Archives for February 2012

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Betterment: A New Hands-Off Option

Last year, I came across a new brokerage firm called Betterment that promotes hands-off, passive investing with ETFs. Despite that being right up my alley, I didn’t write about Betterment at the time because I thought their costs (0.3%-0.9% per year) were just too high.

Recently, however, they dramatically reduced their costs (details below), so I thought it would make sense to take another look to see if they might be a good fit for any particular types of investors.

Before you ask: I have no affiliation with Betterment, and this post is not sponsored by them in any way. They do, however, have an affiliate program, so it wouldn’t hurt to be careful about what you read about them online. (If you don’t know what an affiliate program is, I’d encourage you to read this post.)

How Betterment Works

In short, Betterment creates an ETF portfolio for you based on your risk tolerance, and they rebalance it quarterly as well as any time the account’s allocation strays more than 5% from the desired allocation. There’s no fee for the rebalancing transactions or for putting money into or taking money out of the account.

Instead, according to their new cost structure, there is a simple ongoing fee based on the amount you have invested with them:

  • 0.35% per year for investors with less than $10,000,
  • 0.25% per year for investors with $10,000 to $100,000, and
  • 0.15% per year for investors with more than $100,000.

For Investors with Less than $100,000

For investors with less than $100,000, you only get to choose the overall stock/bond allocation. From there, Betterment breaks it down as follows:

For the stock portion of the portfolio:

  • 25% Vanguard Total Stock Market ETF
  • 25% iShares S&P 500 Value Index ETF
  • 25% Vanguard Europe Pacific ETF
  • 10% Vanguard Emerging Markets ETF
  • 8% iShares Russell Midcap Value Index ETF
  • 7% iShares Russell 2000 Value Index ETF

For the bond portion of the portfolio:

  • 50% iShares Barclays TIPS Bond ETF
  • 50% iShares Barclays 1-3 Year Treasury Bond ETF

Based on those funds’ expense ratios, an investor’s annual costs before considering Betterment’s fee would be approximately 0.17%. Once you add in Betterment’s fee, we’d be looking at all-in costs of either ~0.42% or ~0.32%, depending on whether you have more or less than $10,000 invested with them.

In other words, at these asset levels Betterment is analogous to an all-in-one fund with:

  • A value tilt for the stock portion,
  • Exclusively Treasury bonds for the bond portion, and
  • Costs that are much lower than industry averages, but still higher than what you’d pay for a LifeStrategy or Target Retirement fund at Vanguard.

For most investors at this asset level desiring a hands-off solution, I would still suggest using an all-in-one fund from Vanguard — with the exception being investors who prefer Betterment’s allocation strongly enough to pay an extra quarter of a percent for it per year.

For Investors with $100,000 or More

For investors with $100,000 or more, Betterment provides the option to create a “custom portfolio.” Frankly, I think this is where the service provides something not offered elsewhere. For investors in this category, Betterment would be a way to essentially create your own all-in-one fund. For example:

  • For investors with no choice but to own bonds in a taxable account, it could be a way to create an all-in-one fund that uses tax-exempt bonds.
  • For investors looking to tilt heavily toward REITs or small/cap value stocks, it could be a way to do that.
  • For investors looking to have a very high or very low international allocation, it could be a way to do that.

In Summary

I’m very excited about what Betterment is doing. I think it’s wonderful to have more firms in the marketplace that encourage the use of a “buy, hold, and rebalance” strategy using a diversified portfolio of low-cost funds.

At the same time, I think Vanguard is already doing a great job of meeting most investors’ needs, and they’re doing it at a lower cost.

That said, for investors who:

  • Want a hands-off solution,
  • Are not a good fit (for one reason or another) for the allocation of any of Vanguard’s LifeStrategy or Target Retirement Funds, and
  • Have $100,000 or more to invest…

…I think Betterment’s offering is worth looking into.

