Dear Liz: I always hear you talking about having an emergency savings fund. Most people that I’ve heard talk about this recommend keeping it in cash. I just couldn’t stand watching that money languish in a low-interest savings account, so I recently moved it over to my brokerage account and purchased a few exchange-traded funds. My wife and I are under 30 and we both have very stable jobs. We have adequate insurance (including a home warranty). We also have a $20,000 signature line of credit through our credit union in case of an emergency, in addition to multiple credit cards with high limits and no revolving balances. I feel that we are covered in case of an emergency with the credit line alone. Does all of this sound reasonable to you or should I go back to keeping my emergency fund in cash?
Answer: Lines of credit can be a reasonable substitute for an emergency fund for people who have more pressing financial goals, such as saving for retirement and paying off debt.
But there’s really nothing like cash in the bank for meeting life’s inevitable financial setbacks. Even seemingly stable jobs can be lost, and lines of credit can get used up fairly quickly. If these personal setbacks happen at the same time as a stock market downturn, your emergency fund could dwindle dramatically.
That’s why it’s best to keep emergency cash safe and accessible in an FDIC-insured bank account. You can squeeze a little extra return from the money by opting for one of the online banks that’s paying close to 1%. Trying to squeeze much more, though, increases the odds that it won’t be there when you need it the most.
Dear Liz: I currently have a 401(k) and an IRA, but want something more. A longtime CPA, who is very close to our family, recommended that I buy some stocks, but I’m unsure how to go about this.
Answer: When you’re investing, it’s important to be diversified. That means you should spread your money among different types of investments so you don’t have all your eggs in one basket, so to speak.
You’d need hundreds of thousands of dollars to be properly diversified with individual stocks. When you’re just starting out, it’s a lot smarter to buy mutual funds or exchange-traded funds that invest in a wide variety of stocks. Vanguard Total Stock Market ETF, for example, invests in more than 3,600 companies and has an ultra-low expense ratio of just 0.05%.
The fees you pay for your investments are important, since high expenses can dramatically reduce your total returns. Funds that try to beat the market, rather than match it, often engage in a lot of trading that drives up costs. Funds sold through full-service brokerages can carry high expenses as well.
So look for a discount brokerage that allows you to invest with minimal fees and commissions. Or consider one of the new breed of online advisors, such as Betterment or Wealthfront, that offers a low-cost basket of investments that are selected, monitored and rebalanced using sophisticated technology.
Dear Liz: If I plan to stay invested for more than 15 years and I can tolerate the ups and downs of the market, why would I want to put any of my 401(k) money into bonds instead of putting it all in various stock funds? The bond funds in my 401(k) have a five-year return of 5% to 6% whereas the other funds are 8% to 13%.
Answer: If you look at the more recent performance of those bond funds, you’ll notice that their returns are considerably worse. Many have been losing money lately as interest rates have risen. That poor performance may worsen if the economy improves and rates continue to rise.
But you need to consider more than recent performance when allocating your portfolio. Bonds and cash can cushion your account against big downturns in the stock market. That can help keep you from panicking and selling at a bottom.
If you’re as risk tolerant as you think and decades away from retirement, you might be able to put as little as 10% of your portfolio into bonds and cash. If you’re 15 to 20 years from retirement, a 20% bond allocation may be more prudent. A fee-only financial planner can help advise you about sensible asset allocations, or you can check out the stock and bond mixes of target date funds offered by leading mutual fund companies (such as the Vanguard Target Retirement 2030 Fund, if you’ll be retiring around 2030).
Dear Liz: My spouse has tenure at a university. Given that one of us will always be employed, should we change the way we look at the amount of money we keep in an emergency fund or our risk tolerance for investments?
Answer: Even tenured professors can get fired or laid off. Tenure was designed to protect academic freedom, but professors can lose their jobs because of serious misconduct, incompetence or economic cutbacks, such as when a department is eliminated or a whole university is closed. About 2% of tenured faculty are dismissed in a typical year, according to the National Education Assn.’s Higher Education Department.
That’s more job security than in most occupations, of course. Your spouse also may have access to a defined benefit pension, which would give him or her a guaranteed income stream in retirement. Those factors mean you reasonably can take more risk with your other investments.
As for your emergency fund, you may be fine with savings equal to three months of expenses. But consider that if your spouse were to be dismissed, he or she probably would have a tough time finding an equivalent position. If the institution starts having financial difficulties or if there is any reason to suspect that he or she could be dismissed, a fatter fund could come in handy.
Dear Liz: I’m getting about $500,000 from the sale of my business this year and next year will be getting an additional $1 million. What’s the best way to invest the money so I can make $150,000 to $200,000 a year? I am 55 years old and will have no other income than what I can earn with this money.
Answer: You probably know that “guaranteed” or “safe” returns are very low right now. If you’re getting much more than 1% annually, you’re having to take some risk of loss. The higher the potential returns, the greater the risk.
So even if you could find an investment that promised to return 10% to 13% a year, there are no guarantees such returns would last, plus you would be at risk of losing some or all of your investment. A down draft in the market or an extended vacancy in your real estate holdings could cause you to dig into your principal.
That’s why financial planners typically advise their clients not to expect to take more than 4% a year or so out of their portfolios if they expect those portfolios to last. If you try to take much more out or invest aggressively to earn more, you run a substantial risk of running out of money before you run out of breath.
Dear Liz: The certificate of deposit I owned in my Roth IRA recently matured. I’ve put the money into a Roth passbook account until I can figure out what to do with it. I’m a public school teacher and have a 457 deferred compensation plan to which I contribute monthly. I am 57 and will need to work until I am at least 65. What should I do with the money in my Roth?
