Alphabeticity Bias in 401(k) Investing

It's interesting how little biases creep into how people make investing choices.  For example, the alphabetical order of the 401K choices listed in a plan brochure (or website) can influence the choices that investors make.

This is discussed in a recent paper published in the Financial Review (an academic journal that I c0-edit). 

Here's the paper
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3295400&mod=article_inline

And here's a link to a discussion in the WSJ. https://www.wsj.com/articles/for-some-401-k-holders-picking-funds-is-as-simple-as-abc-unfortunately-11575861000?shareToken=st5b42cefaa561463394d1c01677966180

There are several solutions to this problem.

1. Don't have so many options on the plan in the first place.   If there are just 5 choices, people are more likely to work down the full list.
2. Group choices in more logical groups.   For example, group by "equity" "bonds" "international".  And again, don't provide too many choices.
3. Allow re-sorting of the list.

John Oliver on retirement plans

John Oliver on retirement plans, advisors and fees.

His conclusion:  Index Funds.    Now where have you heard that before?

A 30 second course on asset allocation

From Josh Brown:  http://thereformedbroker.com/2014/11/06/thirty-second-course-on-asset-allocation-2/

Josh cites Jeremy Siegel's classic "stocks for the long run" which argues, that over any 30 year period, stocks virtually always beat bonds.   Still this doesn't mean that everyone should be 100% stocks - a topic that I've blogged on quite a bit over the years.   You can see my old posts here:

http://financeclippings.blogspot.com/search?q=stocks+for+the+long+run

Your daily latte

Saw this article on Marketplace.org today about the cost of daily latte.   Apparently, at some point in the past, the meme was that you're going to live in poverty at retirement because of your latte habit today.

I wanted to check the numbers, so if you assume 250 $5 coffees a year over 30 years, I reckon the future value is about $70,000 in today's dollars.

I assumed a 4% after inflation return, which is important, because I am basically assuming that in real terms, the cost of a coffee stays at about $5.

While $70K is not going to make a monumental difference at retirement, it isn't chump change!

How generous are the top 50 S&P 500 companies' 401K plans

There's a big difference across plans, and it has nothing to do with investment options.   As usual, the details are in the fine print.

Rebalancing my portfolio

You'd think a that finance professor would be monitoring his portfolio daily... however this prof usually has better things to do.  That said, I have to admit that I've been neglecting my portfolio.  But tonight I did a thorough bit of house keeping.  I also learned a few things along the way.

Like most academics my retirement money is with TIAA-CREF, although the basic ideas are the same regardless of provider.

I have two primary goals - first to get all expenses ratios to be under 10 bp or 0.1%, and second to rebalance to 80% equities, 20% bonds.   The first goal is no brainer.  The second goal will either seem horribly aggressive or way too conservative depending on your perspective.  



Here's what I found.

1. Some fees are surprisingly high
I discovered that I had quite a few funds in my account that had expense ratios of 0.40-0.50%.  But there are options in the plan that have expense ratios of less than 0.1%.   What was I thinking!!!   It might seem small, but cutting 0.3% from my expense ratios is a non-trivial amount.  I won't share the details, but let's just say that it would pay for dining out every week of the year.

2. The choices are not the same across plans
I have four plans.  Two from my prior employer and two from my current employer.  For both employers there is an optional plan and the main plan.  The optional plans have much more choice.  For example they contain bond index funds and international index funds.   The main plans have limited choices.

3. I needed to rebalance
I only had 3% in bonds - because I haven't rebalanced in years.  Therefore I rebalanced my current portfolio as follows:
S&P 500 Index TISPX 50%
Bond Index TIBFX 20%
International Index TCIEX 16%
Small Cap Index TISBX 14%

Because of the differing choices across the plans, these rebalancings can't be done evenly.  For example, one plan was rebalanced entirely into bonds because it was a plan that offered the low cost bond index fund.

4. I needed to change future allocations
I set up my future contributions as follows:
S&P 500 Index TISPX 50%
Bond Index TIBFX 15%
International Index  TCIEX 15%
Small Cap Index TISBX 20%

This isn't ideal - I'd like more in international, but the main plan from my employer doesn't offer the international index fund.  So I have to use the 403(b) - which is a smaller contribution.

Conclusion.

Grab a beer, glass of wine or your choice of beverage, sit down with a spreadsheet and take time to do a thorough inventory of your retirement portfolio.  Don't get hung up on choosing funds, instead focus on low cost funds that will deliver your desired stock/bond mix.

Note: despite my goal of getting all fees below 0.1%, I note that TIBFX has an expense ratio of 0.3%.

Figure out your retirement number

http://www.thesimpledollar.com/how-to-quickly-figure-out-your-retirement-number/

1. Take your salary
2. * 0.8
3. * 1.03 ^ number of years til you retire
4. - any social security you expect to get
5. * 20.

The answer is how much you need to save.  The method is pretty simple but it should give you a ball park idea.

