Seven Termites That Eat Your 401(k) (2009-07-27)

Seven Termites That Eat Your 401(k)

by David John Marotta and Matthew Illian

According to a Dalbar Financial Services study that tracks investor returns, from 1989 to 2008 the S&P 500 yielded 8.35% annually. But the average investor only earned 1.87% over the same period. This fact deserves restatement. The average investor received less than a quarter of the general market return and did not even keep pace with inflation.

The study suggests that average investors would enjoy better outcomes if they simply invested in bank certificates of deposit (CDs) rather than trying their hand at more aggressive investing. We certainly do not endorse abandoning the equity markets. Seeing so many people forgo their retirement dreams, however, is very discouraging.

We call the difference between the market return and typical investor returns the "termite gap." Termites eat away at the very foundation of your retirement plans. They hide in layers of financial intermediaries that all take a bite out of your portfolio. And the most dangerous termites lie within your emotions.

Fees are the strongest predictor of a fund's performance. John Bogle, founder of Vanguard Funds, commonly shares a simple and compelling mathematical equation that highlights the importance of managing fees. If the performance of all of the market participants make up the average return (A), then after fees (B), investors underperform the market by the amount of those fees (A - B = C). Thus the higher the fees, the higher the underperformance. And when you find out you have termite damage, the first thing you need to do is call the exterminator.

The obvious solution for average investors is to find proven investments with the lowest administrative fees. However, they are left in a very difficult situation. Most do not have the time or expertise to uncover these hidden costs. In a market with so many 401(k) options, we would expect highly competitive pricing. Instead, investors and plan sponsors of small to medium market cap companies display very little price sensitivity when making 401(k) investment decisions. The Government Accountability Office (GAO) found that 80% of 401(k) participants are unaware they are paying any fees.

Many mutual funds with annual operating fees more than 1% will likely underperform and should be avoided. Request a copy of each fund's prospectus and use a magnifying glass to uncover these first three hidden termites. Look for subjects like "wrap fees," "subtransfer agency fees" and "mortality and expense fees" (M&E). M&E fees are an extra insurance charge in annuity contracts. You may have heard that combining your investments with your insurance is a bad idea. Inside a retirement plan, it is a terrible idea.

The fourth hidden termite is 12(b)1 fees. These fees actually pay for a fund's advertising, which is strange. Consider the consumer outcry if grocery stores started charging an extra line-item fee to cover their advertising.

In addition to the standard investment management expenses, mutual fund companies have agreed to pay retirement plan providers so they can be included on a short list of available funds within a 401(k).

If we were describing the mafia, we would call these arrangements "kickbacks." Retirement plan providers have convinced the public they are merely "revenue-sharing" agreements. However, this is not the sharing you learned about in kindergarten. Mutual fund companies create a new "class" of shares, often called "retirement shares" in standard plans or "insurance class" inside of annuities. These new shares are created with higher fees than the standard fund to pay for these types of fee arrangements: the fifth termite.

Unless you are lucky enough to participate in a large corporate 401(k) plan, you typically will not find more than a small handful of no-load Vanguard funds or index funds in these accounts. You will find a large list of funds that try to justify their high expenses by raising their risk levels through active management. The cost of portfolio turnover is the sixth termite affecting expenses. Higher portfolio turnover increases the transaction costs of buying and selling the individual securities in a mutual fund or other investment account. These transaction costs are not separately identified but are netted with the investment return.

Management fees in the 401(k) industry run about 1.6% for the average equity fund. Add in portfolio turnover costs and the impact of sales charges, and another 1.4% of cost has been added. That brings the 1.6% management fee or expense ratio up to 3% a year for a typical 401(k) plan.

High fees do not need to be put on a 401(k) plan. We've designed dream 401(k) choices for our small business owners with less than half those amounts. Incentives always exist for the industry to hide these fees. So being an informed investor is critical.

The seventh and final termite is found within. Common sense tells us to buy low and sell high. The evidence of mutual fund flows suggests that many investors pull their money out of the markets when it is falling and reinvest it back as it is rising. Behavioral finance identifies and addresses these self-destructive actions. But solutions are lacking. Target date funds and managed accounts have helped guide 401(k) participants away from the folly of focusing too closely on individual fund returns. Unfortunately, the termite damage remains.

Imagine a world without financial termites. A person who makes $60,000 a year and invests in the company's 3% matching retirement plan would have $434,947 in 30 years at market returns (8.35%). If this same investor, subject to the termite gap, receives only average investor returns (1.87%), the portfolio would be worth $143,108, nearly $300,000 less than expected.

