A recent study indicated health care premiums for Californians rose more than 81% between 2000 and 2006.  While managing health care costs is becoming a priority for our law makers, the debate for national health care continues. However, there is a government program already in place that can help individuals reduce their health care costs.  This is the Health Savings Act (HSA) which was signed into law in 2003 as part of the Medicare Act.

Here is a brief summary of how the program works.  Individuals enroll in a qualified high-deductible health insurance plan while opening an HSA with a financial institution.  The HSA would be funded (up to the lesser amount of the deductible, or government mandated caps) throughout the year by either the insured, or their employer.  As medical expenses are incurred, (including the insurance premium) they can be paid for from this account.  The beauty of the HSA is that money contributed to the HSA account is considered pre-tax (like a 401(k) or IRA) and therefore works to reduce the insured’s income taxes.

What Are The Cost Savings Involved?

The cost savings come from one or all of these components:  (A) a decrease in insurance premiums by going to an insurance plan with a higher deductible, (B) a decrease in the insured’s taxable income since money contributed into an HSA is deducted from pre-tax earnings, and (C) the retained option to claim an income tax deduction from itemizing health care deductions (using IRS 1040 Schedule A form). 

„ Decrease in Insurance Premiums: By enrolling in a high-deductible health plan, the HSA participant pays lower insurance premiums than they otherwise would with traditional health insurance – an immediate cost savings. While the initial perception is that higher-deductible HSA insurance leverages the participant’s risk (i.e. betting that their health will continue to be the same or better), that really doesn’t have to be the case at all.  In fact, to the extent the HSA account is funded to the level of the insurance deductible, the overall risk of catastrophic medical expenses is likely to be lower under an HSA due to a narrower range of expenses over which co-pays apply.  In essence, a funded HSA account serves as a “backstop” for medical expenses - with government subsidies .

„ Decrease in Taxable Income:  The means by which the government subsidizes a participant’s HSA account is through the tax breaks provided for contributions to the plan.  All contributions by the taxpayer, up to government mandated maximums, are deductible from income prior to arriving at Adjusted Gross Income (AGI) – similar in many ways to deductions taken for 401(k) or IRA contributions.  Yet, HSA contributions are potentially of even greater value than IRA contributions as there are limits on income, or source of income. For example, let’s assume an individual has a health care plan with a $2,400 deductible.  The amount used to fund the HSA (up to $2,400) will reduce income to arrive at the taxpayer’s adjusted gross income which is then used to calculate income tax.  The higher the income tax rate, the more an individual will save under HSA.  Alternatively, if the taxpayer chose to fund an IRA and had modified adjusted gross income of more than $60,000 for an individual or $85,000 for joint filer, the contribution would not be deductible.

For many individuals taking advantage of an HSA, the benefits can also reduce your state taxes.  Arkansas, Mississippi, Nevada, Oklahoma, and Pennsylvania have passed laws making HSA contributions tax free.  Many other states have pending legislation to do the same.  Check the web page of your state tax authority for updates.

„ Income Tax Deduction from Itemizing Health Care Deductions:  The last area of potential cost savings is with itemizing medical deductions using Schedule A.  Unlike the previous two items, there is no clear path on whether an individual should or should not itemize with an HSA, though any funds contributed to, or used from, an HSA are ineligible for itemization. 

For individuals considering itemizing, the first hurdle is to calculate if your total medical expenses exceed 7.5% of Adjusted Gross Income (AGI).  If so, your medical expenses above this amount for which you did not use HSA funds can be claimed as a tax deduction.   If not, the likely best choice is to pay for the medical expense using HSA.  In our opinion, the ideal approach is to fund your HSA at the start of the year, pay expenses outside the HSA during the year, and then at the end of the year evaluate if you should fund the expenses from the HSA, by re-imbursing yourself, or pay them outside the HSA and itemize on Schedule A (assuming you clear the 7.5% AGI hurdle.) 

The other benefit of itemizing your medical expense instead of drawing funds from the HSA is that your HSA money can grow tax-free if invested wisely.  This will be discussed in the next section.

For those considering itemizing, you should be comfortable with your cash on-hand after paying for their medical procedures.  But going this route allows the insured to benefit from both any HSA contribution deduction and from any medical expense deductions they may be able to claim through Schedule A.  In many cases it comes down to a qualitative decision.

■  ■  ■

For people who already have a high-deductible health plan from their employer, an HSA can still be beneficial.  Any amount (less than or equal to the deductible) that you set aside in an HSA will still qualify as pre-tax money, though contributions made by an employer are not. In this case, the employer contribution is not deductible by the employee, but also not declared as income paid to the employee.

Additionally, the HSA can be used to pay for procedures that are not covered under a traditional health plan such as alternative medicines, long-term health insurance premiums, dental and eyecare.

For any individual who signs up for a HSA, there are additional benefits.  Since the amount of money in a HSA belongs to the individual, the unspent money is portable and can grow by being invested in mutual funds or money markets (depending on your HSA plan options).  Also, any left over money in the HSA at the end of the year is carried forward; thus, a HSA acts like a mini-IRA retirement account for those who never get sick.

Who can qualify for a Health Savings Act?

The HSA is meant to be a broad program helping many individuals.  Generally speaking, an individual must be under 65 years old and have health care insurance with a “high deductible.”  For 2006, a “high deductible” health care insurance would be at least $1,050 for single person, or $2,100 for married couple. 

There are a few more qualification rules.  First, an individual cannot be covered by another health insurance policy that is not a qualified high-deductible plan though one can still have other disability, dental, vision and long-term care policies.  Second, an individual cannot be claimed as a dependent on someone else’s tax return.  And lastly, if an individual has a spouse with a non-high deductible health plan which covers that person, then he or she is ineligible for an HSA.

To qualify in the current year, an individual must open a HSA by the end of the calendar year, though funding the HSA for that particular year can occur by tax day (usually April 15th) of the following year.

Who are the providers of Health Savings Act?

For individuals who have to enroll on their own, you’ll need to purchase the insurance first.  A good place to start would be to see if your current health insurance provider already offers an HSA-compatible plan.  Most do. Otherwise, you can find a list of health insurance companies offering HSA plans in your state at http://HSAInsider.com or http://HSADecisions.org.

Next, you’ll want to set up an HSA saving account with a financial institution.  Most banks now offer HSA accounts – in fact, the number of providers has tripled since 2005.  The banks have a self-interest here in that money left over in the HSA can be accumulated and be used for investments (similar to retirement savings in an IRA or 401k).  With the increasing level of providers, fees for opening/maintaining these accounts, which are already reasonable, are expected to decrease.

How much can an individual contribute to an HSA?

The maximum contribution amounts are listed in the following table.

