Analyzing and Allocating Your Retirement Plan

Whether 3 or 30 years away, retirement is a major investment goal for just about everyone. It is never too soon to begin thinking about where the money will come from. More and more, employers are sponsoring plans that allow you to save part of your salary and invest it toward retirement. For many reasons, these plans are an excellent opportunity to build a foundation for retirement savings. Types offered depend on a variety of factors, most notably the size and nature of the company you work for. Common plans include the 401k and the 403b, but there are others. Most have significant advantages over regular investment accounts, such as tax-deferred growth (you do not have to pay tax on investment earnings until you take distributions from the account). Furthermore, your contributions may also lower the amount of your taxable income. Employer sponsored retirement plans are even more attractive if your employer matches your contributions. Exploring your options can be a big task, especially if you are not an experienced investor. In many cases, your employer will give you a list of investments (usually mutual funds) to choose from. 

Step One – Establish an Investment Plan. Before you even begin to analyze your plan’s investment choices, you need to establish an investment strategy. Essentially, you want to decide on your investment “policy” before you start. Things to consider include: time until retirement, your expectations for investment earnings, and your tolerance for risk. When forming your investment strategy, pay particular attention to the amount of risk you are willing to take. Investment types that typically change less in value from day-to-day include money markets and high-grade corporate or treasury bonds; medium to high risk investment classes usually include real estate, large domestic and international stocks; and small company and emerging market stocks are often considered to be really high risk investments. In the end, you want to decide on what percentage of your account will be invested in each of the above mentioned investment types. This is known as your “Asset Allocation”. An example of an asset allocation is as follows:

15% Money Market

10% International Stock

25% Treasury Bonds

05% Small Company Stock

20% Corporate Bonds

05% Emerging Market Stock

15% Large Domestic Stock

05% Real Estate Company Stock

*Not intended as a recommendation for anyone or any asset allocation. 

Once you have decided on your Asset Allocation, you are ready to find and pick the investments to fill those categories.

Step Two – Obtain a List. …of all of the investment choices (usually mutual funds) that are available within your employer sponsored retirement plan. Your employer may provide such a list, or you should be able to get a list from the investment firm’s website. Make sure the list is up-to-date.

Step Three – Evaluate Your Choices. …begin gathering information on each. It is often better to perform your research using data from a non-biased third-party. Commonly used sources of information on mutual funds are Yahoo! Finance and Morningstar.com. You goal is to find the funds that best fit your investment plan. As an example, if your investment plan calls for 08% in international stock, evaluate the choices and find the best international mutual fund available to you. Begin by searching for each mutual fund and then printing the corresponding data so you can compare side-by-side. Some factors that are important to analyze and compare between funds include: summary / fund objective, manager tenure, expense ratio, annual turnover, holdings, average rate of return, and standard deviation. Remember, when evaluating potential investments, the more data the better. That is, a mutual fund with 10 years of historical data should be more insightful than a fund with only 3 years of data (assuming the fund and its objective have not changed significantly within that time period).

Take your time evaluating and selecting the funds for your retirement plan—you want to finish with a selection of mutual funds that you feel comfortable and confident with.

Summary / Fund Objective – indicates the basic objective of the fund and categories of fund holdings. As a general rule, avoid funds that invest in multiple asset classes. That is, it is better to buy one stock-only fund and one bond-only fund than buying just one fund that invests in both stocks and bonds. By avoiding these mixed funds, you can better assure that your portfolio is allocated exactly as you desire. Additionally, the summary should tell you if the fund invests in high-risk securities attempting to achieve a greater return, or if the fund invests more conservatively. By applying your investment strategy, you can eliminate some funds from consideration based solely on their summaries.

Manager Tenure - reveals how long the fund has been under the direction of the listed manager. The manager (or management team) typically decides the holdings and when to sell or buy more. Therefore, a fund will normally be in better accordance with its description and objective if it has been under the same management for a long period of time.

Expense Ratio - represents the amount subtracted annually to cover operating expenses, manager fees and other costs. The expense ratio and any other fees are deducted directly from the fund, without any immediate notification to the shareholders. As a rule, the expenses of a fund must be disclosed within its prospectus. Although they are sometimes hard to find and difficult for investors to fully calculate, they are there and have a large effect on how much you make. For example, an expense ratio of 2.68% will reduce your return by 2.68% from what it otherwise would be for the year.

Annual Turnover - represents how often a mutual fund’s holdings are purchased and/or sold. For example, a fund with 10 holdings that sells 5 in a given year has an annual turnover of 50%. Though a high turnover does not necessarily indicate anything negative, funds with higher turnover ratios can be at a disadvantage due to a mutual fund’s tax treatment and its requirement to payout a certain percentage of capital gains. Additionally, a higher turnover rate means more transaction costs within the fund, which of course means less return to the investor.

Holdings - indicate what the fund invests in. Reviewing the holdings can show you if the fund sticks to its objective. For example, an international stock fund with U.S. Treasury Bonds is not being true to its objective. However, a large company stock fund with Microsoft and Coca-Cola would appear to be accurately invested. The holdings can also reveal overlap when comparing funds. By analyzing the holdings, you may be able to eliminate two funds with the same holdings. The holdings can highlight many other important factors as well, such as: the overall diversification of the fund, the international exposure within the fund, or the grades of bonds contained within the fund.

Average Rate of Return - will indicate how the fund has performed in the past. This is important, but should not be the sole factor for making your decision. Too often, investors “chase” the mutual fund with last year’s highest return. Be sure to stick to your investment plan and consider all factors such as cost and risk before deciding on any investment. 

Standard Deviation - a measurement of the potential volatility of an investment. Simply stated, it gives the investor an idea of how much fluctuation to expect from a fund. Though it is not certain, standard deviation will allow you to see which fund has been more volatile in the past. By utilizing this statistic, you can rid your portfolio of funds that fluctuate too much or too little for you. And remember, though it is not always true, a higher standard deviation often corresponds to a potential for a higher return, but also a potential for a greater loss.

There are many other factors you can analyze that are not mentioned within this article, such as: beta, alpha, Sharpe ratio, and Treynor ratio. However, using the above listed factors in conjunction with your investment strategy should help you to properly evaluate your employer sponsored retirement plan options. It is important to realize that picking “the best” set of mutual funds is virtually impossible. No matter how much research you or anyone else does, the goal should be to compose a well-balanced portfolio that is generally representative of what you are looking for in terms of risk and return. You should be confident in your fund choices and comfortable enough with your portfolio that you do not have to worry about always changing your investments or constantly watching the market’s every move. Monitor your portfolio and review your allocation along with the mutual fund offerings at least annually, if not more often. Each time you evaluate the investments within your employer sponsored retirement plan, reassess your investment strategy and make sure it still fits your goal.

One should consult with a qualified financial planning professional prior to implementing any financial planning strategies. If you are a real estate planning, insurance, tax or mortgage professional receiving this newsletter, please call our office and introduce yourself to us. We are always seeking to grow our referral network and expose more service professionals to our client base.