Chapter 15
Working It Out: Sample Portfolios
In This Chapter
Establishing your financial goals
Handling life changes
Managing a windfall
Following a prescribed investment pattern
This chapter is where the rubber hits the road. If you read the other chapters in this part of the book, where I discuss the details of money market, bond, and stock funds and everything in between, the concepts and individual funds may be swirling around your brain like random pieces of paper in a city alley during a windstorm. (Chapter 10 covers several important investment selection topics as well, including asset allocation. If you haven’t read that chapter, please do so now — otherwise, you may be less able to make use of the guidance in this chapter.)
In this chapter, I talk through some real live cases. (Of course, the names and details have been changed to protect the innocent!) This chapter should bring a lot of things together for you; I at least hope that it calms the whirlwind.
My goal in going through these cases is to illustrate useful ways to think about investing in funds and to provide you with ideas and specific solutions to investment situations. You may think that you’ll benefit most from reading only those cases that seem closest to your current situation, but I encourage you to read as many cases as your time allows — perhaps even all of them. Each situation raises somewhat different issues, and your life and your investing needs will change in the years ahead.
Don’t worry if your circumstances don’t perfectly match one of these cases; in fact, it probably won’t be a complete match. After all, you’re uniquely you. However, the principles illustrated here are general enough to be tailored to just about anyone’s specific situation.
Throughout these cases, I explain
How your investing decisions fit within the context of your overall finances
How to consider the tax impact of your investing decisions
How to recognize situations in which you may need to make other financial moves prior to (and maybe even instead of) investing in mutual funds
Determine where you stand with regard to your own important financial goals, such as retirement planning (the fund-related ins and outs of which I cover in Chapter 3), before you put together your investment portfolio. The examples in this chapter are arranged from the simpler cases to the more complex.
Getting Started
If you’re just starting to get your financial goals together, you’re hardly alone. If you’re still in school or otherwise new to the working world, good for you if you want to get on the right investing road now! Regardless of your age, though, remember that it’s never too late. Just get started.
Starting from square one: Melinda
Melinda is in her 20s, works as an architect, earns decent money, lives in New Jersey, and has no debt and no savings yet because she just started her first job. Financially speaking, she’s a blank slate, but because she made a New Year’s resolution to get her finances in order, she wants to do something.
Her employer offers her health and disability insurance and a profit-sharing retirement plan, which only her firm may contribute to, but to which small contributions have been made in the past. She wants to invest in mutual funds but doesn’t want hassle in either paperwork or complications on an ongoing basis.
On a monthly basis, she figures that she can save $600. She wants to invest for growth. With her money earmarked for long-term future needs, such as retirement, she sees no need to invest conservatively (even though she does want some of her investments more conservatively invested). She’s in the 28 percent federal tax bracket now, but as her experience in her field increases, she expects to earn more.
Recommendations: Melinda should consider investing $5,000 annually in a Roth IRA (see Chapter 3). In her case, a regular IRA contribution won’t be tax deductible because her employer offers a retirement plan under which she’s considered covered and because she earns more than is allowed to make a tax-deductible contribution to a regular IRA.
Melinda could invest in a fund of funds, such as Vanguard LifeStrategy Growth, Fidelity Freedom 2050, or T. Rowe Price Spectrum Growth (all covered in Chapter 13), which all offer the simplicity of one-stop shopping and reduced annual account fees.
Like everyone else, Melinda should have an emergency source of cash. Although the mutual funds that she’s investing in outside her retirement account are liquid and can be sold any day, she runs a risk that an unexpected emergency could force her to sell when the markets are hung over.
With family to borrow from if needed, she could make do with, say, a cushion equal to three months’ living expenses. She could even postpone building an emergency fund until after she funds her IRA. (Normally, I’d recommend establishing the emergency fund first, but because she has family she can borrow from, I believe that it’s okay to go for the long-term tax benefits of funding the IRA account.) Because she won’t keep a large emergency balance, she could keep her emergency fund in her local bank account, especially if the balance helps keep her checking account fees down. Given her current tax bracket, if Melinda wanted a money market mutual fund, she could invest in a taxable fund, such as Fidelity Cash Reserves or others described in Chapter 11.
For longer term growth, Melinda could invest her monthly savings as follows:
60–70 percent in Vanguard Total Stock Market Index
30–40 percent in Vanguard Total International Stock Index
(These funds are reasonably tax friendly, which is important because she’s investing outside a retirement account and is in a reasonably high tax bracket.)
These funds generally make low taxable distributions and make especially low distributions, such as short-term capital gains, that are highly taxed. They require a $3,000 minimum initial investment, so Melinda needs to save the minimum before she can invest. After the minimum is met and invested in each fund, she can have money deducted electronically from her checking account and invested in these mutual funds.
Silencing student loans: Stacey the student
Stacey is a 25-year-old graduate student in psychology with three years to go before she gets her well-deserved degree. She’s hoping that all this education will fetch her a solid income when she finally gets out of school.
Her current income amounts to about $19,000 per year. She’s also sitting under $25,000 of student debt from her undergraduate days. Both of her loans are in deferment, so she’s not obligated to make payments until she finishes graduate school: One is incurring interest at 7 percent per year; the other is subsidized (the government is paying the interest until she gets out of school).