                 M I N I M U M /  M A X I M U M  INSURANCE DEDUCTIBLE

                                                   2006                             2007                

      Single Person             $1,050 / $2,700              $1,050 / $2,850             

      Family                         $2,100 / $5,450              $2,850 / $5,650 

Since HSAs are funded with pretax money, the guideline rules specify limits for each year and the total annual contribution can not exceed the insurance plan deductible.  For example, if the health insurance plan has a deductible of $1,100, that person may not deposit more than $1,100 in the HSA for that year. Furthermore, contributions are limited by the fraction of the year during which the participant had qualifying high-deductible insurance.  For example, if the high-deductible insurance was in place as of July 1 of the calendar year, the participant could contribute up to ½ of the total annual contribution. Finally, if the insured is between ages 55 to 65, that person can also make additional “catch-up” contributions.  The catch-up amount is currently $700. 

Most health insurance providers have plans with deductibles higher than the maximum.  An individual can still enroll in one of these plans, but calculations are still capped using the maximum HSA contribution amount.

Beware of the penalty in “over funding” your HSA.  The fine is 6%.  An individual can reduce the excessive amount, without penalty, by tax day of the following year (usually April 15th). 

Deadlines

„ 2006

• Obtain Qualified High-Deductible Insurance: before the end of the 2006 year.
• Open HSA Account:  before the end of the 2006 year.
• Last day to fund account:  April 16th, 2007 (for up to the pro-rated portion of 2006 for which you had qualifying insurance coverage).

In conclusion, HSA accounts can help many people reduce their medical expenses.  Any unspent money could earn a return too and be rolled-over into the next year.  For more detailed information about this program, check out the following links:

Valuable Links

• U.S. Treasury Department Frequently-Asked Questions FAQ  
• List of HSA Providers:  http://HSAinsider.com and http://HSADecisions.org
• Federal Tax Deduction Advantages 
  
• Pariveda Blog – Economics of HSAs 

From our cursory overview of Health Savings Accounts signed into law by President Bush in late 2003 as part of the Medicare bill they seem to have outstanding potential to help families and individuals both lower current health care costs and sock away tax-free funds for future qualified medical expenses. Let’s dig a little deeper and quantify the economic benefits to participants by walking through a real-life comparison.

As noted in our first post on this topic, the Health Savings Account (HSA) program works in conjunction with high-deductible insurance plans.  Instead of purchasing traditional, low-deductible insurance participants purchase qualified high-deductible insurance (at least $1,100 deductible for individuals, $2,200 for families in 2007) while setting up a tax-deferred Health Savings Account with a financial intermediary.  The high-deductible insurance offers the Health Savings Plan participant savings in the form of lower annual premiums while the Health Savings Account affords a tax-advantaged means of saving for medical expenses.

HSAs can be funded up to the lesser of the insurance plan deductible or a government imposed maximum - $2,700 in 2006 and $2,850 in 2007 for individuals, $5,450 in 2006 and $5,650 in 2007 for families. As medical expenses are incurred, the participant may elect to pay for them using HSA funds. Any HSA contributions made by the participant, whether used during the year or left to accumulate, can be deducted from gross income come tax time.

High deductible insurance has historically been viewed with the stigma of lower quality coverage perhaps owing to the demographic it was originally intended to serve – those otherwise un-insurable.  Yet with the advent of HSAs, the plans have been re-worked to appeal to a broader audience, with coverage typically similar to traditional health insurance offerings.  Check out your insurance provider’s offerings and we think you’ll see what we mean.

Nonetheless, in order to conduct a relevant economic comparison between traditional and HSA insurance options, it’s crucial to ensure that each plan’s benefits are identical, or at least very similar. For our analysis we chose offerings from Blue Shield of California, specifically the “Shield Spectrum PPO Plan 1500” (traditional insurance) and the “Shield Spectrum PPO Savings Plan 2400” (HSA qualified).  Our selection of Blue Shield of California as an insurance provider and the specific plans chosen are not recommendations, but instead meant to merely serve as an example of how we go about evaluating comparable offerings.  There are certainly a vast number of health insurance providers available to you and product offerings that may, or may not, be more suitable.

In order to keep our analysis succinct we consider only coverage for a 40-year old individual in this post.  It’s likely, though not confirmed, that evaluating family coverage as well as individuals of different ages will result in similar economic conclusions.  If there’s interest, perhaps we’ll formally cover additional comparisons in the future.  Let us know your thoughts.

Comparing Coverage

A quick overview of the comparability of the plans: The traditional insurance offers individual purchasers a $1,500 annual deductible and $40 fixed co-payments while the HSA-qualified offering has a $2,400 annual deductible with $35 fixed co-pays.  Upon reaching the deductible, subscribers to the traditional plan make 30% co-payments with preferred providers (50% for non-preferred) until their out-of-pocket expenses reach $6,000 per year.  Interestingly, individual subscribers to the HSA-qualified offering make identical 30% preferred provider co-payments only until reaching $3,200 of out-of-pocket expenses in a given year. 

Readers can find a thorough comparison of the two plans here, but all-in-all we view the plan coverage is very similar.

Comparing Apples with Apples

In comparing the potential benefits of pairing a qualified high-deductible insurance policy with a Health Savings Account relative to traditional health insurance it’s necessary to look at each option on an after-tax  and “apples to apples” basis.

In this analysis, there are two different tax effects that need to be considered.  First, any HSA contributions provide the participant valuable tax benefits in the year they’re made, but leave funds tied up in an account that can only be accessed for health-related expenses.  Alternatively, individuals subscribing to traditional insurance coverage receive no tax break for HSA deposits, yet the money they use to pay for their health expenses is not constrained – it could be used for healthcare, clothing, or even entertainment (perhaps a big-screen TV?). 

Clearly the different constraints on the cash used to pay for medical expenses under the two strategies make this an “apples to oranges” comparison.  Yet there is a way in which to make them directly comparable – simply assume any remaining funds in the HSA account at year-end are liquidated, paying all taxes and penalties needed to do so.  Then, in each case, the individual would maintain comparable insurance throughout the year, and begin and end with un-encumbered cash. 

From a practical perspective, the process of liquidating an HSA account at the end of the year is a “worse case” scenario that makes little sense, and we advise against doing so.  Yet from a theoretical perspective it does serve the purpose of providing a better economic comparison between the two strategies and allows us to confidently state that “HSA accounts provides at least this much value relative to their traditional counter-parts”.

The second set of tax implications that need to be considered is the affect of itemized deductions on schedule A of the individual’s annual tax returns.  If you recall, medical expenses (including insurance premiums, deductibles, co-payments, etc.) in excess of 7.5% of the tax filer’s Adjusted Gross Income are typically eligible for deduction.  So, while out-of-pocket costs for the traditional insurance buyer may be higher, the possibility of an economic benefit afforded through itemized deductions is also higher.

