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In This Issue: Take Advantage of New Pension Laws Cisco Tale is Fodder for Optimism
Take Advantage of New Pension Laws The surge of new pension laws has widened the window of opportunity for retirement savers. Anyone worried that a current nest egg will fall short of what's needed for a secure retirement has been given a second chance. In light of the pension law changes, this column offers a simple but comprehensive list of the key provisions. This is the list to keep in your wallet, next to the barbecue or pinned on the golf bag to settle arguments and astonish your friends during the long hot summer: 1. The 401(k) voluntary contribution limit will be $11,000 in 2002 and will rise by $1,000 per year until reaching $15,000 in 2006. The limit is currently $10,500. 2. The maximum 401(k) contribution from all sources (i.e., employee voluntary plus employer matching or profit-sharing contributions) is $35,000 in '01. It will increase to $40,000 in '02. 3. The maximum earned income that can be considered for retirement plan contributions - currently $170,000 -- will rise to $200,000 in '02. Previously a company contribution equal to 10% of annual income would have been maxed at $17,000; now it would be $20,000. 4. The dollar limits above have often been superceded by percentage limits. For instance, the maximum contribution for any one employee has been the lesser of $35,000 or 25% of income for 2001. For all employees combined, the average percentage contribution from all sources could not exceed 15% of the entire payroll of eligible employees . Under the new law, this 15% limit has been raised to 25% beginning in '02. 5. The old law would have included a voluntary 401(k) contribution as part of the 25% limit. The new law separates out the voluntary 401(k) contributions, allowing them to be over and above the 25% limit. For all practical purposes, the former percentage limitations are out the window. In most cases under the new laws, the dollar limits rather then the percentage limits will be the controlling factor. 6. "Catch-up" contributions are an option for individuals aged 50 and over. This amounts to an allowance of additional contributions over and above the regular 401(k) voluntary dollar limits. The catch-up allowance in '02 is $1,000. It will rise by $1,000 per year until reaching $5,000 in '06. This means that by 2006, the total 401(k) voluntary contribution will be $20,000 for anyone over age 50. 7. For lower-income employees (those making less than $40,000 per year) there is an increase of the percentage limit from 25% to 100% of income. For employees earning over $40,000, the percentage limit of 100% is capped at $40,000. For these lower and middle-income employees, the voluntary 401(k) deferral is included in the maximum limits. 8. When it comes to IRA's, today's $2,000 annual limit will steadily increase to $3,000 for '02,'03 and '04. Then it will be $4,000 for '05, '06 and '07. It will bump to $5,000 by '08. 9. "Bonus" IRA contributions for people over 50 will be $500 in '02, '03, '04 and '05. These contributions will bump to $1,000 in '06. What are the bigger implications of this grab bag of changes? For one thing, it now makes economic sense to take a second job or send a spouse back to work. An extra $40,000 per year socked away in a retirement plan earning 10% will accumulate to over $1,000,000 in just 13 years. That's one million dollars! Furthermore, the tax deductible treatment of the $40,000 means that it only costs about $25,000-$30,000 of what would have been the additional after-tax take-home pay. This giant "government subsidy" could fill the hole left in our retirement plans by recent stock market declines. It is the closest most of us will come to having a numbered Swiss bank account. Basically, the new laws leave you with no excuse for not saving adequately for retirement. All too often, the government has approached pension legislation with a misguided mindset, but this time they have done something right. These new laws allow us to save aggressively, and almost half of what we deposit is money that would otherwise have disappeared in taxes. When I first read these new provisions, I thought I was in some offshore tax haven. Let's enjoy it while it lasts.