Fortunately, Stacey has the starving-student-thing down cold. She’s so savvy at living cheap that despite her low income she has an extra $150 to play with at the end of every month. (Stacey has an emergency reserve already in place.)
Stacey wants to be debt-free sooner, so her first instinct is to use that money to start paying down those student loans. But Stacey is also excited about investing for her future. Because half of her student loan interest is subsidized, she’s wondering if she’d come out ahead by using her extra money to open and invest in an IRA account.
Recommendations: Stacey should be proud of herself. Living below her means on such a small income, as well as thinking about her financial future, is commendable. She’s asking good questions. Her decision comes down to a comparison of the student loan interest rate to the potential return of her IRA investments. Because she’ll be investing for retirement, which is decades away for a 25-year-old, Stacey’s time horizon is long enough to focus largely or almost entirely on stocks. As I discuss in Chapter 1, stocks historically have returned about 9 to 10 percent per year. Measured against the 7 percent interest she’s paying on her unsubsidized student loan, Stacey can perhaps come out a little ahead by holding off on student loan payments and investing in stocks through an IRA account. (She can deduct up to $2,500 per year in student loan interest on her tax return; her investment returns would ultimately be taxed).
I say that it’s really Stacey’s call as to which option — paying down the 7 interest student loan or investing in good stock mutual funds through an IRA — makes her feel more comfortable. Financially, the choice is a tossup. It’s worth noting, however, that the annual savings of 7 percent that comes from paying down the student loan is a sure thing, whereas the stock market annual average returns of 9 to 10 percent are an expectation and in no way guaranteed. For this reason, I’d be inclined to pay down the student loans at 7 percent.
If Stacey decides to go the IRA route, because she has such a long time horizon, her fund(s) should focus almost entirely on stocks. Ideally, her fund(s) should be diversified across large-, medium-, and small-company stocks as well as international investments. Stacey’s situation is ideally suited for a fund of funds (such as the ones I recommend to Melinda in the preceding section). Alternatively, if she wants to get going with investing $150 per month and not wait to save enough to meet a fund’s minimum, she could invest monthly in an automatic investment plan (AIP) through a company such as TIAA-CREF or T. Rowe Price that waives fund minimums if you sign up for an AIP (see the sidebar “Getting started with just $50 per month”).
Living month to month with debt: Mobile Mark
Mark is a 42-year-old renter who says that he has no desire to own a home. He doesn’t want the feeling of being tied down in case he ever wants to move — something he’s done a lot of over the years. Currently, he lives in California. Feeling that he’s hitting middle age, Mark wants to start socking away money regularly into investments. He has a large folder filled with mutual fund ads and prospectuses but finds most of the material confusing and intimidating. He has about $5,000 in a bank IRA invested in a certificate of deposit.
Mark feels insecure living month to month and being so dependent on his paycheck. One of the reasons he’s feeling some financial pressure is that, in addition to his monthly rent, he has an auto loan payment of about $300 per month and total credit card debt of $6,000. He also doesn’t have any family he can depend on for money in an emergency.
Recommendations: Although Mark has the best of intentions, he’s a good example of someone who’s managed to get his financial priorities out of order. Mark’s best and most appropriate investment now is to pay off his credit card and auto loan debt and forget about fund investing for a while. These debts have interest rates of 10 to 15 percent, and paying them off is actually his best investment.
Like millions of others, Mark got into these debts because credit is so easily available and encouraged in our society. Such easy access to borrowing has encouraged Mark to spend more than he’s been earning. Thus, one of the first things he should do is figure just where his money goes in a typical month. By using his credit card statement, checkbook register, and memory of items he’s bought with cash, Mark can determine how much he’s spending on food, clothing, transportation, and so on. He needs to make some tough decisions about which expenditures he’ll cut so that he can pay off his debts.
Like Melinda (the 20-something architect in the first example), Mark should also build an emergency reserve. If he ever loses his job, becomes disabled, or whatever, he’d be in real financial trouble. Mark has no family to help him in a financial pinch, and he’s close to the limits of debt allowed on his credit cards. Because he often draws his checking account balance down to a few hundred dollars when he pays his monthly bills, building up his reserve in his checking or savings account to minimize monthly service charges makes the most sense for him now. Recently, Mark eliminated about $100 per year in service charges by switching to a bank that waives these fees if he direct deposits his paycheck.
By mainly going on a strict financial program — which included sacrifices such as dumping his expensive new car and moving so that he could walk or bike to work — within three years, Mark became debt-free and accumulated several thousand dollars in his local bank. Now he’s ready to invest in mutual funds.
Because his employer offers no retirement savings programs, Mark should annually contribute $5,000 to an individual retirement account (IRA). Mark doesn’t want investments that can get clobbered: He thinks that he’s been late to the saving game and doesn’t want to add insult to injury by losing his shirt in his first investments. Being a conservative sort, Mark thinks that Vanguard makes sense for him. For his IRA, he can divide his money between a hybrid fund, such as Vanguard Wellington (70 percent), and an international stock fund, such as Vanguard International Growth (30 percent). In addition to his new $5,000 contribution, Mark also should transfer his $5,000 bank CD IRA into these funds. In the event that he isn’t eligible for a tax deduction on a regular IRA, he should definitely fund a Roth IRA.