Answer: As a public school teacher, you probably have a defined benefit pension that will give you a guaranteed monthly check for life once you retire. Depending on how long you’ve taught and where, this pension could cover a substantial portion of your living expenses.
The guaranteed nature of this pension means that you may be able to take more risk with your other investments. That would mean your Roth could be invested in stock mutual funds or exchange-traded funds that offer potential for growth. CDs and other “safe” investments can’t offer that — in fact, your money loses purchasing power since you’re not earning enough interest to even offset inflation.
Since you’re so close to retirement, you should invest a few hundred dollars in a session with a fee-only financial planner who can review your situation and offer personalized advice.
Dear Liz: You always mention fee-only financial planners and I’m not sure about the true meaning. My husband and I have a financial planner who charges us $2,200 per year, but we got a summary of transaction fees in the amount of $6,200 for last year. Is this reasonable? We have $625,000 in IRAs and are adding $1,000 a month. In addition we have over $700,000 with current employers, adding the max allowed yearly. The planner gives advice on allocations for these employer funds as well. Are we paying too much for the financial planner? The IRAs seem to be doing well, but the market is doing well (today!).
Answer: It appears you’re paying both fees and commissions, so you’re not dealing with a fee-only planner. Fee-only planners are compensated only by the fees their clients pay, not by commissions or other “transaction fees” for the investments they buy. One big benefit of fee-only planners is that you don’t have to worry that commissions they get are affecting the investment advice they give you.
You’re paying about 1.3% on the portfolio you have invested with this advisor. That’s not shockingly high, but once you add in all the other costs associated with these investments, such as annual expense ratios and any account fees, your relationship with this advisor may be costing you 2% a year or more. That’s getting expensive, unless you’re getting comprehensive financial planning — help with insurance, taxes and estate planning, as well as investment advice — from someone qualified to provide such planning, such as a certified financial planner.
What you pay makes a big difference in what you accumulate. Let’s say your investments return an average of 8% a year over the next 20 years. If your costs average 1% a year, that would leave your IRAs worth about $3 million. If your costs average 2%, you could wind up with $2.5 million, or half a million dollars less.
Keeping your expenses low would mean you stop trying to beat the market with actively traded investments. Instead, you would opt for index funds and exchange-traded funds that seek to match market returns. These funds typically come with low expenses, often a small fraction of 1%. Using a fee-only planner can be another way to reduce what you pay for advice.
At the very least, consider bringing a copy of your portfolio to a fee-only planner for a second opinion. He or she can give you a better idea of whether what you’re paying is worth the results you’re getting.
Dear Liz: We have $130,000 invested in mutual funds, but the returns the last few years have been less than 4%. With the financial advisor taking 2% as a fee annually, we are not satisfied with the growth. A co-worker suggested buying blue-chip stocks with a strategy to hold and reinvest the dividends. If this is done in a self-directed plan to avoid the fees, we could be netting 4% plus. Is this a good plan or should we trust the advisor’s optimism that our returns will improve soon?
Answer: You don’t mention your age, your investment mix or your goals for this money. But if your portfolio isn’t doing significantly better this year — after all, the Standard & Poor’s 500 stock market benchmark is up about 30% over the last 12 months — you have cause for concern.
Even if your returns were better, a 2% fee is pretty high. Small investors need to keep an eagle eye on costs, since expenses can have a huge effect on your nest egg. Paying even 1% too much could shave more than $100,000 off your returns over the next 20 years.
That doesn’t mean, however, that an all-stock portfolio is a better choice. Individual stocks typically are much riskier than a diversified portfolio of mutual funds or exchange-traded funds (ETFs).
What might make more sense is consulting a fee-only financial planner who can design a low-cost portfolio for you. You can get referrals to planners who charge by the hour at http://www.garrettplanningnetwork.com.
Question: In a recent column you repeat advice I have often read that withdrawing about 3% of my investment capital will reduce the chances of my running out of money in retirement. But that doesn’t make sense to me. I have been retired for over 19 years and I have sufficient data now to extrapolate that I could live for 100 more years with so meager a drawdown because, through good and bad times, my earnings after inflation and taxes always exceed 3%. If I am missing something, I must be extraordinarily lucky because it hasn’t hurt me yet, and at age 77 I think it unlikely to do so in my remaining years. Can you explain this discrepancy between my experience and the consequences of your advice?
Answer: Sure. You got extraordinarily lucky.
You retired during a massive bull market, which is the best possible scenario for someone who hopes to live off investments. You were drawing from an expanding pool of money. Your stocks probably were growing at an astonishing clip of 20% or more a year for several years. Although later market downturns probably affected your portfolio, those initial years of good returns kept you comfortably ahead of the game.
Contrast that with someone who retires into a bear market. She’s drawing from a shrinking pool of money as her investments swoon. The money she takes out can’t participate in the inevitable rebound, so she loses out on those gains as well. All that dramatically increases the risks that she’ll run out of money before she runs out of breath.
It’s the first five years of retirement that are crucial, according to analyses by mutual fund company T. Rowe Price, which has done extensive research on sustainable withdrawal rates. Bad markets and losses in the first five years after withdrawals begin significantly increase the chances that a person will run out of money during a 30-year retirement.
Some advisors contend that a 3% initial withdrawal rate, adjusted each subsequent year for inflation, is too conservative. If you retire into a long-lasting bull market, it may well be. But none of us knows what the future holds, which is why so many advisors stick with the 3%-to-4% rule.