However those choosing the HSA strategy are further disadvantaged relative to traditional insurance buyers when it comes to itemized deductions. According to the Internal Revenue Service you cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the tax-free distribution from your HSA. In fact, you cannot include any contribution to the HSA or any distribution from the HSA, including distributions taken for non-medical expenses, in the calculation for claiming the itemized deduction for medical expenses.

So, while those with HSAs gain tax benefits from contributions made to the account, these benefits are partially offset through lower deductions for itemized medical expenses on Schedule A.  We take both aspects into account in our analysis.

Onto the Analysis

We ran through a range of scenarios for our hypothetical health insurance buyer changing Adjusted Gross Income from $40,000 to $220,000 and the level of medical services purchased from $0 to $15,000 in a given year.  The goal is to see whether any clear trends develop with regards to the relative merits of traditional versus HSA plans using out-of-pocket and after-tax, after HSA liquidation costs for comparison.

We present the case of an individual with $40,000 Adjusted Gross Income and Medical Services of $500 in the case below.

Under this scenario the out-of-pocket expenses during the year were similar yet the after-tax, after-HSA liquidation cost of healthcare were markedly lower under the Health Savings plan – primarily due to the lower insurance premiums required. 

Putting our results in tabular form, here’s what we find.

Regardless of Adjusted Gross Income and medical services required, the HSA account proved to be the better option economically on an after tax, after liquidation basis.  That said, for low service levels the HSA will require the participant to pony up more cash during the year.

Further Thoughts

Want to have your cake, and eat it too?  Consider the following ideas offered by the HSA for America (quite a good resource) on their blog:

1. Put no money in the account, except when you incur a medical expense. This strategy allows you to legally "launder" any money used to pay medical expenses. In other words, by depositing money into your HSA, then immediately withdrawing it to reimburse yourself for medical expenses, you are making your medical expenses all tax-deductible. You may want to use this strategy if you are on a tight budget and want to keep your cash outlay as low as possible.
2. Fully fund the account, or at least put in as much as possible based on your budget. Take money out of the account any time medical expenses are incurred, and let the rest grow tax-deferred. This strategy will maximize your tax deduction, while making your HSA funds available to pay any non-covered medical expenses before your deductible is met.
3. Fully fund the account, but pay all medical expenses from a non-HSA account. Reimburse yourself for medical expenses at a later date. This strategy will allow you to maximize your tax deduction, and will also allow you to maximize the tax-deferred growth of your HSA. You can then reimburse yourself, tax-free, at any time in the future for medical expenses incurred over the ensuing years.

Furthermore, the idea of maximizing contributions to your Health Savings Account annually and waiting until the end of each year to determine the source to use in paying for your medical expenses based on your taxable situation may be of even more value.  If you decide to pay out of the HSA account, simply write yourself a re-imbursement check. However in cases where you have excess cash on hand and qualify for tax deductions for amounts spent above 7.5% of your AGI it may be advantageous to pay for your medical expenses outside your HSA account.

In prior posts, we provided an overview of Health Savings Act signed into law by President Bush in 2004, laying out the details and mechanics of the plans relative to regular health insurance options and providing an economic comparison between the two.  Our conclusion was that High Deductible Health Plans combined with Health Savings Accounts provide individuals and families a terrific way to both lower ongoing medical insurance costs and accumulate tax-free savings for future medical service needs. 

In this post we take our analysis a step further, surveying the landscape of the budding Health Savings Plan account options available through a number of financial institutions.  With over 1,100 banks, credit unions and brokerages offering plans, our survey isn’t exhaustive but our finding do point out the varying range of services and fees charged by HSA providers at large.  We believe this can be of further economic benefit to those wishing to avail themselves of what we think will be a well-adopted and rapidly expanding health-care alternative.

The survey table can be found here.

Who are these guys anyways?

The first thing that struck us in looking at the various HSA account offerings is the plethora of startup firms dedicated solely to servicing this small, but growing, opportunity.  Firms such as HSA Bank, 1st HSA, Exante Bank, and Health Savings Administrators are all big online marketers with products that offer both savings and investment alternatives.  The upside – convenience, as it’s easy to either enroll over the web or download an application. The downside – it’s impossible to know if any or all will be around in five years and, as first movers in the field they’re all looking to exploit the opportunity with fee structures that verge on embarrassing.

Fees, fees & more fees

So let’s talk about fees because the second thing that struck us in looking at HSA offerings is the wide range of fees that are currently being charged.  In all, the prospective investor could be faced with possible setup fees, monthly maintenance fees, closing fees, check fees, and/or debit card fees – and that’s just for savings accounts.  Add in investment management options, which can range from a select group of mutual funds to the more open platform of a linked discount brokerage account, and one may also incur mutual fund maintenance fees, as well as account minimum balance and transaction fees.

HSA-only opportunists all charge account setup fees and monthly service fees along with a variety of incidental fees.

Yet the good news is that fees are generally coming down as bigger financial institutions enter the game.  Products from heavyweights BankAmerica and Wells Fargo, though limited in their investment options, charge only monthly service fees, albeit somewhat high at $3.75 to $5.

Starting Out – Go for Low Cost

Let’s face it, at their core Health Savings Accounts are meant to be backstops for our medical spending needs.  As such, the first few years of having an HSA account should be dedicated to funding the account, not investing the balances.  In this case you’re probably best off with a low-cost option, and among the lowest cost are those offered through local community credit unions.  (We surveyed offerings from Patelco and Stanford Federal Credit Union in the San Francisco Bay area, but offerings in your area are probably comparable.) You’ll have to become a member and may have to open a traditional savings account to gain access to a chosen credit union’s HSA products, but the generous interest rates earned on the account coupled with the monthly maintenance fee savings likely more than justify the trouble.

For those wishing to forego the hassle of opening up a new banking relationship, look to your current financial institution’s offerings.  Calculate the “all-in” annual cost of the offering and see how it stacks up for you.  Keep in mind that for major bank’s products surveyed by us, you’ll need over $2,000 in BankAmerica’s HSA product and $900 in Wells Fargo’s before you actually earn any money, taking current interest rates paid and monthly maintenance fees into account.

Building the Nest Egg – When and How to Invest

In our opinion, one should have at least two years of possible out-of-pocket medical costs squirreled away in an HSA account before contemplating investing the balance.  For individuals that likely amounts to balances of between $6,000 and $10,000 and for families its likely double.  Again, your first priority is to ensure the money is there, if and when you need it.

Even with two years saved, we’d advise HSA participants invest only using lower-risk strategies, plenty of diversification stock sectors and a healthy portion (at least 40%) of income producing investments such as bonds and preferred stocks.

Contributions to an individual’s 2005 IRAs can be made until April 17th, 2006, but if you haven’t done so yet, or are considering your options for 2006, which should you choose – a Roth, or a Traditional, IRA?  In this entry we outline the features of each plan and analyze subtle distinctions between the two that lead us to the opinion that the Roth IRA is likely to prove the better option for a majority of today’s retirement savers.

