By Dr. Ned Gandevani
By and large most people don’t have enough money saved to last through retirement. A recent Boston College study as reported by the NY Times (3/5/2015, Section B1) said the average head of house 55 to 64 “had only about $104,000 in retirement savings.”
Gone are those days where you could receive pension checks during your golden years due to the benefit-defined plans offered by employers. Today a majority of private businesses offer some sort of contribution-defined plans including 401 (k) which has shifted burden on you to save and manage your money for retirement. To encourage you, for instance, your employer may contribute up to 50% of your contribution, if you invest at least 6% of your annual pay. Some may contribute less or even none.
You feel good to have a 401 (k) plan. However, as soon as you inspect the high costs and limited number of funds available in your plan, you realize creating a nest egg for your retirement is more like a dream than reality. Moreover, you are happy to defer your taxes now since they may be lower at the time of withdraw at retirement. However, the current tax growth trend indicates, you may end up paying more taxes than you anticipated.
Here are five ways to check the financial health and vitals for your plan.
- A retirement plan is as good as its funds. If your plan offer a limited number of mutual funds, your chance to creating a great diversified portfolio diminishes. Some plans offer only a handful of mutual funds, while others offer a better variety of funds including Exchange Traded Funds(ETFs) with much lower cost and greater diversification. You may spend a great deal of time creating a robust and suitable investment policy. However, without proper funds in your 401 (k)plan, it would be difficult to mitigate portfolio risk and achieve your financial goals.
- Cost is an important factor that could make or break your future nest egg. Mutual funds typically carry a high management fee. Mutual funds with active management carry much higher fees than the market indexes which have a passive management. In addition to commissions and management fees, your plan may impose an annual maintenance fees for low balance. Higher cost simply means lower return for your plan.
- Not all funds are created equally. If you resolve absorbing the usual high cost associated with mutual funds in your plan, you should consider their risk adjusted performance. A Sharpe ratio measures a fund return with respect to its risk. Comparing different funds for their performance does not reveal the risk taken to produce the return. In addition to a Sharpe ratio, you may use other measures of risk like Alpha and R Squared to evaluate funds in your plan. Alpha measures the fund manager’s performance and ability in creating the return. R Squared measures how close or far a fund has performed compared to its benchmark. Financial websites like Yahoo and Morningstar’s tools should help you choose available funds in your plan based on the different risk measures.
- Your employer does not contribute to your 401 (k). When there is no contribution from your employer towards your plan, there is no need to invest in the plan. By investing in a restricted plan, you end up paying too much with no benefits from your employer. You are encouraged to seek a better tax-deferred alternative for your 401 (k) plan.
- Long vesting schedule. If your plan has a long vesting schedule, when you leave your current job, you may have to forfeit some or all of your employer’s contributions. Some plans may have a cliff vesting schedule that means unless you are employed by specific number of years, you are not entitled to your employer’s contributions.
If you realize you have a mediocre 401 (k), you have several alternatives to consider saving for retirement.
IRA or Roth IRA
The Individual Retirement Account (IRA) is a tax deferred retirement account available for individuals with earned income. Unlike a 401 (k) opened and provided by your employer, you open your own IRA or Roth IRA account with a financial institution or a custodian. Within your IRA or Roth IRA you may invest in stocks, mutual funds, ETFs and some other assets. An IRA or Roth IRA helps individuals save and invest money for retirement. With a traditional IRA, the contribution is generally tax deductible since you defer taxes to the future. While for Roth IRA, you pay taxes now and your withdrawals are tax-free at the time of retirement. For Roth IRA, there are some eligibility requirements.
You may contribute to your traditional and Roth IRAs up to $5,500 (for 2014 and 2015), or $6,500 if you’re age 50 or older by the end of the year; or your taxable compensation for the year. According to Internal Revenue Code (IRC), if you are single or head of household with Modified Adjusted Gross Income (AGI) $61,000 or less, you may contribute to your IRA with up to contribution limit. Or if you are married filing jointly or qualifying widow(er) with modified AGI for $98,000 or less, you can contribute up to the amount of your contribution limit. Your deduction may be limited if you (or your spouse, if you are married) are covered by a retirement plan at work and your income exceeds certain levels.
You can only contribute to an IRA or Roth IRA if you have earned income. According to IRC the following are qualified for earned income; wages, salaries and tips, union strike benefits, long-term disability benefits received prior to minimum retirement age, and net earnings from self-employment.
However, if you are not working, but married to someone who is, you could open Spousal IRA that could be funded by your working spouse for your retirement.
Annuities
To secure a better retirement fund, an annuity is a valuable asset for consideration in your retirement portfolio. An Annuity is a contract issued by an insurance company which pays a stream of income for a period of time or life. Annuities can be immediate or deferred. An immediate annuity begins its payment stream as soon as it is opened. Conversely, a deferred annuity payments does not begin until a later date in the future. You may fund your annuity contract with a lump sum payment when you open it which is called Single Premium Annuity, or you may pay some now and add more in the future periods.
Annuities fall into three major types; Fixed Income, Equity-Indexed and Variable. A fixed income annuity pays you income based on a fixed interest as long as your fund lasts. It functions like a CD, money market or bond. An equity-indexed annuity like fixed annuity provides a guaranteed minimum return while it provides upside potential by investing in the stock market.
Unlike fixed income and equity-indexed annuities which guarantees principal, a variable annuity contains sub-account that could lose the principle by investing in stocks, mutual funds, bonds, real estates, commodities and other assets. Variable annuities seek higher return by investing in a wide array of risky assets.
Common Characteristics of Annuities
There are different types of annuities (i.e. fixed, deferred, variable), however, they mostly share the following common characteristics:
Annuities are financial assets. You can purchase them as an investment vehicle separately or within your IRA and any type of qualified retirement plan like a 401 (k) plan. Since they are tax-deferred vehicle an early withdrawal by age 59 ½ would pose 10% penalty by IRS. However, insurance companies usually allow 10 to 20% of principal to be withdrawn each year with no penalty. An annuity has a declining fees schedule for early withdrawal known as surrender charges. Usually, it’s the heaviest in early years; an annuity may charge 7% for withdrawal in the first year, second year 6% and declines to zero percent at year 7, as an example.
You can invest as much as you wish in annuities unless it is part of your IRA or 401 (k) plan, which is restricted to the amount allowed. Some insurance companies may limit your investment in annuity to a large amount like $5 million.
Advantages and Disadvantages of Annuities
Among advantages of annuities is their tax-deferred feature which helps you save for retirement as much as you want. An annuity contract may provide you a life time income depending on the pay-out options you may choose. Some may guarantee an income for the rest of your life (or single life), or your life and your spouse’s also known as joint life. If one of your investment objectives is to receive income, you should consider annuity for your retirement portfolio.
Annuities carry some disadvantages like fees, expenses, and commissions. The earnings and withdrawals are taxed as ordinary income as compared to a lower rates for long-term capital gain. Your money is locked up. Although you can withdraw your funds early but your withdrawals are subject to early surrender charges. Additionally, like any other retirement plan, you have to pay 10% penalty fees to IRS before age 59 ½. Moreover, annuities are not guaranteed by FDIC. Therefore, the financial guarantee given by an insurance company is backed by the credit worthiness and financial strength of the carrier.
Annuities could enhance your retirement portfolio. However, there are more details that should be reviewed before you make decision on annuities as a viable asset for your retirement portfolio.
If your current 401 (k) plan is a lousy one with high cost and limited funds that does not meet your investment goals and needs, you should seek help from professional financial advisors. The stake is just too high to manage your retirement plan as a “do it yourself’ project.