The Bogleheads' Guide to Retirement Planning (17 page)

An employee stock ownership plan (ESOP) is a defined contribution plan (or a part of one) designed to invest primarily in the stock of the employer. If you participate in an ESOP, it is essential that you diversify away from company stock as quickly as possible. Many employees of large firms hold their employer’s stock in an ESOP or in their regular 401(k). This is a mistake. There is a high probability that employees will lose all those savings if the company goes bankrupt. Since your personal financial risk of a layoff is already highly correlated with the fate of your employer, you need to diversify your retirement portfolio. These risks are even greater when a private company uses an ESOP, since diversification of private shares can be much more challenging.

Some people have great difficulty in trying to manage their own portfolio. This section should help you get started.

The best way to begin evaluating what fund(s) you should hold in your self-directed 401(k), 403(b), or TSP is to sort the options by expense ratio and look for the least expensive funds. If you have access to low-cost target retirement options and all of your investments are in tax-deferred accounts, just choose the appropriate age-based target retirement fund. If you have a TSP account, just choose the L fund with the date closest to your planned retirement.

If you have a taxable account as well, you’ll probably want to invest in the lowest cost intermediate-term bond fund in your plan. That is, most investors should begin by placing tax-inefficient bonds in their plans and IRAs, so that they can put tax-efficient equity funds in their taxable account.

You should look for a bond fund that targets the Barclays Capital Aggregate Bond Index (formerly known as the Lehman Aggregate Index). Vanguard’s Total Bond Market fund tracks this index, which represents a good mix of investment-grade, intermediate-term bonds. Funds that hold short-term or intermediate-term Treasury Inflation-Protected Securities (TIPS) are also good bond holdings. Finally, PIMCO Total Return is a well-regarded, reasonably priced bond fund that’s offered in many plans. If your plan offers Fidelity funds, stick to the Spartan funds or the Four-in-One, which are indexed funds with costs comparable to Vanguard’s.

If you’re selecting bond funds from the TSP, you should use the G fund (rather than the F fund) for most of your bond holdings. Although the F fund is a great option (it tracks the Barclays Index previously mentioned), it can’t compare with the G fund, which offers an unrivaled value proposition:

If you are unlucky enough to have only high-cost options, your lowest-cost fund will probably be one that tracks the S&P 500. You can start with that and build the rest of your portfolio around it.

Some plans offer windows to allow you to purchase any stock or mutual fund, not just the ones on the preapproved menu. In principle, this could make a plan as flexible as an IRA and provide an alternative to expensive, actively traded funds. In practice, most fund windows are a gimmick. The problem is that the fees associated with using the window are so high that they make the overpriced fund menu options look appealing. If you do use the window, it may be most cost-effective to allocate your plan contributions to a money market or stable value fund and then just make your purchases using the fund window once or twice a year to minimize transaction fees.

If you are able to purchase any stock, exchange traded funds (ETFs) offer a low-cost way to hold the entire world’s stock markets and track the bond markets. The lowest-cost ETFs are Vanguard Total Stock Market ETF (VTI), Vanguard’s FTSE All-World ex-US ETF (VEU), Vanguard Total Bond Market (BND), and SPDR Barclays Capital TIPS (IPE). Those four ETFs can satisfy the complete needs of many investors’ portfolios, but only if they’re available at a reasonable cost.

When I became responsible for a 401(k) plan as a result of a company merger, I learned just how bad many defined contribution plans can be. Employees of our small firm were paying tens of thousands of dollars per year in unnecessary fees. Each employee would have 17 percent less money in 20 years under that plan than in a more reasonable plan built around low-cost mutual funds. Assuming the maximum contribution for 20 years, switching to a better plan would mean an additional $200,000 for each employee (including me!) in retirement. Needless to say, I switched our plans.

Unfortunately, there is no reliable process to convince your employer to switch to a better 401(k) plan. The 401(k) industry is rife with shady dealings and payoffs that drain away part of your retirement savings each year. The common practice of revenue sharing (a type of kickback) means that fund companies pay record keepers, administrators, and advisers a portion of their fees. The kickbacks create a disincentive to recommend switching to a better, lower-cost plan.

What’s so strange about bad plans is that the plan trustees (often the chief operating officer and vice president of human resources) are stuck paying the same high fees for their investments as well. There are much better options available, and switching costs are not very high. Unfortunately, very few 401(k) trustees like to be told how bad their plans are. You can write a letter and get your coworkers to sign on, but your managers may not be happy with you for doing so.