A brief discussion:

Step 2.
The 0.8 is pretty arbitrary - but is trying to get at what amount of your current salary you could live off - hopefully the kids will have left home and your house is paid off.  So this number could be 0.7 or less -but don't kid yourself here.

Step 3.
This is to try to get a handle on inflation.  Most forecasts (from long term bonds etc) peg inflation as being pretty low in the future.  So 3% should take account of any increases in your cost of living.

Step 4.
Social Security. You can got the Social Security website and they'll tell you what your benefit is going to be.  http://www.socialsecurity.gov/estimator/

Step 5.
This has nothing to do with you living for 20 years.  By multiplying by 20 you are creating a lump sum that could yield 5% income per year that would be enough for you to live on.   So this step assumes that you invest your retirement portfolio in an account that earns at least 5%.


If you already have some money saved then you can add the following steps:

6. Take dollar amount you have saved *1.05 ^ number of years.

This will give you an estimate of how much your current money will grow to.

2. Subtract this from the answer from #5 above.  This is the new amount you need to save.

3. To find out the amount you need per month, enter this formula in to excel  =PMT(0.05/12,12*years,0,amount needed).

This should give you the amount that you need to be saving each month for the rest of your working life assuming 5% return on your investments.  Arguably this is a little conservative as your income and amount saved will be going up.


Example:
Salary = 100,000, and 20 years to retire.
$200,000 saved currently.
$1,500 SS benefit per month = 18,000 per year.
Assume investment portfolio earns 5% a year.


80% = 80,000

- 18,000 = 62,000

62,000*1.03^20 = $130,000

130,000*20 = $1.44 Million.

Looking at current save money:
200,000*1.05^20 = 530,000

Amount to save = 1.44 M - 530,000 = 910,000

Using excel formula:

=PMT(0.05/12,240,0,910000) = 2,213 per month for the next 20 years (or about 22 % of your gross income).

How expensive are alternatives?

My friend Ron took the time to estimate the expense ratio for various asset classes in the NC Retirement System.   You can see his excellent full discussion here.

Public equity and bonds are at pretty reasonable rates - 0.46% and 0.01%, although I pay less in my 401-K for my stock portfolio, so I still think 0.46% is pretty high.

But the real shocker is in the alternatives space.   Here the fees range from 1.01% to 1.78%!  The worst offender being pure "Alternatives" which includes hedge funds.   Oh, and this category earned a 5.53% in return.

There is no excuse for this.  This is a handout to Wall Street from the tax payers of North Carolina - plain and simple.

Build a portfolio with three assets.

How to build a stripped down, low cost retirement portfolio that will probably beat more complex investment strategies in the long run.

The retirement gamble

The investorcookbooks blog has an interesting post on a recent Frontline TV documentary called "the Retirement Gamble"   The documentary is a must see for anyone saving for retirement - i.e. pretty much everyone.  

The take away is: Buy Index Funds and avoid fees.  Of course readers of this blog will know that I preach those two ideas every chance I get.

Here's the link to the documentary - you can watch it on your computer.

Social security should be indexed to Chained CPI.

The difference between different inflation measures didn't seem too important to most people, until the President unveiled his budget which proposes to link Social Security (among other things) to something called "Chained CPI".  This seems like some arcane adjustment, but in fact it is very important.

Background:   We frequently refer to the change in CPI (consumer price index) as being the rate of inflation - but in reality it is merely one way of estimating the rate of inflation.   The CPI-U (U refers to urban consumers) measures the price level of a representative basket of goods.   The problem with the CPI-U is that it doesn't account for substitutions of one item for another.  For example, this week apples are expensive, but bananas are not, so a consumer may switch between the two.   If the price index is measuring the cost of living, then it makes sense to include these substitutions.  This is what the Chained CPI does.

The President's proposal is to link increases in Social Security benefits to this Chained CPI measure.   Because the Chained CPI doesn't increase quite as fast as the non-chained CPI which is currently being used, the net result is that Social Security benefits won't increase as rapidly.

In the short run, there won't be much of a difference, but in the long run the difference will be far more noticeable.  Not surprisingly, many advocates for seniors are complaining that this amounts to a reduction in benefits.  While technically correct, the fundamental question is what are the benefits that Social Security recipients are entitled to?

As The Economist explains, by indexing Social Security to the ordinary CPI, retirees have, in effect, been getting a real increase in their benefits (note that the word "real" means an increase above the rate of inflation).  Even if we were to link Social Security to an index that tracks a basket of expenditures that are more typical of retirees, the rate of increase would still be less.

Given that we're facing an ever increasing federal debt, this seems like a reasonable and fair way of tackling at least part of the problem.  It is also worth noting that by not dealing with this problem, the children and grandchildren of today's retirees will most certainly be paying more in taxes and getting less in benefits.

Defined benefit or defined contribution? There is a difference.

Unfortunately, my local paper -- the News and Observer, seems a little confused about the difference between a defined benefit plan and a defined contribution plan.

The relevant sentence in the article is:

The discussion comes as state leaders consider a shift from a pension program to a defined-benefit system.

This makes no sense.  The current pension program is a defined benefit system.

