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Investing Blog Roundup: Index Fund Accusations

For most investors, index funds (or ETFs) are the best tool for building a simple, low-cost, diversified portfolio. Many people argue, however, that index funds have detrimental effects not on their shareholders but on the market overall. This week Morningstar’s John Rekenthaler takes a look at three of those assertions.

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Do Dividend Stock Funds Belong in Your Portfolio?

A reader writes in, asking:

“What do you think of dividend funds? Do they have a place in a portfolio for a hands-off investor who is nearing retirement?”

The most important question here is what would be removed to make room for the dividend funds?

For the last several years, with interest rates stubbornly staying at low levels, some people have asserted that high-dividend stock funds can be used as a substitute for bond funds. To put it plainly, that idea is nuts.

For instance, the following chart (made via the Morningstar website) shows the performance over the last 10 years of Vanguard Dividend Growth Fund (in blue), Vanguard High Dividend Yield Index Fund (in orange), and Vanguard Total Bond Market Index Fund (in green).

Dividend and Bond Funds

There’s no question that the two dividend funds are much riskier than the bond fund. Dividend stock funds are simply not a suitable substitute for a bond fund. Bonds can play the role of the “mostly safe” part of your portfolio. Dividend stocks cannot.

But using dividend-oriented funds as a part of your stock holdings (i.e., in order to give high-dividend stocks a greater weight in your portfolio than other stocks) is a reasonable position. It’s not a position I plan to take with my own portfolio, but I wouldn’t tell somebody else that it’s a mistake to do it with their portfolio.

Before diving into dividend-stock strategies though, it’s important to be very clear on one point: it’s total return that matters, not income. A dollar of dividends is no better than a dollar of capital appreciation — even for a retiree. (And if we’re talking about holdings in a taxable account, a dollar of dividends is worse than a dollar of capital appreciation, because you have no control over when it will be taxed.)

So, when viewed from a total-return perspective, how have dividend-stock strategies performed relative to “total market” strategies? It depends what period we look at, and it depends what we use as our measure of dividend stock performance.

For instance, a piece of Vanguard research from earlier this year found that from 1997-2016, global high dividend yielding stocks and U.S. dividend growth stocks both earned higher returns with less volatility than a global “total market” collection of stocks (primarily due to dividend stocks not being hit as hard as the market overall during the decline of tech stocks in 1999-2000).

As another example, the following chart compares the performance of Vanguard High Dividend Yield Index Fund (in blue) since its inception in 2006 to the performance of Vanguard Total Stock Market Index Fund (in orange). Over this particular period, it was basically a tie. (The total market fund ends up with a very slightly higher value.) And you can see that the two index funds have tracked each other super closely.

Dividend and Total Market

Or as one final example (in the international category this time), the following chart compares Vanguard Total International Stock Index Fund (in blue) to iShares International Dividend Select ETF (in orange) since the inception of the dividend ETF in 2007. This one is essentially a tie as well. (Again, the “total market” fund ends up very slightly ahead, and the two tracked each other fairly closely over the period.)

International Dividend vs Total Market

Every time I look into this question I come to the same conclusion: if you want to hold dividend stock funds because you see that dividend strategies outperformed total market strategies over some particular period and you think the same thing will occur over your particular investment horizon, go for it. But, as always, be sure to diversify broadly and keep costs low (i.e., don’t bet your financial future on just a few dividend stocks, and don’t pay a fund manager or advisor a pile of money to pick dividend stocks for you).

And finally and most importantly: dividend stocks are not a substitute for bonds.

Investing Blog Roundup: Choosing a Financial Advisor

Finding a financial advisor who meets your needs is often a challenge. There are many good advisors out there, but there are plenty of bad ones too (i.e., advisors who have insurmountable conflicts of interest, advisors who charge far too much for what they provide, and advisors who simply aren’t well informed about the topics for which they’re providing advice).

Christine Benz has a two-part series this week providing a list of questions you should ask yourself (to figure out what kind of advisor you’re seeking) as well as a list of questions to ask a potential advisor.

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Are Guaranteed Living Withdrawal Benefit (GLWB) Riders a Good Idea?

A reader writes in, asking:

“What do you think of the ‘Secure Income’ rider product for the Vanguard Variable Annuity? I find the combination of safety and flexibility to be very appealing, yet I have learned from bogleheads that a 1.2% fee is not something to be taken lightly.”

As we discussed earlier this year, in general I think that deferred variable annuities are most useful either as:

  1. A tax planning tool in uncommon circumstances, or
  2. A tool to get out of an even less desirable insurance product via a 1035 exchange.

What is a Guaranteed Living Withdrawal Benefit (GLWB)?

For those who are unfamiliar with the product, the “Secure Income” rider for the Vanguard variable annuity is a “guaranteed living withdrawal benefit” (GLWB) rider. With a GLWB rider, you agree to pay an extra annual expense, and in exchange you are guaranteed to be able to withdraw a certain amount per year from the account for the rest of your life.

In other words, a GLWB is kinda-sorta like having the benefit of a regular lifetime annuity, without having to annuitize the account (i.e., without having to turn over the assets). But you pay a significant annual cost for that benefit.

In the case of Vanguard’s GLWB, the annual cost is 1.2% of the “Total Withdrawal Base.” And the amount you are guaranteed to be able to withdraw per year is also a percentage of the Total Withdrawal Base (e.g., 4% for an individual who starts taking withdrawals between ages 59 and 64).

The Total Withdrawal Base starts out as the account value when you activate the GLWB rider. And each year it is recalculated as the greater of either 1) the existing Total Withdrawal Base or 2) the current account value. In other words, the Total Withdrawal Base will not go down as a result of poor investment performance — which means that your annual guaranteed withdrawal will also not decrease as a result of poor investment performance.