It Pays to Start Saving Early: a Realistic Analysis

A reader writes in,

In my opinion, Social Security and Medicare are likely to be around for many years to come. Still, I think it is rational for people under 30 to acknowledge that the benefits will probably be reduced, kick in at a later age, and be means tested to the hilt — thereby making it more important than ever for young people to start saving for retirement as early as they can.

Would you consider writing an article about the benefits of starting in your 20s rather than putting it off? I know there has been a fair amount written about this subject, but there can never be enough information about the power of compounding investments — especially at an early age.

Overstating the Case

It is quite beneficial to start saving early. But I find that most articles making the case for doing so are a bit unfair to their readers because they use unrealistically rosy figures in their math.

For instance, I recently came across a blog post in which the writer calculated the wealth accumulated by age 65 for an investor who makes a $5,000 contribution to a Roth IRA every year. The author used a historical stock return figure of 9.8%, showing that if the investor starts at age 22, he accumulates more than $3.3 million. By waiting until age 35, however, that number is reduced to approximately $960,000.

The message was essentially that you can be filthy rich if you start investing as soon as you finish school.

But there are two major problems with that analysis. First, it uses nominal return figures rather than inflation-adjusted figures. Because we’re talking about a period of time that spans more than four decades, this error makes the resulting figure (the wealth built by age 65) look much larger than it really is — more than 3.5-times as large, in fact, if inflation averages 3%.

Equally important: The article used historical U.S. stock returns for the calculations, implying that an investor today is likely to earn such returns with his/her portfolio. Of course, that assumption is flawed for two reasons:

  • By most estimates, future stock returns are unlikely to be as high as 20th century U.S. stock returns, and
  • Most investors don’t (and shouldn’t) use a 100%-stock portfolio. And with interest rates as low as they are, bond returns going forward are likely to be far lower than historical U.S. stock returns.

I appreciate the motivation behind such articles — it is important to get young people investing early. But what happens if we substitute more realistic return figures?

A More Realistic Analysis

The following table shows the inflation-adjusted wealth an investor would accumulate by age 65 if she invested $5,000 per year (starting at either age 22 or 35) and earned real returns of 3-5% per year.

Assumed Real Return Starting at Age 22 Waiting Until Age 35
3% $458,599 $257,514
4% $600,147 $308,507
5% $793,501 $371,494

So, yes, there’s still a large benefit to starting early. In fact, one could argue that low return expectations make it even more important to start early.

But these numbers don’t exactly strike the, “you could be rich!” chord, which is typically what such articles attempt to do.

If anything, with realistic return numbers, the appeal would more likely be to fear. It’s hard to retire on $300,000 unless you have a pension (or a part-time job) or are willing to rely on Social Security benefits for the majority of your income.

Avoid These 401k Rollover Mistakes

From time to time, I hear from investors who have made mistakes relating to the rollover of a 401(k) or other employer-sponsored plan. Unfortunately, many such mistakes are not reversible, so it’s best to be aware of them so you can steer clear.

Shouldn’t Have Rolled it Over

The first and most obvious mistake is to roll over money from an employer-sponsored plan when it would have been better to leave the money where it was. For example, you should consider keeping your money with your previous employer if:

  • Your employer sponsored retirement plan has lower total costs than what you would have access to elsewhere (This is the case, for instance, with federal employees who have access to the Thrift Savings Plan.),
  • You left the employer at age 55 or later and you want to take advantage of the resulting ability to get penalty-free access to the funds prior to age 59.5, or
  • Your 401(k) includes appreciated employer stock and you want to take advantage of the “net unrealized appreciation” rules.

Poor Planning with Roth Conversions

If you’re planning to execute a Roth conversion in the near future from a traditional IRA that included nondeductible contributions (or if you’ve already executed such a conversion this year), you might want to wait until the year after the conversion to roll over your 401(k).

