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Frequently asked questions about investing for retirement

How does inflation affect my retirement investment planning?
Inflation is a factor whenever you’re investing, but it takes on added importance when you’re saving for retirement. Inflation, of course, is the gradual increase in the cost of living. While it hasn’t been much of a problem over the past few yeas, it hit a staggering 14 percent in the 1980s and has averaged 4 percent over the last 70 years. Assume inflation continues to average 4 percent a year for each of the next 20 years. If you retired today, you would need to earn twice as much 20 years from now just to maintain your current standard of living. And since you won’t be working, you will have to depend on your investments to do the work for you.

Should I be more conservative with my investments as I near retirement?
People who are nearing (or have already reached) retirement age should steadily shift their money out of higher-risk investments and into those that offer more security. The younger you are, the more risk you can take. If an investment doesn’t work out, you’d have plenty of working years left to recoup your losses. The safety of your investments takes on a whole new dimension after you retire, in part because your portfolio-not a job-will generate most of the income you need to survive. However, you should not make the mistake of moving all your assets into fixed income investements because you may find that the performance they give does not keep pace with inflation. A better approach is to increase the allocation into government securities, bank-insured certificates of deposit and low-risk mutual funds that invest in money markets and government securities. At the same time, keep a significant portion of your portfolio invested in equities, that is stock or mutual funds that invest in stock.

Should I be concerned about the volatility of the stock market and the safety of my retirement funds?
Don’t evaluate your retirement investments in isolation, but rather in terms of your overall portfolio. At any age, a prudent way to hedge against uncertainties of the future is to hold a balanced portfolio of stocks, bonds and cash reserves. In the stock market, many factors can cause the return of a stock or bond to vary. One relates to changes in the corporation (issuer) or the way investors perceive the company. The other has to do with movements in the overall market. This means there are two components to the risk that an investor faces: market risk, which is inherent in the securities market itself, and company risk, which has to do with the unique characteristics of any one security and the industry in which it operates. About 70 percent of the risk you face as an investor is company risk. This risk can be eliminated by diversification among different securities. Market risk is the other 30 percent of total risk and cannot be avoided by diversification, for all securities are affected to some degree by the overall market. Mutual fund investors are able to achieve diversification (and the elimination of company risk) by indirectly investing in many different companies. But remember, the diversification a mutual fund provides does not eliminate market risk (or bad judgment by the fund’s management).

Are corporate bonds any safer than stocks?
Bonds overall are less risky due to their fixed interest payments and the prior rights of bondholders over stockholders if a company declares bankruptcy. However, over the long term, bond investments that pay a fixed rate of interest run the risk of lagging behind inflation, causing an erosion of the purchasing power of those payments. Bond prices and yields at issue are tied to prevailing interest rates in the economy. As interest rates fall, bond prices rise because the value of bonds with relatively higher rates increases. When rates rise, the prices of existing bonds fall. This price relationship holds for all bonds, corporate, Treasury, and municipals. The extent of a bond’s rise or fall depends on its maturity; the longer the maturity of a bond, the greater its sensitivity to interest rates. The ups and downs of bond prices in the market are largely irrelevant if you plan to hold the bond to maturity. You get the same steady stream of income throughout the life of the bond. Corporate bonds have lower but steadier returns (the combination of income and change in value) than stocks, and represent a reliable source of income. In addition, when added to a portfolio of stocks, bonds act as a stabilizer because they reduce volatility. The real advantage of stock/bond diversification, however, is that it lowers your risk more than it lowers your potential return. Bondholders have a prior residual claim to corporate assets over stockholders in the event of bankruptcy.

Why are bonds considered less risky than stocks?
Bonds overall are more reliable than stocks due to their fixed interest payments and the prior rights of bondholders over stockholders if a company declares bankruptcy. All investments are designed to produce income or grow in value (sometimes both). Of the two, income is much more reliable than growth. After all, a company’s management cannot make its stock price rise, but it can pay interest to its bondholders and declare stock dividends for shareholders. Therefore, income-producing investments are considered safer (in this case, safety is defined as reliability) than growth-oriented investments because investors can expect to receive their income more reliably than they can expect an investment to grow in value. The greater certainty in bond cash flows over stocks has a price; historically bonds have underperformed stocks with respect to investment yields.

