Given recent events, I suppose I should take a look at how my investments are doing. I am also planning to make some large-ish 401k contributions and need to figure out which asset classes to buy in order to rebalance my portfolio.

* denotes 401(k) holding given limited investment options

Contribution Details
Throughout 2008, my wife has been making regular salary deferrals to her 401k, and has recently reached the annual $15,500 limit. I plan to start contributing to my Self-Employed 401k plan shortly.

YTD Performance
The 2008 year-to-date time-weighted performance of my personal portfolio is -27.9% as of 9/18/08. In fact, despite sizable additional contributions, my portfolio is down over $10,000 since my last update in April. Today might have been a bad day to run these numbers… 🙂

Although not necessarily a benchmark, the Vanguard S&P 500 Fund has returned -20.07% YTD, their FTSE All World Ex-US fund has returned –29.74% YTD, and their Total Bond Index fund is up 2.71% YTD as of 9/18/08. (My emerging markets fund is down nearly 40%!)

Rebalancing Details
First of all, I am not changing my asset allocation or moving into safer investments. In fact, I am doing the exact opposite and buying what has been dropping the most…

I am still following the general asset allocation plan outlined here, with a 85% stocks/15% bonds split [115-Age]. Here is an example of how we implemented the asset allocation across multiple accounts, although I’ve since moved some funds around.

So, it looks like I need to buy more Emerging Market and Broad International. I am now a bit overweight in Bonds and Broad US, so I need to sell those. Due to the limited index fund choices in my Fidelity Solo 401k account, I may start buying ETFs if I can justify the $10.95 commissions.

You can view all my previous portfolio snapshots here.

My mom has been asking me to look over her 401k plan, as she has been worried about its performance and suitability recently. In fact, she changed all the future contributions to 100% bonds a while back. As her 401(k) had somewhat limited choices (although they could definitely be worse), I had to make do with what was available. Usual disclaimer applies: I am not a financial professional.

1. Decide on an asset allocation.
This can be a complex topic, but I put most of my research in this series of posts on asset allocation. Given my mom’s age, years until retirement, other existing investments, and and risk preferences, I recommended an overall asset allocation of 60% stocks and 40% bonds. Currently, she is at 68%/32%. I would definitely like to have at least a broad US stock fund, a broad international stock fund, and a broad US bond fund. It might be nice to have Large-cap Value, Small-cap Value, Emerging Markets, Real Estate, or Inflation-protected Bond funds. The final ratios will be similar to the asset allocation breakdown here.

2. Make a list of fund options and characteristics
First up, you’ll want to gather a list of all your available investment options. Usually this includes about 5-30 mutual funds. If the fund details are not well organized, just ask for the ticker symbol and pull up their Morningstar.com snapshot. Put them in a spreadsheet, and include the each fund’s asset class, any front- or back-end loads, and annual expense ratio. Here are the 15 options in my mom’s 401(k) plan:

Now, I am completely ignoring Morningstar “star” ratings. They are based primarily on past recent performance, which have been shown to be a poor indicator of future long-term performance. You could buy a 5-star fund and have it end up a 1-star fund a few years later. Fund managers change all the time as well. I want to create a low maintenance portfolio that doesn’t involve chasing hot managers or performance.

3. Narrow down the options by cost and asset class.
If I don’t need the asset class, then I cross it out. If there are two similar funds, then pick the cheaper one with lower loads. In my “nice to have list”, if it is too expensive, then it becomes less useful as a diversifier and I cross it out as well. An example is the AIM Real Estate fund, with the 5.5% front load. The 6 bolded funds above are the ones that I am left with.

4. Decide if you are going to do a full asset allocation or cherry pick
It is often recommended that you implement your asset allocation across all your investment accounts (401ks, IRAs, brokerage) as one pie. For example, you might hold all your bond funds in tax-sheltered accounts for optimal tax efficiency. Or your 401k might only have one really good fund, and you can buy the other asset classes elsewhere. If this is the case, then you might want to cherry pick the funds you want for your 401k.

For other reasons, you might just want to implement your entire asset allocation as best you can within the 401k. I’m going to go ahead with this latter route for now.

