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CalPERS’ move is a vote for passive investing
It would be reasonable to assume that the professionals running CalPERS, the California pension fund with $300 billion in assets, would be good at picking stocks. Or at least reasonably good at picking other smart people to pick stocks for them. But in the past year, CalPERS has made two decisions that are telling for all investors when it comes to trying to outperform the market.
Late last year, the pension fund signaled its intention to move more assets from active management into passively managed index funds. These are funds in which you buy a market, such as the S&P 500 or the Russell 2000, unlike mutual funds that try to select winners within a given class of equities. More recently, CalPERS said it would also pull out the $4 billion it has invested in hedge funds. Although hedge-fund honchos make headlines with their personal wealth, the industry has significantly lagged the market in the past three years. “Call it capitulation or sobriety: it’s saying that we can’t beat the market and we can’t find managers who can beat the market, and even if they can, their fee structures are overwhelming,” says Mitch Tuchman, CEO of Rebalance IRA, an investment adviser focused on index-fund-only portfolios.
The CalPERS move is a nod to University of Chicago economist Eugene Fama, who won a Nobel for his lifelong work on “efficient markets.” That theory says that because stock prices reflect all available information at any moment–they are informationally “efficient”–future prices are unpredictable, so trying to beat the market is useless. According to the SPIVA (S&P Indices Versus Active) Scorecard, the return on the S&P 500 beat 87% of active managers in domestic large-cap equity funds over the past five years.
Why can’t expert money managers succeed? Researchers from the University of Chicago say there are so many smart managers that they offset one another, gaining or losing at others’ expense and winding up near the market average, before expenses. “Unless you have some really special information about a manager, there’s really no good reason to put your money in actively managed mutual funds,” says Juhani Linnainmaa, associate professor of finance at Chicago’s Booth School of Business. He says the median managed fund produces an average –1% alpha–that is, below the expected return. Some funds do beat their index–what’s not clear is why. “What is the luck factor?” he asks. “Given the noise in the market, it’s kind of hopeless to try to figure anything out of this.” Linnainmaa’s colleague, finance professor Lubos Pastor, also found that mutual funds have decreasing returns to scale. Size hurts a manager’s ability to trade.
Yet even if managers match the market, they’ve got expense ratios that then eat into returns. Index-fund proponents like John Bogle at Vanguard have long preached that fees dilute performance. A 1% difference can be huge. “It’s not 1% of all your money,” says Tuchman, “it’s 1% of expected returns: that’s 16% to 20%.” The average balance in Fidelity 401(k) plans was $89,300 in 2013. While 1% of that is $893, if you earned 8% compounded over 10 years, your balance would be $192,792; at 7% it’s $175,667, a difference of $17,125. Real money, in other words.
Investors are getting the message, pouring some $345 billion into passive mutual and exchange-traded funds over the past 12 months vs. $126 billion in active funds, says Morningstar. “At the end of the day,” says Tuchman, “an index fund is run by a computer, a robot. We don’t want to believe that a robot can beat Ivy League M.B.A.s–and I’m one of them.” What CalPERS seems to be saying is that the game is over. The robot wins.
What's the the right mix of stocks and bonds for your retirement account? Financial planners explain.+ READ ARTICLE
For the first time since the dotcom era, 83% of this year's IPOs have negative earnings. Does that mean we're in a new tech bubble?
For investors looking to place bets on newly public companies, 2014 has been an amazing year. Through the month of August, 204 businesses have held initial pubic offerings for their stock, for a combined value of $46.4 billion. According to the Wall Street Journal, both of those numbers are the highest the IPO world has seen since 2000.
But 2014 is close to setting another millenium record: The percentage of IPOs where the company has negative earnings–that is, is losing money–is nearing a 14-year peak. A report from Asset Allocation Advisers, using data from SentimenTrader, shows the proportion of in-the-red IPOs recently hit 83%, just one point lower than their previous high in 2000. That year seems to be coming up a lot–remind me what happened around then?
The last time such a large share of IPOs were profitless was at the top of the dotcom bubble, and when that bubble burst, the S&P 500 lost almost half of its value. Gregory Schultz, co-owner of Asset Allocation Advisers, and co-author of the report, thinks more earnings-free IPOs are one indication the tech bubble is back.
