Mutual Fund Investing: Buying a mutual fund for the first time

For millions of investors, finding the right mutual fund is as easy as tapping your company's retirement plan. For millions of other potential investors, the mutual fund can provide a unique investment opportunity to build your own retirement plan. You can read the full article here.

On ETFs: Part Two of What Investment When

This is the mutual fund: There was a time when the art of a fallen empire portrayed something opposite of the reality. In an exhibition at the Asia Society in New York, images from a period in India's past, when the Mughal ruled an empire that spanned from 1707 to 1857, offer the viewer a look at a facade of peacefulness. You are forced to avoid looking at the reality of life in those pre-British days by focusing on images of receptions, celebrations of holidays and the opulence of serenity. While beneath the surface an empire was crumbling under the rule of these princes on palanquins, the art suggests otherwise. We derived the word mogul from these rulers who dressed in pearl-embroidered shoes and decorative tunics.

This is the mutual fund in 2012. The facade belies the undercurrent of decline. It is a time when what was is slowly being replaced by another ruling party, a new-comer to the scene of investing: the ETF. This investment, like the invasion of this nineteenth century country by the British, is on the cusp of replacing the empire of the mutual fund. If you are paying even passing attention to the world of investing, this displacement comes with a price.

The exchange traded fund or ETF is slowly moving to the forefront of our investment options. The question for you, the one you will ask yourself: is this an investment worthy of my attention? Should I look at the picture the enthusiasts of this financial product paint for you and simply admire the brush stroke and the nuance or should you instead focus on the placard alongside the painting for a deeper understanding of the product?

The ETF is building an enviable empire based on the decline of the mutual fund. Largely made of the same materials, the ETF offers many of the same attributes as a run-of-the-mill index fund with several exceptions. Those differences are part of the marketing strategy proponents of this investment push to the forefront. The decision, they suggest goes beyond the what traditional indexed mutual funds offer, giving the investor a different sort of control.

They will tell you that these funds can be bought throughout the trading day. For the average investor, this added ability to buy and sell a fund like a stock on an exchange only leads to more questions. What does this attribute mean to you? Why should this mean anything at all?

Most mutual fund investors are of the buy and hold variety. We use them largely in our defined contribution plans or 401(k)s. They populate a world that is bound by the whim of our plan providers and sponsors. And inside that world, they offer a vision of retirement that is directed by you for you. And while ETFs are making inroads into this closed circle, your current exposure to this investment is largely on the outside of these plans.

The exchange traded fund offers additional options than simple tradability. It offers lower fees in many instances when compared side-by-side with the mutual fund. The difference can be slight but noteworthy over long periods of time. So it may be the best buy-and-hold option for the investor with that mindset. If that is the case, then actively trading ETFs is not a selling point and the fractionally lower fees may make them not worth the effort - or cost.

What does set this investment apart is the construction of the fund itself. Unlike the mutual fund, which is built (or deconstructed) with every contribution (or withdrawal). A mutual fund must sell shares to pay for those exiting the fund and buy shares with new money. ETFs buy a basket of stocks in advance of you ever investing a single dollar. And that dollar doesn't impact the overall "basket" one iota whether you invest in or out. This attribute leads to more stability in the investment, less price variation and more transparency.

But like the Mughal painters whose courtly portrayal of an empire in decline, whose story is masked by opulence and celebration, the artist of the ETF may be masking some truths as well.

The ETF offers a new empire. While the definition of empire is based on how much geographic impact the rulers had at a particular time, the ETF empire is still growing, grabbing investor real estate at an enviable rate. If history offers any indication, the ETF empire will continue to grow, amassing population and expanding boundaries.

And as they do, the territory they claim as their own will be like all empires, hard to rule, sparsely inhabited and lorded over by tribes that only offer allegiance in passing. This will be where ETFs are tested. Not in the traditional and heavily populated markets; but on the fringes.

And this is where you should exercise caution. Like all expansive empires, the rules change the farther one travels from the most populated places. You may think that you are still in the ETF empire and from all indications on the map you are. But the danger in this investment grows with every footfall beyond the center of the empire. This is how the mutual fund began its decline, as fund families looked for more arcane offerings further afield. Will ETFs suffer the same fate, offering the rule of law where law is not always embraced?

Quite possibly. To use ETFs, one must stay close to the glow, the core of the investment idea. Because the farther out you venture, the more likely you will find investment options with higher risks and less transparency, higher fees and more narrow focus. So as ETFs make their land grab be cautious of what the ETF actually is. It is an investment. It does cost less. The risk seems to be lower.

