MONEY Master the Game: 7 Simple Steps to Financial Freedom (26 page)

• 
62% thought they would be able to retire when the year, or “target date,” of the fund arrives.
Unfortunately, this false perception is the cruelest of all. The date you set is your retirement year “goal.” TDFs are not a plan to get you to your goals, but rather just an asset allocation that
should
become less risky as you get closer to retirement.

Considering that there are trillions of dollars in TDFs, a huge percentage of Americans are in for a shocking surprise.

So what are you really buying with a TDF? You are simply buying into a fund that handles your asset allocation for you. It’s as simple as that. Instead of picking from the list of fund options, you buy one fund, and voilà! It’s “all handled for you.”

SORRY, SHE NO LONGER WORKS HERE

After graduating college, David Babbel decided he wanted to work for the World Bank. It would no doubt be an interesting place to work, but for those fortunate enough to be employed there, they also pay no taxes! Smart man. When he applied they turned him away, saying he needed a postgraduate education in one of six categories to land a job. Not one to risk being denied a position, he decided to go get
all
six. He has a degree in economics, an MBA in international finance, a PhD in finance, a PhD minor in food and resource economics, a PhD certificate in tropical agriculture, and a PhD certificate in Latin American studies. When he returned with his fistful of diplomas, they told him they weren’t hiring Americans due to the recent reduction of financial support from Washington to the World Bank. It was
a punch in the gut for him. Not knowing where to turn, he responded to a newspaper ad from UC Berkeley. After they hired him as a professor, he later found out that they ran the ad to comply with affirmative action, but had no intention of getting qualified candidates to respond.

Years later he moved on to Wharton to teach multiple subjects related to finance. But he isn’t just a bookworm. A paper he had written on how to reduce risk in bond portfolios caught the attention of Goldman Sachs. He took a leave of absence and spent seven years running the risk management and insurance division at Goldman Sachs (while still holding down a part-time professorship at Wharton). Later he finally had a chance to work at the World Bank. He has also consulted for both the United States Treasury and the Federal Reserve. But when the Department of Labor asked him to do a counterstudy on whether target-date funds were the best default retirement option, he had no idea the path that lay ahead. On the other side of the proverbial aisle was the Investment Company Institute (the lobbying arm for the mutual fund industry), which “had paid two million dollars for a study and got exactly what they wanted. A study that said [TDFs] are the best thing since sliced bread.” Keep in mind that at this point, TDFs were just a concept. A glimmer in the eye of the industry.

In his study for the Department of Labor, conducted with two other professors, one of whom was trained by two Nobel laureates, Babbel compared TDFs to
stable value funds.
Stable value funds are ultraconservative, “don’t have losses and historically have yields [returns] at two percent to three percent greater than money market funds.” According to Babbel, the industry-sponsored study, which painted TDFs in the best possible light, was riddled with flaws. To make TDFs look better than stable value funds, they pumped out more fiction than Walt Disney. For example, they made an assumption that stocks and bonds have
no correlation. Wrong.
Bonds and stocks do indeed move in step to a degree and they move even closer during tough times. (Bonds and stocks had 80% correlation in 2008.)

Babbel and his team reviewed the study and picked it apart. They had mathematically dissected the report’s fictional findings and were prepared to show its ridiculous assumptions that made TDFs look so superior.

When he showed up on the day to present his conclusion, the economists behind the table, chosen by the Department of Labor to judge both studies, “thought he had some great points that needed further review.” But the secretary of labor “had already made her decision and then quit the next day. She didn’t even show up at the meeting she had scheduled with him.” Dr. Babbel heard that it was prewired. The industry has bought the seal of approval it needed to write its own “fat” check.

Fast-forward, and by the end of 2013, TDFs were used by 41% of 401(k) participants, to the tune of trillions! Not a bad return for the investment community for a $2 million investment in a study Dr. Babbel and his esteemed economist colleagues called “heavily flawed.”

A 2006 federal law paved the way for target-date funds to become the “default” retirement option of choice. Employers can’t be held liable for sticking employee money in target-date funds. Today well over half of all employers “auto-enroll” their employees into their 401(k). According to research from Fidelity, over 96% of large employers use these target-date mutual funds as the default investment of choice.

YOU NEVER KNOW WHO’S SWIMMING NAKED UNTIL THE TIDE GOES OUT

Imagine that it is early 2008, and you are closing in on your retirement. You have worked the grind for over 40 years to provide for your family; you are looking forward to more time with the grandkids, more time traveling, and just . . . more time. By all accounts your 401(k) balance is looking healthy. Your “2010 target-date funds” are performing nicely, and you trust that since you are only two years away from retirement, your funds are invested very conservatively. Millions of Americans felt this way before 2008 wiped out their hopes for retirement, or at least the quality of retirement they had expected. The list on
page 162
shows the top 20 target-date funds (by size) and their gut-wrenching 2008 performances. Remember that these are 2010 target-date funds, so retirement was now only two years away for their investors. Notice the high percentage that certain funds chose to put into stocks (more risky) even though they were supposed to be in the “final stretch” and thus most conservative. To be fair, even if you are retiring, you must have some exposure to stocks, but at the same time, this type of loss could have devastated or at least delayed your plans for retirement.

LESSER OF TWO EVILS

When I sat down to interview many of the top academic minds in the field of retirement research, I was surprised to learn that they were all in favor of target-date funds.

Wait a second. How could that be!?