In April I had the pleasure of appearing on CNBC, along with Vanguard's vice president of retirement services. The topic was how the stock market's downdraft was having an impact on the investment decisions of 401(k) participants. To illustrate my view, I borrowed a line from that noted investment advisor, Charles Dickens. I chose two mutual funds to illustrate how different fund types perform in different markets -- during the best of times and the worst of times. By spreading investments evenly over these two funds, an investor would have been insulated from the 12-month downdraft that has caused so much media hysteria. In one corner is Janus Twenty, a fine example of a growth-oriented fund. In the opposite corner is Van Kasper Comstock, which offers an equally successful representation of value investing. In 1999, Janus Twenty topped Van Kampen by 63 percent. In 2000, Van Kampen outperformed Janus Twenty by 64 percent. So far this year, Van Kampen is the winner by about 20 percent through March, but in 1998 Van Kampen was the loser by about 50 percent. As I said on CNBC, "Every dog will have its day in the investment business." The Janus and Van Kampen funds' results have positioned them as polar opposites from year to year. However, when viewed over the past five years, they wind up surprisingly even. Janus turns out to be the winner, but only by a slim margin. If markets this year continue to favor value investing, Van Kampen will catch up. Buffett The Index Slayer This pendulum swing between growth and value was highlighted last week at the "Capitalists' Woodstock" in Omaha, Neb. - the annual shareholders meeting of Berkshire Hathaway, the company run by Warren Buffett. Value investing is what Warren Buffett does, and he has overtaken the Nasdaq Index for the first time since the beginning of 1999. The S&P 500 index lost 21 percent in the 12 months ending in March, but Berkshire Hathaway, Buffet's investment vehicle, was up about 12 percent in the same period. In 1999, Berkshire Hathaway trounced the S&P 500 by 16 percent. Redemption for any investment style is usually just a market cycle away. What's the difference between value versus growth? There's a simple explanation, which, like the layers of an onion, gets more complicated and intellectually satisfying. Essentially, value investors are discount shoppers who invest in companies that the public has overlooked. These companies have been judged by value investors to be worth more than the total value of all the stock owned by public shareholders. Remember, stock prices bounce all over the place based on overall market conditions, but the appraised value of, say, all those trucks and planes at UPS remains pretty much the same from month to month. Warren Buffett would refer this as the "intrinsic value" of UPS. Growth stocks, on the other hand, are companies that are glamorous and whose sales are rising quickly even if they fail to be making any profit. Remember how excited we were about these stocks two years ago? Working The Grid Whether a mutual fund is investing with a growth or value philosophy is not always apparent from the fund's own literature and prospectus. Morningstar is the best source of this information. Their style box that accompanies each one-page fund description is a short cut to identifying the fund manager's approach. The "style box" is a nine-box grid with "Value, Blend and Growth" across the top and "Large, Medium, and Small" down the right side, referring to the size of the average company in the portfolio. All equity (i.e., stock) mutual funds fall into one of these style designations. Your local library will probably have Morningstar's annual directory, or you can access much of the data for free at www.morningstar.com. Digging deeper, the Morningstar page illustrates the Price/Book ratio, which is the value of the company's stock price compared with its book value per share. The book value is what we described above as the actual appraised value of the company's assets. Complicated accounting rules make this a difficult number to determine, because, for example, real estate owned by a company may have been depreciated in value as buildings have "worn out." In fact, these buildings and the land they sit on may be worth a fortune that is ignored by book value calculations. This explains why good stock analysts visit company facilities to determine what is 'behind the numbers." A low average Price/Book ratio of its investments establishes the fund as a value fund. Conversely, a high average P/B is a growth fund. Something in the middle at about the same P/B as the S&P 500 Index is termed a "Blend." The Morningstar page provides a percentage figure showing how the P/B of the fund in question compares with that of the S&P 500. This is a good tool for accurately determining the extent to which you have money spread between different investment types. With this thorough grounding, we can return to the tale of two funds. Obviously, the best strategy would have been to transfer assets from one fund to the other every time the winner was reaching its peak and the loser was beginning its