But venture into the hinterlands of this growing empire and you will see the dangers increase, the risk become more apparent and while the names of these far flung locales will always suggest ETF, it won't be the same ETF. It is on the fringes that the mutual fund has begun its decline. It will be the same for the ETF if history is any indication.

The Decline of Mutual Funds

The nineteenth century was a time when philosophers were wondering what exactly was free will. To these thinkers, it was a concept that needed help to achieve what they believed was control over your soul. Identifying the seven deadly sins were a product of this effort, blocking their passage into your life allowed your free will to soar where they thought it ought to go.

But often, in this day and age, the exercise is also pressured by more than those temptations of sloth and greed, wrath, pride, lust, envy and gluttony. It is a social one that makes us look to our peers for guidance in what is right and what is wrong. This is certainly true of investors. And because our free will is actually more bound than footloose, this becomes a conundrum of sorts for those inside their company's 401(k) plan.

Call them schools of social thought, call them religion, but once an idea makes sense it becomes the must-have. This is certainly true of exchange traded funds, which have very smart people in this investment's corner. And with good reason that we'll discuss in a future post. For now, it is the mutual fund, that stalwart investment inside those 401(k) plans that is the focus. Why has it lost its luster? In my opinion, the downturn of several years past had a great deal to do with it but something else changed in those fateful months in 2008. But what?

Mutual funds are what we have to work with at the moment. Although you will begin seeing the addition of ETFs to the mix of options available, and there might even be an all-ETF plan coming to your workplace in the future, the mutual fund will reign supreme inside this bounded world of free will investing. You have the right to choose which investments you want. You have the right to contribute as much as the IRS allows. You have the right to make your retirement possible.

And yet, few of you do what is necessary to achieve the goal, a point in life that might be aptly referred to as "from the free choices of your working life" to the "free choices in retirement." Both are bounded by the amount of money you have. You also have the right to choose how tight those bounds will be.

You will soon find out how much everything costs within this plan. It will be a dry read without a doubt but if it does what it is supposed to do, it will shed some light on how much every dollar you invest in your plan is divvied up amongst the providers of the plan. It might be 1% of $100 or a dollar for every contribution of that amount. You can use this as a benchmark on whether your plan is expensive or not.

But what if it's higher than one percent? Fleeing is not an option (in the free will scenario). What that one percent actually does is begins to limit your investment options in two ways. All of the funds in your 401(k) will charge a fee of their own. So the higher the plan's cost, the more higher priced mutual funds as a result becomes unattractive - if inly from the fee perspective. And for some investors, this removes some of the risk they might have found worth taking. What you are left with, and this is in no way a criticism of this kind of investment, is the index fund.

Index funds are incredibly inexpensive. The fund manager is almost non-existent and the stock (or bonds) in the fund are tracking a predetermined basket of stocks (or bonds). The risk is still there but it is greatly underplayed by the those who are fans of this type of fund. The risk however is, as they say, much less than any actively managed mutual fund available. This is a truism with caveats.

When an index fund is created, the real decision is built on how much of which stock will be bought to mimic the index. An S&P 500 index fund may hold 500 stocks. The question is the proportion or as they refer to it, weighting. The risk is also in the lockstep with that decision. If the market goes up, so does your index fund. If the market goes down, you will also shadow the drop in your index fund. If you index didn't keep pace withe index it is mimicking, then weighting is to blame or credit. Not all indexes are created the  same.

In some instances, diversification across a basket of index funds helps offset this sort of risk but if the drop is comprehensive, involving all sorts of regions and investments, this will be of little comfort. So you will pay less for an index but not fully eliminate the risk of owning it.

If your plan costs less than 1%, you have some wiggle room, the opportunity to take on a little more risk than you might have otherwise considered. The smaller more drilled down index funds can provide some of this risk at a lower cost. But some funds who may be benchmarked to the indexes of smaller sized companies and off-shore regions, even some alternative type investments, might seem appealing in small portions.

The best 401(k) is one that mimics your life, the boundaries you have set or have been set for you. You can follow some simple rules here than should reflect the basis of that life.

First: take care of your business. In real life this is paying the bills (on time) and making the money you earn part of a budget. In your 401(k), this means making the matching contribution or 5% if your employer doesn't match. Both numbers have little or no impact on that fragile take home pay and huge difference in your future.