Now debt-free, Mark thinks that he can invest about $400 per month in addition to his annual IRA contribution. His income is moderate, so he’s in the 28 percent federal tax bracket. He wants diversification, but he doesn’t have a lot of money to start his investing program. He has set up an automatic investment plan whereby each month the $400 is invested in the T. Rowe Price Personal Strategy Balanced or T. Rowe Price Retirement 2035 ($50 per month minimum with an automatic investment plan).
Competing goals: Gina and George
George works as a software engineer, and his wife Gina works as a paralegal. They live in Virginia, are in their 30s, and have about $20,000 in a savings account, to which they currently add about $1,000 per month. This money is tentatively earmarked for a home purchase that they expect to make in the next few years. They figure they need a total of $40,000 for a down payment and closing costs; they’re in no hurry to buy because they plan to relocate after they have children in order to be closer to family. (The allure of free baby-sitting is just too powerful a draw!)
Justifiably, they’re pleased with their ability to save money — but they’re also disappointed with themselves for leaving so much money earning so little interest in a bank. They figure that they need to be serious about investments because they want to retire by age 60, and they recognize that kids cost money.
George’s company, although growing rapidly, doesn’t offer a pension plan. In fact, the only benefits his company does offer are health insurance and a 401(k) plan that George isn’t contributing to because plan participants can’t borrow against their balances. Gina’s employer offers health insurance, $50,000 of life insurance, and disability insurance — but, like George’s employer, Gina’s employer doesn’t offer a retirement savings plan.
Recommendations: Deciding between saving for a home or funding a retirement account and immediately reducing one’s taxes is often a difficult choice. In George and Gina’s case, however, they can and should do some of both. At a minimum, George can save 10 percent of his income in his company’s 401(k) plan. Wanting to be somewhat aggressive and considering his age, George could invest about 80 percent in stock funds with the balance in bonds among his 401(k) plan’s mutual fund investment options.
Here are his 401(k) plan options and how he should invest:
0 percent in the money market fund option
20 percent in Vanguard Total Bond Market Index
20 percent in Fidelity Contrafund
25 percent in Dodge & Cox Stock
35 percent in Oakmark International
0 percent in a so-called guaranteed investment contract (GIC) that isn’t a mutual fund but a fixed-return insurance contract (see the sidebar on “Investing money in company-sponsored retirement plans” for a discussion of these investment options)
If George contributes the maximum amount through his employer’s 401(k) and he and Gina still want to invest more in retirement accounts, they can invest $5,000 each, per year, into an IRA.
Gina shouldn’t worry that, if she and George divorce, George would get all the money in his 401(k) plan. As with nonretirement account assets, these assets can be split between a divorcing husband and wife. A more significant concern would occur if, say, George is an isolated dunce and refuses to talk to Gina about the investment of this money for their retirement and makes some not-so-smart moves, such as frequently jumping from one fund to another. (Try discussing this issue with your spouse. If you don’t get anywhere with your spouse, pay a visit to your local marriage counselor.)
What about their $20,000 that’s sitting in a bank savings account? They should move it, especially because George is a fan of USAA, having benefited from their terrific insurance programs as a member of a military family. Initially, he and Gina can establish a tax-free money market fund, such as the USAA VA Money Market fund, as an emergency reserve.
Because they don’t plan to need the down payment money for the home for another three to five years, they can invest some of their savings — perhaps as much as half — in the USAA Tax-Exempt Intermediate-Term Bond fund. Even though they’ll pick up a little more yield, they need to know that the bond fund share price declines if interest rates rise. (For that weighty subject, see Chapter 12.)
George should get some disability insurance to protect his income. (It turns out that his employer offers a cost-effective group coverage plan.) Before Gina becomes pregnant, George and Gina should also purchase some term life insurance.
If George and Gina had little or no money saved and couldn’t save for both the home and get the tax benefits of their retirement account contributions, they’d have a tougher choice. They should make their decision based on how important the home purchase is to them. Doing some of both (saving for the home and in the retirement accounts) is good, but the option of not using the retirement account and putting all their savings into the home down payment “account” is fine, too.
Wanting lots and lotsa money: Pat and Chris
Pat and Chris earn good money, are in their 40s, and live in South Dakota. Pat is self-employed and wants to sock away as much as possible in a retirement savings plan. He figures that he can invest at least 10 percent of his income. Chris works for the government, which offers a retirement plan with the following options: a money market fund, a government (big surprise!) bond fund, and a stock fund that invests in large-company U.S. stocks only.
Pat and Chris want diversification and are willing to invest aggressively. They want convenience, and they’re willing to pay for it. In addition to Pat’s retirement plan, they want and are able to save additional money to invest for other purposes, such as Chris’s dreams of buying a small business and investing in real estate. They currently own a home that has a mortgage that could easily be supported by one of their incomes. Neither depends on the other’s income.
Pat also has an $8,000 IRA account, which is currently divided between a Class B growth stock fund and a Class A total return bond fund (both load funds). Pat hasn’t contributed to the IRA for six years now. He also owns a universal life insurance plan, which he bought from the same broker who sold him the load mutual funds. He bought the life insurance plan five years ago when he no longer could make tax-deductible contributions to his IRA; the life insurance plan is better than an IRA, according to Pat’s broker, because he can borrow from it. The broker told Pat last week that his life insurance plan is “paid up” (he need not put any more money into the plan to pay for the $20,000 of life insurance coverage) and has a cash value of $3,300, although he’d lose $1,200 (due to surrender charges) if he cashed it in now.