climb. In this respect, we should resist the temptation to try "back-testing" past results and assuming that they will apply into the future. (A side note: The Motley Fool, whose formerly high-flying portfolio is now under duress, is one example of how back testing needs to be continually updated to make it apply to current surprising events. After awhile, it's no longer back testing. It's just gibberish.) Meanwhile, the investor who understands the basics of investment style can consider rebalancing periodically to generate improved results over just sticking with an initial mix of fund styles. Here's what happens when we rebalance a mix of the two funds in our tale: A $1,000 investment in Janus Twenty at the beginning of 1996 would have accumulated to $3,204 by December of 2000. The same investment in Van Kampen Comstock would have compounded to $2,578. An even mix of the two funds at the outset would have accumulated to $2,891. Now, let's assume that we rebalanced the two funds by selling enough of the winner and purchasing shares of the loser to start each year with equal amounts. The combined total at the end of 2000 would be $3,176. Our volatility is greatly reduced over what would have been our experience with either fund alone, and our results are within a few dollars of the best-performing fund. Since we never know, beforehand, what fund type will be the winner in any year, we are guaranteed at least some level of satisfaction. In this example, we have set the stage for being at least half right instead of 100 percent wrong. Why does rebalancing a portfolio generate what appears to be a reward for the time? Because it is a form of dollar cost averaging. We are systematically selling the fund that has been the winner for the period and buying the one that has lost. Ironically, the act of rebalancing, in itself, defines us as value investors if we are buying what is comparatively cheap and selling what has become overpriced. To the extent that more of us adopt this strategy, we will become a nation of Warren Buffetts.
Cisco Tale is Fodder for Optimism The recent 80 percent plummet of Cisco Systems shares illustrates two basic principles of investing. First, a falling tide lowers all the ships -- even great ships. Cisco is a splendid company and a marvelous American success story. Yet its stock has undergone severe punishment since hitting its 52-week high of $70. The second lesson is that diversification -- spreading investments over many companies -- offers a cushion against losses of this magnitude. I've written about diversification in past columns, so I won't pursue that point right now. The question at hand is whether Cisco will become the poster child for a new paradigm of investment thinking -- or whether it's fated to be a poignant symbol of excess, hype and miscalculation. The controversial new paradigm is based on the premise that stocks will henceforth be priced higher than their historical levels. That's because investors are now supposedly comfortable with the greater risks that stocks represent compared with bonds. Investors historically have bid up equity prices to about 15 to 20 times earnings. More recently, P/E ratios have soared higher -- closer to 30 to 40 times earnings. Even in the summer of 2001, after months of declining prices, stocks are averaging 29 times earnings, which is still nosebleed territory by historical standards. A recent book, "Dow 36,000" by James Glassman and Kevin Hassett, argues that the stock market can continue advancing beyond the boundaries prescribed by the ever-popular "reversion to the norm." If there was ever an investment tome that trumpeted the clarion call of "This time it's different!" then this book is it. The book's thesis is that a new generation of investors are more sophisticated than our predecessors. We'll tolerate more fluctuations in stock values in the near term because we're confident that, over a long period of time, we'll be well rewarded by our stock holdings. According to Glassman and Hassett, investors are not insisting that a current stream of earnings be offered at a relatively cheap share price. The new breed is willing to pay more than previous generations. Those old paradigm investors would have blanched, fainted, or gone into cardiac arrest at the thought of buying a dollar of earnings for $40. The new generation believes that $40 spent today may be purchasing what in five or ten years will be $5 or $10 of earnings. According to the authors, it's the delicious potential for dramatic future gains that throws historical price earnings relationships out of whack. That brings us to the networking colossus of San Jose. Cisco was founded in 1984 by a Palo Alto couple who borrowed against their home to raise the capital to make some prototypes in their garage. The husband and wife both worked in Stanford's computer sciences department and were trying to figure out a way to communicate with one other by using their personal computers. A mere 17 years later, the company will gross $26 billion in sales. Cisco's sales to China have gone from $100 million to $1 billion in just a few years, and