“It might come in the same box with a different color bow, but like Yogi Berra said, it’s deja vu all over again,” Schultz told MONEY. “The impression I get is if you have a mobile app and a website, you can gather money.”
Why is the market so willing to support the latest web startup, never mind profits? Schultz thinks low interest rates and the Fed’s policy of “quantitative easing” have made investors are more willing to put their cash in risky ventures in hopes of capturing a higher return.
But while some think the new IPO boom could mean the market is overvalued, others see a different explanation. Rich Peterson, an analyst at S&P Capital IQ, says a surge in profitless IPOs is actually driven by the kind of companies seeking public investment. And it’s not just tech stocks. “One of the more popular or active sectors for IPOs has come in the biotech field,” says Peterson. His numbers shows this type of firms taking up about 22% of year’s IPO market so far. “By their nature, biotechnology companies don’t make money [early on], they burn through a lot of cash, so it’s not surprising.”
Early indicators suggest most of 2014’s IPO class is actually doing quite well. Of the 134 companies that did IPOs this year and reported second quarter earnings, 72 beat analyst expectations, and only 54 missed their mark. Peterson cautions that an IPO’s early success does not guarantee good results in the long run, but says the high share of zero-profit IPOs does not concern him.
Of course, the simplest explanation for more earnings-negative IPOs is that stocks are currently in high demand. The S&P 500’s price-to-earnings ratio, based on ten years of average earnings, is a little above 25. That’s higher than historical norms, meaning the public is willing to pay a lot for equities in general. When investors are especially eager to buy stock, it makes sense for companies to obtain capital (or for founders to cash out) by selling shares. In short, the rise of the no-profit IPOs is a predictable side effect of the market boom. Less predictable is when the boom ends.
It pays to invest in your human capital, maintaining your skills and adding to your education
Several years ago I picked up a book published in 1920 by Simon Wilson Straus, president of the American Society for Thrift. His description of the popular image of thrift in History of the Thrift Movement in America still rings true nearly a century later. “Penny-counting, cheese-paring, money-hoarding practices were looked upon by the public as the ideals sought by those who tried to encourage thrift,” wrote Straus. “The man who practiced this virtue, it was felt, was he who hoarded his earnings to such an extent that he thrust aside every other consideration in order to keep from spending his pennies, his dimes, and his dollars.” Who wants to live a “cheese-paring” life? Sounds bad, doesn’t it?
But an emphasis on thrift doesn’t mean living cheaply– far from it. Thrift or frugality is really shorthand for an approach grounded in matching our money with our values. Straus defines thrift this way: “It is the thrift that recognizes that the finer things of life must be encouraged,” he writes. “The skilled workman, the artist, the musician, the landscape gardener, the designer of beautiful furniture, the members of the professions — all those, in fact, who, through the devotion of their abilities, contribute to the real betterment of mankind, must be given support through our judicious expenditures.”
Here’s how David Starr Jordan, founding president of Stanford University, defined thrift at the 1915 International Congress for Thrift in San Francisco. He told the assembled audience that thrift “does not involve stinginess, which is an abuse of thrift, nor does it require that each item of savings should be financial investments; the money that is spent on the education of one’s self or of one’s family, in travel, in music, in art, or in helpfulness to others, if it brings real returns in personal development or in a better understanding of the world we live in, is in accordance with the spirit of thrift.”
Who didn’t have a moment during the Great Recession of looking around their home or apartment, opening closets and drawers, gazing into garages and storage bins, and wondered, “Why did I buy that? Is this how I want to live? I’m paying off credit card debt for that?” The modern Mad Men have done a bang-up job equating the good life with owning lots of stuff paid for on an installment plan. Didn’t we always know this wasn’t quite right? By thinking through “What really matters to me?” the unretired movement will come up with far more sensible answers to the question “How much is enough?” than the financial services industry. Harry West, the former CEO of Continuum and current senior partner at Prophet, hit on the thrift mindset. In our conversation he remarked on the flexibility that comes with minimal expenses and debts. “When you talk to boomers, what you find is that freedom is really, really important. And you think about that because they grew up in the ’60s or were born in the ’60s, which was a time of freedom,” says West. “Freedom is a low overhead.” That expression should be a mantra for young and old workers alike.