More information on getting your employer to improve its plan is available at the Bogleheads Wiki,
www.bogleheads.org.
.

A defined contribution plan provides each participant benefits based on the contributions of you and your employer over time, the total return on the assets, and the fees the plan imposes. Contributions to a defined contribution plan can be made by the employer, the employee, or both, depending on the type of plan.

There are many different types of defined contribution plans. The most common are profit-sharing plans, money purchase pension plans, target benefit plans, employee stock ownership plans (ESOPs), and 401(k) type plans. Each plan has unique features that employees should understand.

A 401(k)-type plan lets you divert a portion of your paycheck to a tax-advantaged retirement account. Your employer may match a portion of your investment, and you should always take advantage of the match. When you switch employers, you can roll over your defined contribution account into an IRA that gives you complete control of the funds you want to use.

A single-premium immediate annuity (SPIA) can pay you and your significant other an income for life. That helps solve the problem of how to budget for retirement when you do not know how long retirement will last. Payouts are set by contract and, like a traditional pension, do not fluctuate, making retirement planning a little easier. Payouts are significantly higher than you can obtain from any comparably safe investment because part of your monthly payment includes a return of part of your principal.

An SPIA is a pure insurance product and provides protection against outliving your portfolio. The amount of money you receive is not connected to the stock market or any other investment, like a variable annuity or an equity-indexed annuity. With a SPIA, there is a risk that the insurer might fail, and that risk should not be ignored when you are choosing a carrier. If the insurer fails, state guaranty associations will provide some protection, but that protection is limited.

The word
annuity
means any regular series of payments, and many different financial products are called annuities. This chapter is about life annuities, a kind of insurance product that works like your own private pension and pays you—and, often, a joint annuitant—income for as long as you live. It is not about the high-cost investment products called variable annuities or equity-indexed annuities, which are products to be avoided. Life annuities, on the other hand, solve the problem of how to budget for a lifetime when you do not know how long you will live. If you rely only on your personal investments, you must budget for the possibility that you could live beyond age 100. You cannot budget for your average life expectancy, but an insurance company can.

Single-premium immediate annuities are also known as life annuity products, lifetime payout income annuities, fixed immediate annuities, and immediate income annuities. You purchase an SPIA for a lump sum of money (the single premium), and the insurance company agrees to make regular monthly payments to you for the rest of your life. It is like buying your own private pension.

The terms of an SPIA are a contract with an insurance carrier to make specified payments. These payments do not fluctuate, except in the case of an inflation-adjusted annuity, where the fixed payment adjusts to the inflation rate. The income is as safe as the claims-paying ability of the insurer. State guaranty associations provide a limited safety net in case the insurer runs into financial trouble.

Table 7.1 shows a sample payout rate for a single premium of $100,000 for a husband and wife (joint annuities) of the same age.

These payouts look attractive compared with bond or CD interest rates. The reason they are high is that the payouts are not interest only. Part of the payment is the premium being returned to you. Since the payments continue for only the life of the annuitants, it is quite possible that if you die young, the total amount paid out will be less than the original premium. Your heirs do not collect the remaining premium. In contrast, you can collect much more than your premium if you live a long time. Thus, with an SPIA you accept the risk of losing money that you do not need in exchange for getting extra money when you do need it.

Single-premium immediate annuities are a form of insurance. You give the insurance company enough money to make regular payments back to you over a period corresponding to your
average
life expectancy. The insurance company then makes regular payments to you for your
actual
lifetime, which may be more or less than the average. Think of an SPIA as insurance against the possibility of running out of money, should you be fortunate and need to fund a retirement lasting longer than you expected.

Most retirees in the United States receive longevity insurance in the form of Social Security. But fewer and fewer of us have longevity insurance in the form of traditional defined benefit pensions (see Chapter 5). An annuity allows you to create your own defined benefit pension. A risk-averse person who faces uncertainty about length of life should consider this option, yet most studies show that few consumers voluntarily annuitize their retirement savings.

If you can support yourself entirely from the interest and dividends from your portfolio without invading the principal, then you do not need to think about an SPIA. But if your portfolio is only large enough to take care of you comfortably for your expected life span and not large enough to stretch the range of your possible longevity, then you should consider whether SPIAs deserve a place in your retirement planning toolkit. When comparing annuities with other options, consider these decision factors: