Q&A: Deferred compensation plans

Dear Liz: I’m 54 and plan on retiring at 55 with a government pension. I have about $450,000 in a 457(b) deferred compensation plan. I owe about $220,000 on my home. I would like to pay off my 15-year, 2.5% interest mortgage. This would free up $1,900 a month and leave us debt-free. Everyone I’ve spoken to says this is a bad idea since I’d lose my mortgage interest deduction and I’d be “investing” in a low-interest vehicle (my mortgage). My only other obligation is my daughter’s college education, and I’m paying that in cash. Am I crazy to pay off this mortgage?

Answer: You’re not crazy, but you probably haven’t thought this all the way through.

The money in your deferred compensation plan hasn’t been taxed. Withdrawing enough to pay off your mortgage in one lump sum would shove you into a higher tax bracket and require you to take out considerably more than $220,000 to pay the tax bill. You could easily end up paying a marginal federal tax rate of 33% plus any applicable state tax — all to pay off a 2.5% loan.

There are a few scenarios where using tax-deferred money to pay off a mortgage can make sense. Some people have so much saved in retirement plans that the required minimum distributions at age 70½ would push them into high tax brackets and cause more of their Social Security to be taxed. They also may have paid down their mortgage to the point where they’re no longer getting a tax break.

In those instances, it may be worth withdrawing some money earlier than required to ease the later tax bill. The math involved can be complex, though, and the decisions are irreversible, so anyone contemplating such a move should have it reviewed by a fee-only financial advisor who is familiar with these calculations.

In fact, it’s a good idea to get an objective second opinion from a fiduciary any time you’re considering tapping a retirement fund. (Fiduciaries are advisors who pledge to put your interests ahead of your own.)

During your meeting, you also should review the other aspects of your retirement plan. How will you pay for health insurance in the decade before you qualify for Medicare? If you’re a federal employee, you should be eligible for retiree health insurance but your premiums may rise once you quit work. If you’re planning to buy individual coverage through a healthcare exchange, what will you do if that’s yanked away or becomes unaffordable? How will you pay for long-term care if you need it, since that’s not covered by health insurance or Medicare?

You can get referrals to fee-only financial planners from the National Assn. of Personal Financial Advisors at napfa.org. You can find fee-only planners who charge by the hour at Garrett Planning Network, garrettplanningnetwork.com.

Q&A: Money in the bank isn’t safe from inflation

Dear Liz: I am 68 and not in very good health due to heart disease. I’m not sure what do with my savings of over $1 million, which sits in online bank accounts, earning 1.25% to 1.35% in 18-month certificates of deposit. (No account contains more than $250,000 to remain under the FDIC insurance limits.) The money will eventually go to my daughter, though I could use it for my retirement. I don’t have the appetite for market swings. What should I do with my money?

Answer: Your money currently is safe from just about everything except inflation. If you want to keep your nest egg away from market swings, you’ll have to accept that its buying power will shrink. There is no investment that can keep your principal safe while still offering inflation-beating growth.

If you do want a shot at some growth, you could keep most of your savings in cash but also invest a portion in stocks — preferably using low-cost index mutual funds or ultra-low-cost exchange-traded funds.

Before you know how to invest, though, you’ll need to think about your goals for this money. A fee-only financial planner could help you discuss the possibilities and come up with a plan. You can find fee-only planners who charge by the hour through the Garrett Planning Network, www.garrettplanningnetwork.com.

Q&A: How to find the right balance when investing

Dear Liz: My brokerage wanted me to start moving from stocks that paid me steady dividends into bonds as I got older. If I’d followed that advice, I wouldn’t be nearly where I am today. I sleep just fine with my dividends. Things can change, of course, but until I see solid evidence otherwise, I am sticking with my plan. I have no idea why the brokerage is still pushing the “more bonds with advancing age” idea.

Answer: Presumably you were invested during the financial crisis and saw the value of your stocks cut in half. If you can withstand that level of decline, then your risk tolerance is a good match for a portfolio that’s heavily invested in stocks.

The problem once you retire is that another big drop could have you siphoning money for living expenses from a shrinking pool. The money you spend won’t be in the market to benefit from the rebound. This is what financial planners call sequence risk or sequence-of-return risk, and it can dramatically increase the odds of running out of money.

Perhaps you plan to live solely off your dividends, but there’s no guarantee your buying power will keep up with inflation. Most people, unless they’re quite wealthy, wind up having to tap their principal at some point, which leaves them vulnerable to sequence risk.

There’s another risk you should know about: recency bias. That’s an illogical behavior common to humans that makes us think what happened in the recent past will continue to happen in the future, even when there’s no evidence that’s true and plenty of evidence to the contrary. During the real estate boom, for example, home buyers and pundits insisted that prices could only go up. We saw how that turned out.

Bonds and cash can provide some cushion against events we can’t foresee. The right allocation varies by investor, but consider discussing your situation with a fee-only financial planner to see how it aligns with your brokerage’s advice.