Average employees cannot make changes to their 401(k) provider. So here are a few words of advice. We usually recommend that people invest up to their match and no higher. Maximize other low-cost investment opportunities, including a Roth IRA, before saving unmatched money in a typical 401(k) plan. If you have left a job or are retired, roll your money over to an IRA that offers low-cost investment options unencumbered by excess fees. If you are currently employed, diversify your investments among index funds and, if necessary, actively managed funds with lower expense ratios.

If you are a business owner or HR director, seek a revenue-neutral investment advisor. In other words, find someone who does not accept revenue-sharing payments or commissions from mutual fund companies. When any mutual fund rebates these revenue-sharing payments, a revenue-neutral advisor will pass these payments back to the plan to offset fees. These investment advisors are more likely to choose low-cost index funds rather than high-cost actively traded funds. The best advisors are fiduciaries. Registered Investment Advisor fiduciaries must disclose fees in writing, invoice the plan sponsor or plan for those stated fees and credit any revenue-sharing fees back to the 401(k) retirement trust. The goal for all employees and plan sponsors should be to capture as much of the market gains as possible.

from http://www.emarotta.com/article.php?ID=347

Now's the Time to Buy a House (2009-07-20)

by David John Marotta

For years I've been annoying local realtors by claiming that real estate values were headed lower. Over the past few years, I've been advising young clients to rent and wait for better deals. And I've been suggesting that those who are holding real estate waiting for it to go back up will probably see their property decrease in value before it goes up.

Early in 2005 I coauthored the column "We Could Be in a Real Estate Bubble" with my father George Marotta. We wrote, "Home values may be peaking and ready to correct." We explained that "Delinquency among the less creditworthy 'sub-prime' market that accounts for 10% of mortgages has jumped to 8.07% from 4.5% in 1999. Delinquencies on FHA loans that make up about 15% of mortgages are at a 30-year high of 11.8%.

"As a result, Americans' equity in their homes, net of debt, has dwindled to 57%, compared with 85% a half-century ago. But those are averages. Thirty-nine percent of homes are owned free and clear, but the remaining homeowners have average debt burdens exceeding 80% of the value of their homes. Mortgages over 80% of the value of the home offer little margin of safety should home prices level off or should they fall as much as 20%."

We ended the column with this prediction: "What can be suggested is that the housing prices boom shows signs of weakness, and that they may correct or at least underperform for the next few years. Higher interest rates will slow housing growth in 2005, but the bubble, if it is a bubble, could pop as late as 2006 or 2007."

Our prediction was accurate. Real estate continued to rise through 2005. But it was relatively flat in 2006, underperforming the markets that appreciated over 15% that year.

Two years later, in "Breaking Spaghetti: A Seven-Year Financial History," I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise leaving many lenders on the brink of bankruptcy themselves. "

Again, the prediction was accurate. In 2007 the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. Residential real estate did even worse. Apartments suffered one of the largest declines, down 25.4%.

Since then, real estate has continued to decline. The Charlottesville Area Association of REALTORS reported that real estate prices declined 8.5% during the first two quarters of 2009 compared with the first half of 2008. The median home price fell to $247,000, a drop of $22,900 over the first half of last year. Midyear sales were down 28% compared to the same period last year.

Although inventories have started to contract slightly, the average days on the market stands at 125, well above a healthy market average of 90 days. Homes priced above $1 million are spending nearly 226 days on the market.

Nathan Rothschild offered the contrarian advice to "Buy when there's blood in the streets and sell to the sound of trumpets." It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011.

So this is the time when you should be looking for deals, which must begin with sound planning. I'm going to give you four pieces of important advice.

First, don't be afraid to make a radically low offer. Even 50% of the asking price is OK if that's what you think it is worth. Foreclosures are going for 20% or 30% of the assessed value in some regions of the country. In this market, if your first offer is accepted, you probably bid too high. When we purchased our house in Charlottesville in 1990, it took seven offers and counteroffers before we reached agreement with the owners.

Second, be patient. Some remarkable deals will be available over the next two years but only for those who are patient, amenable to making a ridiculous offer and willing to walk away. With 3,600 active listings, you can afford to wait for a deal.

Third, know how to structure your purchase to maximize your tax savings. First-time home buyers are eligible for an $8,000 refundable tax credit if the purchase is made before December 1, 2009. As long as you have not owned a house during the past three years, you are eligible for first-time home buyer status. The credit is refundable, meaning the IRS will write you a check even if you don't pay taxes. Phaseouts start at $150,000 for married couples and $75,000 for other taxpayers.

To receive some of that government money, it doesn't matter who pays the mortgage. You may want to consider helping your children or grandchildren buy their first home so they can receive the tax credit. The laws are complex enough that you should talk to a comprehensive financial planner to structure the best intergenerational financial plan and maximize everyone's tax rates and itemized deductions.

