Archives for February 2013

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Insurance Should Stink

Most insurance products stink.

When you buy a term life insurance policy to protect your young family, there’s a very good chance that you’ll collect absolutely nothing in exchange for your premiums.

And when you buy homeowners insurance, there’s a good chance you’ll get back far less than what you spend on the policy.

And when you buy a fixed lifetime annuity, there’s a decent chance you’ll die well before reaching your life expectancy, thereby resulting in an atrocious return on investment for the money you spent on the premium.

And this stinkiness — the ability to “lose” each of these bets — is precisely what makes these products helpful.

Can’t-Lose Life Insurance

Imagine 1,000 thirty-year-old people buying 15-year term life insurance policies on the same day. Because most of these people will not die before age 45, most of these policies will pay out nothing at all. And this is what allows the insurance company to provide such a large benefit to the beneficiaries of the policyholders who do end up dying.

This concept is known as “risk pooling.” And it is what makes insurance worthwhile.

By way of comparison, imagine if our hypothetical 15-year term policy was instead rewritten so that the benefit amount was paid out to each policy holder a) upon death, or b) at the end of the 15-year term. In such a situation, there would be no risk pooling, because every policy is going to have to pay out. As a result, the benefit amount would obviously have to be dramatically reduced — so dramatically, in fact, that there would typically be no point in buying such a policy.

In other words, if an insurance product doesn’t offer the possibility of a very poor outcome, there’s going to be little or no risk pooling going on, and it will typically not be able to offer much bang for your buck in terms of protection against whatever it is the policy insures against.

When An Insurance Product Promises Everything…

Whenever you encounter an insurance product that promises to pay you money regardless of the situation, it’s time to be skeptical.

For example, equity indexed annuities (sometimes called fixed indexed annuities or hybrid annuities) are often sold on the premise that they:

  • Guarantee your capital, thereby protecting you against market declines, while
  • Allowing you to participate in market gains.

It sounds like a win/win. But if the insurance company is insuring you against loss, how can they afford to give you the positive returns that result when the market goes up? Where does the money come from?

As it turns out, the answer is that they don’t give you all of the returns from good years in the market. Typically, they leave out dividends, and they limit the return in other ways such as imposing an annual maximum. (In addition, they typically hit you with large surrender charges if you try to get out of the annuity within the first several years.)

Another insurance product that appears to offer a no-lose proposition is the variable annuity with a “guaranteed withdrawal benefit” rider. These products:

  • Guarantee a certain (non-inflation-adjusted) level of income for the rest of your life (regardless of how poorly the markets perform), and
  • Give you the chance to have that level of income increase if the underlying mutual funds in the annuity perform sufficiently well.

Again, it sounds great. But the reality might not be as good as the sales pitch. The problem is that:

  • The guaranteed level of income is significantly lower than what you can get from a simple fixed lifetime annuity, and
  • The annual costs charged on the investment are quite high — usually well over 2%, sometimes more than 3%.

As a result, it’s difficult for such products to outperform a simple “buy a fixed annuity and invest the difference” strategy. (Note: Vanguard’s GLWB product does have significantly lower costs than most such products, which makes it a much better deal.)

What’s the Catch?

If you can’t figure out the way in which an insurance product stinks — that is, you cannot figure out a single way in which purchasing the product could result in a bad outcome — that is not actually a good sign. In fact, it should be a red flag. More likely than not, it means your evaluation of the product is off-target in some way.

Preparing Your Spouse to Manage the Portfolio

A reader writes in, asking:

“This week there was a great discussion on the Bogleheads about preparing your spouse for how to handle the finances once you’re no longer there. I would be interested in hearing your thoughts on simplifying a portfolio for the sake of a spouse. My current AA has 7 different funds plus a few smaller things we’ve picked up here and there that we’ve never gotten rid of.”

There are several things you can do to put your spouse in a better position to manage the portfolio after you’re gone. For example, I think all of the following actions would be helpful:

  1. Simplify the portfolio to the extent practical,
  2. Provide a specific, written plan for how to manage the portfolio,
  3. Reduce the significance of the portfolio by increasing annuity-type income, and
  4. Establish a relationship with an advisor.

It’s worth noting that such actions are helpful not only for protecting your spouse in the event of your death, but also for protecting you in case of cognitive decline later in life. No matter how smart you are, you’re not immune to Alzheimer’s or dementia. And the fact that you’re still at the top of your game is precisely why you want to be making these decisions right now rather than later, when your abilities might not be as strong.

Simplifying the Portfolio

A portfolio that is simple to one person may be a logistical nightmare for another person. For example, rebalancing even a relatively simple 3-fund allocation would be quite difficult for many investors if the portfolio is spread out across several accounts. If your spouse isn’t comfortable with a spreadsheet, that’s not the type of task you want to leave to them.