Should I put my money in a mutual fund?
Mutual funds have become the investment of choice for millions of investors. The basic idea of a mutual fund is simple. It is an organization whose only business is the investment of its shareholders’ money into cash equivalents (money markets), stocks, bonds or a combination of stocks and bonds, for the purpose of achieving specific investment goals. To do this, it attracts funds from many individual and institutional investors, and it attempts to invest and manage those funds more effectively than investors could do on their own. More and more investors are using mutual funds to achieve at least some of their investment goals. One of the most important reasons why investors choose mutual funds is the availability of past performance records. You can see a complete and unquestionable picture of what a fund has achieved in the past. However, past performance may not be an indicator of future performance.To help you achieve your investment objective, mutual funds can provide you with the three basics of prudent investing: (1) careful selection of securities, (2) diversification and (3) liquidity.

What are the risks of a mutual fund?
The biggest risk is that the companies in which the fund has invested will perform poorly, suffer mismanagement (a la Enron or WorldCom) or otherwise meet with misfortune. Another big risk: some economic, political or other development will cause the overall market to fall, dragging down with it the holdings of your particular fund. These are risks you would face investing in individual stocks as well; at least mutual funds can offer diversification. But some risks are unique to mutual funds. The fund management, for instance, may be doing things you don’t know about or wouldn’t like if you did. What you think is a plain vanilla domestic equity-income fund might, in order to boost returns, invest in derivatives, invest overseas, or invest in growth companies that pay little or no dividend. In a downturn, you could be in for an unpleasant surprise. There is also the risk that the fund will underperform a benchmark index, which means that management fees aren’t buying any added value.

What advantages do mutual funds have over individual securities?
Mutual funds have a number of advantages over individual securities. A key advantage is that mutual funds are generally more diversified . A typical fund invests in dozens of securities. Thus, small investors can achieve a level of diversification greater than they could on their own or with less effort than they could on their own. The funds are professionally managed, which logically should add to your investment returns in the long run. Investing in a mutual fund will also save you lots of paperwork headaches because the monthly and annual statements will summarize short- and long-term gains, dividends and interest earned on your account. Most also offer telephone and online trading, which makes buying, selling or switching funds a snap. Idle cash can be automatically invested at competitive rates in a money market fund and many companies also offer unlimited checking privileges, debit cards and credit cards, much as a bank would. You can even designate a beneficiary so that, when you die, there will be none of the delays and expenses of probate.

How can I put mutual funds into an Individual Retirement Account (IRA)?
Most mutual fund companies have arrangements with a bank or trust company for people who want to put their mutual fund shares into an Individual Retirement Account (IRA). The bank or trust company is considered the "custodian" of the account, and will usually charge a modest $10 or $25 fee for its services. As an alternative, you can open a brokerage account IRA and purchase mutual funds within that. The process is similar to using a broker to buy funds normally, except that a single IRA custodian fee in the range of $25 to $50 will be charged. Some mutual funds offer IRA accounts directly. Whichever method you choose, write a separate check for your contribution. You can usually then deduct the fee on your income tax return, and you’ll have that much more money growing tax-deferred inside your Individual Retirement Account.

How can I use the equity in my home for retirement?
Your home can be a good source of cash to make other investments, as long as you invest wisely and don’t go overboard. There are several ways to tap the equity in your home to get the money needed for investing. 1) If you have a lot of equity in your house, you can refinance and draw out some cash to invest in stocks, bonds or mutual funds. 2) If the rate on your current home loan is relatively low, you might want to leave it untouched and instead take out a small second mortgage to make other investments. 3) You could also set up a home-equity credit line that could be tapped for cash when a good investment opportunity arises. One of the advantages of using your home equity to make other investments is that you can deduct most or all of the interest you pay on the loan-regardless of whether you refinance, take out a second mortgage or set up a home-equity credit line. That’s because you can deduct up to $1 million in mortgage interest charges on your tax return, plus an additional $100,000 in home-equity borrowing. The hitch is that the return on your investments needs to be higher than your cost of borrowing. You need to be very careful about taking a source of financial security, the equity in your home, and risking it on investments that present a significant risk of loss, such as small-cap stocks or high-yield junk bonds.

What is asset allocation?
Asset allocation is the process of deciding how much of your investment portfolio should go into stocks, bonds or other asset classes (as opposed to picking individual stocks or bonds). Your decision in this respect is perhaps the single biggest factor that will determine your long-term investment outcome, so make it carefully. The basis of your decision is how much risk you are willing to take and your investor life cycle phase. More risk should mean, over the long term, a higher return.

