If you’re looking for the latest column, it’s not here. I posted the column today on the main page of my blog. Too many people weren’t clicking on the column link so I decided to make it easier for visitors to find it. So you can look on my main page from now on.
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When should you begin taking Social Security payments?
The process that many people use to answer this question is more reflexive than contemplative. A lot of folks have already predetermined what their magic number is. At age 62, they can start collecting Social Security and they want what they’ve earned– NOW!
If you have saved little and are unable to work any longer, there is little need for an angst-filled examination of various scenarios. If you can’t survive without early Social Security checks, you can keep the calculator in the drawer and take the reduced early bird benefits.
For everybody else, however, there is a financial advantage to poking sticks at the actuarial beast created by this U.S. Social Security Administration. But you can’t begin to formulate an intelligent attack plan until you understand what your options are. Here is a glimpse of what is at stake: If you paid the maximum in Social Security taxes for most working years and you retired at your full retirement age in 2006, you’d be entitled to receive $24,685. The government arrives at your benefit by looking at your 35 highest earnings years in a span that reaches back to age 22. If you started the payments at 62, however, the yearly benefit would shrink to $18,437. If you held off until your 70th birthday, you’d pocket $34,184 that first year.
People often assume that they’ll come out ahead if they grab their benefits at the first opportunity, but that’s often wrong. For the eager beavers, the benefit will shrink depending upon when they were born and how early they grab the cash. If you were born in 1937 or earlier, the reduction in your benefit is 6.7% a year up to 20% if you start the checks three years early.
The federal government’s actuaries aren’t slouches. They have calculated that payments so that an American with the typical life span will collect the same amount of money regardless of when he starts cashing his checks. Typically, the break-even age is 78. If you live longer than that, it would have been better to delay your Social Security.
Here’s an example: Suppose you were grappling with receiving a yearly $15,000 benefit at age 62 or waiting until full retirement age for a $20,000 benefit. Regardless of which choice you made, when you are 77 years old, you would have pocketed the exact same amount of money. But if you made it to your 78th birthday, you’d be financially rewarded if you had the patience to wait those few extra years. Meanwhile, if you had postponed receiving any benefits until 70, your benefits, by the time you reached 80, would exceed all the Social Security cash you would have pocketed if you started collecting checks at age 62.
Of course, none of us know when we will fold our last napkin, smell our last rose and take our last breath. For some people, family history may provide a clue. For those who aren’t satisfied with making a wild guess, you may want to use the calculator at LivingTo100.com, which asks you dozens of questions before arriving at your expected life expectancy. When I tried it, the calculator suggested that I’d live to 94, but if I stopped eating bittersweet chocolate twice a day I could add another 1.75 years to my life. Didn’t sound like much of a tradeoff to me.
If you’re married, however, you’re actuarial gymnastics is even more complicated. Sadly, what many couples don’t consider when weighing things like Social Security break-even points is what could happen when one of them dies. In too many cases, a husband, who earned the bigger paychecks, could be condemning his wife to future poverty if he takes Social Security early. (Obviously, the same thing can happen if the wife is the family’s power earner.)
For couples there is a great benefit for delaying Social Security, especially if the spouse is a low-income worker or didn’t work outside the home, says Henry K. Hebeler, the author of J.K. Lasser’s Your Winning Retirement Plan and the creator of AnalyzeNow.com, which is a excellent resource for retirement software. Hebeler’s Social Security calculator is free and you can also read articles the former aeronautics executive, who has three degrees from MIT, has written on the topic. On his Web site, he receives more questions on timing Social Security payments than any other subject.
“If the high-income spouse takes Social Security at 62, it’s a major penalty to the surviving low-income spouse,” Hebeler says. When a low-income spouse becomes a widow or widower, he or she can take either 100% of the higher wage earner’s benefit or his or her own smaller one. “If you are married and more gutsy, you can make a very good case for the high-income spouse to delay till age 70 and the low-income spouse to delay till his or her full retirement age.”
People should also look closely at the assumption–I’d call it a brash one–that they can take the smaller early payments, invest the cash and come out ahead financially. For starters, if you’re 62 when you take Social Security benefits and you continue to work, your benefits will be reduced by $1 for every $2 earned above a certain amount. This year it’s $12,480. There are plenty of other reasons why you might not want to try this. If you’re tempted, you should take a look at an analysis that T. Rowe Price did on this and other Social Security options in its fall issue of the T. Rowe Price Report. You can find the report at the mutual fund’s web site at www.troweprice.com by typing “Price Report archive” into the site’s search function.
By the way, if you began drawing Social Security checks at 62 and regret it, you can buy your way out of the mistake. You must file a “withdrawal of claim” and return the money. But at least you don’t have to pay a penalty or interest.