Q&A: Investment advisor’s fees

Dear Liz: Two years ago I rolled my 401(k) into an IRA at the suggestion of an advisor after I lost my job. The rollover was $383,000, and a secondary amount of $63,000 was transferred from my after-tax savings to a second account. All the fees for the advisor are taken from my small account and are 1.5% annually. My IRA is now at $408,000. Assuming an average earnings of 3% annually ($12,000), and with the advisor taking 1.5% ($6,000), I’m thinking this is not beneficial to me financially and that can I do better. Also, why is the advisor taking his fee out of my small (after-tax) account? I am 67 and filed for full Social Security in January.

Answer: You should ask your advisor to confirm this, but withdrawals from the smaller account are likely to trigger a smaller tax bill since most of the money there has already been taxed. A withdrawal from your larger account, which is presumably all pre-tax money, would result in a larger tax bill for you.

That’s the end of the good news. Given your age, with perhaps decades of retirement ahead, a good benchmark for you to use to compare your returns would be Vanguard’s Balanced Composite Index, which tracks the performance of funds that have 60% of their portfolios in stocks and 40% in bonds. The index returned 8.89% in 2016 and has a three-year average of 6.49%. Even a portfolio with a much lower proportion of stocks would have gotten better results than you did. Vanguard’s Target Retirement 2015 fund, with a stock exposure of less than 30%, earned 6.16% last year and 4.04% on average over the last three years.

Investment performance shouldn’t be the only way you judge an advisor, but giving up half your returns to fees could dramatically reduce the amount you have to live on in retirement.

Fortunately, you have options. You could hire a fee-only planner who charges by the hour to design a portfolio for you, and implement it yourself at one of the discount brokerage firms such as Schwab, Vanguard, Fidelity or T. Rowe Price.

Or you could explore the digital investment options known as robo-advisors, which invest and rebalance your money using computer algorithms. Some of the pioneers in this field include Betterment, Wealthfront and Personal Capital. Schwab, Vanguard and T. Rowe Price also offer digital investment services directly to consumers, while Fidelity offers it to advisors.

If you still want the human touch, some of the services — including Betterment, Personal Capital, Vanguard and T. Rowe Price — combine digital investment with access to advisors.

Q&A: Annuities and fees

Dear Liz: I must object to a point you made in a recent column. You wrote: “…Also, annuities often have high fees, so you’d need to shop carefully and understand how the surrender charges work.” To write “…annuities often have high fees” is misleading, because there are annuities that don’t have fees, such as fixed annuities and indexed annuities. Coupling that phrase about fees with the admonition “you’d need to shop carefully and understand how the surrender charges work” is also a disservice to the public. Of course, an investor has to understand surrender charges! Just like if they try to end a bank CD too soon, there’s a penalty, or if they try to get out of a real estate deal incorrectly, or if they commit some other kind of breach of contract. That doesn’t mean that annuities are bad investments, especially when their principal is guaranteed, and no fees to pay.

Answer: Thanks for bringing up two areas of confusion that are actually linked.

All investments have costs. Many, including mutual funds and variable annuities, explicitly state their fees. With fixed and indexed annuities, the cost isn’t disclosed. Instead, it’s built into the interest rate spread — the difference between what the insurer earns on your money and what it pays into your account, said financial planner Michael Kitces, partner and director of financial planning research at Pinnacle Advisory Group in Columbia, Md.

“In other words, if the annuity company pays 2.5% on its annuity, it likely earned closer to 3% or 3.5% in the first place,” Kitces said. The insurer keeps the remainder to recover commissions paid to the insurance agent and the annuity’s own profit margins, he said.

Indexed annuities are a little more complicated. These promise investors they will get a certain portion of the return earned by some market benchmark while protecting them from market losses. The insurers use the spread to cover their overhead costs, profits and commissions. But instead of paying the remaining yield into your account, insurers use the money to purchase options that provide the promised participation rate in the index, said Kitces, who writes the Nerd’s Eye View blog at kitces.com.

Either way, surrender charges encourage people to stay invested long enough for the insurance company to get back enough money from the interest rate spread to cover the cost of commissions. If people need their money during the first few years, the surrender charge they pay is designed to make up the difference between what the insurer paid out and what it has received from the yield spread. Surrender charges are typically around 7% to 9% and may persist for seven or more years, although the penalty declines over time.

You’ve heard that “there’s no such thing as a free lunch.” Investors need to understand that they’re paying a price for their investments, even if they can’t see the money directly coming out of their pockets. Costs are a drag on investor returns and how big their portfolios can grow. That’s why it’s important to minimize those costs. When insurers don’t disclose the costs, it’s hard to know how much you’re giving up compared to what you could earn from another investment.

Q&A: Investing during retirement

Dear Liz: I’ll be retiring shortly. After 30 years of public service, I’m fortunate to have a generous pension. I’ll be paying off all my debts upon retirement, including my mortgage. I have a deferred compensation account that I will leave untouched until I’m required to take disbursements at 70 1/2 (15 years from now). Until then I will have disposable income but no significant tax deductions. Short of investing on my own in a brokerage account (and perhaps incurring capital gains taxes), are there any other investment vehicles that perhaps would be tax friendlier?

