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Underestimating Your Returns

January 12th, 2012

When you are estimating your future value of investments, what kind of return do you plan for? Do you aim high, hoping that the optimism will somehow lift the rate of return on your investments? Or do you try to find the market average and stick to that? What if I told you that it is better to aim low and underestimate your returns on your investments?

401k Performance History

Why Your Expected Returns Matters

Even though I am still getting the hang of investing, I have done considerably more than most of my peers. I am starting to speculate about my retirement age and have been forced to ask myself this same question. I think this is an important question to ask because how I answer it will affect my finances. Here’s why I think it matters.

If I estimate a high return, I can make one of two logical decisions:

get really excited about my potential investments and invest more money.
think that I will have enough money for retirement and fulfill my need to splurge a little (or a lot) on things I don’t necessarily need.

While a person’s response to their expectation may vary from person to person, it should be clear that regardless of the response, your expected return affects how you approach your finances and therefore important to consider carefully.

Why I Choose to Underestimate My Returns

When I realized why this question was important, I realized that I didn’t want to lean towards over-estimating my returns. I think this can be a dangerous position to put yourself in. You may over-anticipate a return and even if you go the route of investing more money, you could run the risk of investing too much money in something that won’t perform well at all. This could put me and my family in a difficult position later in life and I don’t want to do that.

So, the question then goes to whether I want to go with the market average, or under-estimate my returns. At first glance, the market average would seem to offer you the best route, right? It would be the most accurate thing to gauge your expected return on your investment and therefore make you better informed for how much you need to invest. There will be ups and downs, but sure the average is the best route to go, right?

Because I don’t choose individual stocks, I know that it will perform with the market average or close to it. Yet, I choose to plan my retirement according to conservative figures for two reasons. Underestimating my return leads me to invest more money. While I could plan my retirement and figure how much I should invest each month/year on the market average, I choose to use a lower % in order to give myself some cushion. I am a person that likes to play it safe. The adage, “Better safe than sorry” echoes in my mind as I type this. The second reason that I underestimate my earnings is because of the potential to win big. If I plan on a modest 5-6% throughout my working years and end up making an average 8-9%, it will seem like I won the lottery when I go to retire. A difference of a few percentage points could make a difference of hundreds of thousands of dollars over 30-40 years.

Overall, underestimating my returns forces me to be more frugal, invest more now, be prepared for a low return. I would much rather be more aggressive in the amount that I am investing now and have financial security later, than to be forced to go back to work when I am 70+.

What kind of return do you plan for?

This was a guest post by Wayne at Young Family Finance. He writes about the every day financial challenges that young families face, like the cost of owning a dog or figuring out an appropriate tip.

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Posted in Retirement

Tags: investment returns lifetime investment returns planning retirement retirement returns saving for retirement

Losing Free Money By Not Participating in a 401k Plan

September 1st, 2011

I once had this friend (let’s call her Daphne) that was a brilliant, vibrant account executive at a large financial company.

I was always impressed by this individual, both with her energy and how fast she processed information. One day we met up for lunch and discussed stock market investing strategies. I was shocked to hear that while Daphne had a regular brokerage account and did some trading, she didn’t participate in her employer’s 401k Plan. To me, her not being in a 401k was analogous to a dolphin that doesn’t like to get wet! I was amazed!

Assuming that her employer’s 401(k) plan was horrible with no match, I commented something along the lines of “your employer’s 401k suck, huh”. Daphne then told me no, in fact she said it was quite generous. Obviously now I was curious, so I asked about the details of her 401k plan. She said that they matched 200% on the first 1% of the participating employee’s salary, then 100% the next 4% of the employee’s salary. Such a plan is very respectable!

Actually it was the first time I had heard of a 200% match, that was pretty amazing in my book. so I asked her if she contributed at least 1% of her employer’s 401k plan. She said “no”. No? I said incredulously. “No”, she said again. Now I think it’s crazy to pass up 100% match on money, but to pass up a 200% match just seems stupid?