Background

As most investors know, the U.S. government provides individual taxpayers the opportunity to tuck away a limited amount of tax-advantaged savings each year through Individual Retirement Accounts (IRAs).  For 2005 and 2006 this amount remains fixed at $4,000. Added “catch-up” contributions (maximum of $500 in 2005 and $1,000 in 2006) are also available for savers aged 50 and older in the calendar year for which they make the contribution.

For most non self-employed savers, the Internal Revenue Service recognizes two distinct tax-advantaged savings options - the Traditional IRA and the Roth IRA.  Savers can open Traditional and Roth plans at most financial institutions and the investment options and fees available through each are generally identical. Yet, there are distinct differences between Traditional and Roth IRAs that merit further attention.  Let’s look at each in turn.

Traditional IRA

In most cases, savers contribute pre-tax money to traditional IRAs.  In effect, contributions lower the saver’s taxable income in the tax year for which the money is contributed so that the saver realizes a tax benefit by making the contribution.  These tax benefits are of greater value to higher income taxpayers than lower income taxpayers and can be calculated as the difference between what one would pay in taxes without making a contribution minus what one would pay in taxes by making a contribution.

All individuals under the age of 70 ½ with compensation are free to contribute up to the lesser of $4,000 or 100% of their compensation.  Non-working spouses are free to contribute up to the maximum as well, though the combined contribution cannot exceed the couple’s combined compensation.

On the negative side, the deductibility of Traditional IRA contributions is limited as follows: 

Individuals: For individuals covered by an employer’s retirement savings plan, Traditional IRA contributions are fully deductible for those with modified adjusted gross incomes (MAGI) up to $50,000.  For MAGI of between $50,000 and $60,000, they’re partially deductible and for MAGI over $60,000 there is no tax deduction. 

For individuals not covered by an employer’s retirement savings plan IRA deductibility is not limited by the saver’s modified adjusted gross income.

Married Filing Jointly: For couples filing jointly where one spouse is covered by an employer’s retirement plan, IRAs are fully deductible for modified adjusted gross income up to $150,000.  MAGI of between $150,000 and $160,000 receives a partial tax deduction and MAGI over $160,000 renders IRA contribution non tax-deductible.

For couples where both spouses are covered under employer retirement plans, contributions to Traditional IRAs are fully deductible for MAGI up to $70,000, partially deductible between $70,000 and $80,000 and non-deductible for MAGI over $80,000.

For couples where neither is covered by an employer’s retirement plan, IRAs are fully deductible for all levels of MAGI.

From a practical perspective, modified adjusted gross income restrictions limit the economic benefit savers are likely to receive in the contribution year to a maximum of about 25% of their contribution.  So, a contribution of $4,000 in 2005 will likely reduce your taxes by $1,000 at most.

Savers who withdraw funds prior to 59 ½ are subject to a penalty of 10% of the amount withdrawn as well as ordinary income taxes. 

After the age of 59 ½ Traditional IRA savers are free to withdraw any, or all, funds from their account(s) without penalty, but all distributions are taxed as ordinary income in the year they are received.  As such, most account holders attempt to postpone taking taxable distributions from their traditional IRAs for as long as possible.  To limit this deferral, the U.S. government mandates that all Traditional IRA account-holders begin taking minimum required distributions from their accounts in the year in which they reach 70 ½.  Initial mandatory minimum withdrawals amount to between 3.65% and 3.77% of the IRA prior-year balance and are based on the account value at the end of the prior year and actuarial life expectancy assumptions.  Subsequent minimum required distributions increase in percentage terms, but may differ in absolute dollar amounts depending on the accounts prior-year balance.

Upon the death of the owner, Traditional IRAs pass to their appointed beneficiaries, typically outside the instructions of a will.  Beneficiaries have an opportunity to stretch the tax-deferral aspects of the IRA as the minimum required distributions are re-calibrated based on their, typically longer.

Roth IRA

Unlike the Traditional IRA, contributions to a Roth IRA are not tax-deductible.  Savers in these plans use after-tax money to fund their accounts, missing out on the upfront tax benefits accruing to those saving through Traditional IRAs.  The benefit of the Roth IRA however is that not only does the principal grow tax-free during the life of the investment, but all withdrawals after age 59 ½ that have been invested at least five years are tax-free as well.  From a practical perspective Traditional IRAs are tax-deferred assets while Roth IRAs are tax-free assets.

Furthermore, the fact that Roth assets have been taxed prior to contribution, benefits Roth IRA holders in two ways.  First, there is no minimum distribution requirement imposed by the government, at any age.  Second, contributions (though not gains on these contributions) can be withdrawn after 5 years without penalty, regardless of the saver’s age.

Individuals of any age with compensation (subject to income limits) can invest up to the minimum of $4,000 or 100% of their compensation in Roth IRAs and, like Traditional IRAs, non-working spouses can contribute an amount such that the couple’s total contribution does not exceed the lesser of $8,000 or their combined compensation.  .

Of course, with any deal this good there have to be stipulations.  The first is that single tax filers with adjusted gross incomes of between $95,000 and $115,000 and joint filers with AGIs between $150,000 and $160,000 are only eligible for partial contributions.  Filers above these amounts are completely ineligible.

Second, to the extent contributions are withdrawn prior to the five year investment window, they will be assessed a 10% penalty.  Also, to the extent investment gains are removed prior to age 59 1/2, they will be assessed a 10% penalty and taxed as ordinary income in the year they are withdrawn.

Exceptions to the 10% Penalty

There are a number of exceptions to the 10% penalty for early withdrawals from either Traditional or Roth IRAs.  Specifically, the early withdrawal penalty does not apply to distributions that:

1. Occur because of the owner’s disability (see IRS Publication 590 for definitions and further details).
2. Occur because of the owner’s death.
3. Are a series of “substantially equal periodic payments” made over the life expectancy of the owner.
4. Are used to pay for un-reimbursed medical expenses that exceed 7 ½% of the owners adjusted gross income.
5. Are used to pay medical insurance premiums, after the owner has received unemployment compensation for more than 12 weeks.
6. Are used to pay the costs of a first-time home purchase (subject to a $10,000 lifetime limit).
7. Are used to pay for qualified higher education expenses for the owner and/or eligible family members.
8. Are used to pay back taxes due to an Internal Revenue Service levy placed against the IRA.

Before considering an early withdrawal however, we recommend you research these exceptions more carefully.

Traditional or Roth – Which is Right for You?

Assuming you’re eligible to invest in either plan, the decision on which is right for you hinges on a number of personal factors including your current and expected future tax rates, fluctuations in annual income, and overall ability to save.  Additionally one should give thought to likely future tax rate changes and the value of implicit “options” afforded savers using the Roth plan.  Let’s look at each factor in turn.