When calculating the percentage of a Roth conversion that is not taxable, the denominator of the fraction includes your traditional IRA balance as of 12/31 of the year in which the conversion takes place. In other words, by rolling over a 401(k) in that same year, you increase the amount of the conversion that would be taxable as income.

Failed Rollovers

It’s not common, but I have heard from a few investors whose 401(k) rollovers have failed completely because they didn’t play by the rules.

You see, when executing a 401(k) rollover, you only have 60 days from the date you receive the money to get it deposited into your traditional IRA or your new employer-sponsored plan. If you fail to get the money moved before those 60 days expire, the entire amount counts as a distribution — meaning that it will be taxable and likely subject to a 10% penalty, and you will have lost your chance to get it into an IRA to take advantage of tax-deferred growth in the future.

Related note #1: When executing a direct trustee-to-trustee transfer (in which the money is moved directly from one custodian to another) as opposed to a rollover (in which the check is made out and sent to you), you do not have to worry about this 60-day limit.

Related note #2: In some circumstances, it’s possible to get a waiver of this 60-day rule. But you need a much better reason than, “I was too lazy to get around to sending a check to my brokerage firm.”

Attempting to Roll Over an Inherited IRA

This mistake is similar to the one above in that it results in a failed transfer, the loss of tax-deferred status, and (often) a whopping tax bill.

When you inherit an IRA, unless you’re the spouse of the deceased owner, you can not roll the money over into your own IRA. You can, however, have the money moved to another custodian (i.e., brokerage firm or fund company). But you have to be very careful about how you do it.

Specifically, the transfer must be a direct trustee-to-trustee transfer, and the IRA at the new custodian must be properly titled in the name of the deceased owner of the original IRA, with you named as the beneficiary. Your best bet here is to call the new custodian, tell them what you want to do, and have them walk you through the process step by step.

Rolling it Over to the Wrong Place

Finally, the most common mistake I see is simply rolling your 401(k) over to the wrong place. When switching jobs, many investors roll their old 401(k) into their new 401(k) without bothering to check the costs in the new plan. In many cases, it would have been better to roll the 401(k) into an IRA at a low-cost brokerage firm or fund company.

(Conversely, if you’re fortunate in that your new employer has a super-low-cost plan, it could be a mistake to roll your old 401(k) into an IRA rather than into the new plan.)

Growth Stocks or Value Stocks for Young Investors?

A young investor asks,

“I have read that a growth tilt is a good idea for a young investor with a long time until retirement. I’m 24 and consider myself risk tolerant. What do you think about using Vanguard’s Growth Index Fund instead of their Total Stock Market Index Fund?”

First, we need to back up a step. When categorizing investments, “growth” can mean either of two different things.

“Growth” as opposed to “Income”

The first possible meaning is a part of a classification system (used, for example, by Edward Jones, Dave Ramsey) in which investments are labeled as either growth, income, or growth-and-income. Using this terminology, most stocks and stock mutual funds would typically be categorized as “growth.” (High-dividend stocks would usually be categorized as growth-and-income.)

I suspect this is what your source meant with his/her suggestion that young investors should allocate a large part of their portfolios to growth investments. But, as it turns out, this growth-as-opposed-to-income characteristic is not exactly what the “growth” in Vanguard’s index fund and ETF names refers to.

“Growth” as opposed to “Value”

Fund companies can name their funds almost anything they want, but with regard to Vanguard’s index funds (and with regard to Morningstar’s classification system), when something says “growth,” that’s as opposed to “value.” And it refers to the fact that the fund owns primarily growth stocks instead of value stocks.

Growth stocks are those of companies whose profits are expected to grow more quickly than average. And value stocks are those of companies whose profits are expected to grow more slowly than average.

But the fact that growth companies are expected to grow more quickly than value companies does not mean that growth stocks are expected to earn higher returns than value stocks. This is because the higher-than-average expected growth in profits is already built into the price of growth stocks. A growth stock will generally only have above-average returns if the company’s profits grow more quickly than expected.