The frugal mindset is spreading, thanks to growing awareness of sustainability. The term sustainability has many shades of meaning, but several themes have emerged in recent years. An awareness of global warming. The desire to cut down on waste. Concerns over the health of the environment. Worries about the vibrancy of local communities. My favorite definition of sustainability comes from the late actor and non-profit entrepreneur Paul Newman: “We are such spendthrifts with our lives,” said Newman. “The trick of living is to slip on and off the planet with the least fuss you can muster. I’m not running for sainthood. I just happen to think that in life we need to be a little like the farmer, who puts back into the soil what he takes out.” Sustainability has gone mainstream and, for growing numbers of people, being frugal is green and being green is frugal.
There is nothing cheap or penny pinching behind the pursuit of judicious expenditures, thrift and sustainability. Instead, thrift is a mindset for trying to match your spending with your values. “In some ways, that what’s financial independence is. You don’t have to answer to anyone because you have enough,” says certified financial planner Ross Levin. “When I am working with clients as they get older or near the end of life, they talk about the things they wish they had done. They talk about their regrets, and the regrets always focus on experiences. It’s always something like, ‘I wish I had done more with the kids when they were younger.’ It’s never ‘I wish I had bought a Mercedes.'”
The urban scholar Richard Florida, in his book The Great Reset, looked at potential economic changes in the U.S. following the Great Recession. His bottom line forecast could have been addressed to aging workers. “The promise of the current Reset is the opportunity for a life made better not by ownership of real estate, appliances, cars, and all manner of material goods, but by greater flexibility and lower levels of debt, more time with family and friends, greater promise of personal development, and access to more and better experiences.”
Unretirement will change not only how an aging population thinks about old age but also how it plans the elder years. Over the past three decades the baby boom generation has been taught to equate planning for retirement with savvy investing. In essence, the retirement planning mantra has been stocks for the long haul, asset allocation and picking mutual funds. But for the typical Main Street boomer the equation has always been wrong and, deep down, we’ve always known we couldn’t rely on Wall Street’s lush return promises. The core of unretirement planning is jobs, and the new unretirement planning mantra is encore careers, networking, and delay filing for Social Security. “You should be looking for the kind of jobs you could do that are challenging and interesting and offer an acceptable income,” says Arthur Koff, the septuarian founder of Retired Brains. “The time to do it is while you’re working.”
Next Chapter in Kansas City, Kansas is housed in a small brick building reminiscent of a bank in a section of town that houses the courts. Karen Hostetler is director of Next Chapter. She turned 65 in 2013. Next Chapter is a small grassroots organization with a mission of helping older workers in transition toward unretirement. I met with Next Chapter activists Pat Brune, Cris Siebenlist and Hostetler in a conference room in the fall of 2013. It was a lively conversation and at one point planning for unretirement came up.
Siebenlist: “Frankly, not everyone will figure it out. They’ll do a little bit of this and a little bit of that. Other people will float around for awhile and say, Is this all there is?”
Hostetler: “You need to plan. It takes commitment to figure it out.”
Brune: “If I could change my transition to what I did, it would have been to be more intentional. I said yes to what came along.”
Hostetler: “Don’t jump into the first thing that comes along.”
Bruning: “I only see my intentions looking back. It’s only later that I see how the dots are connected.”
The work longer message means it pays to invest in your human capital, maintaining your skills and adding to your education. Maybe you’d like to stay at your current company, but put in fewer hours or shift over to a different division. If you want to move on, know your employer is likely to hand you a pink slip soon, or want to start your own business invest in researching your options, from hiring a career coach to investigating temp agencies to picking up a book like Marci Alboher’s The Encore Career Handbook: How To Make a Living and a Difference in the Second Half of Life.
Most importantly, invest in your networks of family, friends, colleagues and acquaintances. Scholars have documented that about half or more of all jobs come through informal channels–connections to friends, families and colleagues. You may also want to create new connections to ease the transition into the next stage of life.
Take this example from Ralph Warner, the founder of Nolo.com, the self-help legal guide business, and author of Get a Life: You Don’t Need A Million to Retire Well. Let’s say it’s a dream of yours to work on environmental causes in retirement, says Warner. The pressures of daily life stop you from getting engaged, however. You’ll get to it, tomorrow. Now you’re 65 or 70 years old. You head toward an environmental organization you admire and say, “Here I am. How can I help you? The answer is going to be probably not much,” says Warner. Maybe help out with the phones or mailings. “Now, take that same person who in their 40s or 50s gets involved with several local environmental groups and at age 70 is a respected senior person. They’re valued and they’re needed. They earned it.”
