Get this: Despite the biggest and broadest decline in financial markets in a generation, the median 401(k) retirement account at Vanguard Group on Sept. 30, 2009, was up 7% from where it was two years earlier, when the market was near its all-time high.

The Reason?…

Continued regular savings matter a lot. If you have continued contributing to your retirement account throughout the stock-market debacle—and even better, if your employer continues to match your contributions—your account probably has more in total dollars than you expected. Younger people, who have smaller balances to begin with, will see a bigger impact from their regular savings.

You can read the full article here.

In a way, continued contributions during a down market masks the losses and helps you feel better about where you are. It’s also a good strategy for making the down market work for you. You can even make it work harder for you by increasing your contributions during the down market. That’s the strategy my wife and I took during this downturn. So far it’s paying off. Our account value is about where it was at the high. Our personal rate of return for 2009 is around 30%.

JLP-

Greetings!

Two countdowns, one problem: Nobody knows about them.

1. In 73 days, the 2010 Roth conversion opportunity will go into effect, allowing people earning over $100,000 to convert to a Roth IRA and enjoy tax breaks down the line.

2. In just 1 day, on October 15, we reach the deadline for Roth conversion take-backs: if you already switched to a Roth in 2008, you can undo the move (“recharacterize”) and convert your Roth IRA back to a traditional IRA, shrinking your overall tax bill and returning taxes paid with interest.

Schwab’s latest survey found that those most impacted by the 2010 change…

• don’t know about the 2010 Roth conversion rule changes (61 percent),

• are confused about the rules (26 percent find it more confusing than health reform),

• are not planning to convert (72 percent).

I kind of fell down on the job on this recharacterization stuff. For those of you who aren’t sure about recharacterization, it’s the process of reversing the conversion of a traditional IRA to a Roth IRA. I was going to explain the process in a post but I really can’t do a better job than was done in this article.

I have never counted myself among the Dave Ramsey fans. Sure, his advice is better than racking up lots of debt and not saving for the future. But, he also generalizes and has a one-size-fits-all approach to the advice he offers his listeners.

What bugs me most is the math behind his assumptions.

For example…

On page 3 of the above-mentioned workbook, is this:

“The American Dream

Imagine if…
A 30-year old couple made $48,000 a year and saved 15% ($7,200 per year or $600 per month) in a 401(k) at 12% growth.

At 70 years old, they will have…
$7,058,863.50 in the 401(k)”

How did Dave arrive at that number? Here’s the math:

That’s a lot of money!

But, how would this look in the real world? I summarized Dave’s information into the following graphic and used 2009″s numbers from the IRS to calculate income taxes.

For my example, I assumed that this couple does not have children. If that were the case, it would probably be possible for them to sock away $7,200 per year. Their budget would be tight unless they economized.

Then comes my next question:

WHERE ARE THEY GOING TO GET A 12% RATE OF RETURN FOR 40 YEARS?

Seriously, WHO assumes a 12% rate of return for 40 years? Later on in the book, Dave stresses diversification. There’s not a properly diversified portfolio on earth that is going to average a 12% rate of return on a consistent basis. The ONLY way you’re going to get that kind of return is to invest ALL YOUR MONEY in small cap stocks, which are highly volatile.

I think the word “imagine” was the proper word to use for his scenario because the only way he’s going to get those numbers is with IMAGINATION!

To bring us back to REALITY, I reran Dave’s numbers using a much more conservative .77% monthly rate of return, which happens to be the geometric average return for the S&P going back to 1926. Take a wild guess at what the 401(k)’s expected value becomes with that number?

And that number’s even somewhat inflated because it assumes 100% of the money is invested in the S&P for all 40 years.

And…

Neither of those numbers include inflation, which would eat up at least half of those accounts.

So why does Dave use such a high number for an assumed rate of return? I would have to say it’s to give people hope (a false sense of hope, but hope nonetheless). When people look at those numbers, they go, “WOW! I can do that? I had no idea!” I will admit, that those numbers are eye-popping.