Current & Future Tax Rates:  Assuming no changes to the tax code, it can be shown mathematically that if a saver’s current all-in tax rate is higher than his realized future tax rate, the Traditional IRA will yield a higher after-tax return, and conversely if a saver’s ordinary income tax rates are lower today than in the future, the Roth IRA will generate higher after-tax returns. 

Given this, the question one needs to answer are as follows:  “How much will I need to withdraw from my IRA annually in retirement to maintain the lifestyle I wish to live?” and “Assuming no changes to the tax code and inflationary trends of arguably 3% per year, what will my tax rate be in retirement?” 

Many professionals argue that one needs 70%-80% of their pre-retirement income to sustain an equivalent lifestyle in retirement.  If so, and you’re in you’re peak earnings years and closing in on retirement, a strong argument can be made for the Traditional IRA, as lower living expenses would drop you into lower tax rates in retirement.  Yet, there are also many who argue that post-retirement income will need to be closer to 100% of pre-retirement income in order to afford ever-escalating healthcare costs and a more active retirement lifestyle than has historically been the norm.

One thing seems certain to us however; owing to inflation, the further out your retirement horizon, the more likely you’ll be pushed into a higher, not lower, tax bracket.  This supports a Roth IRA as the preferred vehicle for younger savers.

Fluctuations in Annual Income:  Job changes - some planned, some not - occur much more frequently today than they did just 15 years ago.  With these disruptions most workers will likely experience significant fluctuations in their annual incomes before retirement.  We advise savers to remain flexible over the years.  When your tax rate is relatively low, take advantage of the Roth plan and when income is easier to come by shift to the Traditional IRA.

Ability to Save:  While savers can choose to make contributions to either plan, recognize that a dollar saved in a Traditional IRA is not the same as a dollar saved in a Roth.  In order to compare plans side-by-side, one must look at each from an “after-tax perspective” – and when this is done the Roth plan comes out as the more generous of the two.

Why?  Think of it like this.  Say you decide to maximize your IRA contribution with a $4,000 deposit.  If you fund a Traditional IRA and you’re in the 25% tax bracket, you’re annual after-tax costs are $3,000.  If instead you choose the Roth and invest $4,000 after-taxes, your out-of-pocket cost is an additional $1,000.

Then, at age 70 ½,  you begin to draw down your IRA by $40,000 annually.  Assuming you’re in an identical 25% tax bracket at that time, the Traditional IRA provides you with after-tax funds of $30,000 while the Roth IRA allows you to keep the entire $40,000.

The chart below presents a hypothetical case showing the lifetime after-tax cash-flows for two investors – one who contributes $4,000 each year to a Traditional IRA and one who contributes the same amount to a Roth.  Both are assumed to invest in identical portfolios throughout their lives.

Though each contributed a nominal $4,000 annually prior to retirement, the Roth IRA holder contributed 33% more after-tax.  In retirement she receives 33% more after-tax income each year and ends life with a residual value 33% higher as well. In short, The Roth allows those who have the resources to build a larger pool of after-tax savings for retirement.

Likely Future Tax Rates: It’s almost certain the U.S. (and state) tax codes will change over the coming decades and, in our opinion, an aging baby-boomer generation and ever-increasing government deficit spending imply that changes to tax rates will be up, not down.  If so, the better savings option, as noted above, is the Roth plan.

Some financial professionals argue that investors should retain funds in both types of plan as a “hedge” against future rate changes.  In our opinion, this is probably not a bad idea, especially if you already have a sufficiently funded Traditional or Rollover IRA.

Implicit Options within the Roth IRA:  We believe one of the most appealing, but often overlooked, aspects of the Roth IRA is that it provides the saver with an “option” to partially withdraw funds from the plan prior to retirement without penalty.  Recall that after 5 years of investment the saver can withdraw up to the original contribution amount (though not earnings on those contributions) without penalty.  This is an attractive option to have, and one not afforded Traditional IRA investors.

Conversions to a Roth IRA

As you’ve probably guessed, our view is that the Roth IRA is likely to be the preferred tax-advantaged investment vehicle for most retirement savers.  In fact, Roth IRAs have become extremely popular savings vehicles over the first seven years of their existence and many individuals have taken an opportunity to convert all, or a part, of their existing Traditional IRAs to Roths.

Here’s what you need to know if you’d like to convert an existing Traditional or Rollover IRA to a Roth.  First, you can only do a conversion in a year where your adjusted gross income (AGI), before the conversion amount is less than $100,000.  This limitation is regardless of whether you’re filing taxes as “single”, “married filing jointly” or “head-of-household”.  Those “married filing separately” are not allowed to undertake a conversion at all.

Second, if you choose to undertake a conversion the 10% penalty for early withdrawal from a Traditional IRA will be waived, but your conversion will be treated as ordinary income for tax purposes in the year of the conversion.

Third, if part of your conversion is of prior non-deductible contributions (after-tax) they will not be taxed on conversion, as they’re already after-tax assets.

Fourth, if you choose to use part of your existing IRA to pay taxes on the conversion, you’ll likely do so by making a withdrawal from your existing IRA prior to converting the remainder.  These funds will be assessed the 10% early-withdrawal penalty (in the case of withdrawal of non-deductible contributions) and ordinary income taxes (in the case of withdrawal of deductible contributions).

Finally, once a Traditional IRA has been converted none of these funds can be withdrawn from the Roth IRA within the first five years without a 10% penalty.  After five years, any or all of these contributed funds can be withdrawn without penalty.

Feel free to contact us with further questions.

Fidelity recently announced several changes to their Freedom fund lineup that will alter their respective profiles and likely have an impact on each of the fund’s returns going forward. In general, we find them to be welcome enhancements, though we’re still not fans of the funds themselves.

Adding Fidelity Freedom 2045 and Fidelity Freedom 2050 to the lineup.

The Freedom funds are designed as dynamic fund offerings for individuals set to retire in a specific year.  Investors choose the fund closest to their targeted retirement date, invest once or on a continuing basis, and then over time the fund’s holdings are altered to reflect a more conservative allocation.  The beauty to investors is that the Fidelity Freedom series represents a “one-stop” approach to investing for a lifetime.  However, this necessitates that Fidelity continue to add new target dates to the lineup (primarily for today’s younger investors).

From a practical perspective, Fidelity Freedom 2045 and Freedom 2050 will have higher stock market sensitivity than their brethren, meaning that in strong market advances they should perform better than shorter-dated offerings, but they also are likely to perform worse in market sell-offs.

Adding Strategic Real Return Fund to the Freedom funds.

The Fidelity Freedom fund series is constructed and managed using other funds from Fidelity’s own lineup.  At any time, it’s likely that any one Freedom fund holds positions in twenty or more Fidelity funds, one of which will now be the Strategic Real Return Fund. 