Second: taking care of your retirement. The brutality of numbers suggests that even if you maximize your contribution, putting as much as the law allows, you will only end up with 75% of your current income in retirement. This simply means that if you can live on 75% of what you make now (ideally socking the rest away for retirement), the transition will be a breeze. You will have lived within that 19th century thinking: your free will will have a budget.

Third: the fun part of the plan. Boring leads to angst and takes away our human-ness. This ignores who we are and the habits we have. If we like to "cut loose" on occasion, our investments should reflect a little of that habit as well. Your "bad habits" or the fun things you do take up less than 10% of your time in real life. Your retirement plan should have 10% devoted to something less conservative, something a little more risky.

I see it as a way to keep you engaged (you will check your plan more often) and to learn balance. Keep that "risky" portion at 10% and the other ninety percent nicely indexed across five or six categories, and you will begin to watch what you are doing in this "retirement life" more closely.

One final word on the lost luster of mutual funds. They have gotten cheaper since the Great Recession and probably will continue to do so. Some will shine, some will falter and others will follow the markets. We provide the luster and if we fail to use the tools we have, we won't be able to see our reflection in the shine.

Next up: The Glow of Exchange Traded Funds

You Need a Financial House First

That person staring back at you in the mirror has a personal finance plan that is hard to argue with or ignore. Your reflection is probably suggesting to you what it suggested back at the turn of the calendar year: to save more, spend less and focus on getting your debt in line. Intimidated by what is obviously an imperfection in your financial life, you agree. Again. Something needs to be done.

Those mirror conversations are often forgotten as soon as you walk away from your own reflection. And with good reason. Only when you are looking directly at yourself do you see someone who has made these types of promises before. Once the two of you part ways, the reality of past decisions thwarts many of these well-intentioned pledges to do better. The question isn't what is better - that answer we know - it is more like how can you do better?

Improving your personal finances is much easier than you might imagine. So let's look at why your reflection is suggesting an overhaul in the first place. You can't avoid the idea that retirement or at least the time of retirement is closing in, often quickly. You can't dodge the fact that in order to retire at all, let alone comfortably, you need to set aside larger portions of your paycheck. No one has ever told anyone they are saving too much. Everyone, on the other hand will suggest that you and millions of others just like you, aren't saving enough.

In this scenario, they will tell you to max out your 401(k). To do this, the average American with the average paycheck in the average 401(k) can set aside $17,000. This number for this average person amounts to almost a third of their paycheck. And most will agree, this is an austerity measure that will not happen no matter how much the financial profession points out its wisdom. The over 50 crowd can toss another $5,500 into these accounts in order to play catch-up pushing the total contribution in this "maxed-out" situation to almost half of the average wage earners paycheck.

Knowing you are under-contributing often is the first roadblock in doing what you've told yourself you need to do. Resignation sets in and the next time you are in front of that reflection you quip: "I'll never retire" or "I'll just have to work longer". These will, without any argument help you achieve your retirement goals. But in suggesting that lengthening your work life is an adequate solution, you are subtracting from your retirement life. Think of it this way: If the speed limit is 55 mph and you drive 45, you will arrive at your destination; it will simply take longer as as you watch your fellow cohorts pass you, you will become discouraged and this will begin to weigh on the journey.

So forget the limits. Instead focus on the percentages: five percent (5%) of your paycheck contributed and producing a modest return will net you about 25% of the income you currently own, ten percent (10%) will get you about 50% of your current wage while fifteen percent (15%) will get you very close to 75% of what your current income is. Of course you will need to contribute and do so over a span of at least 20-years. But is much more do-able that the whole number that is the maximum contribution.

But even if that is do-able, as I suggest it is, something will have to give. A recent New York Life survey, done as they suggested, across the kitchen table, portrays the average American as someone who will try and manage their debt better. This is translated into spending less. Debt as we all know works against you in many different ways. More than simply spending what you don't have and exceeding what your paycheck brings, the cost of servicing that debt acts as a direct subtracting to that 15% and any return you might get in your plan.

So not only will you need to contribute more but at the same time, you will need to draw down that debt faster. What that reflection in the mirror is suggesting is often too austere for even the most parsimonious among us. Who looks at themselves in the mirror and says: "this year, I live on 30% less." While this might be excellent practice for the retirement you probably will experience, it is quickly dismissed.