When it comes to simplifying, most people have a few pieces of low-hanging fruit:

  • Eliminate duplicate accounts by moving everything to one brokerage firm so that you don’t have, for example, traditional IRAs with three different companies.
  • Eliminate holdings of individual stocks and bonds.
  • Eliminate any holdings whose role in the portfolio is questionable in the first place (i.e., anything that you would have already sold if not for simple inertia).

Beyond that, it’s just a question of how simple you want to make the portfolio. For example, you might want to simplify to a “total market” -type portfolio instead of one with separate allocations for various sub-asset-classes (e.g., REITs or small-cap value stocks). Or, you might even want to simplify all the way down to a single all-in-one fund (e.g. Vanguard’s Target Retirement Income Fund).

If, however, a significant portion of the portfolio is in taxable brokerage accounts, there are a few additional things to keep in mind:

  • You may want to continue hanging on to holdings where significant capital gains have built up.
  • If you do not have unrealized capital gains in your holdings, it might be preferable to make these changes now (even though you’re still alive and in full possession of your mental faculties) rather than later, by which point capital gains may have built up, thereby creating a cost for your spouse to make the switch.
  • One-fund solutions might not be the best choice, given the tax-inefficient nature of the fund-of-funds structure.

Providing a Written Plan

In addition to simplifying the portfolio, you’ll want to provide a set of written instructions for how to manage it. The plan should provide clear instructions not just about the target asset allocation, but also regarding:

  1. When and how to rebalance,
  2. How much can safely be spent per year, and
  3. How to decide which account(s) to spend from each year.

Annuitizing More of the Portfolio

Income from a lifetime annuity is easy to handle — all you have to do is decide how to spend it. As such, if you have doubts about your spouse’s ability to manage an investment portfolio, you may want to take actions to ensure that most (or even all) of your spouse’s basic needs are covered by annuity, pension, and Social Security income.

Note: Like purchasing an annuity, delaying Social Security benefits has the same effect of reducing one’s reliance on investment returns, and it is often a better deal than purchasing an annuity on the private marketplace.

Establishing a Relationship with an Advisor

If you think the best plan for your spouse is to use the services of an advisor, I would suggest selecting the advisor and having your spouse meet with the advisor now, before the actual time comes to make full use of his/her services. If your spouse is already comfortable with this person, it will make things much easier when the time comes.

Making the Most of Your Capital Losses

Long-term capital gains are taxed at a lower rate than most other forms of income. Specifically, they are taxed at:

  • A 0% rate if they fit into the 10-15% income tax brackets,
  • 15% if they fit into the 25-35% tax brackets, and
  • 20% if they end up in the new 39.6% tax bracket.*

As a result, when you have capital losses, it’s ideal when those losses can be used to offset ordinary income such as wages (given their relatively higher tax rate) rather than capital gains (given their relatively lower tax rate).

However, in a given year, your capital losses are first used to offset your capital gains. It’s only when your losses exceed your gains that you can use them (subject to a $3,000 limit per year) to offset ordinary income.

Therefore, it can sometimes be beneficial to avoid realizing capital gains and losses in the same year.

For example, if you sold a stock for a $5,000 capital gain this year, and you have another stock (that you plan to eventually sell) that currently has a $5,000 unrealized capital loss, you may want to wait until next year to sell the other stock, so that you can pay the low tax rate on your capital gain this year, then use your capital loss to offset ordinary income over the next two years.

And conversely if you have realized capital losses this year, you may want to wait until next year to realize capital gains (thereby allowing $3,000 of this year’s capital losses to offset ordinary income).

There Are Exceptions!

Due to the annual $3,000 limit on the deduction for net capital losses, the total savings for this strategy is limited to a few hundred dollars per year (specifically, $3,000, multiplied by the difference between your marginal tax rate for ordinary income and your marginal tax rate for long-term capital gains).

In other words, while it’s helpful to keep this strategy in mind, there will often be other considerations that are more important.

For example, if a few individual stocks make up a huge portion of your overall portfolio, it could very well make sense to sell all of them sooner rather than later so that you can diversify your portfolio as quickly as possible — even if doing so is not the most tax-efficient approach.

Or, if you have sold some investments for gains this year, and you have an unrealized capital loss that’s so big that it will not only offset this year’s capital gains, but also provide for many years worth of $3,000 deductions, you may want to just go ahead and take the loss now.

*If your modified adjusted gross income is $200,000 or more ($250,000 if married filing jointly), your capital gains will also be subject to the new 3.8% Medicare surtax on net investment income. But even still, your marginal tax rate for long-term capital gains will be less than your marginal tax rate for ordinary income.

