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June 1, 2003

Avoid Borrowing From Your 40l(k) Plan

Your 401(k) plan is such a tempting place to borrow money from. There are no credit checks or lengthy applications to fill out. You typically receive the loan proceeds in a couple of weeks. Loan proceeds can equal up to the lesser of 50% of your vested interest in the plan or $50,000. The loan can be repaid over five years, longer if it is used to purchase a primary residence. The interest rate is reasonable, typically one or two percentage points over the prime rate.

So why shouldn't you borrow from your 401(k) plan? The most important reason is probably psychological. Your 401(k) plan is intended to help fund your retirement. It shouldn't be used as a piggy bank to dip into every time you need money. If you're serious about your retirement plans, the money in your 401(k) plan should be allowed to grow over the years. Even though you are paying the loan back to your 401(k) plan, investments were sold to provide you with the loan proceeds. While the loan is outstanding, you forego tax-deferred investment growth on that money.

There are other concerns as well. The loan payments must be made on time or the loan is considered a distribution, subject to ordinary income taxes and the 10% federal income tax penalty. If you are laid off, you might have trouble making those payments. And if you lose your job or change jobs, the entire outstanding principal must be repaid in a relatively short time or it will be considered a distribution. You also want to ensure that the amount of the loan repayment won't cause you to reduce or eliminate new 401(k) contributions.

Consider other loan options instead. If you have equity in your home, look into a home-equity loan. Interest rates on home-equity loans tend to be comparable to rates on 401(k) loans. In addition, the interest paid on the home-equity loan is typically tax deductible if the loan balance is less than $100,000. Since interest paid on a 401(k) loan is not tax deductible, a home-equity loan may actually have a lower after-tax cost.

When Should You Start Your Social Security Benefits?

When should you elect to receive Social Security benefits -- at age 62, full retirement age (which is gradually increasing from age 65 to age 67), or age 70? The decision will permanently affect your Social Security benefits. Start at age 62 and your benefits will be permanently reduced by 20.8% to 30%, depending on your year of birth. Wait until age 70 and your benefits will increase by 3.5% to 8% annually, depending on your year of birth.

Since Social Security benefits probably won't be sufficient to maintain your current standard of living, first decide whether you have sufficient retirement resources to even consider retiring at age 62. If that is not an issue, keep in mind that it will take approximately 12 years for someone electing benefits at age 65 to receive the same total benefits as someone electing reduced benefits at age 62. It takes approximately 11 to 14 years for someone electing increased benefits at age 70 to receive the same total benefits as someone electing benefits at full retirement age. You may want to calculate precise numbers for your situation, since your full retirement age and the percentage reduction in benefits at age 62 will impact your answer.

For most individuals, the long payback period may make it worthwhile to start benefits at age 62. And, in fact, more than 60% of retirees elect benefits before age 65, while less than 2% wait until age 70 (Source: U.S. News & World Report, June 3, 2002). But there are a couple of situations when you might want to wait until full retirement age.

If you plan to continue working, consider delaying benefits. Individuals who have attained full retirement age can earn any amount of wages without losing any Social Security benefits. However, between the ages of 62 and 65, you lose $1 of benefits for every $2 of earnings over $11,520 in 2003. Between the ages of 65 and your full retirement age, you lose $1 in benefits for every $3 of earnings over $30,720 in 2003. Individuals earning substantially more than these limits will probably want to wait to start Social Security benefits.

If your spouse is significantly younger and is counting on your benefits, you may also want to delay benefits. While you are alive, your spouse is entitled to the larger of 100% of his/her benefit based on his/her earnings or 50% of your benefit at full retirement age. However, if you elect benefits before full retirement age, your spouse's benefits will be reduced by a higher percentage than your benefits were reduced, provided he/she obtains benefits based on your earnings. If you delay benefits past full retirement age, you receive increased benefits, but your spouse's benefits remain the same, provided he/she obtains benefits based on your earnings.

After your death, your spouse's benefits are based on your benefits and the age he/she elects to receive benefits. He/she receives 100% of your benefit, provided your spouse is over the full retirement age. If he/she is younger than full retirement age, your spouse receives between 71.5% and 100% of those benefits. Thus, the larger your benefit is, the larger your spouse's benefit will be after your death.