Fourteen percent of those surveyed in the New York Life conversation with an agent revealed you will seek help. What you are doing is trading the reflection for a person who will tell you what you have told yourself. Of course this suggests that this financial professional has access to better tools to do what you have promised yourself to do. Ironically, they don't. For a fee, they will tell you what you already know.

Fear might be a motivator and many have taken to making these threats. But fear also brings a natural human reaction: to run in the opposite direction. Comparing where you are now with where you will be because you have done so little so far is a from of this fear. So is comparing you to your cohorts.

The simplest solution: 5, 10, 15. Contribute 5% to your retirement, 10% to your debts and 15% to your mortgage. A five percent contribution to your 401(k) will not impact your take home pay and will probably meet your companies matching contribution. A ten percent increase in payments to your debts will shave years and hundreds of dollars off of the interest you might pay. A fifteen percent payment towards the mortgage principal will reduce the length of your loan by as much as ten years. Doing this will have you arriving at the point of retirement with no debt and no mortgage.

Once the plan is in place and you have done this for five years, begin increasing the contribution by a single percentage point each year. This will be much easier to do as the debt you own is paid off and once the mortgage is satisfied, you will find your reflection congratulating you. This is far better than the criticism it once offered.

Talking Investments on the Radio

Every weekday, I host a financial talk radio show online. The Financial Impact Factor Radio with Paul Petillo, Dave Kittredge and Dave Ng is the one place where talk about money comes alive. Tune in whenever you like. Archived version of the Financial Impact Factor can be found here.

As Jeffrey Kluger writes: “We’re suckers for scale. Things that last for a long time impress us more than things that don’t, things that scare us by their sheer size strike us more than things we dwarf. We grow hushed,” he writes in his book Simplexity “at say, a star and we shrug at a guppy. And why not?” he asks. “A guppy is cheap, fungible, eminently disposable, a barely conscious clump of proteins that coalesce, swim about for a few months, and then expire entirely unremarked upon.” He then suggests that “a star roars and burns across the epochs, birthing planets, consuming moons, sending showers of energy to the limits of its galaxy.” Yet, he points out, “the guppy is where the magic lies.” A star is just a furnace whereas a guppy is a symphony of systems. So it is with the world of finance.

And joining us today on the Financial Impact Factor Radio we have Roger Wohlner, Certified Financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Roger also blogs at Chicago Financial Planner and columnist for USNews and World Report. He has been kind enough to join us today to help us sort through the complexity, the scale we are so impressed with.

That scale, that complex mechanism that Roger has agreed to speak about is the target date fund. If you use one, you should listen to this explanation. If you invest, you should tune in as well.

Listen to Financial Impact Factor Radio with your hosts:
Paul Petillo of Target2025.com/BlueCollarDollar.com and Dave Kittredge and Dave Ng of FinancialFootprint.com

The show is broadcast daily, online at 6amPST/9amEST.

2012: The six resolutions that matter

This article written by Paul Petillo originally appeared at Target2025.com

Jimi Hendrix once wrote: "I used to live in a room full of mirrors; all I could see was me. I take my spirit and I crash my mirrors, now the whole world is here for me to see." When it comes to the reflection staring back at us, our retirement, like those images, are a search for imperfection. We don't look at ourselves to admire how good we look; we look for flaws. We don't imagine a future; we see the relics of past decisions.

If you consider yourself a Baby Boomer, the reflection in the mirror is an image that polarizes: we are comfortable in the what the future holds or we are worried. There is good reasons for this feeling of either hope or dispair, with no real middle ground. This group has seen the demise of the defined benefit plan (pensions) and the introduction of the defined contribution plan (401(k)). You have seen the greatest bull market in investing history and witnessed two major crashes that have rattled your confidence in the decade following. You are the first generation to realize that your future is in your hands and you were not ready for the responsibility.

If you are younger than a Boomer, you are the first  generation to have never seen any other opportunity to finance your future than with a 401(k). And you have come to realize that this is not the plan it was intended to be. 401(k) plans were not designed to be the one and only vehicle for retirement. We were sold a notion that this was the end-all-to-be-all plan that would afford us a better retirement than our parents only to find out that it hinged on two extremely volatile concepts: your ability to consistently earn money and your level of contribution. Your 401(k) became your anchor and your wings.

I imagine that many of you will look back on the highlights of 2011 and find yourself in either one or two camps: you were able to hold onto your job, pay your bills and put some money away for retirement or you will be looking back at a year of indecision, regret and the promise to do better in 2012. You may be celebrating simply getting through it or wishing it never happened. To that, I offer some simple resolutions to embrace in 2012.