I shared with each of them much of what you have just read, and while they didn’t disagree that there are issues with TDFs, they pointed to the time before TDFs existed, when people were given the choice to allocate as they wished. This arrangement led to more confusion and, quite frankly, really poor decision making. The data certainly supports their point.

In my interview with Dr. Jeffrey Brown, one of the smartest minds in the country, he explained, “If you go back prior to these things [TDFs], we had a lot of people who were investing in their own employer’s stock. Way overconcentrated in their own employer’s stock.” He reminded me of Enron, where many employees put 100% of their savings in Enron stock, and overnight that money was gone.

When people had 15 different mutual fund options from which to choose, they would divide the money up equally (1/15th in each one), which is not a good strategy. Or they would get nervous if the market dropped (or sell when the market was down) and sit entirely on cash for years on end. Cash isn’t always a bad position for a portion of your money, but within a 401(k), when you are paying fees for the plan itself, you are losing money to both fees and inflation when you hold on to cash. In short, I can see Dr. Brown’s point.

If the concept of a target-date fund is appealing, Dr. Brown recommends a low-cost target-date fund such as those offered by Vanguard. This could be a good approach for someone with minimal amounts to invest, a very simple situation, and the need for an advisor might be overkill. But if you don’t want to use a target-date fund and instead have access to a list of low-cost
index funds from which to choose, you might implement one of the asset allocation models you will learn later in this book.
Asset allocation, where to park your money and how to divide it up, is the single most important skill of a successful investor.
And as we will learn from the masters, it’s not that complicated! Low-cost TDFs might be great for the average investor, but you are not average if you are reading this book!

If you want to take immediate action to minimize fees and have an advisor assist you in allocating your 401(k) fund choices, you can use the service at Stronghold (
www.strongholdfinancial.com
), which, with the click of a button will automatically “peer into” your 401(k) and provide a complimentary asset allocation.

In addition, many people think there aren’t many alternatives to TDFs, but in section 5, you’ll learn a specific asset allocation from hedge fund guru Ray Dalio that has produced extraordinary returns with minimal downside. When a team of analysts back-tested the portfolio, the worst loss was just 3.93% in the last 75 years. In contrast, according to MarketWatch, “the most conservative target-date retirement funds—those designed to produce income—fell on average 17% in 2008, and the riskiest target-date retirement funds—designed for those retiring in 2055—fell on average a whopping 39.8%, according to a recent report from Ibbotson Associates.”

ANOTHER ONE BITES THE DUST

We have exposed and conquered yet another myth together. I hope by now you are seeing that ignorance is not bliss. Ignorance is pain and poverty in the financial world. The knowledge you have acquired in these first chapters will be the fuel you will need to say “Never again! Never again will I be taken advantage of.”

Soon we will begin to explore the exciting opportunities, strategies, and vehicles for creating financial freedom, but first we have just a couple more myths to free you from.

CHAPTER 2.7

MYTH 7: “I HATE ANNUITIES, AND YOU SHOULD TOO”

The Fed chief’s largest assets last year were two annuities.

—“Fed Chairman Bernanke’s Personal Finances Are No Frills,” USA Today, July 21, 2008

LOVE ’EM OR HATE ’EM?

I came across an online ad that read “I hate annuities and you should too.” The typical internet “hook” promoted a free report on how annuities are terrible investments and that a strategy using stocks and bonds is a much better approach for long-term growth and security. Of course, the advertiser was readily available to sell you his expert stock pickings for a fee. What’s not mentioned in the bold print of the ad is that the advertiser is an active-approach stock picker. And as we’ve already learned from experts Warren Buffett, Jack Bogle, Ray Dalio, and David Swenson—as well as academic research results—active management is ineffective in beating the market on a consistent basis. Their results are inferior to a simple index, which usually has fees that are 500% to 3,000% cheaper, with greater performance. This marketing strategy often works, though, doesn’t it? Compare yourself with what’s perceived as a terrible product, and suddenly yours doesn’t look so bad.

But not everybody hates annuities . . .

On the flip side, I was blown away to find that the former Federal Reserve chairman Ben Bernanke, arguably the most influential man in finance at one point, certainly appreciates the use of annuities in his personal finance plan. Bernanke had to disclose his investments before becoming chairman of the Fed. The disclosure showed that he held a relatively low amount of stocks
and bonds, while his annuities were his
two largest holdings.
My immediate thought was, “What does he know that I don’t?”

So which is it?

Are annuities the best thing since sliced bread or just a deal that is good for the insurance company and brokers selling them? The answer? It really depends on the type of annuity you own and the fees the insurance company will charge you. Let’s explore.

During the process of writing this book, I was searching for the world’s most respected minds to explore the best ways for readers to lock in a guaranteed lifetime income stream; a paycheck for life without having to work. After all, isn’t this why we invest in the first place? As I conducted my interviews, Dr. David Babbel was a name that was continually “rising to the top” during my research. If you recall from the last chapter, he is the Wharton professor with multiple PhDs who advised the secretary of labor on two studies on target-date funds.

In early 2013 he presented his own personal story in a report on how he debunked the advice of his Wall Street buddies, who encouraged him to let his investments ride and hope for more growth, and created a lifetime income plan. So instead of risking a penny in stocks or bonds, he used a series of guaranteed
income annuities,
staggered over time, to give him the safe and secure retirement he wants and deserves—a lifetime income plan. The annuities he used also gave him a 100% guarantee of his principal, so he didn’t lose in 2000 or in 2008 when the market crashed. Instead, he was comfortably enjoying his life, his wife, and his grandkids with complete peace of mind that he will never run out of money.