In other words, while growth companies are expected to grow more quickly than value companies, funds that own primarily growth stocks are not expected to grow any faster than their counterparts. (In fact, if anything, it’s the value funds that have higher expected returns.)

For example, Vanguard Small-Cap Growth Index Fund does not have higher expected returns than Vanguard Small-Cap Index Fund or Vanguard Small-Cap Value Index Fund. And Vanguard Growth Index Fund’s expected returns are no higher than those of Vanguard’s Total Stock Market Index Fund.

So, for a young investor, it’s possible that personal circumstances would make a tilt toward growth stocks advantageous. (For example, if you had reason to think that your job safety had an unusually strong correlation to value stock returns, you might want to tilt your portfolio away from them and toward growth stocks so as to reduce the likelihood of your portfolio crashing at the same time that you get laid off.) But such cases are not common. And a desire to increase the risk and expected return of your portfolio is not really a good reason to tilt toward growth stocks.

Investing Blog Roundup: Can I Retire Yet?

I came across a blog this week that I hadn’t encountered before. It’s called Can I Retire Yet, and its subject matter is mostly in keeping with the type of things we discuss here on Oblivious Investor. To kick things off, I thought I’d share a semi-controversial article from the blog:

In addition to the above find, there was an abundance of enjoyable investing-related articles this week. I hope you find some of them helpful.

Investing Articles

Thanks for reading!

Finding Answers to Tax Questions

A reader writes in asking:

“2011 was my first year with a full-time job, and I’m attempting to prepare my tax return on my own. The form instructions are better than I’d expected, but I still have several questions. Instead of emailing you or somebody else with every single question, I’d prefer learn how to find this stuff on my own.

But the IRS’s site isn’t the easiest to navigate, their search tool kind of sucks, and I’m never sure whether I can fully trust articles that I read elsewhere. Do you have any trusted resources that you use on a regular basis that you can recommend?”

In my experience, the key to finding answers to tax questions is, naturally, to use Google. More specifically though, the key is to use Google to search a specific site. This can be done by adding “site:whateversiteyouwanttosearch.com” to any query.

For example, if you wanted to search IRS.gov for information about the Child and Dependent Care Credit, you could try the following Google search:

site:irs.gov child and dependent care credit

Additional tip: If you’re looking at a particularly lengthy document and struggling to find the applicable material, you can simultaneously hit the control and F keys (command + F for Mac OS) to search the document for a specific word or phrase.

Tangent: As you might imagine, this type of Google search has tons of other uses as well. For example, to find answers to Social Security-related questions, you can use Google to search “site:ssa.gov.” Or to find that Bogleheads thread from last year in which Taylor Larimore shared something particularly insightful about safe withdrawal rates, you could search “site:bogleheads.org taylor larimore safe withdrawal rates.”

Searching the Internal Revenue Code

It’s important to remember, however, that most documents on the IRS website (including IRS publications) don’t actually count as legal authority. Granted, the IRS is a credible source, so you can usually count on them to be correct, but if you want to be absolutely sure, the place to look is the actual Internal Revenue Code.

The place I always look when I want to read an IRC section is Cornell University’s website. But again, the site’s search function leaves much to be desired. And doing a Google search with “site:cornell.edu” isn’t much better because, as you’d expect, Cornell’s site includes a vast array of pages other than those on which the IRC is published.

Fortunately, you can use Google not only to search a specific domain, but also to search certain directories on that domain. So, in this case, if you take a look at the URLs for Cornell’s Internal Revenue Code pages, you’ll notice that they all begin with http://www.law.cornell.edu/uscode/text/26/. So if we again wanted to find information about the Child and Dependent Care Credit, we could do the following Google search:

site:http://www.law.cornell.edu/uscode/text/26/ child and dependent care credit

Of course, that still leaves you with the challenge of figuring out what the heck the actual code section(s) means. 🙂

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