Tuesday, March 8, 2011

Self-managing Retirement Money

Someone I know self-manages his IRA. He directs his (discount) broker to buy certain stocks and to sell them based on his knowledge of a specific industry. Over the years, he has grown a nice nest egg from very little cash investment through this method. I applaud him, even while I know that I do not have similar expertise about an industry that would allow me to replicate his hands-on management style. The publishing industry, my field, is in utter flux right now over ebooks. The dust won’t settle for a while. Possibly this is the moment to invest in some epublishing start-ups. Possibly not. I don’t have the instinct to guess right about them, so I’m not going to try. I'm not unusual in wanting my retirement money to be managed by someone else so I don’t have to think about it. By allowing that situation, though, I am potentially setting myself up to be a victim of some fund manager’s folly. Do you have intimate knowledge of an industry that would give you a more-than-fighting chance of picking individual stocks on the rise? If so, perhaps active management of your portfolio, or a piece of it, would benefit you.

My friend who self-manages does not have the goal of amassing a huge amount of principal and then pulling it out as cash, which is the typical IRA or 401k plan. He has a far different goal. Although he buys and sells some of his stocks based on how the stocks are valued so he can make a quick profit, his purpose is to amass more cash to buy more stocks. He looks for stocks that pay dividends. We don’t usually think about dividends with IRAs and 401ks, because we usually arrange for all dividends to be reinvested automatically in the very same products. This is advantageous during our highly taxed years when we are earning our maximum. Later, however, this is not necessarily the best strategy. My friend, who is at retirement age even though still working, now allows the dividends to be paid to him directly. That money supplements his income from other sources. Meanwhile, he has not reduced his principal.

Hearing about this, I realized that the common way of thinking about IRAs and 401ks is all or nothing. Either we keep it all in various funds, locked up and not paying out a dime, to rise and fall according to the whim of the stock market, or we take it out as cash and spend it. Moreover, we are told that there is a formula for taking it out, usually around 3% or 4%, by which we can sell out on a yearly basis and keep our principal intact. This isn’t exactly true, though, if the stock market is not doing well. (We’ve certainly seen that situation in the last few years.) Meanwhile the federal government wants us to sell out of these funds on a regular basis, starting at age 70 1/2, whether we want to sell or not. At that time, we have to start converting our tax-deferred savings into taxable income, or face stiff penalties. We can do that, but we don’t have to let it all be cash. We can convert the required amount of principal (less the government automatic withholding of 20%) to the very same or different financial instruments as simple investments. Investments that pay us dividends or interest.

This strategy does not reduce principal dramatically. Most people expect to cash out their principal, and so they worry about it running out. If we create an income stream rather than sell off the principal that doesn’t happen. This method harks back to the old-fashioned concept of living on cutting coupons. Coupons were the quarterly dividends that bonds paid, and rich people bought the bonds and then cut the coupons and redeemed them for cash. Organized correctly, these became a constant flow of income, income not affected by the ups and downs of stocks. Also, if we don't spend down our principal but live on dividends or interest instead, we can leave an estate for our children, which an important consideration for some people.

It’s very daring to self-manage one’s retirement money, but at some point we all do have to make decisions about it anyway. Why not think about this method?


Dionne Daniel said...

So retirement fun management has different approaches. Mulling over the consequences of every decision you make can help you shape your future. But it's still amazing that your friend was able to manage it by himself.

Ravi Agarwal said...

I agree that self-managing the retirement money is kind of risky. It’s the ultimate source that you might have, that’s why must be very careful on handling it. But I’m glad that your friend was able to do it himself. So, what about you? How do you plan managing yours?

Ravi Agarwal @ MEDIQ Financial Services