One: Revisit your idea of retirement. You can promise to save more money for your future, increasing your contribution to your plan or perhaps, in the absence of a plan, begin one of your own using IRAs. But you do this without really looking at that future. Retirement will not be the same of any two of us. For some it will be a life of struggle, an ongoing effort to make ends meet when they may never  met while they were working. For some it will be the realization that the balance between the now and the future relies on a level of personal sacrifice we were smart enough to embrace while we were working. For others, it will simply be a resignation of sorts, a belief that it will never happen.

Retirement is three things: A time when we find new opportunities outside the confines of what we called a career, a place of unimaginable risk and/or a chance to take a breather. It is not a place of no work and all play. It is not a time spent waiting for the end to come. It is not what we imagine because, if we looked closely at that image we see flaws. So we don't look as closely at those who are retired, examine how they live and ask if this is what they had planned. In revisiting the idea of retirement, your concept of that future, consider looking closer. If you don't like what you see, resolve to change it. But don't look away.

Two: Don't reflect on what you've done. You made mistakes; we all have. Some of us took too much risk, some not enough. Some contributed as much to their retirement as their budgets allowed, others did not. Some of us made poor mortgage or credit decisions, others did not. No matter what you did or didn't do, looking back will not improve the look forward.

Looking forward doesn't mean turning your back on on any of those events. It means focusing all of your energy on fixing them. This is a twofold effort, the first being getting the budget you may not have in line with your paycheck and focusing on paying down your mortgage (keep in mind that even if your home is underwater - meaning your mortgage is greater than the value of the house itself - the interest you pay on than loan is eating away at your future invest-able or save-able dollars). Does this mean you should not put money away in a 401(k) plan and redirect every dollar to the day-to-day? Not at all. Keep in mind that a 5% contribution will, in almost every instance, not impact your take home pay.

Three: Don't over think the process. From every corner of the financial world you will hear: rebalance your 401(k). If you chose a minimum of four index funds spread across four sectors, or four ETFs that do the same thing, rebalancing is a waste of time. You diversify so you can capture ups in one market and downside moves in another and your contribution doesn't allow you to buy more when one market moves up and allows you to buy more when it goes down.

We want to think we are in control when in fact, the only thing you actually control is how much money you want to put in. Markets will do what they do best: move. It might be up one day and down the next. It doesn't really matter. What matters is that you do something and in 2012, it should be significantly more than you are doing now.

Four: Stop being selfless. One of the hurdles we are told, for women investors specifically, is their inability to put themselves before their family. This is a cause for concern of course but not  a disaster in the making. Take a good long and hard look at your family and ask yourself: could I spend my retirement years living with any of them? Do they want you to?

Five: Embrace the truth. Now there will be an increased amount of pressure from every financial professional to get advice on your investments. This educational effort will evolve in the next several years from long, drawn out seminars on how your 401(k) works to short, ADD friendly videos that last several minutes and offer key points on what to do. The truth still relies on your ability to put more money away. Five percent will net you 25% of your current take home in retirement. A ten percent contribution over the average working career will pay you about 50% of what you earn today in retirement. Fifteen percent contributed to a 401(k) plan with average (modest) historical returns will allow you to live on 75% of your current income. Can you handle that truth?

Six: Stop worrying about it. According to HealthGuidance.org, you are killing yourself with worry. Michael Thomas writes: "Worrying leads to stress and stress has been linked with a number of health problems. People who suffer from high levels of stress are much more prone to cardiovascular disease, gastrointestinal issues, weight problems and there has even been a link made between stress levels and certain cancers." Instead resolve to do more saving than you have ever done, spend less than you did last year and embrace the reality of what fixed income is. Retirement is fixed income. Resolve to live like that now.

Paul Petillo is the Managing Editor of BlueCollarDollar.com/Target2025.com

Are Actively Managed ETFs (Exchange Traded Funds) Worth a Look?

Investors are divided into two groups: those that see themselves as investors and those that use their 401(k) accounts to invest for their retirement. The latter group tends to refer to this activity as savings, a word that has long since distressed me for its inaccuracy. The other group, the ones who think they can invest, tend to fall prey to the next new thing or on the flip side, spend a great deal of time and money trying to mimic an index fund. This group wants to be their own mutual fund manager and does everything but charge the trailing fees that a mutual fund does.



