The Value Neutral Retirement Plan
Since the crash of 2008, we have seen markets recover, but has your 401(k) recovered? A lot of 401(k) plans are at a standstill even though markets are turning upwards. Why? In many cases, it’s due to a shift into very low-risk investments. The stock market seems to unstable, gold has become a bubble-prone commodity and bonds have turned out to not be the safe haven many consumers thought they were. Couple this with low inflation, and many investors opt for a low-risk low-return approach.
FDIC insured bank accounts
Sometimes, it’s not the individual investor that decides to go into low-risk territory; it is instead a decision made by a professional investment manager. Prudential Retirement – who manages the 401(k) plans for over 3.5 million people – did for instance put substantial amounts of client money in FDIC insured bank accounts in the wake of the 2008 crash. This begs the question – if you’re gonna keep your money in a bank account with no interest or low interest, why do it through a professional investment manager and pay their fees?
Target date funds
Target date funds (TDF:s) has sailed up as a popular alternative for risk-adverse investors and investment managers. But are they any good? Let’s take a closer look at what a target date fund is.
A target date fund is a mutual fund in the hybrid category that adapts its asset mix (stocks, bonds, cash equivalents, etc) according to a pre-selected time frame. A target date fund can thus be set to adapt itself to the date when the investor plans to retire from the workforce.
- Emilia entered the workforce a few years ago and is hoping to retire in 2055. She therefore picks a target-date 2055 fund for her retirement investments.
- Jennifer, who is much older than Emilia, is hoping to retire in 2025. She therefore picks a target-date 2025 fund for her retirement investments.
Since Emilia’s TDF has long time-horizon, the fund managers are likely to weigh it heavily toward stocks right now, and just include a small amount of bonds and cash equivalents. Jennifer’s TDF will on the other hand hold much more bonds and cash equivalents, to make it less volatile. There isn’t much time for Jennifer’s TDF to recover before she retires.
TDF managers re-balance the TDF:s asset portfolio each year. Eventually, Emilia’s TDF will become less stock-heavy and include more and more lower-risk investments.
TDF:s have been criticized for marketing a one-size-fits-all approach, where the planned retirement year is all that matters.
An annuity is a contractual financial product designed to offer reliable cash flow for an individual. Annuities can begin immediately upon deposit of a lump sum, or they can be structured as deferred benefits.You can for instance purchase an annuity while in your 30s and set it to start paying out once you have reached 65 years of age.
Annuities are typically sold by financial institutions. You hand over money to them, and they try to grow them during the accumulation phase. At the predetermined point in time, the annuity leaves the accumulation phase and enters into the annuitization phase. This is when you start receiving money. Annuitization is the process of converting an annuity investment into a series of periodic income payments.
Annuities may be annuitized for a specific period of time or for the life of the annuitant. Annuities designed to pay out for the rest of your life are a popular choice among those who fear that they will outlive their other financial resources.
An important aspect of annuities that one needs to consider is their illiquidity. You deposit money and that money is (typically) locked in for a prolonged period of time. This can be an excellent choice for retirement investing, but does give you less flexibility than many other investment options. The lock-in period is called surrender period. With some annuities you can withdraw money during the surrender period, but only if you pay a penalty fee. The penalty usually decrease in size over the surrender period, making it more expensive to make an early withdrawal and less expensive to make a withdrawal towards the end of the surrender period.
Fixed vs. variable annuities
With variable annuities, the size of future payouts will depend on how much the annuity fund grows. With fixed annuities, the periodic payments are of a fixed sized.
Cost of living riders adjust the annual base cash flow for inflation.
Variable annuitants carry market risk, which is why hybrid fixed-variable annuities have been created. Riders and other features are added to safeguard the principal – or more. It is possible to purchase an annuity where you can benefit from positive growth, while at the same time be ensured a lifetime minimum withdrawal benefit even if the portfolio drops in value.
With many annuities, it is possible to add a rider that will accelerate the payouts of the holder of the annuity is diagnosed with terminal illness.