5. Consider Target-date Funds or Pre-Set Model Portfolios
Many 401(k)s include an even simpler option, either all-in-one Target-dated funds or pre-set portfolio mixes. But all target-date funds are not made the same. Look at the prospectus and see what funds are included within them, and if they charge you an extra layer of management fees on top of the fees of the underlying funds. Many are crap, and you could do much better with your own custom mix. My mom’s 401k has no such option.

She does however, have a few options for pre-set model portfolios. These are basically a set ratio of selected funds (the pink and blue highlighted items above), which are are automatically rebalanced once a year. Shown above is the breakdown the “balanced model” option. However, I don’t like them because they include several expensive funds and exclude some of what I think are the best funds. Not including the large front-end loads of two of the funds, the average weighted expense ratio of the model portfolio was 0.59%.

6. Construct Your Custom Portfolio
In the end, I chose the 5 funds below. I decided to leave out Windsor II (Large Value fund) for the sake of simplicity. I calculated the averaged weighted expense ratio to be 0.48%.

7. Explain and Implement
Now, I have to explain to my mom why I picked these funds, and how they may perform in the future. If she wants, I may shift it to 50% stocks/50% bonds. I’ll check in on it again after a year to show her how to rebalance. This is not the perfect portfolio, but it will be better than her previous hodgepodge, and also be easier to manage.

As outlined in this previous post about One Way To Track Your Progress Towards Financial Independence, you can say you’ve reached financial independence when your “passive” investment income equals your monthly expenses (“crossover point”):

The above chart was taken from the Your Money or Your Life, which also says the best way to generate income is by purchasing 30-year Treasury Bonds. But there are a variety of other ways that retirees generate income for retirement. Each one has their own pros and cons.

High-Grade Bonds or Certificates
U.S. Treasury bonds are a very safe and reliable way to generate regular income, as it is guaranteed by the U.S. government and they are very liquid. A similar situation results you invest in bank CDs or other investment-grade corporate or municipal bonds. The primary drawbacks are lower returns, especially relative to inflation. The 30-year bond is currently yielding somewhere around 4.5%. The current real (above inflation) yield for a 20-year TIPS (inflation-indexed bond) is only about 2.20%.

This means that if you want both the highest safety and you wish to only live off the interest of your money without ever touching the principal, you can only withdraw about 2.2% each year. That’s only $183 per month for each $100,000.

60/40 Asset Allocation with 4% Safe Withdrawal Rate
Although there is still much ongoing debate, the “4% rule” is based on on research by William Bergen:

William Bengen, a U.S. researcher, has back-tested a 4% withdrawal rate with a balanced portfolio of U.S. stocks and government bonds earning overall market returns and found that you would have been able to safely withdraw 4% of your portfolio over any 30-year period since 1926. [source]

The general idea is that if you have a portfolio with an asset allocation of 60% stocks/40% bonds, you can withdraw 4% of the portfolio each year with only a small chance of running out of money somewhere down the line. A 4% withdrawal rate would be $333/month for each $100,000. However, your portfolio will experience wilder swings, and this rigid method is very sensitive to the returns in the first years of retirement. If you have a bad decade upfront, your chance of going broke rises quickly.

Income-Focused Mutual Funds
These are mutual funds who primary objective is not growth, but to create a stable income stream from a combination of stock dividends and bond interest. The secondary objective is some capital appreciation, which ideally will help the income stream to keep up with inflation.

A passive index fund example is the Vanguard Target Retirement Income Fund (VTINX), which is currently yielding 4.05%. A popular actively-managed example is the Vanguard Wellesley Income Fund (VWINX), which is currently yielding 4.71%. Both of these funds hold roughly 35% in stocks/65% in bonds. Wellesley has been around since 1929, and many retirees swear by the reliable income it produces.

Managed Payout Mutual Funds
A new breed of mutual funds actually adjusts to help you spend your money as fast as you like. You choose how fast you wish to withdraw your money (3%? 5%? 7%?), and the fund does it’s best to accommodate that without going broke. Vanguard has their Managed Payout Funds, and Fidelity has their Income Replacement Funds.

These funds help you create regular monthly payments like an annuity, but still include risk from the stock market. They are also very new and could be seen as unproven.