They’ve just won the aging boomer trifecta: an income, a community and a mission.
Don’t get me wrong: Saving is important. Max out your 401(k) and IRA. Create a well-diversified, low-fee retirement savings portfolio. Savings is your margin of safety because life has a way of upending well-thought-out plans. An unexpectedly ill parent. A divorced child moving back home with the kids. For Robert Lawrence, it was a detached retina.
Lawrence was a teacher at Jefferson Community and Technical College (now Kentucky Community and Technical College) in Louisville. He taught there for about 20 years, commuting up to 10 weeks every year to visit his partner in New York City. Lawrence planned on retiring at age 66. Just after his 64th birthday, he stopped by a colleague’s office for a brief “hello” and ended up listening to a long, detailed explanation why his colleague planned working until age 70. The conversation convinced Lawrence to hold off retirement for another six years.
That is, until two months later. His retina detached and several surgical repairs didn’t hold. He retired at age 65 in 2005, sold his home, downsized and moved into his partner’s condo in Jackson Heights, Queens. His partner, age 75, is a consulting engineer, often putting in 40 hour workweeks. “If it had not been for health reasons I certainly would have been working,” says Lawrence.
A surgeon in New York fixed his retina. Lawrence now volunteers at a hospice in Manhattan, visits with grieving caregivers after the death of a loved one, and helps out at his local church. With a comfortable pension and some savings he chose flexibility over pay. The reason: Lawrence and his partner are railroad “rare mileage” collectors. “We’re railroad fanatics,” he says. They ride the rails throughout the U.S., often seeking out obscure lines to collect their miles. “The only reason I did not seek out teaching in New York is my partner didn’t want me to because of these trips,” adds Lawrence. “He’s in command of his own time as a consultant. If you’re teaching, you’re not.”
When it comes to retirement planning, the goal should be to put your savings on auto-pilot as much as possible. Instead, spend your time creating opportunities for an income and meaning later in life. The return on the unretirement investment will dwarf anything you’ll get from picking a good mutual fund.
Chris Farrell is a contributing economics editor for Bloomberg Businessweek and senior economics contributor for public radio’s Marketplace Money, Marketplace, and Marketplace Morning Report. Excerpted from Unretirement, copyright 2014 by Chris Farrell. Reprinted by permission of Bloomsbury.
The biggest dilemma in retirement investing may be how hard it will be to grow our savings in the next decade.
There have been a lot of predictions from professionals lately about what kind of returns we can expect on our investments, and it doesn’t look good. In June PIMCO bond guru Bill Gross announced at the Morningstar conference (and subsequently to almost every media outlet in existence) that a close-to-zero interest rate was the “new neutral.” Gross envisions a market where bonds return just 3% to 4% a year on average, while stocks return a modest 4% to 5%.
Gross’s forecast echoes that of a number of other investment experts, including Ray Dalio, the head of Bridgewater Associates, the world’s largest hedge fund, who called this post-Recession era we are in “the boring years,” during which investors are likely to earn returns of just 3% for bonds and 4% for equities.
These low-return predictions are based, in part, on diminished expectations for the U.S. economy, with the IMF recently warning that our GDP growth may get stuck at 2% for the long term unless Washington adopts significant reforms.
A 4% return would be a huge decline from the historical performance of the U.S. stock market, which has earned an average annual 10% over the last 40 years. Many financial planners still use 8% to 10% as the expected return for stocks in 401(k)s and other investment portfolios. All of which presents a real predicament for those of us in the middle of our careers who have been assuming strong growth will carry us over the finish line.
You see, the real benefit of starting to invest early, the reason people in their 20s are exhorted to open retirement accounts, has always been the power of compounding in the last 10 or so years of a 40 year horizon—the hockey stick uptick on a line graph. But in order to experience that exhilarating growth curve, you need to earn an average annual return in the high single digits, not the low single digits. Compounding simply doesn’t have as much power if you start off earning 10% for 20 years and then earn only 4% for the second 20 years.
If these predictions come true—and I hope that they won’t—it will be much more difficult to make money off of money in the future. This will impact just about everybody age 40 or older: current retirees and people living off fixed incomes, those hoping to retire in five to ten years, and those in mid-career who will need to rethink their strategy moving forward.