This is a good move in our opinion as it will add a little more diversification to the Freedom funds and exposure to sectors of the market relatively under-invested in by most traditional mutual fund offerings.  While the Freedom funds should benefit, the bigger winners in our opinion are the investors already well-positioned in the markets in which Strategic Real Return invests – namely inflation protected debt, natural resources and REITs, which will now be supported by hundreds of millions more in capital flowing into these sectors.

“Structural Enhancements”

Fidelity is also altering the risk profile of its Freedom fund series to account for the increased longevity of its investor-base as well as increased consumer inflation, particularly in the area of healthcare.

Again, we think these are logical changes. The practical effect of these enhancements will be to increase the market sensitivity of all funds in the series with the shortest-dated funds seeing their market exposure rise most on a percentage basis.  So, for example, while the Fidelity Freedom 2000 portfolio shows a market sensitivity (or beta) of 0.24 in our work as of December, it will likely rise to 0.30 – 0.35 in the not-too-distant future.  Still, that’s an increase of 20% or more from current levels, so investors should be aware.

Longer-dated fund offerings will likely see commensurate absolute changes in beta, though the percentage change will obviously be less.

Conclusions

As we’ve noted before, we’re not big fans of the Fidelity Freedom series, or other Target Maturity fund offerings owing to their overly passive nature and the relatively quality of the underlying funds included, yet Fidelity’s changes should benefit shareholders in the long-run.

Hedge fund assets continued to grow, though at a decreasing rate in 2005.  Yet, as Forbes points out, for all the hype, the performance has been lacking.

"As an investor, last year certainly wasn't a year to remember. Hedge funds notched an average 8.03% return for the year--better than the 4.9% returned by the S&P 500 index and better than the -0.61% logged by the Dow Jones industrial average, according to data complied by Hennessee Group."

Moreover, many actively managed mutual funds fared better.

"But what the data do not do is compare hedge fund performance with that of mutual funds--those comparatively boring investment pools for ordinary mortals. According to Morningstar, some 4,757 actively managed stock funds (42% of all actively managed funds) beat the broad Hennessee hedge fund index and returned performance better than 8%."

So, where's the beef?  Kinda makes you wonder why so many investors are beating down the door looking to give up 1-1 1/2% management fees and 20% upside, doesn't it?

Wow, this is really discouraging.

"...of the more than 100 large, U.S. and European multinational organizations Hewitt selected for its Global Retirement Benefits Research Survey, only a paltry 4% said that enabling employees to retire is a top priority."

That's it.  4%?  Even higher nutritional content in the meals served at the company cafeteria probably garnered higher support.  So much for the social safety net.

Funny how these things evolve.  30 years ago most employers provided pension plans for their employees.  Employees dedicated themselves to their employer and the employer provided each employee a promise of a "retirement annuity" (aka pension) based on their years of service and highest salary attained.

401(k)s came about under the guise that such a program would make pensions "portable" and allow employees to make investment decisions better suited to their needs.  In order for employers to remove their liability for poor employee investment decisions, ERISA mandated that employers had to provide adequate investment education to their plan participants. That's why you see those ever-so-helpful "investment descriptions" beside each fund option on your 401(k) websites.  You know the ones that show investment returns over the past 1, 3, 5, 10 years as well as what sectors the fund invests in and investments the fund held at the end of last year?  In most cases, that's your investment education...

Well, I guess it could be worse - at least the employers surveyed were being honest.

Separately Managed Accounts (SMAs) have been one of the investment industry’s fastest growing “products” over the last decade - ramping from $75 billion in 1994 to $650 billion today.  In comparison, the combined assets of all listed U.S. Mutual Funds and Exchange Traded Funds (ETFs) currently stand at approximately $8.5 trillion and $264 billion respectively.  Almost all traditional, and some online, brokerages as well as a small contingent of Registered Investment Advisers now offer SMAs to clients with $100,000 or more to invest ($250,000 for fixed income only accounts).  At the least you should be familiar with SMAs as a product line. Optimally you should know whether they make sense as an investment vehicle for you. In the paragraphs that follow, we’ll lay out the basics and give you our opinions on the merits of the structure.

Like mutual funds, SMAs were created to provide investors with professional investment management for their assets. For an all-in fee of between 1.5% and 2.75% per year, you can enroll in an SMA program and have access to a wide array of investment professionals, strategies, and markets.  Your financial advisor works with you to segment your portfolio into various “sleeves” that are then allocated to the managers you select.  You retain the flexibility of re-allocating among managers, styles and markets to provide ongoing diversification and/or exposure to timely opportunities.   

Unlike mutual funds, where your assets are pooled with those of other investors and managed directly by the selected portfolio manager, SMA accounts hold individual stock and bond positions recommended by the professional managers you employ.  So instead of having one account with 10 mutual fund holdings, you have one account with 10 sleeves, each holding numerous individual stocks and bonds.  The advertised benefits relative to mutual funds – customization, one “all-in” fee, and better flexibility in managing taxes.  The enhanced customization and tax management touted by SMA supporters come from your ability to “over-ride” the professional manager’s decisions on what is purchased for your account and when specific positions are liquidated.

Comparing Advisor-Guided SMAs to RIAs using  Mutual Funds

From a high-level perspective, SMA accounts are quite similar to fee-only Registered Investment Advisor (RIA) managed accounts that use mutual funds.  Investors in either structure gain two levels of professional expertise in managing their accounts.  Asset allocation expertise typically comes from the investor’s direct advisor, while specific sector insight comes from the sub-advisor (or “sleeve manager”) for SMA accounts and from mutual fund managers in the RIA directed mutual fund account. 

Yet when one delves deeper into the operational aspects of the two structures the differences may be enough to bias you in one direction, or the other.  Below we provide our opinions on how SMAs stack up relative to RIA’s using mutual funds.

The Good

Fees: “All-in” fees are generally comparable between SMA programs and RIA’s using mutual funds.  Additionally, fees under each structure typically decline as client assets under advisement increase and are, in many cases, negotiable.  In our research however it was rare to find SMA fees disclosed on any broker websites whereas many RIAs are quite forthcoming with this information. The table below shows typical fee structures for each platform. 

Tax Management:  Perhaps the greatest marketing point made by SMA proponents is increased client flexibility in managing their unique tax situation.  Mutual funds, due to their structure, force all investors to realize gains and losses annually based on the mutual fund manager’s decisions throughout the year.  For arguments sake, assuming the typical fund makes 5% distributions annually (probably reasonable), all of which are taxed at short-term federal and state rates of 45% (probably aggressive), an investor could be forced to pay taxes of 2.25% of the portfolio value each year using the mutual fund structure. 

Clearly avoiding, or at least postponing, taxes would be preferable and a tax-efficient SMA account should be a means to do so. Yet Cerulli Associates, an independent market research company, found that only a third of SMA clients have realized better tax management of their accounts through the structure. 