So I asked “Why”, in a voice that was a bit too high-pitched (think of when you hear people say “Really” in such a tone).

She explained to me about how she was divorced and money was tight, then she said that all her relatives have died early and she expect to go out the same way. When I heard this, I thought “But you have 2 kids?”. Just being a friend though, I had to nod my head acknowledging that it sounds tough. But then I said, perhaps she could do the 1% then do a hardship withdrawal, but she said the paperwork wouldn’t be worth it. And I understand her point, so we parted ways after a great lunch.

1 Year Later…

About 1 year later, we were at lunch again, celebrating that she got a promotion (a 50% increase in pay, very impressive) at work. After an entertaining and fun lunch, I asked if she decided to open a 401k now that she has a lot more money. Surprisingly, she said NO. I was at a loss for words. How could a person that is physically beautiful and mentally gifted not see the value in contributing to such a generous 401k plan?

This was the first time I began to believe that even smart people make bad financial moves sometimes. My friend has since move to a different state (her employer is very large) and I’m bad at keeping touch. I wish her well, and hope that she finally broke down and decided to participate in a 401k plan…

What do you think of my friend? Do you think that she is afraid that she will jinx herself by opening a 401k plan? Perhaps she believe that if she does, she will die earlier since her family dies early…

Why would an otherwise brilliant person not take advantage of free money?

Bests,

MR

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Posted in Retirement

Tags: 401k foolishness 401k miss 401k plan employer match on a 401k plan losing free money money mistake money mistake by genius passing on a 401k plan passing on free money

The DOs and DON’Ts of Retirement Plans After a Layoff

July 14th, 2011

The dos and don’ts of retirement plans after a lay off

Since the economic downturn, more and more people have found themselves being laid off from work. But, if you were part of a retirement plan with your employer, for instance a 401(k), then what should you do with it if you are laid-off from your job?

Coming up are some of the dos and don’ts to help you decide the best course of action should you find yourself in this predicament.

DO…ask for help.

Company layoffs are a very complicated area and there are a variety of circumstances that can affect your severance package, including the size of the payoff you receive and what happens to your employer-offered benefits.

That is why it is a good idea to seek professional financial and legal advice if you find that you are being laid off. Be sure to pick a representative that has a good grasp of company and employment law and can go through your employment contract and enter into a dialogue with your employer about the details of your severance package, including things such as payment of unused holidays and the matched payment into your 401(k).

DON’T…rush into any decisions.

The stress of being laid off can make it easy to rush into decisions regarding your severance package as you don’t want to drag out any dealings with the company that is laying you off.

However, there are some very important financial decisions to be made that will have a direct impact on your future so you should take your time and seek advice on the best way to manage your benefits.

And don’t let your (former) employer hurry you along as if you have over $5,000 in your 401(k) you can leave your (former) employer to sit on it until you are 65.

In the meantime you can determine whether to just leave the current plan running or open a new account, such as an IRA.

Again, it may be a good idea to seek professional financial advice at this point in order to ascertain what your best course of action is.

DO…be aware of your rights.

As mentioned earlier, company layoffs are a very complicated area and certain benefits are protected by law. For instance, if you are under the age of 59½ and you have been retired then you may be eligible for a 72T distribution which will enable you to access some of your 401(k) without paying the 10 per cent penalty fee.

Another instance whereby your 401(k) is protected is if you lost your job through a company-wide downsizing in which at least 20 per cent of employees were laid off. If this is the case then you are considered to be fully vested as you are part of a ‘partial termination’ of the 401(k).

As before, it is a good idea to seek professional advice on your rights.

DON’T…cash it in.

When you lose your job your whole world is turned on its head as you are facing the very real prospect of not being able to meet the demands of your personal finances. And because so many people are worried about how they will meet the repayments on mortgages, loans or credit cards when they are out of work, they cash in their 401(k) to give themselves some breathing space and meet the urgent bills.

However, when you cash in your 401(k) you leave yourself open to taxes and penalty fees and you also lose any cumulative savings benefits.

Once again, it is worth seeking professional advice at this point to work out the best way to grow your savings.