Recommendations: First, Pat should get rid of his load mutual funds and his current broker. The broker has sold Pat crummy mutual funds. The funds have high fees and dismal performance relative to their peers. He could transfer his fund monies into something like Vanguard Star.
Pat doesn’t need life insurance because no one depends on Pat’s income. Besides, it’s a lousy investment. (For the compelling reasons why you’re better off not using life insurance for investing, see Chapter 1.) Pat should dump the life insurance and either take the proceeds or roll them over into a variable annuity (which I explain later in this chapter).
Pat can establish a Keogh retirement savings plan and stash away up to 20 percent of his net self-employment income per year (See Chapter 3 for more on Keoghs). He could establish his Keogh plan through a discount brokerage account that offers him access to a variety of funds from many firms. Over the years, he could divide up his Keogh money as follows:
15 percent in Dodge & Cox Income or Harbor Bond
15 percent in Vanguard Total Bond Market Index
10 percent in Vanguard Total Stock Market Index
10 percent in Fairholme
20 percent in T. Rowe Price Spectrum Growth
15 percent in Oakmark Global
15 percent in Vanguard Total International Stock Index
Because Chris doesn’t have international stock funds as an investment option, Pat can invest more in these than he normally should if he were investing on his own. In Chris’s retirement plan, contributions could be allocated this way: approximately one-third into the bond fund and the remainder in the stock fund.
As for accumulating money for Chris to purchase a small business or to invest in real estate, Pat and Chris should establish a tax-free money market fund, such as the Vanguard Tax-Exempt Money Market fund, for this purpose. As could George and Gina earlier in this chapter, Pat and Chris can invest in a short- to intermediate-term tax-free bond fund if they anticipate not using this money for at least several years and want potential higher returns.
Changing Goals and Starting Over
Life changes, so your investing needs may change as well. If you have existing investments, some may no longer make sense for your present situation. Perhaps your investment mix is too conservative, too aggressive, too taxing, or too cumbersome given your new responsibilities. Or maybe you’ve been through a major life change that’s causing you to reevaluate or begin to take charge of your investments. The following sections offer some examples sure to stimulate your thinking about an investing makeover.
Funding education: The Waltons
One of the biggest life changes that makes many adults think more about investing is the arrival of a child or two. And after contemplating all the fear-mongering ads and articles about how they’re going to need a gazillion dollars to send their little bundles of joy off to college in 18 years, many a parent goes about investing in the wrong way.
The Waltons — Bill, 42, and Carol, 41, along with their two children, Ted, 3, and Alice, 5 — live in the suburbs of Chicago in a home with a white picket fence and a dog and cat. They own a home with a mortgage of $150,000 outstanding. Their household income is modest because they both teach.
The Waltons have $40,000 in five individual securities in a brokerage account they inherited two years ago. They also have $20,000 in two of that same brokerage firm’s limited partnerships, now worth less than half of what they paid for them years ago. Bill and Carol prefer safer investments that don’t fluctuate violently in value.
They have $25,000 invested in IRAs within a load domestic stock fund and $10,000 in a load foreign stock fund outside an IRA. Bill hasn’t been pleased with the foreign fund, and Carol is concerned about supporting foreign countries when so many Americans are without jobs. Both of them like conservative, easy-to-understand investments and hate paperwork. They also have $10,000 apiece in custodial accounts for each of the kids, which Bill’s dad has contributed for their educational expenses. Bill’s dad wants to continue contributing money for the kids’ college expenses.
Bill just took a new job with a university that offers a 403(b) retirement savings plan, which he can get with many of the major mutual fund companies. He wasn’t saving through his old employer’s 403(b) plan because, with the kids, they spend all their incomes. Carol’s employer doesn’t have a retirement savings plan.
Recommendations: First, Bill should be taking advantage of his employer’s 403(b) plan. Though he may think that he can’t afford to, he really can. If need be, he should dump the individual securities and use that money to help meet living expenses while he has money deducted from his paycheck for the tax-deductible 403(b) account. (Always consider the tax consequences if you consider selling securities held outside of a retirement account. In the Waltons’ case, these securities have only been held for a couple of years and were worth approximately the amount of their tax cost basis — see Chapter 18 for more on tax basis.)
TIAA-CREF would be a fine choice for Bill’s 403(b). He could allocate his money as follows:
100 percent in Fidelity Freedom 2030 or Fidelity Freedom 2035 (fund of funds)
or
100 percent in Vanguard LifeStrategy Moderate Growth (fund of funds)
Bill and Carol could hold onto their load domestic stock fund investment that they have in their IRAs: This fund has a solid track record and reasonable annual fees of 0.7 percent. Its only drawback is its sales load of 5.75 percent, which is water under the bridge for Bill and Carol because it was deducted when they first bought this fund.
Their foreign stock fund isn’t a good fund and has high ongoing management fees. They should dump this fund and invest the proceeds in some better and more diversified international stock funds, such as those in Chapter 13. And regarding Carol’s concerns about supporting foreign companies, many companies today have operations worldwide. If she’s strongly against investing overseas, I suppose that she can choose not to invest her IRA money overseas, but her portfolio will likely be more volatile and less profitable in the long run. Foreign stocks don’t always move in lock step with domestic ones, and some foreign economies are growing at a faster rate than our economy.