So we have one group who "invests" and the other who "save".Both use essentially the same tools and with any luck, practice the same prudent practices. Tempting both groups is the ETF or exchange traded fund. When these we first introduced, about a $1 trillion worth of investments ago, they were heralded as the one thing investors needed to keep their assets where they could get to them, when they needed them.

Trading like stocks, you could buy an ETF in the morning, sell it if you wanted to at noon, and buy it back before the end of the day. This was a genius move on the part of Wall Street and began generating buckets of cash via trades. Mutual fund companies wanted a piece of the action and jumped in as well with ETFs that looked eerily similar to index funds they were already selling.

The cost of the trade was about the only thing you could toy with. So they eliminated that fee. But not to be allowing you to do something for free, they found another way to charge you. Back on January 6th, 2011, I wrote: "a Vanguard spokesman said the company believed “that the ability to attract and retain clients, particularly high-net-worth clients, will improve the bottom line and ultimately result in lower fund expense ratios.” The truth is that instead of charging for the trade, they charge you to hold the ETF in your account."


Now, three years into the first appearance of the actively managed ETF, we wonder if this will be as wildly popular as the indexed ETF (which has sliced and diced the market in such a way that no corner of the investment world is un-indexed and because of that, has added to the volatility in the marketplace, particularly at the close of trading). Perhaps but the wary investor and more than one "saver" should approach these tools with caution.

Does an actively managed ETF cost less than a actively managed mutual fund? The short answer is yes. Mutual funds bought outside of your 401(k) - where fees tend be lower and in some cases, different - have fees for distributions and marketing. While these fees are annoying and do take away from your returns, they are needed to attract new investors, pay for research into which stock is next on the buy or sell list and to pay for the services of the fund manager. Could they be lower? Yes. Have they dropped significantly? Over the last several years, yes. But what about their ETF counterpart?

Without many of those "trailing fees", actively managed ETFs are less expensive. But few people add in the cost of the trade when they think of purchasing an ETF and each time you buy or sell, this acts as a fee - albeit right up front.


Several other comparisons come to mind. The transparency of ETFs, which must disclose what they hold everyday seems on the surface like it would be a grand idea. But when it comes to this type of investment, transparency and rules for trading tend to make this a dangerous place. In an index fund or ETF, the investments mimic an index, set and left alone for a year, sometimes longer.

In an actively managed ETF, which discloses its holdings and must disclose its building or restructured portfolio almost as it executes the trade, it allows investors outside of the ETF to "front-run" the fund and buy at a cheaper price than the fund would pay. This is not good for the ETF manager if the stock they are buying is somewhat illiquid.


Taxes are another issue. Mutual funds tax you quarterly and yearly. Index ETFs tax you only when you trade them and because they don't turnover (trade their securities often) as much, the taxes, once levied are less. Actively managed ETFs only charge you taxes when you sell the fund but, because they trade often, the taxes you will pay will be higher than indexed ETFs.

Now there is little I can say that will dissuade you from buying an actively managed ETF once they become more widely available and have logged a track record (currently, they have less than three years under their belts). If you find them in your 401(k) and they are cheaper than actively managed mutual funds, they might be worth looking at if you are looking at adding some risk.


This investor tool is not going away. And it will add to some additional volatility as traders in these funds move around much more than those that hold individual stocks and/or mutual funds. And that can't be good no matter how you view who you are: and "investor" or a "saver".

Are you asking the right questions about your portfolio?

Most questions you should ask yourself about your retirement you do not ask. It isn't because you don't have the question in hand. In many instances you do but you simply fail to seek the answer. For example: when would like to retire is much different that when will you retire. Both queries speak to the same time in your life when your current working career shifts into another realm. But the answers, like the questions, are different.



Target date funds, the darlings of the skittish post-2008 investor, the new-hire and the plan sponsor who believes they are doing the right thing by their employees, the funds that pick a date in the far-off distant future, a point in time when your retirement is supposed to happen don't answer the question the way we all assume. In fact, they may not answer it at all.

Target date funds are designed with, among the obvious pick-a-date moniker, an asset allocation shift over time. If you buy into a fund, such as one that picks 2040 or 2050 as a retirement date, you will have, at least according to the sales pitch, an aggressive to conservative journey spanning the next 30 to 40 years. The idea is that your fund will find the right investments to gradually ease you from being exposed to equities and the potential growth they offer to fixed income and the protection they offer over that time period.