This article was provided by Andreas Nicolaides, a personal finance author at UK-based MoneySupermarket.com.

Thanks,

MR

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Posted in Retirement

Tags: layoff 401k Retirement plans after getting layoff severence package

First Look: Individual 401k

April 25th, 2011

You may have heard of this investment option by the names “Solo 401k” or “Self Employed 401k“, but I like the name Individual 401k, so that’s what I’m going to use to describe this great retirement option.

What Is An Individual 401k?

It’s a plan that enables small business owners (preferrably one with no employees) to contribute much more than a Roth IRA. This plan allows you can contributed up to $49,000 a year, if you have enough profit! How’s that for a contribution!!!

If you are self-employed you can contribute $16,500 + 25% of your compensation from your business… up to $49,000.

If you have a very profitable business, this would definitely be an option to consider!

The tax benefits of an individual 401k are as follows.

Contributions to an Individual 401(k) plan are tax-deductible
Earnings grow tax-deferred.
Contributions are not taxed until withdrawn.

The Individual 401k is most benefitial to small businesses that don’t have any employees. Once an employee enters the picture the paperwork gets much more complex, since the plan must be offered to each employee.

I’m not in a position to take advantage of this great option. But if you own a small put profitable business where you don’t have any employees, this plan may just be your thing!

Interested in opening up an individual 401k, check out at Charles Schwab’s Individual 401k offering.

-MR

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Posted in Retirement

Tags: individual 401k retirement plan Self-Employed 401k Solo 401k

3 Strategies to Maximize Benefits from your Pension Annuity

December 21st, 2010

3 Strategies to Maximize Benefits from your Pension Annuity

If you are in the process of looking for a pension annuity that will protect both you and your spouse from financial problems in the future and provide you with income for your retirement, it goes without saying that you will want to do everything in your power to find the annuities with the most benefits for the money that you invest. This is an extremely important thing to make sure of, since a pension annuity is an investment that will protect you during a time of your life when your age and physical condition can restrict the type of work that you are capable of doing.

The first thing that most people think of when they are looking for the best pension annuity to invest in for their future is the interest rate that it provides. They are also often heavily concerned about which plans will offer the most benefits as well. But in order to get the most out of a pension annuity, it is important to carefully choose which features should be purchased in which combination in order to get the most out of the plan. There are several different ways in which this can be accomplished.

Here are 3 ways in which to combine features to get the most out of a pension annuity.

1. One option that you have is to wait a while before you decide to purchase an annuity if this is a possibility for you. In most cases, you can only buy an annuity if you are between the ages of 55 and 75. The later on in your life you are when you decide to purchase an annuity, the more money you can expect to receive in return for your investment. The reason for this is that you will receive larger monthly payments. This is because your remaining lifespan is expected to be shorter. The shorter the amount of time remaining in your life, the more money the insurance company can pay out each month, which gives you more money to live off of without having to continue working.

2. Another possibility is to think about is who to purchase an annuity under if it is a joint annuity. It is often a good idea to purchase the annuity under the husband’s name. The reason for this is the fact that men are expected, on average, to live for a shorter period of time. For this reason, when an annuity is purchased under the husband’s name instead of the wife’s, the payments are typically larger because fewer years of life are expected.

3. When looking at the plan, it is also a good idea to look at it in order to find out if impaired life benefits are included in the annuity. As an example, if you have a medical condition that reduces you life expectancy, this should also be another reason that the insurance company will offer larger payments each month. This might seem backward to people who are used to shopping for health insurance, which will charge higher premiums if you have a health condition. Even so, this is how it works. The shorter your expected lifespan, the larger the monthly payments.

Of course, these three strategies are not everything when it comes to deciding on a plan that is right for you. It is also very important to shop around in order to find the best company available. The company should not only offer good rates, it should have a long history demonstrating that it is financially stable.

Annuities are one of the few financial topics that I don’t have much experience with, so the guest post Lisa is very welcome!

I hope you enjoyed and learned something new from this post on annuities!

-MR

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