Retiring Without Worry

If you're like most people, the recent market decline has done more than cause your investments to decline substantially. It's probably also caused you to rethink your retirement plans. After all, the only thing worse than retiring later than you planned is to retire and quickly run out of money.

But how can you ensure you'll have sufficient funds to last your entire retirement? So many of the variables used to calculate how much you need for retirement seem uncertain. What is a reasonable rate of return for your investments over the long term? How long will you live, knowing life expectancies are increasing? How much can you count on from Social Security and pension plans? If you're concerned about running out of money during retirement, then you need to be very conservative with your retirement assumptions. Some tips to consider include:

  • Assume your retirement expenses will be at least 100% of your current expenses. Most rules of thumb indicate you need between 70% and 100%, but figure on 100% to be safe. Nowadays, retirees want to travel, pursue hobbies, and live an active lifestyle. That generally means you'll need the higher end of these estimates.

  • Add a few years to your life expectancy. You should probably plan on living until at least age 85 or 90. If your family has a history of longevity, add a few more years to these figures. While you may find it hard to believe you'll live this long, you don't want to reach age 75 or 80 and find out you've run out of money. At that point, you might not have the option to return to work.

  • Reduce your estimates of Social Security benefits. The Social Security Administration sends benefit statements every year around your birthday, telling you how much to expect in benefits. While the Social Security system is currently in sound financial condition, that is expected to change after all the baby boomers retire. To be safe, count on benefits that are somewhat less than the Social Security Administration is estimating and don't plan on adjustments for inflation.

  • Cut back on your living expenses now. This has a two-fold impact on your retirement. First, it frees up money to set aside for your retirement. Second, you get used to a lower standard of living, which should also reduce your expected lifestyle for retirement.

  • Reach retirement with no debts. Mortgage and consumer debt payments consume a significant portion of most people's income. Pay off all those debts by retirement and you significantly reduce your cost of living.

  • Forget about early retirement. Saving enough to last from age 65 to age 85 or 90 is a daunting task. Trying to retire at age 55 or 60 is just not practical for most individuals, unless you're willing to significantly reduce your lifestyle. Working a few more years can go a long way in helping fund your retirement. Those years are typically your highest earning years, so hopefully you'll save significant sums during that period. Also, every year you work is one year you don't have to support yourself with your retirement savings.

  • Consider working during retirement. Especially during the early years of retirement, you should consider working on at least a part-time basis. Even modest earnings can help significantly with retirement expenses.

  • Plan on making conservative withdrawals from your retirement assets. Don't plan on taking out more than 3% to 4% of your balance annually. With that level of withdrawal, your funds should last for decades.

Another Look at Risk Tolerance

After all the pain caused by market volatility over the past three years, how much have we learned about our tolerance for risk? We know we're much happier when the stock market is going up rather than down. We probably realize our portfolios were too risky back in 2000 and wish we had made different choices back then. But how many of us have actually assessed our tolerance for risk and made portfolio choices based on that assessment?

What you are trying to assess is your emotional tolerance for risk, or how much price volatility you are comfortable with. Some questions that can help you gauge that risk tolerance include:

  • What long-term rate of return do you expect on your investments? This will help you determine the types of investments needed to meet that target. Review historical rates of return over a long time period to see if your estimates are reasonable. High return expectations can cause you to invest in asset classes you aren't comfortable with or that you may be tempted to sell frequently. A better alternative may be to lower your expectations and invest in assets you are comfortable owning.

  • What length of time are you investing for? Some investments, such as stocks, should only be purchased for long time horizons. Using them for short-term purposes may increase the risk in your portfolio, since you may be forced to sell during a market downturn.

  • How long are you willing to sustain a loss before selling? The market declines of the past three years will give you some indication of how comfortable you are holding investments with losses.

  • What types of investments do you own now and how comfortable are you with those investments? Make sure you understand the basics of any investments you own, including the historical rate of return, the largest one-year loss, and the risks the investment is subject to. If you don't understand an investment or are not comfortable owning it, you may be tempted to sell at an inopportune time. Over time, your comfort level with risk should increase as your understanding of how risk impacts different investments increases.

Ensuring your investments are compatible with your risk tolerance is an important component of your investment strategy.

