Saturday, October 22, 2016

The Hidden 401(k) Fee Trap: Administration Fees

My employer offers a 401(k) plan through Fidelity which offers different tiers of investment options. I can choose from a variety of actively and passively managed mutual funds, "target retirement" funds, as well as individual stocks if I choose. Most millennial investors hear the same story from the financial press about 401(k)'s: contribute up until your employer match. It is indeed good advice because it's never a good idea to leave free money on the table. After all, if you earn $50,000 in a year and contribute 5% to your 401(k) with a dollar for dollar employer match, you will have $5,000 in your 401(k) at year end instead of $2,500; nothing beats doubling your money without any additional work! However, I wanted to take some time to focus on something that many millennial investors may overlook but can be equally dangerous as passing up free money: hidden fees in the 401(k) plan.

The U.S. Department of Labor has published a good guide that examines the variety of fees and expenses within 401(k) plans. Remember, all fees and expenses reduce investment returns, and therefore the long-term returns your 401(k) may earn. The Dept. of Labor guide discusses a scenario where a 1% increase in fees reduces a retirement account balance by 28% at retirement...that's a huge hit! 

The hidden 401(k) fee trap that I mention in the post title refers to the fact that while many people are familiar with the fees and expenses charged by mutual funds (i.e. sales charges and management fees), your 401(k) plan administrator may actually charge a plan administration fee, among other fees. Generally these fees are charged at the plan level and some percentage may also get passed on to individual employees. This blog post will be the first in a series of posts discussing these different fees.

A plan administration fee may be taken directly from your investment returns (a silent killer!), or you may pay it yearly, sometimes as a flat fee deducted from your account at the end of the year. There are multiple arrangements, but this fee is levied to pay for administrative services such as accounting, records keeping, and possibly even for additional service and support that your employer may have contracted for. Some employers automatically enroll employees in financial advice/planning programs, or offer other services that you ultimately pay for. Since many large corporations have so many employees enrolled in 401(k)'s, the overall administration fee burden on employees may be smaller, and in turn, larger for employees who work for smaller businesses. 

In July 2012, the Dept. of Labor enacted a rule to ensure that plan administrators mail you a fee disclosure so you can see exactly what fees and expenses you may be subjected to while enrolled in your 401(k). Most investors likely just discard this notice, but you should pay special attention to it. You can also log into your 401(k) account, or request this information from your HR or Benefits Dept. where you work. 

What can you do? Some employers may allow you to opt out of additional services that are paid for by the administration fee, so you may be able to lessen your fee burden that way. As the Dept. of Labor says, "generally the more services provided, the higher the fees." You should question whether you really use or even need the extra services that are being offered. This is particularly relevant when you are charged a yearly fee that is deducted directly from your account balance and not paid out of plan assets, because you will see the fee deduction at the end of every year.

Why is this all important? Consider the following. If you have a $10,000 401(k) account balance and are charged a 1% yearly administration fee, that's $100 that is taken away and won't contribute to long-term compounded investment returns. Assuming your 401(k) balance never changes (it will as the market moves up and down and as you invest more during your career), that yearly $100 charge turns into $3,000 over a 30 year career! With a 7% annual return, that $3,000 alone would become $22,836 over a 30 year career. The silent killer indeed!

Saturday, October 15, 2016

Dividend Reinvestment for Millennials

It only took 5 years between my last post and the post before it, so a 6 month gap shouldn't be considered too bad! I hope to be able to post more in the coming weeks as time permits, but today I would like to focus on a very important topic that many millennial investors tend to ignore in favor of flashier strategies: income investing through dividend reinvestment.

While readers know I am a big advocate of index funds, I also think high dividend yield stocks can play an important role in millennials' investment portfolios, especially when the dividends are reinvested. I have covered the topic of dividend reinvestment before, but basically it means that whenever a company pays its quarterly dividend, those dividends will go towards purchasing more shares of stock in the company instead of being routed to your account's cash balance. The tax implications are exactly the same whether the dividend is paid out in cash, or if it's reinvested; most millennial investors will pay a 15% tax on qualified dividends. 

The reason income investing is enticing is that it can basically set an investor up for a large pot of passive income later in life. For example, if you buy 100 shares of Verizon Communications (VZ), you will receive $56.50 in dividend income every quarter ($0.565 quarterly dividend x 100 shares). As of 10/14/16, Verizon stock was trading at $50.28, so by reinvesting dividends, you are basically acquiring an additional share of stock every quarter - which in turn will earn more dividends - and this acts as an attractive source of compounding. The website buyupside features an easy to use dividend reinvestment calculator which helps to explain how dividend reinvestment increases long-term investment returns. As an example, assuming a 30 year investment horizon and 5% annual dividend and stock price growth rates, a $50 stock paying $2.00/year in dividends will result in 324.34 shares at the end of 30 years, and a total value of $70,088 versus $35,561 without reinvestment. This equates to a 30 year annualized return of 9.2% versus 6.76% without reinvestment. This is particularly beneficial later in life, because once an investor hits retirement, he or she can stop reinvestment and allow the dividends to be paid in cash to be used for whatever the heart desires. 