Regarding custodial accounts, Bill and Carol need to remember that the amount of financial aid their kids will qualify for decreases as more money is saved in the children’s names. Bill’s dad should hold on to the money himself or give it to Bill and Carol. (This latter option has the added benefit of increasing Bill’s ability to fund his 403(b) account and take advantage of the tax breaks it offers.) Bill and Carol (and you as well, if you have children) should read Chapter 3, which has important information you should know before you invest in funds for college.
The limited partnerships are bad news. Bill and Carol should wait them out until they’re liquidated and then transfer the money into some good no-load mutual funds.
Rolling over (but not playing dead): Cathy
It’s a surprise to her as much as it is to her friends and family: Cathy has a new job. Although she was happily employed for many years with a respected software company, she got smitten with the entrepreneurial bug and signed on with a well-funded start-up software company. Her 401(k) plan investment of about $100,000 is invested in the stock of her previous employer. The company is waiting for Cathy’s instructions for dealing with the money. It’s been nine months since she got sucked into the vortex of the insane hours of a start-up company.
Nearing 40, tired but invigorated from those long days at her new company, Cathy has resolved to make some decisions about where to invest this money. She’s comfortable investing the money fairly quickly after she thinks she has a plan. Cathy wants to invest somewhat aggressively: Although she enjoys working hard, she happily imagines a time when she doesn’t need to work at all. She likes the idea of diversifying her investments across a few different fund families. She also wants to minimize her paperwork by setting up as few accounts as possible while at the same time minimizing transaction fees.
Recommendations: Cathy should sell her stock through her old employer and transfer cash. This sale will save on brokerage commissions. Having her retirement money in one company’s stock like this is risky.
For the best of both worlds, Cathy can establish an IRA through Vanguard’s brokerage divisions, which would give her access to all the great Vanguard funds, plus access for a small fee to non-Vanguard funds. She could invest the money as follows:
20 percent in Vanguard Total Bond Market Index
30 percent in Vanguard Total Stock Market Index
10 percent in Vanguard Selected Value or Fairholme or Sequoia
10 percent in Primecap Odyssey Growth
10 percent in Oakmark Global or Tweedy Browne Global Value
10 percent in Vanguard Total International Stock Index
10 percent in Masters’ Select International or Dodge & Cox International
Wishing for higher interest rates: Nell, the near retiree
Nell is a social worker. Now 59 and single, she wants to plan for a comfortable retirement. In addition to owning her home without a mortgage, she has $225,000 currently invested as follows:
$60,000 in a bank money market account
$110,000 in Treasury bills that mature this month
$55,000 in an insurance annuity that’s invested in a “guaranteed investment contract” through her employer’s nonprofit retirement savings 403(b) plan
Nell currently earns $40,000 per year and has received pay increases over the years that keep pace with inflation. She has $300 per month deducted from her paycheck for the annuity plan. Her employer allows investments in the retirement plan through almost any insurance company or mutual fund company she chooses. She’s also saving about $800 per month in her bank account. She hates to waste money on anything, and she doesn’t mind some paperwork.
Nell is concerned about outliving her money; she doesn’t plan to work past age 65. She’s terrified of investments that can decrease in value, and she knows a friend who lost thousands of dollars in the stock market. She says that her CDs and Treasuries were terrific in the 1980s when she was earning 10 percent or more on her money. She’s concerned now, though. She keeps reading and hearing that many large, reputable companies are laying off thousands of workers, but the stock market seems to be once again rising to high levels. She wishes that interest rates would rise again.
Recommendations: First, Nell should stop wishing for higher interest rates. Interest rates are primarily driven by inflation, and high inflation erodes the purchasing power of one’s money (see Chapter 12). The problem here is that Nell’s portfolio is poorly diversified. All her money is in fixed-income (lending) investments that offer no real potential for growth and no real protection against further increases in the cost of living.
Even though she’s planning to retire in six years, she’s certainly not going to use or need all of her savings in the first few years of retirement. She won’t use some of her money until her 70s and 80s. Thus, she should invest some money in investments that have growth potential.
Nell also could and should invest more through her employer’s retirement savings plan because she’s saving so much outside that plan and already has a large emergency reserve. In fact, she should invest the maximum amount allowed under her employer’s plan: 20 percent of her salary. She also can do better to invest in no-load funds for her 403(b) plan instead of through an insurance annuity, which carries higher fees. Vanguard and its hybrid funds (which are far less volatile because they invest in many different types of securities) are logical choices for her to use for her 403(b). I’d recommend the following investment mix for Nell’s 403(b):
25 percent in Vanguard Wellesley Income
25 percent in Vanguard Star
25 percent in Vanguard Wellington
25 percent in Vanguard LifeStrategy Moderate Growth
In addition to putting future money into these mutual funds, Nell should also decide whether she wants to transfer her existing annuity money into these funds as well. First, she should check her annuity account statement to see whether the insurance company would assess a penalty for transferring her balance. (Many insurance companies charge these penalties to make up for the commissions they have to pay to insurance agents for selling the annuities.)