The only real solution, as far as I can tell, is to save more and spend less. You can try to earn more, but another strange feature of this recovery-that-doesn’t-feel-like-a-recovery is that while unemployment has dropped, wages have remained stagnant. Besides, depending on your tax bracket, you would have to earn a lot more to get to the same amount after taxes that you could put aside by saving.
So while the investment pundits are making their predictions and coining their phrases, allow me to offer my own: we may now be entering the era of the New Frugal. After three decades of a declining personal savings rate, from 10% in the 1970s to 1% in the 2000s, the financial crisis of 2008 brought savings back up above 5% where it continues to hover. My prediction is that if stock market returns become stagnant, we might continue to see a reduction in consumption and an increase in savings.
What this all means for the economy as a whole I will leave to the experts to ponder. All I know is that if I can no longer expect a 10% average annual return on my retirement fund, I’m going to be a heck of a lot more conservative about how much I spend.
The banks has agreed to provide billions of dollars in "consumer relief." Here's what that actually means.
Last week, Bank of America agreed to pay almost $17 billion dollars in a settlement with the Justice Department. The settlement is about what Bank of America (and Merrill Lynch and Countrywide, which BoA later acquired) disclosed to investors about mortgage-backed securities, not about how it treated homeowners. Nonetheless, a large portion of the settlement—$7 billion—will be used for consumer relief.
So who will actually see some of that money? Bank of America can pay off its new obligation in four ways:
Reducing the principal or modifying payments on some mortgages. Mortgage modification isn’t anything new—the government has had programs to encourage banks to do this for years, though they’ve been criticized as too little or too late. However, compared to past settlements, the BoA deal does break some ground by targeting the relief. For the first time, 50% of principal reductions will go to borrowers in the areas hardest hit by the housing crisis. The Office of Housing and Urban Development has published an interactive map of these areas here. The settlement also gives the bank incentives to prioritize FHA and VA loans.
Bank of America’s agreement with the government also provides more substantial aid than previous settlements in certain cases. For example, BoA is required to provide $2.15 billion in principal forgiveness, which consists of lowering underwater mortgages to 75% of the property’s long term value, and reducing the mortgage’s interest rate to 2%.
“Those borrowers who do get assistance through the settlement are getting pretty substantial assistance,” says Paul Leonard, founder of the Center for Responsible Lending.
In addition to principal reduction, BoA will receive credit toward the settlement amount by forgiving mortgage payments, allowing for delayed payments, or extinguishing some second liens and other debts.
Who actually gets this help, though, is up to BoA. “Bank of America still gets to make all the final calls,” Leonard explains. “Even if I’m a borrower in default in a hardest hit area, who would seem like natural candidate for assistance, there is no entitlement to me.” As for the timetable, the bank has until 2018 to provide this aid, although the agreement includes incentive to finish early. BoA suggests anyone in serious hardship call 877-488-7814 to see if they qualify for an existing program.
More low and moderate income lending. For low-income Americans, first time homebuyers, or those who lost their home in a short sale or foreclosure, it can be extremely difficult to get a loan—even with a good credit. This settlement offers BoA credit for giving mortgages to these groups, or those in hardest hit areas, as long as they have respectable FICO score.
Building affordable rental housing. It’s also hard to find cheap rental housing, and financing for such development is scarce. As part of BoA’s agreement with the Justice Department, the bank will provide $100 million in financing for construction, rehabilitation or preservation of affordable rental multi-family housing. Half of these units must be built in Critical Family Need Housing developments.
Getting rid of blight and preventing future foreclosures. One side effect of the housing crisis was the large number of abandoned or foreclosed homes plaguing neighborhoods across the nation. BoA will earn credit for demolishing abandoned homes, donating properties to land banks, non-profits, or local governments, and providing funds for legal aid organizations and housing counseling agencies. The bank will also receive credit for forgiving the principal of loans where foreclosure isn’t being pursued.
Housing advocates say they’ll be keeping an eye on how quickly BoA and other banks that have agreed to consumer relief act on these programs. One worry is that by going slowly they could end up paying off the settlements with modifications and lending they would have done anyway. “If the promised relief arrives, as written, then it will bring a measure of relief that is badly needed by a lot of communities out there,” acknowledges Kevin Whelan, national campaign director of Home Defenders League. “But compared to the damage these institutions caused, it’s not really a large amount of money.”