Individual Dividend Stocks
I know of several retirees who manage their own portfolios of individual stocks. These people accumulate shares in companies with a history of reliable stock dividends, like General Electric and Coca-Cola, and live off the dividends. An ETF of top dividend producers, DVY, currently yields 5.14%.

I would be wary though that the share value of these stocks can vary widely without the cushion of bonds. DVY has dropped by over 20% so far this year, which is indicative of many similar dividend stocks.

Income Annuity
With a simple version of an immediate annuity, you hand over a lump-sum upfront in return for fixed income payments for life. Of course, if you die early then you don’t get your lump sum back. However, you could live until 110. It’s almost like life insurance in reverse. A special risk here is that your insurance company must stay solvent the entire time, so you must check credit ratings.

I went to ImmediateAnnuities.com and looked into a Joint Annuity, where the income payments keep coming as long as one of us are alive. A rough quote for a 40-year old says that each $100,000 paid will get me about $450 a month. That is the same as saying I can earn 5.4% interest forever, but remember that I lose the principal. Of course, this value goes up with age. For a 60-year old couple, you can get 6.4% forever. At age 70, you can get 7.5% forever.

How much income will a million bucks get you?
Based on these numbers, with $1,000,000 one could get anywhere from $1,830 a month (very little risk, no principal loss) to $5,833 per month (fixed annuity at age 65, all principal is given up). I’d probably end up going with something in between, but it is food for thought.

Okay, so I view my last post on 401k loans as a failure. I tried to use as little math as possible in explaining why 401k loans are not a bad idea due to the incorrect concept of “double taxation”. Instead, I probably managed to confuse many of you all further. I have tried to come up with a better example with the math thrown back in, and think I have found one. Please give me another chance! 🙂

The Method

If double-taxation really occurs in 401k loans, that would mean that taking out such a loan somehow negates the inherent tax-advantages of the 401(k) plan. Certainly, taking a loan and paying it back would be worse than just leaving the 401(k) completely alone, right? I am going to walk slowly through three scenarios that will show that this is simply not true. The three hypothetical scenarios:

1. Elton contributes $10,000 to a 401(k) and does nothing. He does not take any loans of any type. He waits a year and pays for his $10,000 wedding in cash.
2. Elton contributes $10,000 to a 401(k). He then takes out a 401(k) loan of $10,000 to pay for his wedding, and then repays the $10,000 a year later using after-tax money earned from his job.
3. Elton contributes $10,000 to a 401(k). He then takes out a credit card loan of $10,000 to pay for his wedding, and then repays the $10,000 a year later using after-tax money earned from his job.

Very Simple Assumptions

Annual gross salary is $20,000. Income tax is 25% of gross income. There is no interest charged on any loans, as I’m just trying to isolate the issue of double-taxation. There is no growth in the funds, either. He doesn’t need to eat or sleep, so no other expenses. 😉 (And yes, 401(k) loans are usually capped at 50% of total balances.)

The Results

Scenario #1: No Loans

1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
2. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
3. He spends $10k on his wedding. The 401k stays at $10,000 the whole time.

Scenario #2: 401k Loan

1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
2. He then takes a $10k 401k loan out, and puts the $10k in his bank.
3. He spends $10k on his wedding, and his bank balance goes down accordingly.
4. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
5. Finally, he pays back the borrowed $10,000 back into his 401k using the money he earned in Year 2.

Scenario #3: Credit Card Loan

1. In Year 1, Elton makes a total of $20k gross. He contributes $10k pre-tax to his 401k, and pays taxes on the remaining $10k.
2. He then borrows $10k via his credit card.
3. He spends $10k on his wedding.
4. In Year 2, he again makes $20k gross and does not make any additional 401k contributions.
5. Finally, he pays back the borrowed $10,000 back into his credit card using the money he earned in Year 2. The 401k stays at $10,000 the whole time.

Recap
In all three scenarios, the amount of taxes paid is the same, and the final result is the same. Total taxable income over two years is $30k in all 3 cases. Final taxes paid: 25% of $30k, or $7,500. You end up with a 401k with $10,000 of pre-tax money in all 3 cases. No additional taxes are paid by taking out a 401(k) loan.

It does not matter even if he spends the $10,000 borrowed and pays it back later with after-tax money! Thus, I still conclude that there is no “double-taxation” on 401k loan principal.