So which fund do you pick if you can't or won't answer the either question? Imagine a 25-year old entering the workforce. They have the opportunity to pick a fund that reflects an investment arc spanning 40 years. Even if they don't understand how to invest or what to invest in, there is little likelihood that this employee will stick with this plan and this fund over that period. Few people buy any mutual fund and devote that sort of loyalty to a fund that almost predicts diminishing returns (all in the name of capital preservation).

As the worker ages, things change. Life happens and in the process, you become more educated, perhaps more risk tolerant (or averse), and you understand the markets better. This changes your investor approach to these funds. You begin to question their strategies, how they allocate the money you dutifully send each paycheck, and whether the fund is doing as advertised. And after all of that, you would have to aks yourself, when will I retire? And if I do, will I keep this fund?


Target date funds come with risks. Many of which are well-known even if they are not well understood. The Labor Department is looking to clear up this confusion for target date investors even if the information is already available - if under used.

Among those risks are disclosure of the fund's asset allocation. Depending on your time horizon, the fund you pick and how that mix of assets changes over time, every target date fund differs in their approach. Now keep in mind, most of us will encounter these funds in a 401(k) plan and have little ability to shop around for a target date fund that does better. Also keep in mind that "better" is a tough call. Any comparisons made between two similarly named funds ends right there.

The Labor Department would also like the the significance of the target date explained. Even the most novice of investors can grasp the target. What they can't wrap themselves around is the fund's investment policy. Few can and because of this, even fewer read this already published information. And what troubles the Labor Department the most about these funds, often given set-it-and-forget-it status in the minds of many of these investors is the inclusion of a including a statement that the fund could lose money - and it might happen close to retirement.


How could something so simple become so complicated? You pick a retirement year (simple) and the fund matures with you (simple) and because there are no guarantees (complicated) and no way of telling whether this is the right fund on the day you put your first dollar in it (even more complicated), how do you know?
Charles Jaffe of Marketwatch believes it is a "to or through" question. Will you have the fund at retirement invested as conservatively as possible or will you be keeping a couple of decades after you retire? Something this simple should be this complicated. The question is really to or through but "why bother"?

I have no problem with auto-enrollment of new hires. I have no problem with educating and offering these new employees some insight on how their 401(k) operates and what it offers. I do however have a problem with the perceived safety of the target date fund in the plan and the seemingly risk-free idea that this is a fund you keep  even if the employee will not stay with the company - or that particular fund - forever or at least until that retirement date.


Making target date fund reporting more transparent as the Labor Department proposes is not going to make the task of choosing easier for those considering this type of fund or who have been auto-enrolled in one. Most mutual fund investors know that there is risk - some can even describe it. Most know that there are no guarantees. Yet target date funds seem to offer a false assurance that time is on your side in a way that is not so for other retirement investors. And that is a problem.

Make Your Retirement Work the Way You Want: Self-Directed IRAs

Many Boomers may have rolled their 401(k) in an IRA (I hoping you didn't cash it out) and in doing so, was faced with which investments were best.  Some of us already have IRAs but still crave a little more control and possibly, greater returns.  There is a way to do all of these things.

Today we are going to tackle the self-directed IRA. We all know what an Individual Retirement Account or IRA is. Briefly, it is the retirement tool for those of us who may not have access to a 401(k) that defers taxes for retirement. The deferring part is not really as complicated as it seems. In a 401(k), you have your contribution taken out before you pay taxes; in an IRA, you pay with after-tax money and then take the deduction when you file, basically subtracting the taxes from your contribution to be paid later.

How is a regular IRA different than a self-directed IRA?

The differences are not as obvious as the title of these products sounds. An IRA is an investment chosen by you and you direct the funds to it for your retirement. It seems like this should be called self-directed but in reality, it is very different from what the IRS views as a self-directed IRA.

In a self-directed IRA, you become the manager of the whole process. Rather than simply sending money to a mutual, fund company, the most common sponsors of IRAs, you direct the underlying investments. In the previous example, the institution is the middleman. In a self-directed IRA, the institution, whomever or whatever one you chose, does what you tell them to do.

While it might seem complicated and finding good help at a reasonable cost is not that easy, the rules are relatively straightforward. Following to the letter is something you have assumed was done for you in the past; not it is up to you.

Find a Trustee for your Self-Directed IRA

A person looking to open a self-directed IRA is in the same position as someone who is opening a Solo 401(k), which we discussed a couple months ago in our retirement planning for small business owners. You need to find a company that will open the self-directed IRA and act as a Trustee, essentially doing whatever you tell them to do. Then you sign broker-to-broker papers and you are done.