The new Acorns app rounds up card purchases and invests the difference for growth, with no minimums and low fees.
Americans spend $11 trillion a year while saving very little. So it makes sense to link the two, as a number of financial companies have tried to do over the past decade. The latest is the startup Acorns, which hopes to hook millennials on the merits of mobile micro investing over many decades.
Through the Acorns app, released for iPhone this week, you sock away “spare change” every time you use your linked credit or debit card. The app rounds up purchases to the nearest dollar, takes the difference from your checking account, and plunks it in a solid, no-frills investment portfolio. So when you spend, say, $1.29 for a song on iTunes, the app reads that as $2 and pushes 71¢ into your Acorns account. With a swipe, you can also contribute small or large sums separate from any spending.
The Acorns portfolio is purposely simple: Your money gets spread among six basic index funds. The weighting in each fund depends on your risk profile, which you can dial up or down on your iPhone. More aggressive settings put more money in stocks. But you always have some money in each fund, remaining diversified among large and small company stocks, emerging markets, real estate, government and corporate bonds. The app will be available for Android in a few weeks and through a website in a few months.
Why Millennials Are the Target
Micro investing via a mobile device clearly targets millennials, who show great interest in saving but have been largely ignored by financial advisers and large banks. Young people may not have enough assets to meet the minimum requirements of big financial houses like Fidelity, Vanguard, and Schwab. With Acorns, there are no minimums. There are also none of the commissions that can render investing in small doses prohibitively expensive. “We want small investors who can grow with us over time,” says Acorns co-founder Jeff Cruttenden.
This approach places Acorns in the middle a rash of low-fee, online financial firms geared at young adults—including Square, Betterment, Robinhood, and Wealthfront. Such firms hope to capitalize on young adults’ penchant for tech solutions and lingering mistrust of large financial institutions. Cruttenden says a third of Acorns users are under age 22. They like to save in dribs and drabs—and manage everything from a mobile device.
Acorns charges a flat $1 monthly fee and between 0.25% and 0.5% of assets each year. The typical mutual fund has fees of 1% or more. Yet many index fund fees run lower. The Vanguard S&P 500 ETF, which invests in large company stocks, charges just 0.05%. If you have a few thousand dollars to open an account, and the discipline to invest a set amount each month, you might do better there. But remember that is just one fund. With Acorns you get diversification across six asset classes—along with the rounding up feature, which seems to have appeal.
Acorns has been testing the app all summer and says the average account holder contributes $7 a day through lump sums and a total of 500,000 round ups. Cruttenden says he is a typical user and through rounding up his card purchases has added $521.63 to his account over three months.
A New Twist on an Old Concept
Mortgage experts tout rounding up as a way to pay off your mortgage quicker. On a $200,000 loan at 4.5% for 30 years your payment would be $1,013.38. Rounding up to the nearest $100, or to $1,100, would cut your payoff time by 52 months and save you $26,821.20 in interest. Rounding up your card purchases works much the same way—only you are accumulating savings, not cutting your interest expense.
Bank of America offers a Keep the Change program, which rounds up debit-card purchases to the nearest buck and then pushes the difference into a savings account. Upromise offers credit card holders rewards that help pay for college. But Acorns’ approach is different: the money goes into an actual investment account with solid long-term growth potential.
One possible drawback is that this is a taxable account, which means you fund the Acorns account with after-tax money. Young adults starting a career with a company that offers a tax-deferred 401(k) plan with a match would be better served putting money in that account, if they must choose. But if you are like millions of people who throw spare change in a drawer anyway, Acorns is a way to do it electronically and let those nickels, dimes, and pennies go to work for you in a more meaningful way.
Read more on getting a jump on saving and investing:
- Ready to Start Saving? Do it Right
- The One Thing You Have to Know to Invest on Your Own
- Get the Most from Your 401(k) at Any Age
Open a Roth IRA for your child's summer earnings, and talk her through the decisions on how to invest that money, suggests financial planner Kevin McKinley.
In my last column, I extolled the virtues of opening—and perhaps even contributing to—a Roth IRA for a working teenager. In short, a little bit of money saved now can make a big difference over a long time, and give your child a nice cushion upon which to build a solid nest egg.
Besides underscoring the importance of saving for retirement early and regularly, opening a Roth IRA can help your child become a savvy investor (a skill many people learn the hard way).
