Just How Risky Is Your Portfolio?
If you're like most people, you probably evaluate your portfolio in terms of its return. However, return isn't the only factor you should consider; also important is the amount of risk you take in pursuing those returns. The term "risk" is often understood to mean the risk of loss. However, a portfolio is generally a means to an end, such as paying for retirement or a child's college tuition. In that context, "risk" also means the risk of not meeting your financial needs. Risk-adjusted return Let's say that Don's portfolio earns an average of 7% a year for 10 years. However, his annual returns have been very uneven; one year his return might be 11%, another year it might be down 10%. Meanwhile, Betty's portfolio also has averaged a 7% annual return in the same time, but her returns have been more even; she hasn't had spectacular years, but she has avoided any negative annual returns. You might think both would end up with the same amount of money after 10 years, but that's not necessarily the case. It depends in part on the timing and size of the declines in Don's portfolio. A big loss in the first year or two means he'll spend valuable time recovering rather than being able to make the most of compounding; that can affect future growth. That's why it's important to consider an investment's risk-adjusted return. Volatility measures One of the most common measures of volatility is standard deviation, which gauges the degree of an investment's up-and-down moves over a period of time. It shows how much the investment's returns have deviated from time to time from its own average. The higher the standard deviation of an investment or portfolio, the bumpier the road to those returns has been. Another way to assess a portfolio's volatility is to determine its beta. This compares a portfolio's ups and downs to those of a benchmark index, such as the S&P 500, and indicates how sensitive the portfolio might be to overall market movements. An investment or portfolio with a beta of 1 would have exactly as much market risk as its benchmark. The higher the beta, the more volatile the portfolio. (However, remember that investments also have unique risks that are not related to market behavior. Those risks can create volatility patterns that are different from the underlying benchmark.) The risk of not achieving your goals Another way to evaluate risk is to estimate the chances of your portfolio failing to meet a desired financial goal. A computer modeling technique known as Monte Carlo simulation generates multiple scenarios for how a portfolio might perform based on the past returns of the asset classes included in it. Though past performance is no guarantee of future results, such a projection can estimate how close your plan might come to reaching a target amount. Let's look at a hypothetical example. Bob wants to retire in 15 years. A Monte Carlo simulation might suggest that, given his current level of saving and his portfolio's asset allocation, Bob has a 90% chance of achieving his retirement target. If he chose to save more, he might increase his odds of success to 95%. Or Bob might decide that he's comfortable with an 85% chance of success if that also means his portfolio might be less volatile. (Be aware that a Monte Carlo simulation is a projection, not a guarantee.) Are you getting paid enough to take risk? Another approach to thinking about portfolio risk involves the reward side of the risk-reward tradeoff. You can compare a portfolio's return to that of a relatively risk-free investment, such as the inflation-adjusted return on a short-term U.S. Treasury bill. Modern portfolio theory is based on the assumption that you should receive greater compensation for taking more risk (though there's no guarantee it will work out that way, of course). A stock should offer a potentially higher return than a Treasury bond; the difference between the two returns is the equity's risk premium. While understanding risk premium doesn't necessarily minimize risk, it can help you evaluate whether the return you're getting is worth the risk you're taking. |
Understanding 401(k) Plan Fees and Expenses
If you direct your own 401(k) plan investments you'll need to consider the investment objectives, the risk and return characteristics, and the performance over time of each investment option offered by your plan in order to make sound investment decisions. Fees and expenses are factors that may affect your investment returns, and therefore impact your retirement income. Why should I care about plan fees? In a 401(k) plan, your account balance will determine the amount of retirement income you will receive from the plan. While contributions to your account and the earnings on your investments will increase your retirement income, fees and expenses paid by your plan may substantially reduce the balance of your account. Assume that you're an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7% and fees and expenses reduce your average returns by 0.5%, your account balance will grow to $226,556 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5%, however, your account balance will grow to only $162,846. The 1% difference in fees and expenses would reduce your account balance at retirement by 28%.* The following table demonstrates how varying levels of fees and expenses can impact the growth of a hypothetical 401(k) plan account after 35 years, assuming a $25,000 starting balance, 7% annual return before expenses and fees, and no additional contributions. Average Annual Fees and Expenses Ending Balance After 35 Years* 0.0% $266,915 0.5% $226,556 1.0% $192,152 1.5% $162,846 How do I learn about my plan's fees? The first step is to become informed about the different types of fees and expenses charged by your plan, and the way they are allocated to plan participants. The best way to do this is to study the fee disclosure information that your 401(k) plan provides to you. Investment fees By far the largest component of 401(k) plan fees and expenses is associated with managing plan investments. Your disclosure statement should clearly indicate the total annual operating expenses of each investment option. For example, in the case of a mutual fund, these operating expenses may include investment management fees and 12b-1 fees. These fees are charged against the assets of the fund and reduce the fund's total return. The annual operating expenses will be shown both as a percentage of assets (expense ratio) and as a dollar amount for each $1,000 invested. For example, a fund may have an expense ratio of.15%, or $1.50 for each $1,000 invested. In this case, $10,000 invested in the fund would cost $15.00 annually (10 times $1.50). Your plan's disclosure material will also describe any shareholder-type (transaction) fees that apply to each investment option--things like sales charges and loads, withdrawal fees and surrender charges, and fees to transfer between investment options. Your plan must also provide a chart that lets you easily compare information about each investment option. For example, if your plan allows you to choose among different mutual funds (or from different families of mutual funds), the difference in fees and expenses may help you choose between two or more funds that are otherwise similar in performance and investment strategy. Administrative fees The day-to-day operation of a 401(k) plan also involves expenses for basic services--plan record keeping, accounting, legal and trustee services--that are necessary for administering the plan as a whole. Sometimes employers pay these expenses. Sometimes they're paid by the plan, and either allocated to all participants in proportion to account balances (that is, participants with larger accounts pay more of the allocated expenses) or charged as a flat fee to each participant's account. Your fee disclosure should contain an explanation of any fees and expenses that may be charged to participants' accounts. You'll also receive an explanation of any fees and expenses that may be charged to your individual account--for example, fees for taking out a loan or processing a qualified domestic relations order. Remember that fees and expenses are just one factor to consider when choosing an investment for your 401(k) plan account. You'll also need to consider a fund's investment performance in relation to the fees charged. However, all things being equal, minimizing the fees and expenses you pay to your 401(k) plan may help you increase your retirement nest egg--so be informed and review all your options carefully. |
Retirement Plans for Your Small Business
A retirement plan is a critical part of a competitive benefits package. Although small business owners can sponsor a qualified retirement plan like a traditional 401(k), profit-sharing, or defined benefit plan, these plans can be expensive to maintain and relatively difficult to administer. Luckily, there are a number of simpler alternatives. Simplified employee pension (SEP) plans A SEP plan allows small business owners to set up traditional IRAs, called SEP-IRAs, for themselves and each employee. You must generally contribute a uniform percentage of pay, up to 25%, for each eligible employee (up to $50,000 in 2012), but you don't have to make contributions every year. The plan must generally cover any employee aged 21 or older who has worked for you for three of the last five years and who earns $550 or more during the year. Your employees don't directly contribute to the SEP plan, although they can make their regular annual IRA contributions to their SEP-IRAs if they choose (SEPs are traditional IRAs and can't accept Roth IRA contributions). All contributions to the plan are fully vested (that is, immediately owned by your employees), and your contributions are fully deductible. Most employers, regardless of size, can establish a SEP plan. SEP plans have low startup and operating costs, and can be established using a two-page IRS form. SIMPLE IRA and SIMPLE 401(k) plans You can adopt a SIMPLE IRA plan if you have 100 or fewer employees who earn $5,000 or more. A SIMPLE IRA plan lets your eligible employees contribute a percentage of their salary on a pretax basis, up to $11,500 in 2012 ($14,000 for employees age 50 and older). Each employee who earned $5,000 or more in any two prior years, and who is expected to earn at least $5,000 in the current year, must be allowed to participate in the plan. You're required to either match each employee's contributions dollar for dollar--up to 3% of the employee's compensation--or make a fixed contribution of 2% of compensation for all eligible employees. (The 3% match can be reduced to 1% in any two of five years.) Like SEPs, all contributions to the plan are fully vested, and your contributions are fully deductible. SIMPLE IRA plans are easy to set up (you fill out a short IRS form to establish the plan), easy to administer, and inexpensive to maintain. You can let each employee set up a SIMPLE IRA account at a financial institution of his or her choosing, or you can select the financial institution that will serve as trustee and initially hold all plan contributions. Note that unlike any other retirement plan, early withdrawals (before age 59½) from SIMPLE IRAs during the first two years of participation are subject to a 25% penalty tax, unless an exception applies. After the first two years of participation, the penalty tax drops to 10% (consistent with other retirement plans). SIMPLE 401(k) plans are similar to SIMPLE IRAs, but can also allow loans and Roth contributions. And in most cases, you don't have to perform complicated discrimination testing. But because they're still qualified plans (and therefore more complicated and costly to establish and administer than SIMPLE IRAs), and allow less deferrals than traditional 401(k)s, SIMPLE 401(k)s haven't become popular retirement plans. But don't rule out a 401(k) plan entirely No employees? Then there is one qualified plan you should consider--the individual 401(k) plan (also known as a solo 401(k) plan). An individual 401(k) plan is a regular 401(k) plan combined with a profit-sharing plan. You can elect to defer up to $17,000 of your compensation to the plan for 2012 ($22,500 if you're age 50 or older), just as you could with any 401(k) plan. Contributions can be pretax or Roth. In addition, as with a traditional profit-sharing plan, your business can make a tax-deductible contribution to the plan of up to 25% of your compensation. Total contributions to your account in 2012 can't exceed $50,000, plus any catch-up contributions (or, if less, 100% of your compensation). If you're self-employed, compensation is your earned income from your business. Since an individual 401(k) plan can cover only the business owner and his or her spouse, it isn't subject to the often burdensome and complicated administrative rules and discrimination testing requirements that generally apply to regular 401(k) and profit-sharing plans. If you're a small business owner and haven't established a retirement savings plan, what are you waiting for? It's time to select the plan that best fits your needs, and the needs of your employees. |