Keep in mind, that if you have a Solo 401(k) for self-employed investors, this process was already completed. If you have what is known as Customized Business Pension, you are also ready to take the next step. Sometimes, a self-directed IRA is referred to as checkbook IRA and the rules may require you to open an LLC or limited liability company. Either of these plans removes the custodian and that makes the investment possibilities immediate and up-to-you.

This is relatively easy and worth the effort. But you do have to be careful. Be sure that whatever the self-directed IRA profits from is paid to the trust and not to you directly. This will be the same as a distribution before they are done without penalty. This means that any gains in the IRA will be tax-deferred. So what you are doing is making your money work harder for you now than it might have been in the past.

You can invest it virtually anywhere: a franchise, rental property, annuities, you name it. You are in charge. The only two things you cannot invest in are life insurance and collectibles.

The Rules

There are few rules to follow when choosing your investments. One, you can’t invest in yourself or the spouse of the IRA owner. For that matter, the Internal Revenue Code or IRC prohibits you from investing with any of your lineal descendants and ascendants. This also includes an entity with combined ownership greater than 50% by a disqualified person(s), a 10% owner, officer, director or highly compensated employee of such entity or a fiduciary of the IRA or person providing services to the IRA.

You can’t sell your assets to the IRA either. You can’t use it to loan money to your kids or pay yourself fees for the work you have done. And you can’t use it to buy the home you live in now.

Opportunities for the Post-Recession World

This types of retirement plans opens a whole slew of possibilities for someone who as an IRA or possibly has been rolled over into one because of a job loss. There are some hard fast rules, which you can check last week’s show link to hear about, but done right, this can create outsized gains your plan may not have created otherwise.

First off, I want to caution you. Not so much about following the rules, but understanding right away, that every investment involves risk and investing in real estate can involve quite a lot of it.

The money in this IRA can be used to buy anything from Single family and multi-unit homes, apartment buildings, co-ops, condominiums, commercial property or land, improved or unimproved, leveraged or not.

The goal here is to find income producing property and have it pay your IRA. Whether you buy the property outright or finance it, the IRA owns the asset, not you.

Can You Finance this sort of loan with your IRA?

Because the IRA owns the property and the property’s value is the collateral for the loan, the only thing you have to figure out is how to pay off the loan. If the property is producing income, it pays the IRA which in turn pays the mortgage holder. Sometimes you can use other assets in the IRA or permissible contributions can be made. This is what is known as a non-recourse loan because you cannot extend credit to your own IRA.

The whole transaction needs to flow through the IRA as if it were separate from you, which it sort of is.

The cost is broken down into two categories. Management fees that the custodian charges. Not all firms who manage retirement accounts can so your choices are limited. I’ve included a few links to begin your research but by no means are these companies recommended. This is relatively small, niche market with only about 2% of the almost $4 trillion invested in IRAs under management.

And the cost of property management, taxes, and repairs is another fee the IRA must pay. With any luck, the property will be able to cover these costs with the rental or lease payments.

Some might say “buyer beware”.

Whenever you have such a small marketplace, oversight is not always done the same way it is done among bigger segments of the investment world. I expect that this particular segment of the world will begin to grow rapidly as folks realize that their old job isn’t coming back, their unemployment insurance is about to run out and they haven’t borrowed from their IRA – so far.

Another reason you should be careful is more about what you know. Buying real estate with your retirement money is actually done best by folks who have some prior knowledge about what they are getting into. Perhaps they were involved in the business before. That doesn’t mean it can’t be done, but the more you bring to the game, the better your chances of winning.

You might also look into a franchise with this money. You can also buy debt. Your IRA can become a lender of sorts buying notes on cars, Treasury bills, even lending money to companies looking to raise capital. Always wanted to invest in a hedge fund, with a self-directed IRA, it can invest. Want to invest in precious metals, foreign stock or partnerships and/or joint ventures; your IRA can do this as well.

A couple of simple pieces of adviceObviously there is the risk factor, which makes this not the be-all-to-end-all for all investors. But if you know what you are investing in and the pitfalls of that investment, you can calculate the costs in advance, this can be like heaven-sent. If you are looking at real estate, the potential is there for people who have the money to pursue some amazing bargains. 

Paul Petillo is the Managing Editor of Target2025.com