March 2008 Archives

One of the challenges of putting a successful 401K plan together is fund selection. Obviously, picking funds with low expenses should be a priority. But then the question is what asset classes do you choose. Do you have the options available for the sophisticated investor? Do you you keep things simple and use mostly target retirement funds? Or offer both and the run the risk of too many funds confusing participants?

Lessons from previous 401k plan

In our previous 401k plan,  we could pick 12 out of 40 preselected funds. 3 Vanguard funds were available but the rest were all actively-managed funds with expense ratios ranging from 0.50% to 1.75%. (And of course, there was the extra 0.50% asset charge to employees and another 0.50% to the employer.) We picked the best option from each category -- how successful was the lineup? Here is how plan assets were directed:

Money Market                     32% (cash)
Dodge & Cox Stock                16% (large value)
Vanguard Morgan Growth           15% (large growth)
American Funds Capital World G&I  7% (europe/japan value)
AIM Real Estate                   7% (reit)
Vanguard Total Bond               6% (intermediate bonds)
T.Rowe Price Mid Value            5% (mid value)
Bridgeway Aggressive Growth       5% (small growth)
Vanguard Index 500                3% (large blend)
California S&P Small Cap Index    2% (small blend)
John Hancock Lifestyle Growth     1% (moderate growth)

Looking at where the money went, the lineup is disappointing. Obviously, people were confused by the choices leading a whopping 32% in money market. Then there was a solid number of people picking Dodge & Cox and Morgan Growth since those two had decent track records and relatively low expense ratios (0.52% DODGX, 0.39% VMGRX). The rest of the selections ended up being random noise. One participant would choose random ABC fund at 1%+ ER, another would choose XYZ at 1%+ ER.

Of particular interest is how far down Vanguard Index 500 is on the list. We had access to Signal shares at 0.07% ER in this plan which meant people were more attracted to exciting fund names. Growth, aggressive growth, growth+income? Gotta be better than a regular index cuz they grow fast! (Yeah, I'm sure they read through the prospectuses and decide those funds fit their investment strategies better.)

Employee Fiduciary fund lineup

With this past experience in mind, I fleshed out the following criteria:

• Choose index funds not only with low expense rates but with bland names. If you don't have a "ABC Enhanced Credit/Leveraged Aggressive Growth" fund staring in your face, you won't have people mesmerized by the name thinking choosing that fund would let them get away with saving less.
• Offer a menu where picking all funds in equal percentages is a viable plan. (Thanks to The Finance Buff for posting this advice at Boggleheads.)
• A final consideration was to be mindful of what happened in the 70's. The 70's was a terrible era where both stocks and bonds returned -3% real return annually due to high inflation. If you were retired and drawing down your portfolio, some gold and commodities might have kept you off Alpo.

The question still left on the table: use a few broad index funds or many market subset indexes. Part of me wanted to go with just a few funds to reduce performance chasing behavior (although the existence of TSP market timing newsletters say you can never eliminate the possibility). On the other hand, a high percentage of plan dollars belonged to a small number of sophisticated investors -- should I limit their choices in order to force participants to choose specific investment strategies? In the end, I decided on the many fund option with the hope of education working on a small number of employees. The funds I chose were:

Bonds/Fixed Income

Vanguard Prime Money Market
Vanguard Intermediate Bonds
Vanguard Inflation Protected Securities

Domestic Stock

Vanguard Value
Vanguard Growth
Vanguard Small Value
Vanguard Small Growth

International Stock

Vanguard European Stock
Vanguard Pacific Stock
Vanguard Emerging Markets

Other

Vanguard REIT
PIMCO Commodity Real Return D*
American Century Global Gold

Target funds

All Vanguard target funds available on demand

*PIMCO Commodity Real Return D ordinarily costs 1.24% per year. However, 0.25% of this amount is a 12b-1 fee which Employee Fiduciary rebates to us dropping our effective cost to 0.99%. Over time, we will accumulate enough assets to get into Institutional class decreasing costs to 0.74%.