What is the difference between strategic and tactical asset allocation?
Strategic asset allocation is a passive, buy-and-hold strategy where assets are allocated among the general categories of cash and cash equivalents (money market funds, etc.), debt (notes and bonds), and equity (stock). Arguments among academics and investment professional exist as to the impact strategic asset allocation has on total return. Some studies suggest it accounts for over 90% of the investment return. In other words, individual security selection may be far less important than the proportion given to the asset classes. Tactical asset allocation is an active investment strategy incorporating market timing, contrarian investing and other techniques. It is a trading strategy rather than a buy-and-hold strategy.

What’s so important about asset allocation?
How you allocate your investments is a key factor that determines how well your investment portfolio performs. If every penny you own is invested in high-risk commodity futures, you have the potential to earn huge profits-or lose everything that you have invested. Conversely, if you have your money allocated among several different kinds investments-stocks, bonds, money market funds and the like-your return is likely to be lower but your chances of losing everything are slim. Younger people can generally afford to take more risks than older people, in part because younger people simply have more working years ahead of them to earn money and bounce back from an investment that turns sour. Older people have to be more conservative, because their highest-earning days are behind them and recouping from a bad investment would be more difficult. An asset allocation strategy can help you to accomplish two important goals: first, it can help you to ride out the ups and downs of the market by diversifying your investments, and second, it lets you adjust your exposure to risk, based on your desired levels of safety and return on investment.

I’m only a few years away from retirement, how should the assets in my portfolio be allocated?
Asset allocation refers to the way you have your money divided into different investments with different levels of risk. If you’re five or so years from retiring, you’re considered a "pre-retired" investor. You have probably already begun shifting your mental focus toward how you will live after you quit working, so your investment strategy must shift as well. You can still afford some moderate risk, but not so much that one bad investment will knock your retirement nest egg right out of the tree. If much of your wealth is "on paper" (i.e. in investments that can lose a substantial portion of their value, such as stocks) plans should be made to begin converting it to more conservative investments and cash equivalents.

Now that I’m retired, how should I allocate the money in my investment portfolio?
Asset allocation refers to the way you have your money divided up into different investments with different levels of risk. Once you have retired, you can’t afford the risks a young investor could take because your working years are over and rebounding from a bad investment could be difficult. A top priority is protecting your nest egg from inflation. If much of your wealth is "on paper" (i.e. in investments that can lose a substantial portion of their value, such as stocks) plans should be made to begin converting it to more conservative investments and cash equivalents.

What are considerations to buying a new home?
Builders may have a target market in mind for their new-home projects. Some may tout communities as glamorous to upscale urban professionals seeking amenities such as a golf course, hot tubs and tennis courts. Yet a playground and swimming pool might be central to a project geared toward families while the next one offers seniors a walking trail and an easy-to-care-for yard. Do not be tempted to move into a "glamorous" community where you might be able to afford the house but not the lifestyle. In addition, similar-looking new houses often come with restrictions imposed by the developer on house color, landscaping, renovations and anything else a homeowner possibly could do to make their house deviate from the preferred look. Marketing experts try to appeal to buyers’ tastes by promoting images for their developments. Don’t buy into it. Form your own opinions and only buy a home where you feel comfortable.

What are the historical rates of return for cash, bonds and stocks? How should these returns affect how my assets are allocated?
To create a successful long-term investment plan for a lump sum of money, it’s important to strike a balance between the three major financial asset classes.
1. Cash and cash equivalents provide a stable investment value and current investment income. This group includes money market funds, T-bills, and bank CDs.
2. Bonds are interest-bearing obligations issued by corporations, the federal government and its agencies, and state and local governments. The yields offered by these securities are generally higher than those of cash reserves, but their value fluctuates with interest rates and bond market conditions.
3. Common stocks represent ownership rights in a corporation. They offer potential for capital growth and often pay dividends. Stock market risk can be substantial, however, as any one who invested in 2000 or later can tell you. Your investment returns depend to a great extent on how you allocate your money among these three asset classes. Common stocks have historically delivered the highest returns.
Since 1926, according to Ibbotson Associates, the average annual return on stocks has exceeded 10%. The return on bonds has been 5% and on cash reserves less than 4%. Although stocks and bonds offer the potential for higher returns than cash reserves, they also expose you to more risk, particularly in the short term. Also, remember that these historical returns are averages, which means that to get a 10% average return, annual returns greater than 10% must be offset along the way by annual returns of less than 10%. Finally, historical average returns do not assure future returns.