If the penalty is high, she might delay the transfer a few years: These penalties tend to dissipate over time (because the insurer has use of your money long enough to compensate for the agent’s commission). If, however, the annuity is a subpar performer (a likelihood, given its high fees), she may want to go ahead with the transfer despite a current penalty. (See Chapter 16 for how to do proper transfers.)
With the $170,000 in money outside of her retirement accounts, Nell can gradually invest (perhaps once per quarter over two years) a good portion of this money into a mix of funds that, overall, is more conservative than the mix she’s using for her 403(b). She can be more conservative because she’d likely tap the nonretirement money first in the future. She should reserve $25,000 in Vanguard’s U.S. Treasury money market fund, which pays more than her bank account. Nell wants to have her emergency reserve in an investment that’s government backed.
Nell can use taxable funds for the other $145,000 because
She’s in a low-to-moderate tax bracket.
She’s nearing retirement.
Investing solely in tax-friendly funds wouldn’t meet her needs. (The stock funds would have to be growth oriented — increasing the risk beyond Nell’s comfort level.)
I recommend that she invest the money as follows:
25 percent in Vanguard Total Bond Market Index
20 percent in Vanguard Wellington
25 percent in Fidelity Freedom 2020
20 percent in T. Rowe Price Retirement 2020
10 percent in Fidelity Puritan
If you’re older than Nell, you can use a similar but more conservative mix of funds. For example, if you’re in your 70s, for the 403(b), you could substitute the Vanguard LifeStrategy Income fund in place of the LifeStrategy Moderate Growth fund and invest 40 percent in that fund and 20 percent each in the other three funds (Wellesley Income, Star, and Wellington). For the nonretirement money, you could shift the Fidelity Puritan money to the Vanguard Total Bond Market Index fund.
Lovin’ retirement: Noel and Patricia
Noel and Patricia, both age 65, are retired, healthy, and enjoying their long days unfettered by the obligations of work. They take long road trips together to pursue their hobbies. Noel is an avid fisherman, and Patricia is a wildlife photographer.
Together, they want about $4,500 per month to live on. Social Security provides $2,000 per month, and Noel’s pension plan kicks in another $1,500 per month. That leaves an extra $1,000 per month that must come from their $400,000 nest egg, currently comprised of
$260,000 in bank CDs
$40,000 in a money market
$100,000 in IRAs, most of it in hybrid funds and bonds
They are in a low tax bracket.
Noel and Patricia have an outstanding $50,000 mortgage at 7 percent interest.
Recommendations: A good portfolio for a retiree must not only provide an income for today’s expenses but also protect income for the years down the road. Noel and Patricia are managing to get by on the current income from their investments. However, with only 10 percent of their nest egg invested for growth in stocks, they’ve left themselves quite exposed to the ravages of inflation. Their retirement could easily last another 25+ years. Unless they allocate their assets more aggressively, their nest egg may not last that long.
They can accomplish all their goals if they’re able to boost their portfolio’s total average annual returns from 6 percent to 8 percent. (You have to crunch some numbers to figure out where you stand in terms of retirement planning; see Chapter 3.) Averaging 8 percent annual returns shouldn’t prove difficult; Noel and Patricia can boost their stock allocation to about 50 percent.
First, however, when the CDs mature, Noel and Patricia should go ahead and pay off the remaining $50,000 of their mortgage. Even if they invested a bigger portion of their portfolio in potentially higher returning investments such as stocks, they can’t easily expect to get an overall return that much better than 7 percent, the interest rate they’re currently paying on the mortgage. True, the tax deductibility of mortgage interest effectively reduces that interest rate a bit, but don’t forget that they must pay income tax on investment dividends and profits as well as on retirement account withdrawals, which effectively reduces the rate of return on their investments.
As evidenced by their current investment choices, Noel and Patricia are conservative, safety-minded investors. And although they could be more aggressive, Noel and Patricia can’t be too aggressive, given their ages. Thus, paying off their mortgage, which carries a 7 percent interest rate, makes good sense. In addition to the psychological satisfaction of owning their home free and clear, by eliminating their monthly mortgage payment, Noel and Patricia will reduce their cost of living, taking pressure off their need to generate as much current investment income.
They can also afford to move quite a bit of money out of their money market fund into better yielding bond funds; $9,000 in the money market, enough to cover six months of expenses together with their Social Security and pension checks, is plenty.
So, after paying off the mortgage and withdrawing cash from the money market, they’ll have $241,000 to invest in funds in a nonretirement account. They could invest it as follows:
20 percent in Dodge & Cox Income or Vanguard Total Bond Market Index
20 percent in Vanguard Wellesley
20 percent in T. Rowe Price Balanced
40 percent in Vanguard LifeStrategy Conservative Growth
Noel and Patricia need about $1,000 per month from this money, which works out to $12,000 per year on $241,000 invested in nonretirement accounts and $100,000 invested in IRAs. To get $12,000 per year from $341,000, those investments would need to produce an income of about 3.5 percent per year. The preceding mix of funds recently yielded about 3 percent, so they would need to use a small amount of principal to reach their annual income goal. For more details about how to plan retirement withdrawals to make your money last, please see my newly coauthored book, Personal Finance for Seniors For Dummies (Wiley).
With their IRAs, they could keep their financial affairs really simple and use a fund of funds, such as Vanguard’s LifeStrategy Moderate Growth.