Model Portfolios

Core in the education campaign was the development of model portfolios for employees to choose. I knew as much as I could try to teach people about investment strategies, people would forget everything 2 days later and ask "what funds should I pick?" (And as the plan trustee, I can't answer that question.) So I picked portfolio strategies advocated by various investment/finance authors and fitted them to our fund menu. The portfolios I presented were:

• Harry Browne's Permanent Portfolio
• Larry Swedroe's Concentrated Risk Strategy
• Scott Burn's Couch Potato
• Scott Burn's Margaritaville
• Bill Schultheis' Coffehouse
• David Swenson's Yale U Index
• Equal percentage of all funds
• Equal percentage of all stock and commodity funds

Employee selections

After all the write-ups and presentations, now it came time to see whether my groundwork would be effective in (1) getting employees to participate and (2) avoiding major investment mistakes. Here are the results after a few months of contributions:

Participation

100%

Percentage of Salary Contributions

8%

Model Portfolios Chosen

Coffeehouse   35%
Swenson       20%
Equal         20%
Swedroe       10%
Couch Potato  10%
Custom         5% 

Overall asset percentages

Stock         69%
Bonds         22%
Commodities    9%

Fund percentages

Vanguard Small Value              13% (small value)
Vanguard Value                    13% (large value)
Vanguard Inflation Protected Sec  12% (intermediate tips)
Vanguard Intermediate Treasury    10% (intermediate bonds)
Vanguard REIT                      9% (reit)
Vanguard Emerging Markets          9% (emerging)
Vanguard European Stock            7% (european)
Vanguard Pacific Stock             7% (pacific)
Vanguard Growth                    6% (large growth)
Vanguard Small Growth              5% (small growth)
PIMCO Commodity Real Return D      5% (commodities)
American Century Global Gold       4% (gold)
Vanguard Prime Money Market        1% (cash)

35% of participants picked the Coffeehouse Portfolio so there is some overweighting to Large Value and Small Value. Otherwise, the fund picks look far more balanced than with the previous plan.

While doing background research for this article, I came across Los Angeles Times' Retirement at Risk series. Part 3 of the series on teachers is especially sickening. (Quick summary: teacher unions endorse ripoff annuity pushers in return for cash.) Moral of the story -- picking the right vendor can make a huge difference in the performance of a retirement plan. Of even bigger consequence for employers are the recent lawsuits over 401k expenses. Leaving open the possibility of a lawsuit 20 years in the future claiming unnecessary fees has penalized employees millions is a bad business decision -- never mind the hit owners & management would take as 401K participants.

With costs and fund choices forefront in the equation, my company chose Employee Fiduciary to administer our Safe Harbor 401K.

Costs

As of this post, Employee Fiduciary's cost schedule is:

Type                 Amount             Period    Paid By
-------------------  -----------------  --------  --------
New Plan Setup       $500               One Time  Employer
Existing Plan Setup  $1000              One Time  Employer
Administration Cost  $25/employee       Annual    Employer
                     $1500 minimum
Asset Charge         0% assets < 1M     Annual    Employee
                     0.06% assets > 1M

The 0.06% asset charge is a passthrough fee from MG Trust which is the entity that actually holds plan money. Since, Employee Fiduciary is not in control of this fee, there is risk MG Trust may increase it in the future.

Under our previous 401K plan, the per employee administrative fee was less at $1250/year. However, the employer paid an additional asset fee starting at 0.50% and gradually decreaseing to 0.10% at the 5M total assets. Crunching the simple math, eliminating the employer asset charges pays for the $1000 conversion fee and $750 termination fee in less than a year.

The average fund expense ratio from our previous plan was 0.74%. An additional non-decreasing 0.50% asset charge against employees was added on top. Added together, 1.24% is par for the course when compared to the average 401K plan. However, I'm used to investing directly at Vanguard for 0.25% so that was sore spot with me. Given our current contribution amounts, a 1% reduction in fees could be another million dollars for plan participants after 20 years.

Fund Choices

Employee Fiduciary uses an open architecture for investment choices. This means you can choose almost any mutual fund as long as you meet the fund requirements. From what I can tell, most investor-class fund shares have no minimums for group retirement plans. For example, Vanguard's minimums are usually $3000 for individual investors -- however, I was able to add Vanguard funds to our lineup even though I did not yet have the target dollar amounts for each participant. (I ran into the "almost" with Northern Global Real Estate -- no idea why this plan was not available to us.)