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During the past two Sundays, you’ve read a lot about why 401(k) costs matter. You now understand that your 401(k) isn’t free, but how much is it costing you? Here’s how you can find out:
Do your own price check. Every mutual fund sitting in your 401(k) has its own price tag. You should find out what each one is. Here’s a frame of reference: Today’s typical retail mutual fund sports an expense ratio of 1.4%. That means, for example, if you’ve got $25,000 invested in an average-priced fund, you’d pay $350 for that investment for the year. Your goal should be to find funds in your 401(k) lineup that cost less than that–if there are any. At the same time, you’ll want to avoid the 401(k) scalpers lurking in your workplace menu.
Paul Yossem, an advisor with Wheeler/Frost Associates, Inc., in San Diego, provided me with a great example of the kind of nasty surprises that can be stinking up your 401(k). Yossem, whose fee-only firm puts together 401(k) plans, was invited by a company in Escondido to evaluate its workplace program. Yossem determined that the average fund in the company’s 401(k) lineup was 1.80%, which isn’t great. But several funds cost over 2% a year and one hideous option charged 3%, which I think qualifies it for the armed-robbery category.
You can check a fund’s costs by looking at its prospectus, which you can easily obtain by visiting the mutual fund’s web site and downloading it. If you don’t have Internet access, contact your 401(k) provider. You should also be able to obtain key facts about your fund by visiting Morningstar.com. Because funds can offer different share classes, which charge varying fees, you’ll want to make sure you have the right fund ticker symbol.
Locating a fund’s expense ratio won’t necessarily reveal all your charges. You’ll need to look further, for instance, if you invest in a lifestyle fund, which provides a one-stop mix of stocks, bond and cash that’s packaged for conservative, moderate or aggressive investors. Lifestyle funds are often slapped with an extra fee that may range from an additional .25 percent to one percent. You might not uncover this cost unless you hunt for the footnotes in a prospectus.
You also should check to see if you are paying a wrap fee with plans that are arranged by stockbrokers, commissioned financial advisors and insurance companies. If you’re unlucky enough to invest in a 401(k) that relies upon an insurance company annuity, you will certainly be paying more than just the expenses for the mutual funds, which are called sub accounts in annuity lingo. In some 401(k) group annuity plans, Yossem has uncovered expenses that have reached as high as five percent! I gasped when he told me that.
You should, by the way, be just as price conscious if you’re investing in a 403(b) plan, which is the type of account that teachers use. Educators enjoy one advantage over the working stiffs that are chaffing at their employers’ ragtag 401(k) lineups. Teachers aren’t locked into one 403(b) provider. They are free to find a 403(b) on their own, but this responsibility comes with its own perils. Despite the ability to choose lower cost plans, millions of teachers select those pesky variable annuities with their high fees, unnecessary insurance charges and generally miserable returns. Teachers get stuck with these dogs because they trust the salesmen, who corner them in the faculty lounge or finagle an invitation to their homes. The lower cost options, such as those provided by Vanguard Group, T. Rowe Price, TIAA-CREF and Fidelity Investments, don’t dispatch people to schools to drum up business. Enterprising teachers must contact these firms by telephone.
Take a hike. What happens if your 401(k) is grotesquely expensive? You may want to consider bailing from your 401(k) after you’ve sunk in enough cash to secure your employer’s yearly matching contribution. An excellent alternative is an Individual Retirement Account. For almost everyone, the best IRA choice will be a Roth IRA. If you are at least 50, you’re free to contribute up to $5,000 into an IRA this year. Younger investors can chip in $4,000. If you can afford to kick in even more money after maxing out an IRA, I’d recommend putting the rest of your cash in low-cost, tax-efficient mutual funds in a taxable account.
Of course, you’ll be in worse shape financially if you stop your 401(k) contributions and never bother feeding your backup IRA. To prevent this nightmare from happening, here’s a better alternative: Before you cut back or eliminate 401(k) contributions, make sure you’ve set up an automatic deposit feature for your IRA. You can have money taken out of your savings or checking account on the same day every month.
Scatter your money. Of course, costs aren’t the only reason you need to remain alert. Too many employees think that they’re investment geniuses if they’ve divided their money amongst a handful of mutual funds. But they may or may not diversified. You won’t know unless you understand what the investment mission is of each of your mutual funds. Once again, you can turn to the prospectus or Morningstar to investigate a fund’s mission.
Ultimately, what you want to own is a basket of investments that includes the major investing categories. A typical investor should own funds that invest in large-cap stocks, small-cap stocks, foreign stocks and a bond fund. And if they are low cost, all the better.
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Last week, I asked readers if they knew how much their 401(k) plan is costing them. Since then, I’ve heard from irate readers, who suspect that they’re being ripped off. So far, however, only one guy, who has contacted me, thinks he’s pinpointed how much he’s paying.
During the past 16 months, this reader figures he’s paid close to $7,000 in 401(k) fees. When he complained to his company about what he considered to be a bloated tab, here’s the response he got: “Suck it up. There is nothing you can do about it.”