The Bad

Portfolio Drift: Almost by definition, an investor using either SMA or RIA structures has made an implicit philosophical decision that attempting to out-perform the broad market has merit – otherwise they’d be better off saving the management fees and buying/holding a portfolio of similarly risky index funds.  So, for both SMA and RIA clients, the main goal is to derive economic benefits from the insights of both their advisor and sub-advisors over and above the broad market, after fees and taxes are considered.

Yet by constraining the very advisors you seek to empower through restrictions on what assets they can buy, or when they can realize gains and losses, aren’t you defeating the purpose?  How good would that sub-advisor track record look over the past 5 years if she wasn’t allowed to sell her largest gainers at what she thought were appropriate times?  If you choose to hold onto Google shares purchased through your large-cap growth sleeve because of their low cost basis when your selected manager is selling out, isn’t there a potential tradeoff with future performance?

Sure there is – but you don’t hear many SMA proponents talking about that.  The more constraints you place on a portfolio advisor, whether through an SMA or RIA/mutual fund structure, the less your performance is going to look like that of your advisory professionals.

Overhead:  At present, the SMA structure is more complex for the individual investor.  Not only do you have to enroll in the program, but you are then required to sign management contracts with each sub-advisor with whom you work.  You then receive trade confirmations for each transaction made in any portfolio “sleeve”.   So, if you decide to decrease the weighting of your small cap value sleeve (holding 20 stock positions) in lieu of emerging markets during the year, you’ll need to sign a new sub-advisor agreement and keep track of all the resulting rebalancing trades needed to reposition the account.

Diversification:  Simply put, for most individual investors with limited funds (say under $500,000) the mutual fund route offers better diversification opportunities for individual investors than the SMA structure – across individual assets, markets and market sectors, and even investment strategies.  There are three main reasons for this.  First, in an SMA account, there is a minimum investment to be made with each sub-advisor that is typically higher than corresponding mutual funds.  For a $250,000 account you may be able to invest with 5-10 different SMA sub-advisors but you could easily construct a mutual fund portfolio of 25 mutual funds.  Second, each SMA sleeve will likely hold a lower number of investments than a corresponding mutual fund.  The result – your SMA account may have exposure to 100-200 investments while a mutual fund account could have exposure to thousands of individual investments.  Third, the selection of markets covered and investment strategies afforded mutual fund investors far outnumbers the opportunities within the SMA structure at present.

Rebalancing & Flexiblity:  As an RIA using mutual funds, the turnaround time for going from one portfolio allocation to another can be as little as a few days.  Thus flexibility to take advantage of changes in the investment landscape and market dislocations is relatively high.  Day-to-day an RIA’s focus is on proactively positioning client accounts to benefit from these changing tides.  Will an SMA account advisor do this for you or will you be left reallocating your assets less efficiently – perhaps only once or twice a year during scheduled meetings?   Even if your SMA advisor is proactively attuned to the market, the overhead associated with moving out of one sleeve into a new sub-advisor may be prohibitively high.  What’s the turnaround time and effort needed to sign up with a new sub-advisor?

The Ugly

Track Records:  Since the SMA structure has been around only about 10 years, most sub-advisors have limited track records on which to base your investment decisions.  Even these can be murky at best.

• Are these track records of actual “sleeves” the sub-advisor manages? (probably yes)
• Are client positions the sub-advisor has advised selling out of but which clients continue to hold for tax purposes included? (good question – we don’t know the answer here)
• Does the sub-advisor offer similar mutual funds? If so, given the likely lower number of assets held in an SMA account, how closely have the managed accounts tracked the performance of the similarly positioned mutual fund?

Evaluating a mutual fund is difficult, even with daily pricing data.  Evaluating an SMA sub-advisor will prove more even more challenging for investors and their SMA advisors.

Our Takeaway

At present, we don’t see SMAs as efficient from strategic, operational, or tax planning perspectives.  That being said, they are evolving and have the potential to be beneficial, primarily for tax planning purposes, in the future. 

SMAs, like most financial products created by the brokerage industry, have been promoted primarily for their benefit.  Specifically, they offer the brokerage industry a way to generate a more stable recurring revenue stream from clients, with minimal oversight, in an era of reduced trading revenues. 

Chuck Jaffe, a senior columnist with MarketWatch seems to share many of our sentiments on SMA’s.  His article “Separately managed accounts no more than a pig in a poke,” was recently published in the San Francisco Chronicle.

Thoughts?

Lifestyle Funds
The belief that as investors' age, their risk profile should change from growth and capital appreciation to income and capital preservation has been widely held for quite some time. Lifestyle funds were created to explicitly market this concept over 20 years ago. Today most large fund management companies offer lifestyle funds that are typically branded as a series of mutual funds going by the names "income", "conservative", "balanced", "moderate", "growth", and "aggressive". Fidelity's lineup is known as the Asset Manager series while Vanguard's and T. Rowe Price's are offered under the LifeStrategy, and Personal Strategy brands respectively.

Each individual fund within a company's lifestyle lineup is managed against a customized benchmark of stocks, bonds and cash that the management company believes to be most appropriate for the targeted audience. For example, the Fidelity Asset Manager: Income fund is managed against a benchmark of 20% stocks, 50% bonds and 30% money market instruments while Fidelity Asset Manager: Growth is managed against a benchmark of 70% stocks, 25% bonds and 5% money market. Most lifestyle funds hold individual securities and are actively managed, seeking to add value over their pre-defined benchmark.

While the concept of reducing investment risk over time has been well received, the practical aspects of when to change allocations and how to do so remain confusing for some. In an effort to simplify the process even more Target Retirement funds were born.

Target Retirement Funds
The idea behind Target Retirement funds is fairly simple: estimate your retirement date and purchase the fund closest to that date, then you're on auto-pilot! The sponsoring investment company manages the fund so that as the retirement date draws closer, the fund's investments become more defensive.

For example, with 25 years left until retirement and access to the Fidelity lineup you might purchase the Fidelity Freedom 2030 fund. At present, the fund has market sensitivity of about 80% of that of the U.S. stock market (as measured by the S&P 500). In twenty years with five years left until your retirement date, Fidelity Freedom 2030 will have scaled back its stock market sensitivity to roughly 40% of the S&P 500, comparable to the Fidelity Freedom 2010 fund today. This fund's risk is reduced by taking on more fixed income and money market exposure over time.

The benefit to investors; simplification of the decision-making process. Target Retirement funds let investors make a single investment decision that provides ongoing diversification and risk-reduction over time. No more worrying about whether you're in the "right" or "wrong" retirement plan investment options, or how your investment allocation should change over time. Simply focus your efforts on saving more.