the same growth is anticipated for India. In the late 1990s, Cisco became a darling of both institutional and individual investors and was briefly the most valuable company in America (as measured by market capitalization), pulling ahead of Microsoft, General Electric and Exxon. Right now, though, it's raining pretty hard on Cisco's parade. The demand for Internet hardware and telecommunications equipment is depressed. A legion of feisty new competitors is on the attack, salivating at the prospect of biting into Cisco's historically huge profit margins. Cisco has laid off employees and put expansion plans on hold. Cisco's stock has suffered terribly, as have shareholders who were late arriving at this particular party. Investors need to ask if this will be a long, tormented struggle back to respectability. Remember that RCA needed about forty years to return to its 1929 stock value, when it had a monopoly on the hardware of radio technology. Or will Cisco perform more like resilient Nifty Fifty stocks, which collapsed in the '70s but rebounded to deliver tremendous rewards in the '80s and '90s? If you buy the more optimistic picture -- namely, that Cisco's current woes only reflect a momentary overstuffing of its product pipeline -- then we might expect its earnings per share to increase again in the near future. With a stock price around $18, Cisco could represent a tremendous value. It's like the stockbroker who was once asked when would be a good time to buy Microsoft. He responded, "The stock market is open about 210 days of the year, and any one of those days is a good time to buy Microsoft." The authors of "Dow 36,000" would say the same for Cisco. During times of pervasive market gloom, it's heartening to read books that claim that the stock market is underpriced (Harry Dent's "Roaring 2000's" books are good examples of this genre). Be aware, however, that the rationale underlying these books can be a little suspect, because sooner or later there's a message that you should consider working closely with a broker or advisor. As the author of two books on 401(k) investing, I've had a little exposure to the bookselling business. Appealing to the investment community is a big part of that selling challenge. If your book talks about how great the stock market and stockbrokers can be, then you receive paid invitations to speak to large groups of investors, who, in turn, buy your book. Even with that caveat, I'd recommend "Dow 36,000." Any investment book that doesn't put us to sleep will improve our comprehension of how different investments can serve our needs. This book's underlying premise is that a buy-and-hold strategy is the best answer to attaining a long-term financial goal. That's a sensible and praiseworthy idea, especially for retirement investors who are building a 401(k) or IRA over many years.
Medical Expenses
What does all of this mean? We should all anticipate an increase in our out-of-pocket medical costs in the coming year. Daycare Expenses
Daycare expenses can only be reimbursed after services have been completed. This means that, if you pay $600 for your July daycare on 7/1, you can not be reimbursed until the month is complete, 7/31 . However, you will save about $210 in taxes each month. Are You Paying Too Much In Taxes? If you had access to a Flexible Benefit Plan, and as little as $1000.00 in health related and/or daycare expenses, but chose Not to participate—You paid an extra $300-$400 in taxes that you could have avoided! When you take advantage of a Flexible Benefit Plan (also called a Cafeteria or Section 125 Plan), you’re saving the Combined Effective Rate on each dollar (see table below). This means that a married couple, with a combined income between $75,000 and $110,000, could save $.35 on every dollar they run through the plan.
Have You Thought About What You Spend On Medical Expenses Each Year? I’m
not just talking about your portion of insurance premiums. What
about the $5 & $10 co-payments you make each time you see
the doctor or fill a prescription? How much did you pay your
dentist this year for cleanings, x-rays, and maybe a filling
or crown? Does anyone in your household wear prescription glasses
or contacts? With a little planning, you can set aside pre-tax
dollars (through a Flex Plan) to pay for all of these expenses,
plus daycare for your children while you are at work, and Maybe you’re thinking that it is just easier to itemize your medical expenses on your tax return at the end of the year and get your tax break that way…Think Again! Although the I.R.S. allows you to itemize your out of pocket health related expenses, you will only receive a federal tax credit for any amount in excess of 7.5% of your adjusted gross income. The married couple in our example above would only receive a credit for medical expenses that exceed $5625.00. A Section 125, or Flexible Benefit Plan, allows you to save taxes on all of your qualifying health related expenses up to the plan maximum for the year. That same married couple would be turning their backs on almost $2000 in tax savings if they chose the tax credit over a Flex Plan.