ETFs are also available under Employee Fiduciary's architecture. However, the cost is an annual $500 per ETF offered to manage discrete share issues. Because it is a fixed cost, high plan assets are needed before ETFs become the better choice. Let's use a simple example with Vanguard Large Cap Index:

0.07% Vanguard Large Cap ETF
0.12% Vanguard Large Cap Admiral
0.20% Vanguard Large Cap Investor
Investor class to ETF: 500 / (0.20% - 0.07%) = 384K
Admiral class to ETF:  500 / (0.12% - 0.07%) = 1M

For more exotic asset classes not offered at Vanguard, the spread may be much less. Let's look at International Real Estate for example:

0.48% iShares S&P World ex-US Property Index
1.07% Fidelity International Real Estate
FIREX to WPS: 500 / (1.07% - 0.48%) = 85K

Come by next time to read about choosing a fund lineup.

My wife just gave birth to a baby girl over the weekend so my routine will be in chaos for the coming future. I have a few articles already written and scheduled for release -- whether I can sneak in brief moments to write more in between feedings and diaper changes, I don't know yet.

If you are running a company, sooner or later you will need a retirement plan in order to compete for workers. For a small company, the top three options to look at are: SEP-IRAs, SIMPLE-IRAs and 401Ks. Each has their own unique sets of rules and may be the right choice for you.

SEP-IRA

Typically, SEP-IRAs are recommended for self-employed situations. It is an easy plan to implement with high contribution limits and little administration overhead. If your business is incorporated, you can contribute 25% of wages to a retirement plan. If not incorporated, you can contribute 20% of net profit. In addition, you can sign your company up directly with Vanguard at no additional costs over an individual IRA account. Sounds good, right? There is one slight complication -- the contributions are made in addition to salary by the employer only and must be applied at the same rate to all employees. This makes individual choice very limiting for both company owners and employees. Owners typically will want to shelter as much income as possible but if they put the maximum 25% of their salary away into tax-deferred space, every employee would receive a similar contribution. Likewise, any employee wanting to accelerate their retirement savings would not have the option to do so.

(A Keogh plan looks very similar to a SEP-IRA except for pre-declared contribution percentages and more paperwork since it is a pension plan. With the advent of the SEP-IRA, there should be no reason for a small company to choose a Keogh.)

SIMPLE-IRA

SIMPLE-IRAs are available for companies with 100 employees or less and operate like 401Ks. Employees decide how much of their salary they want to defer and the employer makes matching contributions. Employees must make either 2% matching to all employees whether they participate or not -- or up to 3% elective 3 out of 5 years. Both matching schedules require immediate vesting.

Reasons for choosing this plan -- one page annual filing, low cost of administration. Like with a SEP-IRA, you can open up an account directly with Vanguard at the cost of an annual $25 per fund used per employee. (The fee is paid by the employee until they accumulate $100K in total assets at Vanguard.) As the I in IRA stands for individual, employees have the right to withdraw or rollover any contributions after a 2 year waiting period.

Now for the bad:

• Lower contribution limits compared to SEP-IRAs and 401Ks. For 2007, employee contributions are limited to 10.5K versus a 401K's 15.5K. Catchup contributions for employees over 50 are 2.5K versus a 401K's 5K.
• An employer may not match more than 3%. My guess this is to avoid self-employed from contributing 10.5K + 328% matching to reach the 45K maximum qualified plan limit on ~50K of income.
  
• $25 per fund charge at Vanguard means employees must pick a single target retirement fund to avoid extra fees until they build up a significant amount of money.
  

(There is also a similar plan called the SIMPLE 401K where the only difference seems to be the ability for employees to take loans out against their assets. However, I don't know of any fund company offering this option.)

401K

If you are a hermit who just left your cave, read up about 401K plans at Investopedia. Otherwise, there's no point in going over basics you should know already or can read about on anywhere else. Instead, I'll jump right to employer issues.