Are GLWB Riders a Good Idea?

Relative to simply owning the same variable annuity (without purchasing a rider) and taking the same size distribution each year as would be provided by the rider, the rider’s overall effect is to:

  1. Accelerate the likelihood and rate of account depletion (because of the additional cost), but
  2. Guarantee that income will still continue to be paid in the event that the account is depleted (because the TWB is locked in at a higher value).

Increasing the annual withdrawal rate from a portfolio by 1.2% (as would be the case when the Vanguard GLWB is activated) significantly increases the rate at which the portfolio will be depleted. In addition, if/when the account value does fall at some point, because the TWB is “locked in” (i.e., it doesn’t fall), the GLWB fee (1.2% of the TWB) will actually be more than 1.2% of the account value, which will cause the account to deplete even faster.

In short, the GLWB rider has the effect of guaranteeing some level of income, at the cost of reducing the amount that is ultimately left to heirs. Of course, that in itself isn’t necessary a bad tradeoff. Plain-old lifetime SPIAs involve the same tradeoff, and they’re broadly considered to be a useful tool in financial planning.

So the question is primarily: is the GLWB a good deal? That is, is the safety added by the guarantee worth the cost? Or would there be a more cost-effective way to get the same level of safety?

For instance, for a 62 year old male, the Vanguard GLWB rider guarantees a 4% income stream. So a $100,000 account would produce $4,000 of annual income (to start with — it could go up if the portfolio performs well soon after activating the rider).

Conversely, based on a quote from, $64,620 would be enough for a 62 year old male to purchase a lifetime SPIA that guarantees $4,000 of annual income. And that would leave $35,380 to be invested as desired to leave to heirs, provide for spending increases later, or some combination thereof.

Which is likely to work out better? That depends on investment performance as well as how long the person lives. In short, it’s not an easy question to answer.

And this, to me, is one of the reasons why I think most people (not necessarily everybody) should stay away from riders (and to a lesser extent, variable annuities in general) — it’s quite hard to analyze whether a specific guarantee is worth the cost. Earlier this year I wrote the following about variable annuity riders in general, and I think it’s applicable here:

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they believe it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick.

As far as analyses that have already been done by smart, qualified people, here are a few that may be of interest:

One thing we can say with a high degree of confidence is that if our hypothetical 62 year old male has a desire for safe lifetime income, one thing he should definitely be doing before purchasing either type of annuity is delaying Social Security. With interest rates as low as they are right now, the deal offered by delaying Social Security is meaningfully better than the deal any insurance company would offer on an annuity.

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Investing Blog Roundup: In Defense of the Easy Way

As we’ve discussed at various points previously (here, for example), it’s the overall allocation of your portfolio that matters, not the allocation of each individual account. And, given that fact, you can often minimize costs (either in the form of expense ratios, tax costs, or both) by allocating each account differently to take advantage of the best option(s) for that particular account.

As Jim Dahle recently pointed out, however, some people will find the “all one portfolio” approach to be rather harder to implement than the “same allocation in each account” approach. And that’s not a trivial point. It’s important to be able to confidently manage your portfolio.

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Thanks for reading!

What’s the Maximum Expense Ratio Somebody Should Pay for a Mutual Fund?

A reader writes in, asking:

“As I try to select among the funds in my 401k plan, is there a limit to the high end of expense ratio that you suggest not going beyond?”

The maximum expense ratio that I would pay for a fund depends on the context. Specifically, it depends on the availability of a less expensive suitable substitute.

For example, consider an investor with a $100,000 portfolio, all of which is in her 401(k). She has decided that her ideal asset allocation would be:

  • 60% in US stocks,
  • 20% in international stocks, and
  • 20% in bonds.

And, in her 401(k), the lowest-cost investment options in each of those categories are:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

Our investor has a dilemma. She wants a 20% international stock allocation in her portfolio. But she would have to pay an extra 0.6% per year for that part of the portfolio in order to have such an allocation (rather than just allocating the entire stock part of the portfolio to the US stock index fund).

Frankly, if I were in that position, I wouldn’t pay the additional cost. I appreciate international diversification, but an avoidable cost of 0.6% per year is a high hurdle for the diversification to overcome in terms of added value.

But what if our investor’s lowest-cost investment options were as follows?

  • An actively managed US stock fund, with an expense ratio of 0.65%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, our hypothetical investor would now only be paying an additional 0.05% per year for her international allocation. The international fund’s cost hasn’t changed at all, but it has become quite a bit more attractive because the alternative (i.e., keeping the entire stock allocation in the US stock fund) has become more expensive.

Point being: The maximum expense ratio that it makes sense to pay depends on the cost and suitability of the nearest substitute. In our first scenario the 0.7% expense ratio was too high because there was a low-cost substitute (albeit an imperfect substitute). In the second scenario, the 0.7% expense ratio was not prohibitive, because there was no low-cost substitute.

What if There Are Multiple Accounts?

Let’s look at one more hypothetical scenario. Our investor still desires an allocation of 60% US stocks, 20% international stocks, and 20% bonds. And the options in her 401(k) are the same as in our first scenario above:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, however, her portfolio consists of $50,000 in her 401(k) and $50,000 in a Vanguard IRA. In this case, she has no reason whatsoever to pay the high cost of the international fund in her 401(k), because she could achieve her desired overall allocation by buying an international index fund/ETF in her IRA.

Again, the overall conclusion is that the maximum “acceptable” expense ratio for a fund varies based on the availability of less expensive suitable substitutes.

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