Stay Inside The Lines The last year or so has been sobering for those who thought they had figured out how to beat the market. This has been especially truer for the vaunted market analysts who have been exposed, as a group, as Wizard-of-Oz wannabes. Unfortunately, they did a lot of damage before being discovered. Still, there is something to be learned from watching the comeuppance visited on much of the world of investing. Where investing is concerned, there is always the matter of risk to deal with. As Warren Buffet, arguably the most successful investor of the 20th century, has famously pointed out, the central task in investing is to “not lose money”. He means that, in the end, you should do all you can to make sure that you get back at least 100 cents of every dollar you invest after accounting for inflation and taxes. That’s not as easy as it sounds but there are ways to not only improve your chances but to create considerable wealth in the process. The following are the basic rules of successful investing: Keep it simple. Don’t try to invest in everything. Stick with stocks and bonds. Invest for the long term. You can get poor very quickly: getting and staying rich takes time. Buy and hold. Put time into choosing your investments and then stick with them. Changing your mind, timing the market, or following trends, is very expensive: some people call it speculation. Re-invest all dividends. They have the same impact on investments as compound interest has on savings. Buy low-expense, no-load mutual funds. This way you can spread your risk over many stocks and bonds. This is the only way that most folks can diversify. Don’t try to beat the market. It’s a fool’s errand. In the long run, you will do far better to buy the entire market by investing in a total market index fund for stocks and as broad an index fund for bonds as you can find. Dollar-cost average your investments by investing regularly. Some people call this hedging your bets. Make your 1st investment a 401(k). If your employer offers a defined contribution retirement plan such as a 401(k), or 403(b), start your investment program there.
Keep It Simple The bookstores and the Web are crammed with books and articles on the subject of investing. Most of these either pick through historical data, or use statistical sampling and complicated formulas in an effort to rationalize the equities marketplace. Still others flog a particular investing strategy, analyzing in great detail each type of investment vehicle from growth, to value, to income, to various combinations of stocks and bonds. While there is much to be learned about the world of investing by reading books and articles on investing, they mostly make it difficult for the average investor to figure out what to do. It’s not that these writers provide no insights. Taken together they fairly analyze the world of investing. Some are even easy to read. For the most part, however, they unnecessarily complicate what should be a fairly simple process. In the end, what all the statistics and studies are demonstrating is that there are just two things we need to know about stock market behavior: First, in the short run the market is powerfully influenced by speculators (gamblers)—day traders and others looking to profit from a series of successful guesses about what other investors will buy and sell a stock for during any given trading session. That makes it completely unpredictable. Second, in the long run—meaning over 5 or more years—the underlying fundamentals of investment take hold, crowd out the speculators and dominate market results. These fundamentals are a.) earnings growth, and b.) dividend yield. To illustrate this point, the records show that, during the entire 20th century, the combined inflation-adjusted returns of U.S. corporations from dividend yields and earnings growth averaged about 7%—only slightly less than the total stock market return over the same period. However, the same records show that in any 10-year period, stocks have always outperformed other investments, and have even outperformed bonds most of the time. But, you have to stay in the market to profit from this knowledge. As an example, a study done on the 31-year period from 1963 to 1993 showed that $10,000 invested at the beginning of that period and left in the market without making any changes to the portfolio would have grown to over $240,000. But, if the money had been taken out of the market for any reason one day at a time for only the best 90 days of that period, the $10,000 investment would have grown to just $21,000. Now, similar results on the upside would have occurred had you taken your money out day-by-day during the worst 90 days. The point in each case is: how could you possibly know when those days would happen? The moral to the story is—don’t try to time the market. You will likely be the loser. Stay in it for the long term and accept predictable, if unspectacular, results.
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