As if air travel weren't bad enough -- no food, lost luggage, security threats -- now we also have to contend with disgruntled pilots. Delta Airlines received court approval Sept. 5 to terminate a defined-benefit pension plan for pilots. Once the Pension Benefit Guaranty Corporation approves the decision, there will be one fewer pension plans for American workers. Delta joins U.S. Airways
According to a recent survey by Wells Fargo's benefit consulting group, only one-third of American companies still offer a traditional pension. More telling is that of these companies, 52% plan on terminating, reducing, or restricting their pension plans. "Clearly, employers expect workers to accept greater responsibility for their long-term financial security," said Laurie Nordquist, head of Wells Fargo Institutional Trust Services. Uncle Sam clearly agrees; how else can one explain Social Security's current crisis, not to mention years of blown federal budgets?
The pension challenge
It is unrealistic to hope the trend in pension terminations will reverse. Whether or not your employer has a pension plan, the 401(k) and the individual retirement account are most likely going to be your key sources of retirement income. Unlike pension plans, they move with you between jobs but guarantee only the return generated on your contributions. Individuals are free to choose how much to contribute and, often, what to invest in.
The problem is that we're not doing very well with our newfound investing freedom. Dalbar, a Boston investment firm, reported that from 1984 to 2000, individual retirement accounts returned a meager 5% annually, while CalPERS (California's state employee pension) earned 9.38% over the same period. In general, returns on individual defined contribution accounts lagged 2% behind company-managed defined benefit plans. Over a 30-year period, assuming $5,000 annual investments, that 2% difference means $250,000 less for retirement.
Why do the company-sponsored plans beat individual accounts? For starters, company pension plans are run by investment professionals. Assuming the company makes good on funding the plan, the investment managers generally perform well; many of them have years of education and experience in the field, not to mention that managing investments is their full-time job. But this doesn't mean individual investors are doomed to underperform. While they may not have as much time to dedicate to managing their portfolios as professional money managers do, individual investors can eliminate most of that 2% performance gap by cleaning up simple errors in retirement account planning.
The pension solution
Step one: Diversify. Company pension funds do not completely invest back into the company stock; neither should your retirement account. Your salary and health care are likely dependent on the profitability of your employer; why increase your risk by holding company stock? Yet so many 401(k) participants make this dangerous mistake. Because of company matching policies, contributions into 401(k)s are often in the form of company stock, but as soon as those shares vest, you should diversify into other stocks and investments. If you need more encouragement to fix this problem, type "Enron 401(k)" into Google. The average Enron 401(k) account was 60% Enron stock!
The second reason why individual accounts fall behind is their level of portfolio risk. This is best controlled through asset allocation. It is the equity portion of the portfolio that will drive the risk and return. Young workers, with 30 years or more of the rat race ahead of them, should have at least 60% in equity funds. Anything less will not deliver sufficient long-term gains. An equity mutual fund or exchange-traded fund can deliver the entire U.S. equity market in one cheap trade, with expense ratios lower than 0.25%.
The remaining assets should be money-market funds, bonds, inflation-protected treasuries, and emerging-market or non-U.S. equities. A good initial allocation for a young investor would be 70% U.S. equity, 20% corporate bonds, 5% emerging markets, and 5% inflation-protected treasuries. These asset classes can all be captured in low-cost funds and ETFs. Keep it simple, hold four or five funds, and rebalance the portfolio once or twice per year, back to your target allocation. Investors closer to retirement age should shift the allocation from the risky investments (equity, emerging markets, and corporate bonds) to the less risky (treasury bonds and money markets). Returns will decrease, but so will variability. When you're ready to buy that boat at last, you don't want your account to lose $50,000 in one bad market week.
With a diversified portfolio, asset-allocated to an age-appropriate risk level, the individual retirement account can keep pace with a professionally managed company pension fund. To close the last of the performance gap, the individual investor must pay attention to costs and fees, just as the professionals do. Money managers spend much of their time negotiating costs and fees because they understand how those little bites can turn exceptional portfolio returns into mediocre performance. Don't sweat short-term market events; focus on what you can control -- costs.
A few simple guidelines will help you keep your hard-earned returns. For starters, never open an account that charges a maintenance fee. With the proliferation of brokerage firms, you can easily find a fee-free home for your IRA. As for your 401(k), your employer shouldn't have a maintenance fee at all. In addition, pay careful attention to the expense ratio when selecting mutual funds or ETFs. There are dozens of U.S. equity index funds with nearly identical performance, and their annual fees are easily found on the Internet. The same holds true for the other asset classes, provided you aren't buying something too exotic.
Finally, beware of transaction costs. For your IRA, you shouldn't be paying more than $15 per trade. If you are, move your account elsewhere. In your 401(k), the program will define trading policies. Regardless of specific transaction costs, the easiest way to minimize them is to limit your trading. In this type of account, you'll perform better by trading only when rebalancing the portfolio to your target allocations.
Pension plans are becoming quite rare, so you can't settle for poor 401(k) or IRA performance. But that doesn't mean you have to take on extraordinary risk in your account. Earning close to the historical U.S. stock market return (10%-12%) will provide a very comfortable retirement cushion. And by fixing the common mistakes in your individual account, you can lower your risk and increase your expected return.
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Fool contributor Ryan Popple doesn't own any of the stocks mentioned in this article, and he'll probably never see any of the money that Social Security takes out of his paycheck. He welcomes your feedback. The Fool has a disclosure policy for the ages.
