type the ticker symbol for your fund into the search box (it is a five-letter string of letters ending in X that will be listed alongside a fund’s name in your 401(k) material). Then click on the portfolio tab, scroll down, and you will see a breakdown of how much of that fund is invested in developed markets and how much is in emerging markets.
BEST INVESTMENTS OUTSIDE YOUR CURRENT 401(K)
Let’s talk about the right investments for your rollover accounts as well as any regular taxable accounts. The advice here is exactly the same advice I gave to younger investors in the previous class. For retirement assets outside your 401(k), you have the freedom to choose among the thousands of investments offered by the discount brokerage you use. That includes mutual funds, individual stocks, and individual bonds, as well as exchange-traded funds (ETFs). Please go to
this page
–
this page
for my investment advice.