Dealing with a Mountain of Moola
Sometimes the financial forces are with you, and money pours your way. Hopefully, this windfall happens for good reasons instead of due to a negative event. Regardless, a pile of money may overwhelm you. The good news is that a lump sum gives you more financial options. The following sections describe the ways a couple of people handled their sudden wealth.
He’s in the money: Cash-rich Chuck
Chuck is a successful Pennsylvania entrepreneur in his late 30s. Starting from scratch, he opened a restaurant eight years ago. Today, he’s reaping the fruits of his labor. After several relocations and remodels, Chuck has built himself quite an operation, with 40 employees on the payroll. It’s difficult for him to believe, but his restaurant’s profit is now running at around $500,000 per year. Not surprisingly, money has been piling up at a fast rate. He now has about $800,000 resting in his business bank checking account paying next to no interest.
He owns a home with a mortgage of about $250,000 but has no money in retirement savings plans. Chuck doesn’t want to set up a retirement savings plan at his company because he’d have to make contributions for all of his employees in a plan such as an SEP-IRA or a Keogh (which I cover in Chapter 3).
Chuck has been planning to open another location. He figures that a second location will cost around $400,000, but, as he says, “You just never know with construction work what the total tab may be.” He considers himself a conservative investor.
Recommendations: The first thing Chuck should do is get his pile of money out of the bank and into a safer investment. Bank accounts are federally insured only up to $250,000 — so if his bank fails (and banks have and will continue to fail), he’ll have a lot to cry over. Besides, money market funds pay much better interest than his checking account does.
Chuck has several options for investing his excess money. The first is to pay for the cost of a second location: With his savings, he can likely buy a second location with cash. But he faces a couple of drawbacks to using too much or all of his cash on a second location:
The issue of liquidity: You can’t write checks on a piece of real estate (unless you establish a home equity line of credit).
The issue of diversification: If he doesn’t use all his savings on a second location, he can invest in things other than his business.
Another option for Chuck is to pay off his home mortgage. Yes, he gets a decent tax deduction for his mortgage interest on Schedule A of his Form 1040 — although some of the tax write-off is lost because of his high income. However, because Chuck has all this extra cash, paying off the mortgage saves interest dollars. That would leave $550,000 in his money fund.
If he paid down his mortgage and didn’t want to pay all cash for his second restaurant location, he could take out a business loan. However, that loan would likely be at a higher interest rate than the rate he pays on a mortgage for his home (because banks consider small-business loans riskier). Because some of the home mortgage interest isn’t tax-deductible, the options are close to a financial wash in Chuck’s case. So he could pay off the mortgage and perhaps use some of his remaining money to pay for part of the second location, and the rest could be financed with a business loan.
He should keep a good cushion — say, around $200,000 — for operating purposes for his business. (A bank line of credit may be useful to line up as well). Some entrepreneurs, including those who’ve gone on to achieve great success, have violated these principles — and more — by not only pouring all their savings into their business but also by borrowing heavily. I say: To each his own. There’s nothing wrong with going for it if you’re willing and able to accept the financial consequences. However, if the going gets tough and you don’t have a safety net (such as family members who could help with a small short-term loan), you could get wiped out.
Because Chuck uses his current bank account for keeping his excess cash as well as for check writing, he could establish a tax-free money market fund with check-writing privileges. Some brokerage accounts, such as those offered by discount brokers (such as Fidelity, Vanguard, and TD Ameritrade), offer unlimited check writing. (See Chapter 11 for more on money funds.) Beyond the money market fund, Chuck could begin to invest some money ($100,000 to $200,000) in reasonably tax-friendly mutual funds through Vanguard:
20 percent in Vanguard PA Long-Term Tax-Exempt
35 percent in Vanguard Tax-Managed Capital Appreciation
15 percent in Vanguard Tax-Managed Small-Cap
15 percent in Vanguard Tax-Managed International
15 percent in Vanguard Total International Stock Index
In place of the previously mentioned stock funds, Chuck could use some exchange-traded funds (ETFs). For example, in place of the two domestic stock funds, he could invest in Vanguard’s Total Stock Market ETF. In place of the foreign stock funds, he could use Vanguard’s FTSE All-World ex-U.S. ETF.
Inheritances: Loaded Liz
About a year ago, Liz, who’s in her 40s, received a significant inheritance. She received about $600,000; $150,000 of this sum was a portfolio of individual large-company, higher yielding stocks, and the balance came as cash. The stock portfolio is being managed by an out-of-state adviser, who charges 1.5 percent per year as an advisory fee and places trades through a brokerage firm. Despite the fact that the portfolio usually has only about eight stocks in it, trade confirmations come in about once per month.
Liz currently is a college professor and makes about $50,000 per year. She has approximately $40,000 invested in the TIAA-CREF retirement plan, with 80 percent in the plan’s bond fund and 20 percent in its stock fund. She’s saving and investing about $400 per month in the plan because that’s the amount she can afford. Liz also has $110,000 in a bank IRA CD that will mature soon.
Liz currently owns a home and is happy with it. It has a mortgage of about $90,000 at a fixed rate of 7 percent. She wants to retire early, perhaps before age 60, so that she can travel and see the world. She’s wary of risk and gets queasy over volatile investments, but she’s open to different types of funds. She likes to use many different companies but doesn’t want the headache of a ton of paperwork. Liz prefers doing business over the phone and through the mail because she’s too busy to go to an office.