For investors who tend to shy away from individual stocks, the same benefits can be had by reinvesting the dividends paid by your mutual funds. Most bond funds distribute interest payments monthly, and most actively and passively managed funds pay distributions quarterly. 

A word of caution, however. Not all high dividend yield stocks are created equal. Many are master limited partnerships (MLP) which have run into trouble lately, others are companies with high yields due to poor financial position (yield goes up as a stock price goes down provided the dividend isn't cut), and some simply don't generate enough free cash flow to fund the dividend. Companies with strong free cash flow and payout ratios (dividend per share/earnings per share) in the 0.50 range may be attractive income investment candidates. Never purchase a stock on yield alone without doing more research into the sustainability of the dividend. It's important to consider the long-term dividend payout track record, as well as the cyclicality of the industry the company is in, among other factors.

Friday, April 1, 2016

After a Brief Hiatus, I'm Back

The old saying goes that "life is what happens while you're busy making other plans." So here I write this post, nearly 5 years removed from my last. As you may imagine, a lot has certainly happened since then. My last post was made on October 4, 2011 when I had just graduated from college and began my first job. Since then, I have gotten married to the love of my life, been a member of the workforce for 4 1/2 years, and went to business school at nights while working full-time in order to earn an MBA. The cliche that time flies couldn't be more accurate.

What those 5 years have given me is valuable perspective (life experience, anyone?) that accompany entering adulthood. It's one thing to write about financial management and investing for those just entering the real world, but it's another to actually live it on a daily basis. I'm happy to note that the very investing ideas that I was discussing nearly 5 years ago are the same ones that I implement in my life now. My 401(k) asset allocation is balanced yearly between 3 funds and it's a basic allocation that should work for most young investors:

55% - broad, total stock market index fund
35% - total international index fund
10% - bond index fund of choice

The last option - the bond fund - is not a necessity for most investors under 30, and it may very well be your preference to remain 100% invested in equities. After all, as interest rates rise, the price of bonds go down in an inverse relationship. Since the Federal Reserve raised its target fed funds rate (i.e. 'raised interest rates') in December 2015 for the first time since 2008, many economists expect a pattern of tightening may continue over the next year or so depending upon economic conditions. As the Fed continues to raise rates, bond prices are likely to fall which may hurt bond investor's returns. This doesn't matter much to the long-term Generation WI$E investor, but it's important to note. However, having some exposure to bonds gives you the added benefit of extra income and diversification. If you own the bond fund in your 401(k), you will receive tax-deferred monthly income from the bond fund that can be reinvested to buy more shares in order to leverage the benefits of compounding.

There will certainly be much more to discuss over the coming weeks and months as both the world and financial information flow has changed dramatically in the 5 years since I last posted. I'm looking forward to sharing more of my real world financial journey with you as I continue my goal to make us all members of Generation WI$E.

Tuesday, October 4, 2011

It's Time for Some Inaction!

Like most people, I'm finding it very hard to distance myself from the grim news that has dominated the financial headlines over the past few months. Everyday seems to bring another story of a European bank or country on the brink of failure, the U.S federal government's fiscal issues leading the country to the verge of financial meltdown and more and more bad news on the economic front. It's safe to say that all of this is leading to heartburn for many investors, particularly those who are most exposed to equity markets and have thus received the brunt of the market's move to the downside. 

We will thus hear the requisite talking heads on CNBC and other financial news networks extolling the virtues of "buying aggressively" or from the opposite end of the spectrum "moving assets into cash, Treasuries, precious metals and other safe havens". My advice to you is relatively simple and may seem to go against the grain but it's battle tested and makes sense: simply stay the course, continue with your investment plan and let the market work its issues out. 

As soon as we become reactionary and allow market movements severely dictate how we invest in the here and now, we have let our emotions get the best of us. This is not to say that we shouldn't put some more funds to work since stock prices are low - in that case, it may make sense to buy some more shares of your index funds to better dollar cost average - but avoid any actions that run contrary to what your investment plan is. If, for example, you contribute 10% of your pre-tax pay to your 401(k), it may make sense to up that percentage to 15% or so if you can afford to do that. However, slashing that rate to 0 or upping it to 30% simply doesn't make much sense. Believe me, that type of reaction to current market gyrations occurs a lot more frequently than you realize! As the legendary John Bogle noted, "Don't do something. Just stand there."