Getting Your Investment Portfolio Back On Track

The recent market declines have been steeper and of longer duration than many expected, making it difficult to determine how to adjust your portfolio. Should you leave it alone, hoping the market will quickly rebound to much higher levels? Or should you sell everything and put your money in cash accounts? The appropriate answer probably lies somewhere between those two extremes. What you should do is thoroughly review your portfolio. Consider these tips when analyzing your portfolio:
  • Take another look at your financial goals. Now it's time to face reality. If your portfolio declined substantially in the past three years, it will probably affect your financial goals. Recalculate how much you need to save on an annual basis, based on your investments' current value and a reasonable future rate of return. Be prepared to readjust your goals. For many people, one of the most painful results of the market declines has been the realization that they are now going to have to delay retirement.

  • Set an asset allocation strategy for the long term. The most basic investment decision you'll make is how to allocate your portfolio among the various investment categories, such as cash, bonds, and stocks. You want to ensure your portfolio is diversified among a variety of investments, so when one category is declining, hopefully other categories will be increasing or not decreasing as much. To decide how to allocate your portfolio, you'll first need to come to terms with your risk tolerance. Factors like your time horizon for investing and return expectations will also impact your decision. Once you've decided on an asset allocation strategy, you'll need to adjust your current portfolio to get it in line with that allocation.

  • Thoroughly review each investment in your portfolio and decide whether you should continue to own it. Some stocks will rebound from the recent market declines, while others may never rebound. If you think an investment won't rebound or will take a long time to do so, you may want to sell it and reinvest in others with better prospects. It's a painful thing to do, since most investors have an aversion to selling at a loss. But it's an important step if you want to make sure your portfolio is on track going forward. Also make sure your remaining investments are all adding diversification benefits to your portfolio. Just because you own a number of investments doesn't mean you are properly diversified. Often, investors keep purchasing investments similar in nature. That doesn't add much in the way of diversification and makes the portfolio difficult to monitor.

  • Look for investments you'll be comfortable owning for the long term. It's tempting to look for the biggest winners in investments and put your money there. In essence, however, you are chasing yesterday's winners rather than tomorrow's winners. You need to keep in mind that the best performing investment category will change from year to year. A better strategy may be to select a diversified portfolio of investments you'll be comfortable owning for the long term, so you have some money invested in each of the major investment categories.

  • Use dollar cost averaging to invest. If you've been investing throughout the market declines, you have probably been purchasing at lower and lower prices, making you wonder whether it makes sense to keep putting money in the market. The point of dollar cost averaging is to invest a set amount of money in a certain investment on a periodic basis. When prices are lower, you will purchase more shares than when prices are higher, following half of the investing principle of "buy low and sell high." But the most important part of dollar cost averaging is that it forces you to continue investing when you really don't want to invest. In the long run, when and if the stock market rebounds, you will probably be glad you had the discipline to continue investing during this market downturn. (Keep in mind that dollar cost averaging does not guarantee a profit or protect against losses. Because it involves continual investment regardless of fluctuating price levels, you should consider your ability to continue investing through periods of low price levels.)

  • Pay attention to taxes. Taxes are probably your portfolio's largest expense. Ordinary income taxes on short-term capital gains and interest can go as high as 35%, while long-term capital gains are taxed at rates not exceeding 20% (10% if you are in the 15% tax bracket) for sales before May 6, 2003 and at rates not exceeding 15% (5% if you are in the 10% or 15% tax brackets) for sales on or after May 6, 2003. Dividend income is now taxed at the same rates as long-term capital gains. Using strategies that defer income for as long as possible can make a substantial difference in the ultimate size of your portfolio. Some strategies to consider include utilizing tax-deferred investment vehicles (such as 401(k) plans and individual retirement accounts), minimizing portfolio turnover, selling investments with losses to offset gains, and placing assets generating ordinary income or that you want to trade frequently in your tax-deferred accounts.

  • Review your portfolio at least annually. You can't just adjust your portfolio now, and then leave it on autopilot. You need to keep an eye on your portfolio, in case market or company situations require changes. By reviewing your portfolio annually, you'll have an opportunity to make adjustments on an ongoing basis, which should prevent major overhauls in the future.


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