Cost -- You will not be able to setup and make the annual ERISA filings yourself. You will have to hire a third party administrator to manage the plan for you. The big boys (Vanguard, Fidelity, T.Rowe Price, etc.) only will deal with you directly if you have enough plan assets or are willing to pay a nice annual fee. This means you must be diligent investigating the fee schedules. Here is a Boggleheads post I wrote a few months back listing about a dozen low-cost 401k options.

Plan Testing -- The IRS frowns on deferring too money for owners and highly paid employees (97K+ for 2007, 102K+ for 2008). Hence, annual contributions must be tested against formulas. If a plan is deemed top heavy, contributions must either be returned (don't file those individual tax returns early) or additional matching must be made on behalf of non-highly paid employees. In a small company where a large percentage of employees could be highly paid, this ends up being a crippling limitation. Luckily, there is a solution called the Safe Harbor 401k. It simply is a regular 401k except with mandatory 100% matching up to the first 3% of salary and another 50% for the next 2% with immediate vesting. Additional matching is possible but where discretionary (ie, depends on profits), it is capped to 4% total on 6% of salary.

The plan my company switched to was a Safe Harbor 401k administered by Employee Fiduciary. My next posts will talk about the plan EF offers and the funds we picked.

Part 1 of my investment spreadsheet articles was included in the latest Carnival of Personal Finance over at Quest for Four Pillars. I'm way down on the list but better to be near the end than in the middle. Amongst the other articles at this carnival, there are a few that relate to topics I've written about or will write about.

Amateur Asset Allocator wrote about variable annuities and gave all the detailed reasons of why you would not want to use them. If you want to see the mathematics behind how bad it can be, check out Investment Spreadsheet Part 3.

Funny About Money talked about libel and slander insurance for bloggers. I have a future topic planned about various insurance policies business owners must consider because you won't be able to just get away with the standard health, auto and homeowner categories.

Spreadsheet Goodness

This is part 3 of a 3-part series.

• Part 1
• Part 2
• Part 3

Download the spreadsheet as:

• OpenDocument: InvestmentTaxSummary.ods
  
• Excel: InvestmentTaxSummary.xls

In parts 1 and 2, we looked at retirement and taxable accounts. Now let's really dig deep into the rabbit hole.

Non-deductible IRAs

Say you have the option to put money in a non-deductible IRA? Is that the better option than putting it in a taxable account? Non-deductible IRAs defer taxes on growth until withdrawal with qualified capital gains/dividends converted to regular income.



The ending $29K number is less than holding taxable index funds. The only case this would make sense is for REITs, Bonds or high-turnover stock picking.

Variable Annuities

Variable annuities act just like non-deductible IRAs. You can treat the two the same except for two differences. (1) No limits on contributions. (2) It uses a nominal insurance contract to provide tax deferred growth which requires extra expenses (mortality risk expense) to pay for the insurance. Now if you called up Vanguard directly to open a VA, they would charge you a 0.30% M/E in addition to their standard fund expenses. (Other companies offering low-cost VAs include Fidelity at 0.25% and Jefferson Mutual at a fixed $240/year.) In this case, we modify the return from 10% to 9.70%.



The ending number is just a tad below a taxable account holding a diversified index portfolio so I would not use a VA to hold any investment that has a significant amount of qualified gains. On the other hand, if you have used up all money in your 401K/IRA/Roth IRA/HSA, using a VA to hold Bonds and REITs may produce better results than forcing other high yields into taxable. From these numbers, it does not "seem" like the complete ripoff people constantly say VAs are.

Variable Annuities Part 2

Unfortunately, low-cost VAs are not the norm in the industry. The typical insurance company will charge M/E of 0.75% to 2%. Let's use 1.25% as the average and see what happens.



This number is just slightly higher than the 100% income rate taxable option. Great, you saved on taxes -- too bad all the tax savings went to the insurance company. (Politically/economically, would it be better for an insurance company to earn profits versus the government collecting taxes? Well that's a totally different discussion.)

There are specific instances where a high-cost VA can provide some interesting benefits. For example, if you can't get life insurance due to health problems, some companies offer a death benefit rider to their VAs which may give you enough coverage for funeral expenses and a bit of inheritance tax.