Finally, be sure not to miss out on the low mortgage interest rates. But don't buy down any points. Most families do not keep their homes long enough to justify the cost of buying down the interest rate on their mortgage.

My parents' mortgage when I was growing up was at 4.00%. I never thought rates would get anywhere near that low again. When my wife and I bought our first home, we were able to assume a 12.5% mortgage when rates for new loans were at 18%. Today you can get a 30-year fixed mortgage with no points for as low as 5.0%. Rates are at historical lows, so the next few years are the time to take advantage of them.

There's blood in the street, so don't miss this opportunity to look for a great real estate deal.

from http://www.emarotta.com/article.php?ID=346

A Full Credit Lockdown (2009-07-13)

by David John Marotta

In my first job teaching computer science, someone stole my wallet off my desk during my office hours. Although I canceled all my credit cards, the thief used them around town, buying everything from clothes to tobacco. In those days cards were run manually on paper, and there was usually no instant electronic verification.

Identity theft is becoming distressingly common as personal information becomes easier to swipe. Internet sites all ask the same security verification questions. One site could easily collect your information and then try using it on others. For example, a student filled out a credit card application outside a university football game with the promised bonus of a free T-shirt. The perpetrators used all his information on a real credit card application but changed the mailing address. By the time the student realized his identity had been stolen, creditors were hounding him for hundreds of dollars of charges.

Having your identity stolen costs an average of $40 and 10 hours defending your name and cleaning up the mess. It happens to about 0.8% of the U.S. population each year. Even if your time is worth $100 an hour, the average loss to you is only about $8 annually. So clearly it's not the monetary cost that bothers people. What's really worrisome is the potential vulnerability and personal violation they feel. Fortunately, there is a simple and easy way to acquire a full credit lockdown so no one can initiate changes to your credit without your permission.

Your credit information is stored at three main credit bureaus: Experian, Trans Union and Equifax. At the end of 2003, Congress passed legislation that requires these bureaus to allow you to put a fraud alert on their credit reports. The alert only lasts 90 days, but during that time lenders have to verify your identity before they can issue a credit card in your name.

Since then, several companies have used this law to offer a renewal of the fraud alert every 90 days on your behalf. LifeLock is the best known among these services. The company went so far as publishing its CEO's Social Security number and daring people to try and steal his identity.

LifeLock's one-stop service initiates a fraud alert with all three bureaus and renews and monitors your credit status for $10 a month. As a result, you receive less junk mail and sleep better at night. They will pay up to $1 million in losses due to stolen credit.

This service angered the credit bureaus. They make most of their money by selling credit information about you to lenders. If the lenders actually have to verify the information, it becomes too expensive for them to act on. The data for LifeLock customers wasn't worth the cost required to verify it, damaging the bottom line for the credit bureaus.

In retaliation, the credit bureaus accused LifeLock of deceptive marketing practices. Experian sued in California court claiming that the 2003 law only permits individuals to put an alert on their credit. They claimed that LifeLock posed as individuals and put alerts on an account even when no suspicion of identity theft existed, costing Experian millions of dollars to process the requests.

In a decision last month, a California judge found LifeLock's practice illegal. Only family members, guardians or an attorney can make the request on behalf of an individual. Fraud alerts ought to be standard and permanent for everyone.

The decision is surprising, and the case seems disingenuous for the credit bureaus. They have turned free credit report legislation into a multimillion-dollar industry through their own deception and fear mongering.

Although LifeLock's service was convenient, you can still duplicate their services by placing a credit security freeze on your own credit record. A credit freeze does everything a fraud alert does and more. First, it is permanent, not just for 90 days. Second, it prevents lenders from seeing your credit report unless you specifically grant them access. This strategy prevents identity thieves from getting new credit in your name even if they have every bit of your personal information.

If you do apply for additional credit, you will have to remove the freeze temporarily or give the specific party who wants to access your information your personal identification number (PIN).

If you plan on applying for additional credit cards or getting a new cell phone provider or cable package, a credit freeze may not be advisable. And those promotions linked to new credit card applications will no longer flood your mailbox. But these deals are never a way to build real wealth. Get the few credit cards you need, and don't let any promotional offers suck you in.

For Virginia residents to initiate a security freeze, each credit bureau charges a onetime $10 fee. If you have already been the victim of identity theft, the charge is waived. However, some states do not permit credit agencies to charge its customers for placing a security freeze. We recommend a credit freeze for anyone who has already established the credit they need. A freeze both reduces the frenzied marketing of additional credit opportunities and the potential harm of compromised personal information.

After a few minutes of effort and $30 in payments, your credit should be locked for life. Here is how to accomplish securing your credit at each bureau:

-At Experian (888-397-3742), go to http://www.experian.com/consumer/security_freeze.html.

-At Trans Union (888-909-8872), go to https://annualcreditreport.transunion.com/fa/securityFreeze/landing to start the process.