But,…

Thoughts?

As you can see from the graphic below, the withdrawal amount can have a drastic affect on the portfolio’s value—especially in down years.

I assumed that the retirement account began 2004 with a balance of $1,000,000, invested like so (rebalanced annually to keep the same allocation):

I then ran two hypotheticals based on a 4% and 5% withdrawal rate to show how they impact the portfolio’s value over time (you can click on the graphic to see a larger version):

The portfolio took a pretty big hit in 2008, losing 18% of its value. It has rebounded nicely so far in 2009 but is still well below its value at the end of 2007.

My advice is to stay flexible on your withdrawal rate. If you can afford to take a smaller withdrawal after a down year, then consider doing so.

1. The balance is just a few thousand shy of its previous high-water mark. Yes, that number includes contributions but it’s still shows drastic improvement from the low.

2. Last year’s personal rate of return was somewhere around -40%. This year’s is currently at 29.3%. Remember, the personal rate of return takes into account contributions.

I don’t know where the economy/market is headed but I’m content to stay the course and believe it will pay off in the long run. I have tweaked our 401(k) investment selections a bit but haven’t moved money from asset class to asset class. We are still 100% equities, divided evenly between large-cap, midcap, smallcap, and international. NOTE: I’m NOT recommending this allocation for anyone. I’m just telling you how we are investing our 401(k) account.

Hi,

Your article on 401(k) loans was very informative.

I am trying to decide between 401(k) loan and withdrawal. My 401(k) is not currently active, meaning I do not contribute anything towards it. I have moved to a new employer and my 401(k) was with the old employer.

I am looking to arrange funds for about 10K. I would be grateful to you if you could let me know which option is better?

Thank you,
M.

M.,

First off, you can’t take a 401(k) loan from a 401(k) with a former employer. Had you had an existing loan on your 401(k) when you left your previous company, you would have had to either pay it back or pay taxes and a 10% penalty on the outstanding loan balance.

Now, it might be possible to move your old 401(k) into your new company’s 401(k). Then, it might be possible to take out a loan through your new company. You’ll have to check with your new company’s human resources manager to find out the specifics.

I don’t recommend the withdrawal route because you’ll be taking a 30% haircut on the withdrawal (20% withholding plus a 10% penalty). On a $10,000 loan, you’re looking at losing $3,000. That’s a lot of money.

One last thing I want to address is your reasoning for withdrawing money from your 401(k) in the first place. You don’t mention your reason in the email. I hope it’s for a good reason (perhaps to purchase a house). By withdrawing money now, you are forfeiting future growth on the withrawal, which could be significant. At least with a 401(k) loan, you are paying yourself back in a relatively short time period.

My recommendation is that you try to find the money some other way if you can’t do a loan. If there’s any way possible to avoid withdrawing funds from your 401(k), go that route.

The definition of personal rate of return (I put together a tutorial here) on Fidelity’s website is:

Your Personal Rate of Return is calculated with a time-weighted formula, widely used by financial analysts to calculate investment earnings. The calculated value reflects the result of your investment selections as well as any activity in the plan accounts shown. Other personal rate of return formulas may yield different results. Remember, past performance is no guarantee of future results.

That explains why our personal rate of return looks so good. For one, we increased our contribution amount AFTER the carnage of January and February. Two, the company’s profit-sharing contribution was also deposited in March, missing the bad months of January and February. In other words, our number could look much worse.

My point?

INVEST!

Invest regularly and forget about it! Have your allocation plan set up and STICK TO IT! Don’t worry about the news. If your 401(k) balance is going to bug you, DON’T LOOK AT IT! The worst thing you can do is allow your emotions to take control. Decisions made on emotion almost never work out.