Permanent Insurance: Whole Life, Universal Life, Variable Universal Life

Now let's kick this spreadsheet into high gear. Suppose you have an agent hot on your heels to sell you some type of permanent life insurance policy. First, if you don't max out your 401K/IRA/Roth IRA/HSA, there's no need to consider -- get term life and invest the difference. But say you do that already, you meet your desired allocation target in low tax-drag taxable accounts and you still have plenty of money to invest. Before we start popping numbers into our spreadsheet, we must look through a prospectus with a fine-toothed comb. From reading through a Western Reserve Variable Universal Life (VUL) prospective, I extracted out the following costs:

• Sales Load
  • 6% for policies $0-$250K, years 1-10
  • 2.5% for policies $0-$250K, years 11+
  • 3% for policies $250K-$500K, years 1-10
  • 2.5% for policies $250-$500K, years 11+
  • 0% for policies $500K+
• Standard Unit Charge
  • 0.096% of policy face value, years 1-10
  • 0%, years 11+
• M/E
  • 0.75% years 1-10
  • 0.60% years 11-15
  • 0.30% years 16-20
  • 0% years 21+
• Average fund expense ratio: 0.75% (+0.50% higher than Vanguard funds)
• Cost of insurance: we will ignore this component for simplicity purposes -- the assumption here is you would pay this cost through term coverage also

With this in place, we begin with target premium numbers. Target premium is the amount the insurance company believes to be adequate to fund the policy. For a mid-30's non-smoker, the target premium looks to be about 0.70% of the policy face value. We will add the Sales Load and Standard Unit Charge to the W/D (withdrawal) column to simulate the charges.

100K VUL -- Target Premium



If tax rates stay the same, the 100K VUL will never catch up to the taxable portfolio. Now we are in historically low tax rates -- especially for long term capital gains and qualified dividends. In what kind of tax environment would this policy catch up after 30 years? So we go over to the Taxable Tax Rate cell and slowly increase the number. Right about 30% is when the two 30 year numbers match ...

... With major caveat. The "tax free" benefit of permanent insurance comes in the form of loans against the policy. At the time of passing, the death benefit payout pays off the loan leaving the remainder for your heirs. This means if you "borrow" money from your policy, it must remain in force or otherwise a total disaster occurs -- all money borrowed immediately gets converted to taxable income! So in effect, you can only tap some percentage of your policy for your own use with. In this case, I've randomly guessed 80% as the number.

250K VUL -- Target Premium



With lower sales load starting at the 250K threshold, this improves the VUL performance by ~3% over the full sales load but still not a very enticing option.

500K VUL -- Target Premium



With no sales load, this policy's total cash value almost matches the taxable portfolio after 30 years.

100K VUL -- 7-pay

For almost everybody, insurance is an absolutely horrible investment vehicle. However, there is a small subset that might be able to benefit from it. The Standard Unit Charge appears to be a fixed amount per year. To make it a smaller percentage, put more money in. For a mid-30's non-smoker, the quote I received says the IRS will allow annual contributions up to about 3.5% of policy face for 7 years. (This is called 7-pay because you fully fund your policy in 7 years.)



In this calculation, we bumped up the Max Borrow amount to 90% due to the larger CashValue:PolicyFace ratio.We see the 100K VUL funded at 7-pay limits catches up to a taxable portfolio after 30 years versus never at the target premiums.

250K VUL -- 7-pay



Break even at 17 years.

500K VUL -- 7-pay



Getting rid of the sales load has brought break even point to about 6.5 years. Sounds like a viable option -- assuming:

• you max out all traditional retirement vehicles 401Ks, IRAs, HSAs, etc.
• you have a portfolio of tax-efficient investments in taxable
• you have a big emergency fund to avoid tapping into the policy early (surrender charges + losing the tax benefits)
• you will have plenty of money in retirement so you can keep the policy in force
• you don't need to tap all the money and will leave ~20% of the policy's cash value as death benefit for your heirs

This is the type of investment you might carefully consider if you are investing at 40K-50K annually (90K-100K for a couple), can guarantee that investment stream for the next 7 years and can live with the limitations. Obviously, this is beyond the realm of most mortals as the median household income in this country is 50K. Who has that much money after taxes and expenses? This is the reason why VULs are commonly referred to as retirement plans for the rich.