Answer: A variable annuity could provide tax deferral, but any gains you take out would be subject to income tax rates, which are typically higher than capital gains rates. (Annuities held within IRAs are subject to required minimum distributions starting after age 70 1/2. Those held outside of retirement funds will be annuitized, or paid out, starting at the date specified in the annuity contract.) Also, annuities often have high fees, so you’d need to shop carefully and understand how the surrender charges work.

Many advisors would recommend investing on your own instead and holding those investments at least a year to qualify for lower capital gains rates. This approach is particularly good for any funds you may want to leave your heirs, since assets in a brokerage account would get a “step up” in tax basis that could eliminate capital gains taxes for those heirs. Annuities don’t receive that step-up in basis.

You also shouldn’t assume that waiting to take required minimum distributions is the most tax-effective strategy. The typical advice is to put off tapping retirement funds as long as possible, but some retirees find their required minimum distributions push them into higher tax brackets. You may be better off taking distributions earlier — just enough to “fill out” your current tax bracket, rather than pushing you into a higher one.

Q&A: Advice for an investing newcomer

Dear Liz: I am not versed at all in money matters. I have no clue where to invest or even if I should invest. I have $5,000 squirreled away that I am totally comfortable investing for 12 months because I feel I would have no need for it before then. Can you make a suggestion where I should put it to make a safe return?

Answer: An FDIC-insured bank account.

Investing requires a longer time horizon and a willingness to risk losing some of your principal. If you can’t do either, you need to stick with low-risk, low-reward options.

Q&A: How much risk is too much in retirement?

Dear Liz: If you have all your required obligations covered during retirement, is having 70% of your portfolio in equities too risky?

Answer: Probably not, but a lot depends on your stomach.

Retirees typically need a hefty dollop of stocks to preserve their purchasing power over a long retirement, with many planners recommending a 40% to 60% allocation in early retirement. A heftier allocation isn’t unreasonable if all of your basic expenses are covered by guaranteed income, such as Social Security, pensions and annuities. Ideally, those pensions and annuities would have cost-of-living adjustments, especially if they’re meant to pay expenses that rise with inflation.

Historically, retirees have been told they need to reduce their equity exposure as they age, but there’s some evidence that the opposite is true. Research by financial planners Wade Pfau and Michael Kitces found that increasing your stock holdings in retirement, where the allocation starts out more conservative and gets more aggressive, may reduce the chances of running short of money. Their paper, “Reducing Retirement Risk with a Rising Equity Glide-Path,” was published in the Journal for Financial Planning and is available online for free.

That said, you don’t want your investments to give you ulcers. If you couldn’t withstand a big downturn — one that cuts your portfolio in half, say — then you may want to cushion your retirement funds with less risky alternatives.

Q&A: Mixing family and finances

Dear Liz: I have a relative who is a certified financial planner. He suggested we invest in annuities from which he will make commissions. When I asked him about his commission amount, he said he doesn’t feel the need to disclose that information because the fees don’t come out of my investment, therefore making them irrelevant. He says his fiduciary responsibility makes disclosing his commissions unnecessary. Is this correct?

Answer: Your relative needs to review the CFP ethical requirements. He wasn’t required to disclose dollar amounts or percentages of compensation until you specifically asked for that information. Once you did, he’s obligated to tell you. He (and you) can learn the details on the CFP Board of Standards site (www.cfp.net).

Commissions are far from irrelevant, especially when the product is as expensive and complicated as an annuity. Before you invest in any annuity, you should run the investment past a fee-only certified financial planner. Fee-only planners are compensated only by fees their clients pay and not by commissions that could influence their advice.

Q&A: What to consider when investing in target date retirement funds

Dear Liz: I have 100% of my 401(k) in a fund called “Target Retirement 2030.” This fund is made of several other funds, so does that qualify as “diversified”?

Answer: It does. Target date funds have become increasingly popular in 401(k) plans because they do the heavy lifting for investors. The funds select asset allocations and grow more conservative in their mix as the retirement date approaches.

Target date funds aren’t perfect, of course. Some are too expensive. The typical target date fund charges about 1%, but Vanguard and Fidelity charge as little as 0.15%.

Another issue is the “glide path” — how quickly the funds get more conservative. There’s no consensus about what the right glide path should be, and investment companies offer a lot of different mixes. Any given glide path may be too steep for some people and too shallow for others, depending on their circumstances. As an investor, you can compensate for that by choosing funds dated later or earlier than your targeted retirement date. If the 2030 fund gets too conservative too fast for your taste, for example, you could choose the 2040 fund instead.

Despite the downsides, you’re likely to be much better off in a target date fund than you are in some of the other options. Too often novice investors take too much or too little risk without realizing it. They may have all of their money in “safe” low-return options, which means they’re losing ground to inflation. Or they may have all their money in stocks, including their own company’s stock, and would be unprepared for a downturn wiping out a good chunk of their portfolio’s value.

Even those who know they should diversify often do it wrong by randomly distributing their contributions across their investment options. If you don’t know what you’re doing, or you simply prefer investing professionals to take charge, target date funds are a good way to go.