Just to be clear:

A defined benefit retirement plan is a plan where the beneficiary is promised a specific financial benefit based on some formula of years served and contributions made into the plan.   A pension plan is an example of a defined benefit plan.

A defined contribution plan is a plan where the beneficiary pays into the plan and gets a financial benefit that depends entirely on how well his/her contributions have grown in value.   A 401k plan is an example of a defined contribution plan.


Thanks to Ron for the link.

The case for passive investing

This is a great video advocating for passive (or index fund) investing.   The film is made for a UK audience but is applicable to anyone who invests anywhere.  

While the film was funded by an investment management firm, it is accurate and not misleading.  The points they make are correct and are borne out by the academic research.

Finally it is worth watching just because you get to see some of the big names in finance - Jack Bogle, Ken French, David Booth (Chicago B School named for him), and of course Bill Sharpe - the guy who developed the CAPM and got the Nobel.

Via: Reformed Broker

A safe savings rate

How much of your annual income should you save for retirement?

On one hand you can take a conservative approach and assume a very low rate of return.  This is along the lines of what Zvi Bodie argues, and I personally work on the assumption that my portfolio will earn about 3% in real terms which means that I have to save more.  Contrary to Bodie though, I don't invest all in TIPs, instead I have a more typical asset allocation.  The trouble with this method is that you can over save - meaning that you sacrifice too much now for the future.

Another approach  is detailed in a paper that was sent to me by one of my students (thanks Ben).   In this paper, the author estimated the proportion of income should be saved over 30 years to create a portfolio large enough to generate 50% of that persons salary into retirement.  The author used the past long term market performance to run the model.  The conclusion reached from the analysis is that you need to save about 16% of your income to fund your retirement.

There are some big caveats to this number though.  If you start late and only save for 20 years, then you'll need to save 30% of your income.

Bottom line:  If you are not saving between 15% and 20% of your income, then you better hope that your kids do well, because you're going to end up living with them.  

How unbiased are financial advisors?

Not very -  according to a well crafted double blind study. (Full paper here).

The study found that too often advisors took clients portfolios and re-worked them in ways that would earn them the highest commissions.

My advice:  Index.  Fees and commissions are very detrimental to your wealth.

Do equities always outperform in the long run?

An interesting overview of the equity risk premium from the psy-fi blog.

A couple of key takeaways:

First a quote from Buffet:

Warren Buffett, as usual, looks at this differently. Taking a hindsight view of the twentieth century in US markets:

“To break things down another way, we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points.”

And:

So, do stocks always outperform (in the long run)? No, they don’t. And don’t expect long-run market returns in excess of 7% going forward. It might happen, but it probably won’t.

A point I try to drive home in my classes is that the assumption that stocks will earn their historic average return is very optimistic.  I think investors should assume a 2% real return and plan accordingly - which in most cases means saving more.

More on target date funds..

Freakonomics blog talks about why not all target date funds are alike.

IQ and Investing

Robert Shiller discusses a recent Journal of Finance article that finds a link between IQ and the amount of exposure to stocks an individual has in his/her retirement portfolio.

Shiller concludes that what is needed is more financial education.  I couldn't agree more.

Why target date funds are like hotdogs.

Target date mutual funds are portfolios of funds that adjust the allocation to stocks and bonds based on how close the fund is to its specific target date.  These funds are, in theory, great for people saving for retirement, as they gradually reduce the risk exposure of the fund as the retirement date gets closer.  By buying a target date fund, the retiree doesn't have to worry about rebalancing his/her portfolio each year.

This article explains the idea pretty nicely and contains a graphic showing how the allocations might change over time.

So what's not to love about target date funds?  A lot actually.   Ron Elmer has done a nice investigation of exactly what goes into one of these funds.  You can read it here.  The analogy I'd like to make is one of making hotdogs.  The good cuts of meat (the good funds) are generally sold directly to the public, but the nasty stuff is mushed up and put into hotdogs (target date funds).   To understand why this is so, you need to know a little bit about how mutual funds come and go.  

Most mutual fund companies are constantly starting new funds.  But no one wants to put money in these new funds because they don't have a track record.  In addition, because they are small, their expense ratios are often pretty high.  But the mutual fund company can stick these start up funds in a target date fund.   Because people buy the target date fund without paying attention to the funds within the fund, they will put money into these start up funds.  The start ups that do well will most likely be sold directly to investors (these turn out the be the good cuts), but the ones that do badly will be closed or folded into other funds and replaced with a new startup.

As a result, at least for the target date fund that Ron looked at, the fund is heavily weighted towards new, high fee funds that have poor track records.  Case in point, the Fidelity Freedom 2035 fund has an expense ratio of 0.77% which is basically the average of the funds it contains.   This is much higher than the expense ratio of an equivalent portfolio of index funds.

As a side note,  the Fidelity Freedom 2035 fund is one of the options offered to employees at my institution.

Playing it safe as a long term strategy

An interview with Zvi Bodie who advocates for a very conservative approach in retirement planning.