Okay, that’s it. Carry on…

Until last fall, Pam Nintrup thought the financial adviser she had hired two and a half years before was doing a good job. He’d consolidated her and her husband’s scattered accounts onto one statement and run computer scenarios to determine whether her goal of retirement by age 60 was achievable. It was, he said. He then suggested a stock-heavy mix of investments to help Nintrup, 57, meet that goal.

But with her portfolio down more than 40% since last December, Nintrup’s early-retirement plans are out the window, and doubts about her counselor are mounting. Why wasn’t her money invested more conservatively given her imminent retirement? Is the adviser’s explanation — that bonds didn’t cushion the stock losses as well as anticipated — good enough? Why should she stick with the same plan, as he recommends, when it has done so poorly?

The article doesn’t tell us how this woman’s portfolio was allocated. Regardless, it’s easy to look back and say stuff like, “Why didn’t my advisor see this coming?” What if the money had been invested more conservatively and the market had gone way up and she missed out on the gains? You think she would have been pleased? Hindsight is 20/20.

Think back to the late 90s when some advisors weren’t jumping on the tech bandwagon and their clients were upset with them because their dentist was making money hand-over-fist by daytrading tech stocks. These advisors were losing clients because they weren’t making money fast enough.

Then the tech bubble burst and people were upset because their advisors were investing too heavily in tech stocks.

Bottom line: unless you have a crystal ball or some other magical power, it’s impossible to protect yourself from the market. The only thing you can do is make sure you have a decent asset allocation plan invested in low-cost funds. Stick with your plan but be willing to make changes if necessary. The woman in the example may want to work longer or maybe work part time once she turns 60. Or, she may want to save more towards her retirement now. Or, perhaps a combination of both.

In a speech before the Mutual Fund Directors Forum on Monday, Ms. Schapiro said the investment results from these target funds have been “troubling” in recent times, with an average loss in 2008 among 31 funds with a 2010 retirement date at almost 25%.

She said the SEC is “closely reviewing target-date funds’ disclosure about their glide paths and asset allocations.”

Source: SEC Takes On Target-Date Funds ($)

I don’t think asset allocation disclosure is the problem. Anyone can lookup and find the asset allocations for these funds. It’s easy to do. The problem was that the nearly every asset class was down last year. There’s not a whole lot that can be done about that!

I don’t have the list of the 31 funds, but I checked and Vanguard’s 2010 Target Retirement Fund was down 20.67% last year. I think when looking at these numbers, we have to realize that the funds are designed for a long-term retirement. As of March 31, 2009, Vanguard’s 2010 fund is 52.84% stocks, 47.13% bonds, and .03% short-term reserves.

That’s a fairly conservative mix if you ask me.

I do think that mutual fund companies need to stress that there is a chance for loss of principal. That said, people usually tend to forget those little details when everything goes to hell. It’s human nature.

This finding from Scott’s piece reminds me of what I pointed out about the 2009 Fortune 500:

In the 12 months ending Feb. 28, only 12 companies in the Standard & Poor’s 500 provided a positive return. Over 200 companies lost at least half their value.

Finally, this last part regarding how fees can really eat into retirement plans, is telling:

All other things being equal— gross return and career contributions — a federal government worker with a virtually cost-free plan who starts saving 6 percent of income at age 30 will accumulate about 10.5 years of final income by age 67.

A private-sector worker with a typical plan will accumulate only 8.5 years of final income by the same age, if the plan has costs of 1 percent a year.

A worker with a plan that costs 2 percent a year will accumulate only 7 years of final income by age 67.

Those are big differences. Put another way, 2 to 3.5 years of income are siphoned off by the costs of typical plans.

I have a feeling that changes are coming… Let’s hope they are for the better and not some kind of socialist program.

I still think education and SELF-DISCIPLINE are the keys. Employees need to understand just what they are giving up when they elect not to sign up for their 401(k). They need to be updated once a year with something that says, “This is what you could have in your account had you signed up.” Of course, this may do nothing more than lull people into doing nothing since they already feel like they missed out.

I’ll try to highlight the other five articles in the series as they become available.