-At Equifax (1-888-766-0008), you can put a lock on your credit by visiting https://www.freeze.equifax.com.

The process is not standardized across the three credit bureaus. Each uses a different methodology. But with a little effort, your credit will be safe and secure.

Each bureau will give you a PIN. They are likely to be all different. Don't lose these. Trying to get a security freeze lifted when you have forgotten the PIN necessary to change your credit security is a catch-22 you don't want to experience.

from http://www.emarotta.com/article.php?ID=345

Last-Minute Tax Savings for College Expenses (2009-07-06)

Last-Minute Tax Savings for College Expenses

(2009-07-06) by David John Marotta and Matthew Illian

My youngest will be a first-year student at the University of Virginia this fall. My coauthor Matthew's oldest child is almost two years old. So he is just beginning to think about college funding and I'm about to start withdrawing from my final 529 plan.

With a well-designed 529 college savings plan, you can fund a college education at a deep discount. But even if you haven't saved much for college beforehand, simply passing college expenses through a 529 plan can save you $200 to $2,000.

A 529 college savings plan offers three types of tax savings. Virginia residents receive a state tax deduction in 2009 on contributions up to $4,000 per account. Students are permitted to attend a college out of state. If you don't live in Virginia, you can research your own state’s tax benefits. In every state you receive both federal and state tax-deferred growth and tax-free distribution when you are ready to use the money. These latter two tax benefits are the most significant. But you must invest early.

The Virginia state tax deduction, in contrast, is available merely for putting money into a 529 plan. You are allowed to make a withdrawal immediately to pay for college expenses. This worthwhile tax deduction can help trim expenses. Consider it Virginia's way of promoting higher education.

Make sure you understand what counts as an educational expense before you begin this process. The withdrawal must be for tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution. In a recent change, a personal computer now also qualifies.

If you are paying tuition and fees, have a check sent directly from your 529 account to the college. This direct deposit will simplify bookkeeping and make filing your taxes easy. If your fees are spent elsewhere, keep receipts of all the qualifying expenses.

Consider Paul and Ali Hewson, whose oldest child Jordan will begin college in the fall. The Hewsons haven't saved much, but Paul's career is really taking off. So they now have the money to pay for Jordan's college expenses. As Virginia residents, they are entitled to a $4,000 state tax deduction if they put at least this amount into one of the state's approved 529 plans. At the 5.75% state tax rate, they will net a $230 savings for 2009 after they file taxes in 2010.

Jordan has decided to bypass Virginia's fine in-state institutions and attend a more expensive private college. Consequently, the Paul and Ali now have $40,000 of upcoming qualified educational expenses they can pass through a 529 plan to build a decade worth of carry-forward state deductions. Virginia 529 plans allow for an unlimited carry-forward deduction until the amount of contributions has been deducted. Assuming the tax laws and rates remain the same, the Hewsons will take a $4,000 deduction each year for the next decade. They will accrue a total savings of $2,300 savings over this 10-year period.

Paul and Ali can use any of the three different 529 plans in Virginia to accomplish this savings. We estimate it should take no more than an hour to set up the accounts and an hour to make the disbursements.

The CollegeAmerica program, the state-sponsored plan run by American Funds, must be accessed through a financial advisor. Unless you have a relationship with a fee-only advisor, you will pay a hefty commission to use this plan. If you can access the American Funds without paying a commission, invest your pass-through money in the Money Market Fund, the most liquid and stable investment in the plan. This fund requires a $1,000 minimum deposit for the initial setup. With the American Funds, expect to pay a $10 account setup fee and a $10 annual maintenance fee that kicks in if you hold the account through the end of the year.

Investors can access the state-run Virginia Education Savings Trust (VEST) program directly at www.va529.com to begin online enrollment. The plan charges a $25 annual fee in November and no other setup costs. It also has a money market fund available as part of its nonevolving portfolio investment options. Both the VEST and CollegeAmerica programs have received the highest scores from a recent Wall Street Journal report and other rating groups.

Virginia also has a program administered by the Union Bank & Trust called CollegeWealth. You can open a money market account at a Union Bank branch to receive the state tax deduction. If you are comfortable completing this task online, you may find working with a local bank difficult only because you must go there to complete all your paperwork.

Better than waiting until the last moment to start funding a 529 plan, consider investing now. With a depressed stock market, your funds can expect a healthy return for the next several years until your child is ready for college. If you have grandchildren you can get the same tax deductions by opening accounts for them. If you do not have a lump sum available to invest, start a monthly contribution from your paycheck directly into a college savings account. Although you may have to wait until your children bless you with grandchildren, they will ultimately thank you for it.

from http://www.emarotta.com/article.php?ID=344