Recommendations: First, Liz should maximize her retirement contributions even though she thinks that she’s saving all that she can afford. She has all this extra money now that she could draw upon and use to supplement her reduced take-home pay if maximizing her retirement contributions doesn’t leave enough to live on.
This extra cash also affords Liz another good move — getting rid of the mortgage. It’s costing her 7 percent interest pre-tax (around 5 percent after tax write-offs), and she’d have to take a fair amount of risk with her investments to better this rate of return.
Liz also needs to invest her money more aggressively, particularly inside her retirement accounts. All of her IRA and 80 percent of her employer’s retirement plan money are in fixed-income investments. In the TIAA-CREF plan, she can invest 30 percent in the bond fund, 40 percent in its stock fund, and 30 percent in its global equities fund.
She could transfer her IRA account to a discount broker and invest it as follows:
40 percent in Vanguard Star
20 percent in Fidelity Freedom 2030
20 percent in T. Rowe Price Spectrum Growth
10 percent in Vanguard Total Stock Market Index or ETF
10 percent in Dodge & Cox International or Masters’ Select International
After paying down the mortgage and keeping an emergency reserve of $40,000, as well as another $70,000 for remodeling, Liz would have $250,000 in cash plus the stocks. She should sell the stocks because their dividend income is taxable and she’s paying 1.5 percent per year (plus commissions) to have her account managed. The account has underperformed the S & P 500 by an average of 3 percent per year over the past five years. She could transfer these shares to Vanguard’s discount brokerage division and then sell them there to save on commissions as well as to have money at Vanguard to invest in its funds. Then Liz could invest the remaining $400,000 once per quarter over the next two to three years as follows:
20 percent Vanguard Intermediate-Term Tax-Exempt
40 percent Vanguard Tax-Managed Balanced
25 percent in Vanguard Total Stock Market Index or ETF
15 percent in Tweedy Browne Global Value or Oakmark Global
Getting Unstuck . . .
Some people feel overwhelmed when they’re making investing decisions. If you’re one of those people — and if you’re willing to pay the price and put in the hours to interview and select the right person and firm — you can hire a financial adviser (see Chapter 24). But if you’re not willing to put in that time and money, don’t worry — you can still keep things simple (without sacrificing quality). Table 15-1 can help you establish and maintain a simple, yet solid, mutual fund portfolio by using funds of funds (which I discuss in Chapter 13).
Table 15-1 assumes that you’re investing money for retirement and that you’re willing to take on a moderate level of risk. (Remember that, because funds of funds hold thousands of individual securities, they’re more than diverse enough to be used “exclusively.”) When investing money in a retirement account (or if you’re not concerned about taxable distributions, in a nonretirement account), use the recommended mix of funds for your age in the second column. When investing retirement money that happens to be in a nonretirement account, you can avoid taxable distributions by using the recommended selection of funds for your age in the third column.
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Table 15-1 Eric’s Keep-It-Simple Portfolio |
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Your Age |
Suggested Vanguard Funds |
Tax-Friendly Vanguard Fund Mix* |
|
Less than 36 |
100% LifeStrategy Growth |
54% Total Stock Market Index26% Total International Stock Index20% Intermediate-Term Tax-Exempt |
|
36–45 |
50% LifeStrategy Growth50% LifeStrategy Moderate Growth |
47% Total Stock Market Index23% Total International Stock Index30% Intermediate-Term Tax-Exempt |
|
46–55 |
100% LifeStrategy Moderate Growth |
40% Total Stock Market Index20% Total International Stock Index40% Intermediate-Term Tax-Exempt |
|
56–65 |
50% LifeStrategy Moderate Growth50% LifeStrategy Conservative Growth |
33% Total Stock Market Index17% Total International Stock Index50% Intermediate-Term Tax-Exempt |
|
66–75 |
100% LifeStrategy Conservative Growth |
27% Total Stock Market Index13% Total International Stock Index60% Intermediate-Term Tax-Exempt |
|
76–85 |
50% LifeStrategy Conservative Growth50% LifeStrategy Income |
20% Total Stock Market Index10% Total International Stock Index70% Intermediate-Term Tax-Exempt |
|
86 or more |
100% LifeStrategy Income |
13% Total Stock Market Index7% Total International Stock Index80% Intermediate-Term Tax-Exempt |
* If you live in California, Florida, Massachusetts, New Jersey, New York, Ohio, or Pennsylvania, you can substitute the state-specific Vanguard bond fund appropriate for your state in place of the Intermediate-Term Tax-Exempt fund. Although the state-specific bond funds are more volatile because they invest in longer term bonds, they pay slightly higher yields.
* If you prefer to use the Vanguard Tax-Managed funds that I discuss in Chapter 13, simply substitute 67 percent Tax-Managed Capital Appreciation and 33 percent Tax-Managed Small Capitalization for Total Stock Market Index; and Tax-Managed International for Total International Stock Index.
* If you’re investing larger balances and understand ETFs (see Chapter 5), you could use Vanguard’s Total Stock Market Index ETF in place of the domestic stock funds in the table and Vanguard’s FTSE All-World ex-US ETF in place of the foreign stock funds.