What is liquidity? What are liquid assets?
Liquidity is a measure of how easily you can unload your holdings in a particular investment without losing substantial value. Liquid assets are those most readily converted to cash within a year or less. Generally, the more aggressive an investment is, the more subject you are to the risk of holding an illiquid asset. Stocks of small companies and junk bonds, for instance, are relatively easy to buy and sell under normal conditions. But when bad news hits these markets or investors become cautious, the ability to sell at a fair price may temporarily vanish.

Does keeping your money in cash mean literally cash?
Cash and cash equivalents are a financial asset class but generally are not considered an investment. Cash equivalents are used to park "uninvested" cash for future investments or for maintaining an emergency reserve. Cash equivalents generally refer to investments in securities with maturities of less than one year and that are safe from loss of principal. These include checking, savings and certificates of deposit (CD) accounts at banks and savings and loans, money market mutual funds and Treasury bills (T-bills). Cash instruments play an important stabilizing role in your investment portfolio. No matter how much or how little your cash earns in interest, it cannot fall in principal value, which certainly cannot be said for stocks and bonds. However, cash will fall in purchasing power due to inflation. Many cash instruments, including money market accounts, NOW accounts and passbook savings accounts, are instantly accessible either by writing a check or withdrawing cash at an automated teller machine (ATM). Other cash vehicles, including CDs and T-bills, which have short maturities, allow you to get at your money when the instruments mature in a few months. The liquidity of cash is one of its main advantages.

What are cash equivalents?
Cash equivalents is a generic term for various short-term instruments, such as U.S. Treasury bills, certificates of deposit and money market fund shares with maturities of less than one year. The term is used because those types of securities can be quickly and easily sold to raise cash. While CDs can be quickly turned into cash, they are not very liquid due to the loss of value from penalties imposed if cashed before maturity.

What is an asset allocation, or lifestyle, fund?
An asset allocation fund, sometimes called a lifestyle fund, is designed to provide you with the diversification needed to weather virtually any market or economic environment. Most of these funds have been created over the past five or six years. They typically invest in a variety of assets -- domestic stocks, foreign stocks, bonds, money market instruments -- that you’d normally buy in separate funds. Many 401(k) plans now offer several asset allocation funds, each with a different investment mix and risks ranging from the very conservative to the very risky. In essence, when you invest in a lifestyle fund, you’re hiring a manager to make your asset allocation decisions for you.

Why buy asset allocation mutual funds?
Purchased primarily for total return, asset allocation mutual funds invest in stocks, bonds and money market securities. One feature of such a fund is flexibility-the fund may shift all or most of its assets into one type of security, such as all stocks or all bonds. The portfolio manager usually uses an asset allocation model to time the market. This helps him decide when to shift the assets. Market timing is the technique of trying to buy low and sell high rather than staying fully invested for the long term. The typical investment objective of an asset allocation fund is capital appreciation. The basic risks associated with the fund are risk of principal, credit risk and interest rate risk.

Can variable annuities be used as part of an asset allocation strategy?
A variable annuity’s investment alternatives should have fundamentally sound objectives that seek long-term superior investment returns commensurate with the market risks assumed by an investor. For example, the Vanguard Variable Annuity Plan offers these investment choices: money market portfolio, high-grade bond portfolio, balanced portfolio and equity index portfolio. A variety of investment alternatives offered by variable annuities give you the flexibility to tailor your investment portfolio to meet your particular needs. You can allocate the investments in variable annuities to spread your risk across a balanced portfolio of stocks, bonds and cash reserves. There is no single answer to determining the best balance. According to Ibbotson Associates in Chicago, the long-term (70 years) return on cash reserves has been 3.7%, on bonds, 5.0% and on stocks, 10.3%, but your yield from investments in a variable annuity may be lower than similar investments held in an IRA or 401(k) account, both because of the related insurance costs and generally higher fees. The earnings do grow tax-deferred, and there may be a death benefit in excess of the cash value of the varible annuity. Also, some variable contracts have evidence to show their returns are slightly better than the retail fund counterpart because the manager does not have to keep as much of the fund in cash reserves to meet redemption requirements. With variable annuities redemptions occur much less frequently. For historical returns and information on variable annuity plans, see "Grow Rich With Mutual Funds Without a Broker" by Stephen Littauer (Dearborn Financial Publishing, Chicago). We should note, however, that the asset allocation is the underlying investment mix associated with the variable annuity, not the annuity itself.