Final Words

Remember all numbers and projections I showed here are mere samples. Don't come away from these articles with the idea that X is always better than Y. It will always be up to you to do due diligence on your own situation and options. Research, analysis and critical thinking -- use your brain and it will be your most important tool to evaluate investments. Download and have at it.

Spreadsheet Goodness

This is part 2 of a 3-part series.

• Part 1
• Part 2
• Part 3

Download the spreadsheet as:

• OpenDocument: InvestmentTaxSummary.ods
  
• Excel: InvestmentTaxSummary.xls

Previously, we looked at samples of the usual assortment of retirement accounts. The standard retirement options are actually the easiest model since the math behind the taxes is straightforward -- either apply taxes before, after or never. Now let's look at taxable investments.

401K versus Taxable Index funds

I have seen the question asked before -- my employer does not offer matching, should I instead put my money into taxable investments and pay 15% tax on gains? Well head over to the Taxable section and give it a test. Now we have another variable to look at. Yr Distrib is the portion of gains that are distributed every year as a taxable event. For example, if you own a diversified portfolio with an average 2% dividend yield and 0.5% turnover, that would be a 25% yearly distribution based on a 10% annual return (2.5 / 10 = .25). We then put tax as 15% long-term capital gains + dividends, 25% regular income, 5% state income for a total of 22.5% as the effective tax rate.



At $30.5K after taxes, it's quite a beat-down from 401Ks. For a taxable account to break even, income tax rates would have increase up to 44% ((54666-30581)/54666) after you stop contributing while LTCG/QDIV rates remained constant.

Taxable Accounts: Growth Index Funds

Let's say you put decided to put everything into just Growth Index funds where average yields+turnover is about 5%? Does that improve the situation?



About 4.7% better -- certainly some potential for splitting assets across low yield and high yield categories if you invest more than the 401K+Roth IRA annual limits.

Taxable Accounts: Systems Trading

What if you prefer system trading where you turnover your portfolio every year? (Examples: Magic Formula, Dogs of the Dow, etc.)



Looks to be a 11%+ drag compared to the growth index option, 7%+ compared to total stock indexes. Do systems trading under tax-advantaged accounts if possible.

Taxable Accounts: Income Tax Rate

What if we have taxable investments/strategies at regular income tax rates -- say bonds or day trading. (For this exercise to isolate the tax consequences, assume bonds return 10%.)



Ouch, quite a big tax hit. We just went from $38K for 401Ks/Roth IRAs to $32K for Growth Index Funds to $24K in this case. Absolutely the top priority for sheltering under some type of retirement account (or to avoid completely in the case of day trading).

Taxable Accounts: REITs

With REITs, the yearly dividend distributions are taxed at income rates. However, the capital gains are at qualified rates. To get a close projection, set the yearly distribution to 40% (4% yield / 10% total return = 40%) and the default tax rate to 30%. At year 20, set yearly distribution to 0% (assume you sell before the big end of year distributions) and then the tax rate to 20%.



At these tax rates, it's about par with systems trading tax drag. At higher tax rates, the impact will be higher.

Taxable Accounts: Different Tax Rates?

Something to keep in mind -- we have historically low LTCG/QDIV tax rates. LTCG rates used to be 28% and there was no concept of QDIVs. And from the rumblings, it's possible qualified gains might have to be bumped up to 20% or 25% as part of fixing the AMT package. We are also at historic low dividend yields -- before the 90s boom period, 4%-4.5% was the average yield. Let's see what happens when we change these parameters.



So investments in an 80's like environment incur a 9% tax drag compared to the tax rates today.

Taxable Accounts: Cost Basis

One last variable to look at. Suppose you invested $5000 over the years and it has grown to $10,000 now. In addition, there has been about $1,000 in taxable distributions. So to account for only $4,000 of the starting balance being taxable, we would enter $6,000 in the Cost Basis field.



To be continued in part 3 (variable annuities, variable universal life) ...