Introduction
Pension plans are good and you should consider them when seeking employment. The extent an employer contributes to a pension plan for you will be very positive over time. In some plans, like a 401k, your employer may match your own contributions by a set percentage. Buying company stock can also be part of a retirement plan.
There are a few things everyone needs to know:
Accounting – The financial statements you see about your individual plan account, particularly the 401k, are somewhat misleading by format. Most of the time they have you focused on the total dollar amount of your account which lumps your payroll deductions with the invested part of the plan. You need to separate those items which you can do by examining the information on the statement closer. You may need to break it down manually using principal and income accounting. The problem is that by commingling everything, your invested part could be losing money which is masked by your new money additions to the plan making the total dollar amount of your account larger than before. So for a better understanding, look for the figure that only shows your payroll contributions (new money). Then look for information that shows only the performance of the funds in which you are invested. You can then better see how much you are making. Also, instead of reinvesting back into the funds, it may be better to let any money earned from the fund pay out into your account, kept in the account, and be directed to some type of interest paying account in the plan. Keep in mind that the dividends and capital gains earned from a fund are really new money. If reinvested in the fund they create a new cost basis and a new measurement of performance for that amount. You do not have to reinvest them back into the fund. Again, it can get confusing when they are automatically reinvested in the fund distorting the actual performance. You could end up throwing good money after bad. By taking them as new money and placing them into an interesting bearing fund in the plan you can get faster compounding. In certain periods, it may not make as much but it is at least much safer.
Costs – Operating a plan costs money. These are primarily administrative fees charged by the sponsor who are large financial institutions. Some of these costs may be paid by the employer. There are also investment management fees usually within the plan and in the investment funds you choose. You should familiarize yourself with the costs and if applicable, try to get your employer to regularly search for lower cost plans. All sponsors offer the same types of funds so the performance is not that much different between them, but the operating costs can be.
Management – In many types of plans, such as the 401k and variable annuities, you can direct the investments among the choices inside the plan. The sponsors always recommend that you stay fully invested in stock and bond funds. That advice traps you into their business model. They make the most money for themselves when you are fully invested in those types of funds. Even when the fund is losing, they still make money. Sometimes their fees can be more than the actual performance of the fund. This is a mistake and can lead to poor performance. There are times when you should be more or less invested in any category. Use a cash money market fund in the plan as another investment choice.
Those are the main factors, but before continuing, here is a special note on bonds and bond funds. We have been in a bond bull market since the early 1980’s. It’s an anomaly, especially because it has been going on so long. Even though rates could stay low a while longer, there will be a time when interest rates will resume higher. This will be a problem since many people have never experienced a period of rising interest rates and the effect that has on lifestyle and investment. When rates are rising consistently, the value of existing bonds, particularly with maturities beyond ten years, falls. The interest rate on the bond does not change but the price to sell the bond prior to the maturity date will be lower. The reason is that the interest rate of existing bonds will be lower than the interest rate of new bonds. The lower price valuation on the older bonds brings that discrepancy into balance. Although it could be a while longer before interest rates begin to rise steadily, we are at a crossroads. If interest rates stay low or go lower, it will most likely be because the economy is weak. However, if they begin to creep up as the economy strengthens, it will be bad for the bond market. So it may be prudent to start to reduce your investment in bond funds that hold longer term bonds, those beyond ten years maturity. In particular, if the economy weakens, even though that may be good for bonds, reduce investments in corporate bond funds while leaving government bond funds intact for the moment. Individual bonds are better to own than bond funds. Since funds are usually the only thing available in self directed plans you don’t have that option which is a disadvantage. In a bond bear market, (interest rates going higher), the value of those bond funds could fall behind and never recover. A floating rate bond or fund does not have this problem as the rates will be generally current to the market. It is very important for you to watch interest rates closely as we go thru this cycle.
To conclude the introduction, you need to be aware of the safe money option. Originally, all self directed plans offered an option such as a money market fund, an interest bearing account or a stable value fund. Due to changes in regulations and other matters, some plans no longer have a good safe money option. If you do not have one, have your employer insist that the sponsor add one to the menu. A government money market fund would be a good choice. If some other type of equivalent safe money option is not available, a short to intermediate term government bond fund can be used.
Main Recommendations
First, direct your paycheck deductions to go to a cash equivalent type of fund or interest account in the plan, such as mentioned above. This way, new money is safe and begins earning interest immediately. As that portion of your portfolio grows you can then allocate some funds from that option into other funds. Keep in mind that you want to be very conservative with your pension money. Consider that if a fund goes down 10-20%, it must come back that same amount just to break even. Large losses realized or on paper are hard to make up, especially if you can only use mutual funds. It could also take a long time before they do recover. If you bought the S&P 500 in 2000, you had to wait 14 years for it to come back near the previous high. During that wait, stocks dropped twice terribly. Also, the losses in a plan are not tax deductible.
Due to the instability in the world, market volatility has been high and will probably continue. That risk needs to be actively managed. Also, investment options could be reduced. For instance, if we encounter rising interest rates over time, bonds and bond funds would be less useful for your plan. Also, if the U.S. dollar continues to depreciate, that will have a dramatic effect on your retirement plans. FYI, all paper currencies are losing value due to inflation although the decline has been muted with the current cycle of low inflation. That could change quickly. Some of the loss of value also has to do with government policies. When they say the dollar is strong, what that really means is that with the falling real value of all currencies, the dollar is falling at a slower rate than the others.
At this point, the stock market is valued a bit on the expensive side which would make it a good time to reduce equity positions. You can take some profits now and reduce your risk. Going forward, the strategy of allocating between cash positions and stock funds may be the best. Try to use safer stock funds like the S&P 500 Index or large capitalization funds that pay dividends. Preferably let the dividends and distributions pay into the plan and invest in the cash type fund to begin earning interest. Now some advisers may say that this is market timing and you should not try to do it. What they really mean is they can’t do it or don’t want to try. Remember, they make the most money when you are fully invested in those funds. This is not about day trading; it is taking advantage of cyclical changes in the market. It can be done. I can give you real life examples from the many 401k plans I advise for my clients. In 1999, I began to recommend the sale of the stock funds in the plans. When the tech bubble broke in 2000, my clients were around 30% invested in stock funds and the rest in money market funds. So when the market dropped dramatically, the value of their plans was only slightly lower. Having taken profits earlier they could then invest at lower prices. Again, I began advising in 2007 thru 2008 to redeem stock funds and re allocate into the cash type funds. When the market broke down, the plans already had nice profits and were largely spared the huge losses incurred by everyone who was fully invested. We then bought into the market at lower prices.
This type of management is possible and will lead to strong performance in the pension plan while reducing risk at the same time.
There are two larger scale issues that will affect your retirement.
First. Social Security is in serious trouble as the population ages and the workforce to support retirees may continue to diminish. Last year, there were more expenditures than revenue. Since the Social Security Trust Funds can only invest in government securities there could be a longer term problem developing in the Trust Funds and also in the general budget. There will likely be changes to the retirement ages and the taxing of benefits. Even though your contributions into Social Security are substantial the program will be less valuable to you in the future.
Second. Most States are underfunded in the pension plans they have for their government workers. Some States more than others. If you live in a State with this kind of problem, you may find your State taxes go up over time to pay for that deficit.
In the end, retirement is not just about your savings but also about how society is managed. You need to work on both you individual plans and observe, or better, influence how the government manages our country.