Make the Initial Contribution
Your child needs to earn money if he or you are going to contribute to an IRA on his behalf. For the 2014 tax year, the limit for a Roth IRA contribution for those under age 50 is the lesser of the worker’s earnings, or $5,500.
The deadline for making the contribution is April 15, 2015. But you can start sooner, even if your teen hasn’t yet earned the money on which you will be basing the IRA contribution. (If the kid doesn’t earn enough to justify your contributions, you can withdraw the excess with relatively little in the way of paperwork or penalties.)
For a minor child, you will have to open a “custodial” Roth IRA on her behalf, using her Social Security number. Not every brokerage or mutual fund company that will open a Roth IRA for an adult will do so for a minor, but many of the larger ones will, including Vanguard, Schwab, and TD Ameritrade.
As the custodian, you make the decisions on investment choices—as well as decisions on if, why, and when the money might be withdrawn—until she reaches “adulthood,” defined by age (usually between 18 and 21, depending on your state of residence). Once she ages out, the account will then need to be re-registered in her name.
Depending on which provider you choose, you may be able to make systematic, automated contributions to the IRA (for example, $200 per month) from a checking or savings account. To encourage your teen to participate, you might offer to match every dollar he puts in.
Have the “Risk vs. Reward” Talk
How an adult should invest an IRA depends upon the person’s goals and risk tolerance—the same is true for a teen. You can help set those parameters by pointing out to your child that, since he’s unlikely to retire until his 60s this is likely to be a decades-long investment, and enduring short-term downturns is the price for enjoying higher potential long-term gains.
You might also show him the difference between depositing $1,000 now and earning, say, 3% annually vs. 7% annually over the next 50 years—that is, a balance of $4,400 vs. a balance of $29,600. Ask your child: Which would you rather?
No doubt, your kid will choose the bigger number.
But you also want this to be a lesson in the risks involved in investing. You might talk about what a severe one-year decline of 40% or more might do to his investment and explain that bigger drops are more likely in investments that have the potential for bigger growth. Now how do you feel about that 7%?
Some teenagers will be perfectly fine accepting the risk. Others may be more skittish.
You also might explain that there are options that will not decline in value at all—such as CDs and money market accounts. But should he choose those safer options, he’ll be trading off high reward for that benefit of low risk. In fact, while his money will grow, it will likely not keep up with the rate at which prices grow (“inflation,” in adult terms). So his money will actually be worth less by the time he’s ready to retire.
Some risk, therefore, will likely be necessary in order to grow his money in a meaningful way.
Choose Investments Together
Assuming he can tolerate some fluctuation, a stock-based mutual fund is probably the most appropriate and profitable strategy—especially since a fund can theoretically offer him a ownership in hundreds of different securities even though he may only be investing a few thousand dollars. You might explain that this diversification protects against some of the risks of decline since some stocks will rise when others fall.
A particularly-suitable option might be a “target date” or “life cycle” fund. These offerings are geared toward a specific year in the future—for instance, one near the time at which your child might retire.
Target date funds are usually a portfolio comprised of several different funds. The portfolio allocation starts out fairly aggressive, with a majority of the money invested in stock-based funds, and much smaller portion in bond funds or money market accounts.
As time goes by—and your child’s prospective retirement draws nearer—the allocation of the overall fund gradually becomes more conservative.
The value of the account can still rise and fall in the years nearing retirement, but with likely less volatility than what could be experienced in the early years.
One low-cost example of this type of investment is the Vanguard Retirement 2060 Fund (VTTSX).
Of course, if you choose a brokerage account for your child’s Roth IRA, you have the option of purchasing shares in a company that might be of particular interest to your kid. Choosing a company that is familiar to your child may not only inspire her to watch the stock and learn more about it, but eventually profit from the money she is spending on “her” company’s products.
If you’re going to go this route, you should include a discussion on the increased volatility (for better or worse) of owning one or two stocks, rather than the diversification offered by the aforementioned mutual fund.
Kevin McKinley is a financial planner and owner of McKinley Money LLC, a registered investment advisor in Eau Claire, Wisconsin. He’s also the author of Make Your Kid a Millionaire. His column appears weekly.
Read more from Kevin McKinley:
- The Surprising Place Your Kid Should Save His Summer Earnings
- Four Reasons You Shouldn’t Be Saving for College Just Yet
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- The Simple Formula That Can Help You Achieve Financial Independence