Most of the large brokers offer their own lineup of Target Retirement funds with varying retirement dates, often in five year increments. Fidelity's brand is offered under the Freedom series, Vanguard's are known as Target Retirement funds, T. Rowe Price offers the Retirement series, and Schwab's are known as Target funds.

Target Retirement funds generally invest in other of the issuing company's fund offerings. For example, the Fidelity Freedom series holds between 15 and 20 Fidelity funds while the Vanguard Target Retirement funds hold 4 or 5 Vanguard index funds. Until recently, investors were often subjected to two sets of management fees when purchasing these funds - one for the underlying funds that make up the Target Retirement fund portfolio and a smaller one (typically less than 0.25%) for the management of the Target Retirement fund itself. The trend of late has been to do away with the smaller fees imposed by the Target fund.

Now at a 401(k) Plan Near You!
As evidenced by a recent Hewitt Associates study, employers are buying the lifecycle message big-time. "Almost two-thirds (63 percent) of large employers offered pre-mixed/lifestyle funds in their 401(k)s in early 2005, up from 55 percent in 2003" (and 35 percent 2001).

Investors seem to be biting as well. According to a recent Lipper survey, assets in life-cycle funds have more than doubled since 2000, and they grew 38% in December 2004, to $139.7 billion, from $101.4 billion in 2003. This represents between 8 and 10% of total defined contribution assets. Breaking this total out further, assets in lifestyle funds rose 28%, to $95.8 billion, while those in target retirement funds jumped 65%, to $43.9 billion.

Judging by current initiatives among defined contribution plan sponsors, investment in Lifecycle funds is poised to grow dramatically over the coming years. In an effort to increase participation in their company's 401(k) plans, many fund administrators have either begun, or have plans to begin, "automatic enrollment" of new employees into their 401(k) plans! How do you like that? Unless the individual specifically "opts-out" of the plan altogether or specifies their own investment allocations, a certain percentage of their pre-tax salary will be withheld from their paychecks and invested in what the plan administrator deems a "suitable investment". And many administrators see lifecycle funds as the suitable investment of choice.

So, how do these options stack up from a performance perspective?

Evaluating Lifecycle Fund Performance
We evaluated the lifestyle fund offerings from Fidelity, Vanguard and T. Rowe Price.

Additionally we analyzed the Fidelity Freedom target retirement fund lineup. Vanguard and T. Rowe Price Target Retirement offerings were not reviewed due to their limited operating history.

Like most investment products, it looks to us like lifecycle funds, both LifeStyle and Target Retirement, are sold not bought. Performance proved to be generally poor when compared against similar risk portfolios made up of just the Vanguard Total Stock Market Index (VTSMX) and Vanguard Total Bond Market Index (VBTIX) funds.

In evaluating the lifestyle fund offerings we relied on "beta" estimates provided by Morningstar at www.morningstar.com. Beta measures the sensitivity of each fund to movements in the U.S. stock market and Morningstar's are calculated using the last 3 years of operating data for each fund. We assumed each fund beta was constant over the analysis period, which probably isn't far from reality.

Overall, the Lifestyle funds under-performed their respective similar risk benchmarks over the analysis time period. For investors this means one could have achieved superior results by simply buying a combination of a total stock market index and a total bond market index fund, in proportion to each fund's market beta and rebalancing annually. (Eg. The performance of the Fidelity Asset Manager: Income fund could have been consistently beaten, except in 2003, by an investor purchasing 29% stocks and 71% bonds).

One exception to the poor performance was the T. Rowe Price fund lineup. Each of the T. Rowe Price funds outperformed their respective benchmarks by between 0.30% and 1.5% per year, and in each of calendar years 2000 through 2004. We view this record as outstanding.

For investors in all Vanguard and Fidelity funds, except Fidelity Asset Manager: Aggressive, investors have been paying for the convenience of a pre-determined asset allocation through sub-par returns.

Evaluating the Fidelity Target Retirement funds presents a bit more of a challenge, as each of these fund's betas change over time. We handled this by altering the benchmark betas each year to reflect the decreasing risk of each Target Retirement fund. (More information can be obtained upon request). Additionally, for this analysis we looked only at the time period from 2000 through 2005 Q2 - again a period of both market advances and declines.

While the methodology is a bit more trying, the results were similar. All of the Fidelity Freedom funds under-performed their respective dynamic benchmarks by greater than 0.60% per year. In fact, of the 35 periods covered (5 full years plus ½ year for Freedom Income through Freedom 2030 and 4 full years plus ½ year for Freedom 2040) in only 7 periods did the Target Retirement funds out-perform their respective benchmarks. Moreover 4 of these out-performance periods were during 2003, a period during which the riskiest sectors of both the stock and bond markets advanced dramatically. 

To put this under-performance in perspective, let's look at the long-term. After all, that's what Target Retirement funds are all about! Assume the relative performance of the Fidelity funds is indicative of their long-term abilities. Further let's assume that stocks and bonds return 8% and 4.25% respectively per year over the next 35 years. Finally we'll assume a 30-year old investor buys into the Target Retirement Fund message and puts a lump sum $20,000 into the Fidelity 2040 fund today with the intention of retiring in 35 years. How would he do?

On average, the Target Retirement fund investor would have a beta of 0.6875 over the 35 year period and a passively managed account would appreciate at a rate of about 6.83% per year ((8% x .6875) + (4.25% x .3125)). Had the investor replicated the risk profile with index funds the portfolio would be worth about of $201,972 after 35 years.

Instead, the investor purchases the Targeted Retirement fund. Based on our analysis, on average the Fidelity Freedom funds have under-performed their passively managed benchmarks by about 1.46% per year over the past 4 ½ years, so reduce the passively managed annual return of 6.83% by this amount to arrive at 5.36%, let's say 5.4%. After 35 years the Targeted Retirement fund grows to $126,023. The potential difference of $75,950, or a staggering 38% of the passively managed terminal value, may best be viewed as the cost of "one-decision" convenience!

We'll be the first to admit that this back-of-the-envelope analysis is based on quite a few assumptions that may prove overly pessimistic toward Target Retirement funds in the future, but as they are based on historical data, they are by no means out of the realm of possibility.

We'd advise investors to steer clear of both Lifestyle and Target Retirement funds, except for the T. Rowe Price Personal Strategy funds. Based on the past five of realized returns, the cost of convenience is simply too high!

A Curious Side-Note
Can someone please fill me in on why Fidelity's Freedom funds don't currently hold many of their best performing mutual fund offerings including: Fidelity Contrafund, Fidelity Capital Appreciation, Export & Multinational, Canada, Low-Priced Stock, Balanced, Japan Small Companies, Real Estate…okay, I'll stop there. I can understand why there is no position in Low-Priced Stock since it is closed, but doesn't a five-star ranking by Morningstar for 3, 5 and 10 years (in the case of Contrafund) merit some exposure?