By: Thomas W. Batterman, CTFA
Today, people are thinking about their retirement finances wherever they happen to be in the workcycle. Whether you have IRAs, a 401(k) plan or a 403(b) program, retirement fund investments need to take into account your financial objectives, as well as how any other money is invested.
Although some investors look for some magic formula to assure success, there isn't one. Anyone should be questioned who tries to convince you that they have the answer. At the same time, it is critically important that the overall investment mix between stocks and bonds be appropriate for your overall financial situation.
If you have 15, 20, or more years to go before you will be accessing your retirement funds, you do not want your investing to be too conservative. You want to make sure you have at least some investments, if not a majority, in the stock market, either directly or indirectly, through mutual funds.
International investments should not be ignored. Some money should be invested in stocks abroad, including the emerging international markets. An appropriate overall mix is important. For example, the emerging international markets have outperformed the S & P three to one through September 30, 1999. A strategic allocation strategy helps take out wild swings in the performance of specific asset classes while keeping your portfolio focused on your specific financial objectives.
Unequivocally, annuities should be avoided. There is simply no place for annuities in a 401(k) or 403(b) account. Whether fixed or variable, annuities are relatively inefficient as investment vehicles. Their main benefit, deferral of tax on earnings, is of no value in a retirement account since those earnings are already tax deferred. You are only paying extra for a tax deferral feature in an annuity that has no value to you. Investing directly in stocks, bonds, or mutual funds save the cost of the annuity wrapper and should lead to better performance regardless of your objective.
Even worse, many investors are seduced into buying annuities with the lure of what appears to be a high return. Just like the credit card offers of a low, low "introductory" interest rate that quickly disappears and is replaced by a high rate, so do promotional rates on fixed annuities, last generally for a year and then can drop to 3% or 4%. When the investor sees what's happening and attempts to get out, there is a severe penalty for early withdrawal.
In the same way, variable annuities are nothing more than mutual funds wrapped in an insurance contract. Which mutual funds are used? Those of the insurance company, of course.
There is also the issue of the fees charged by companies selling annuities. These are usually high and may be "embedded" so they are not easy to detect by investors. The problem with paying high fees is obvious; your retirement money is being drained off, thus harming your return. In effect, your financial pocket is continually being picked.
It's only fair to say as you approach retirement, your overall investment philosophy should become slightly more conservative. Your portfolio's stock exposure should be gradually reduced in favor of developing more significant exposure in fixed-income vehicles such as CDs, government bonds or high quality corporate bonds.
As you go through this process, do not forget the differing tax treatments available to you on gains in your stock portfolio. For the younger investor, the compounding effect of stock market returns on a tax-deferred portfolio is a powerful wealth building tool.
This changes, however, as you get older. Then, the growth on your stock portfolio inside of your retirement account is ultimately going to be taxed at ordinary income tax rates. That same gain outside of your retirement portfolio will be taxed at much more favorable capital gain rates and may actually completely avoid tax at your death because of stepped-up basis rules!
As you near and enter distribution stage on your retirement accounts, consider shifting your retirement account investments more heavily toward fixed-income instruments and moving your non-retirement investments more heavily toward stock investments. The tax-deferred compounding of stock market returns that is important when you are younger often creates a higher tax cost as you approach and enter retirement. Be sure to keep your overall balance of stocks and fixed income in line, though.
As you do this, the vehicles you use for stock investing may have to change. Inside a tax-deferred retirement account, mutual fund capital gain distributions are of no consequence. However, these same distributions outside your retirement account can dramatically impact your tax liability-- and you have very little control over the realization of your gain. You can't control when a fund chooses to pay dividends. An adjustment in your method of obtaining your stock exposure might be warranted, since obtaining exposure through individual stocks gives you better control of capital gains than do mutual funds.
Where should you put your retirement money? As can be seen, it all depends on where you are, whether you are younger or getting closer to retirement. The key to successful retirement fund investment is having the right strategy for your stage of life and adjusting as you go along.
* * * * * * * * *
Thomas W. Batterman, CTFA and President and Senior Relationship Manager for Vigil Trust & Financial Advocacy, Wausau, WI, has 17 years of experience in the financial advisory field. He is a licensed attorney and is a member of the National Association of Personal Financial Advisors. His firm, Vigil Trust & Financial Advocacy, was started in 1988 as the State of Wisconsin's only registered investment adviser with full corporate trust capabilities and is a founding member of the Association of Independent Trust Companies.