In one respect, this candidate for employer of the year is right. In the 401(k) arena, workers are about as powerful as a bunch of kindergartners storming Chuck E. Cheese. Employees don’t get to select the mutual funds that end up in their 401(k) menu and they don’t have a say in what their workplace retirement plans cost them. While the employer holds all the aces, it’s the voiceless workers, who have the most at stake.
And that’s why it’s infuriating when stuff like this happens all too frequently: A boss chooses his old college roommate, who is a stockbroker, to put together a 401(k) plan for his firm or replace an existing one. The lucky broker is careful to only choose mutual funds that will, in turn, reward him financially. Some of these guys can make tens of thousands of dollars, and in some cases hundreds of thousands of dollars, a year for pretty much being in the right places at the right times. And it’s the workers who are picking up the tab. Every time they sink money into their 401(k) mutual funds, the worker’s investment returns are eroded by higher fees that are assessed, in part, to cover the broker’s reward plan.
So what does the broker have to do to justify his windfall? In some cases not much. Even if the broker does little more than annually entertain the firm’s owner with dinner and a round of golf, he’ll continue to be paid handsomely year after year.
Employers, however, can’t immunize themselves from completely botching their 401(k) responsibilities. Employers, both big and small, are supposed to be following the Employee Retirement Income Security Act of 1974, better known as ERISA, that mandates that they act as fiduciaries for their workers’ retirement money. One of ERISA’s requirements is that every employer with a 401(k) plan must establish a prudent management process to oversee their retirement plan providers. And that means they have to know what the heck is going on in plain sight and under the table.
As part of this oversight duty, an employer needs to know what the retirement plan is costing and where the money is going. In my lucky broker example, it’s highly doubtful that the boss understands how much his 401(k) point man is pocketing from the fund fees versus what his expenses are. And this same lack of knowledge can be true for much larger companies that depend upon major 401(k) players such as Fidelity Investments, Vanguard Group, T. Rowe Price, Merrill Lynch, Principal Financial Group and Hartford to run their plans.
What a workplace should be doing is monitoring how much cash is being generated for 401(k) expenses and where it is going. Companies should also compare how the costs and the services stack up to other 401(k) vendors. When companies aren’t vigilant, it’s more likely that workers will be gouged. “A missing prudent management process will almost always lead to excessive costs,” observes Ronald E. Hagan, chief executive officer at Roland/Criss Fiduciary Services in Dallas, which advises workplaces on their fiduciary responsibilities.
What is an unreasonable cost? It depends upon how big a workplace plan is. If a company has less than $1 million in assets the costs are going to be much higher than for employees who work at a place that has at least $10 million in the 401(k) kitty. Little plans are often stuck with insurance company providers, which typically assess among the stiffest fees.
With insurance plans, the mutual funds and/or variable annuities will typically be expensive and they will often be slapped with dubious wrap fees. Most 401(k) annuities will also stick investors with onerous mortality insurance fees, which are unnecessary. Companies should be looking for alternatives as soon as the plan acquires $1 million in assets, suggests Hal R. Schweiger, a fee-only advisor at Capital Financial Advisors, LLC in La Jolla, which puts together 401(k) plans. Actually, companies of any size should be seeking bids from 401(k) vendors every three years or so in an attempt to lower costs and obtain better services.
If you’re feeling helpless right about now, here is something you can do: Ask your company if it has documented your plan’s fees and costs. Chances are it won’t know and that’s partly because of a phenomenon I wrote about earlier called revenue sharing. Outside 401(k) administrators and commission-based financial advisors often pick mutual funds for a workplace menu that includes 12b-1 fees that originally were supposed to be used by funds for marketing. In the 401(k) universe, the funds use this cash to pay the 401(k) administrator or plan advisor for picking it. Of course, you don’t have to be a cynic to ask if the funds being selected are the best of show or simply the ones with the deepest pockets.
Typically, the administrator uses at least some of this money to cover such costs as the bookkeeping responsibility. But as the assets in a 401(k) plan grow over the years, few employers ever ask if this revenue sharing has gone beyond paying the basic expenses and mushroomed into a huge cash cow for the administrator. This can happen since expenses like bookkeeping and maintaining a toll-free number are pretty much fixed costs, or vary by number of employees not by the dollars in the account. The revenue sharing money, however, can continue mushrooming thanks to stock market gains and workers’ weekly contributions.
While it’s standard practice, workplace retirement plans don’t need to rely upon revenue sharing to pay costs. Companies can use low-cost mutual funds for their employees that don’t generate revenue-sharing cash. When going that route, employers can pick up the tab for administrative costs or pass them along to their employees. The big 401(k) players can set up these types of plans, as can fee-only investment advisory firms that routinely make sure all expenses are transparent.
For employers who blow off ERISA, here’s something that might get their attention: Dozens of lawsuits have been filed against employers for failing to live up to their 401(k) responsibilities. CEOs might assume that it’s the outside 401(k) administrators that risk getting clobbered in court, but they are wrong. The targets of these employee lawsuits, which should continue to multiply, are the workplaces and their executive officers. Gulp.
Next week: One more week on 401(k)’s.
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