Wednesday, September 28, 2011

Wall Street's Flavor of the Week

It seems like it was just yesterday that John Paulson was the darling of the investment community, earning billions of dollars in personal profit and causing fellow institutional investors to hang on his every word and action. How times have changed! A headline on today states, "Rivals Scout Paulson Assets" - if that doesn't sound dire, I don't know what does! I've brought this subject up before but it bears repeating because it shows how fickle investors are - you can be the "can't miss" investment manager one day and a goat the next. 

On Wall Street, you're only as good as your last trade. This goes for all types of investors and helps make the case for passive management much easier. After all, a handful of institutional investors - from hedge fund managers to mutual fund managers - are wildly outperforming their benchmarks at any given moment. The question then becomes how much staying power do those managers have; in Paulson's case, it appears, only a couple of years worth. In the case of the actively managed mutual fund manager, the same is true. It was only a few years ago that Bill Miller, the manager of Legg Mason's Value Trust had his 15-year streak broken of beating the returns of the S&P 500. From 1991-2005, Miller's fund posted returns that were greater than those of the index and was lauded in the press as an investment titan. There is no doubt that Miller is a great finance mind but even he admits that much of his streak was due to luck: "As for the so-called streak, that's an accident of the calendar. If the year ended on different months it wouldn't be there and at some point the mathematics will hit us. We've been lucky. Well, maybe it's not 100% luck—maybe 95% luck."       

The problem for investors like you and I comes when we're tasked with picking the managers who can consistently outperform year in and year out. Here's some food for thought: What's amazing about Miller's success is that consistent outperformance is so rare (1 in 2.3 million, according to Michael Mauboussin), yet the ultimate goal of most individual investors is to invest in mutual funds that can post that type of outperformance...which never comes. If that's the case, why are we throwing good money after bad?

Sunday, September 18, 2011

It's Much Easier to Spend What's Not Yet There

Much of what there is to be learned about managing your finances properly comes when we tame our emotions and focus on the psychological aspects of financial decisions. A mistake that many people make when they get paid is that they have much of their cash on the way out as soon as it comes in. This typically happens when an individual has credit card bills and other debts to pay. The easiest way to avoid this type of occurrence is to make sure you only charge to your credit card(s) that which you know you can easily pay back when you have income come in. Secondly, even if you find yourself stuck with some bills, be sure to keep contributing to your 401(k) for the tax and compounding benefits and save a set percentage of every paycheck for an emergency fund. Ultimately, the 401(k) and emergency fund contributions are two cash "outflows" that shouldn't make you feel bad because by making them, you're only helping yourself. 

By not "segmenting" (outside of the 401(k) and emergency fund contributions) your money before your actual paycheck is deposited, you will immediately begin to see substantial savings. After all, it's much harder to spend money when you can actually see your account balances declining with each purchase, rather than simply thinking about it and accounting for it later at which point you'll likely realize that most of your paycheck is gone before it's even arrived!

Monday, September 12, 2011

The Benefits of the High-Yield Index Fund

Many people are often faced with the seemingly difficult situation of trying to maximize their income due to lack of sufficient cash flow. This becomes even more of a problem as economic growth slows and employers lay off workers and cut salaries in order to help manage their cost structures during a downturn. Luckily, there are some investments that offer regular distributions that can help add a few extra dollars to your household balance sheet every month.

One such investment is a high yield bond index fund. High yield bonds - also known as "junk bonds" - are the debt of corporations and other entities that may be experiencing financial distress. As a result, investors receive a higher interest rate as compensation for the greater risk to their invested cash. As Rob Williams, director of Income Planning at Schwab notes, "Defaults on investment-grade bonds have historically been low, though the frequency increases as credit quality declines."   

Better still, the diversification of a high yield bond index fund ensures that if one issuer were to default, the likelihood of a significant impact on the rest of the portfolio is minimum. How do such funds help maximize current income? The funds pay out their distributions monthly and in the case of the Vanguard High-Yield Corporate Investor Shares (VWEHX), currently yields 6.91%. Thus, even though the numbers might appear small in the beginning - only $30 or so extra a month on a $5,000 investment - you have the choice of taking that cash every month to maximize current income or reinvesting it to help your stake compound which will lead to even higher passive income amounts in the future. 

Overall, high-yield bond funds are a much better avenue for investing in high yield securities due to their overall lower risk profile, low fees and impressive long-run returns