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When It’s OK to “Sell Low”

If there’s one tidbit of investing advice that everybody has heard, it’s that you want to buy low and sell high.

But I can’t count the number of times I’ve heard from people who are making poor investment decisions because of a misunderstanding of how and when to apply the “buy low, sell high” maxim. In reality, there are a number of times when it makes perfect sense to “sell low.”

Tax-Loss Harvesting

As a reminder, tax-loss harvesting is when you sell an investment in a taxable account for a loss (which you can then use to offset capital gains and, subject to a $3,000 annual limit, your other taxable income) and simultaneously purchase another investment that can perform a similar role in your portfolio. (You’ll want to make sure, however, that the replacement investment is not “substantially identical” to the first investment, so as to steer clear of the wash sale rule.)

When you tax-loss harvest, you are “selling low.” But that’s not a problem, because, with regard to your replacement investment, you’re also “buying low” at the same time. And you achieve some tax savings in the process.

Rebalancing Between Accounts

Imagine that you recently realized you could achieve substantial cost savings by:

  • Selling your bond and international stock holdings within your 401(k) in order to switch to a less-expensive U.S. stock fund, while simultaneously
  • Selling your U.S. stock fund in your IRA and buying more of your bond and international stock holdings in order to keep your overall asset allocation the same.

As with tax-loss harvesting, it would be perfectly OK to “sell low” to implement the above plan, because no matter what it is you’re selling low, you’re going to be “buying low” at the same time, in another account.

And, as with tax-loss harvesting, you achieve some savings in the process.

The Investment Doesn’t Belong In Your Portfolio In the First Place

If you have an investment that you’ve decided no longer deserves a place in your allocation (e.g., an individual stock or a mutual fund with unnecessarily high costs), the price of that investment being less than the price you purchased it for is not a reason to keep the investment while you wait for it to “come back.”

The only reason that you would want to keep the investment in your portfolio is if you have a reason to think it will outperform whatever you plan to (eventually) replace it with. And in most cases, if you have already decided the investment is likely to underperform over the long haul, there’s little reason to think it will outperform over the short haul.

What to Do When the Market Crashes

A reader writes in, asking:

“I always hear that ‘the market is right and has already factored in all relevant news‘ If that’s the case, then how do you explain times when the market plunged? And if the market was right when it plunged what should I have done? – stayed in the market or pulled my money out also since if the market was right I should also be going with the flow.”

The idea of an efficient market is that it factors all known information into investment prices. But it can’t know the unknowable. That’s why there are big moves (up or down) whenever a big piece of previously unknown information comes to light.

The hypothetical example often used is of a company whose fate depends on the outcome of a court case (e.g., whether or not the court strikes down a patent for their one and only product). If the court rules against them, shares of the company will be worthless. If the court rules in their favor, shares will be worth $100.

If the market estimates that the company has a 50% chance of winning the court case, shares of the company will currently be priced at $50. That’s the “right” price given the known information, despite the fact that the shares will obviously be worth either much more or much less in the very near future.

And the same thing happens at the overall market level. In late 2008, the market’s estimation of the probability that our economy would collapse went up dramatically — so stock prices fell dramatically. Once it became clearer that such an outcome probably wasn’t going to happen (at least not in the immediate future), stocks prices came back up.

Because an efficient market prices in known information so quickly, it only makes big moves in response to new information. In other words, if we assume that our market is efficient, the market’s current price and recent price moves don’t tell us anything about what the market is going to do.* What the market is going to do depends on what new information comes to light — something that’s, by definition, unknown right now.

So What Should We Do About Market Crashes?

When the market crashes, we don’t necessarily know it’s coming back in the near future. It’s possible that it could keep going down. So, how a given investor should respond to a crash depends on the investor’s situation.

  • An investor with a high tolerance for risk (i.e., somebody who can afford to lose the money and who is comfortable with volatility) would rationally choose to rebalance back into stocks (that is, buy more of them).
  • Investors with less risk tolerance might rationally choose a “do nothing” approach. That is, they don’t sell their stocks, but they don’t buy more either.
  • Investors with very low risk tolerance (i.e., investors who cannot afford to lose any more money) could rationally pull their money out of stocks and move it into something safer such as a fixed annuity that promises to pay out regardless of what the stock market does. (Of course, one could make the case that this investor shouldn’t have had so much in stocks to begin with. But that’s a separate discussion.)

*As it turns out, there’s evidence that our market isn’t perfectly efficient in this sense. Over short periods of time, the market tends to exhibit a very slight amount of momentum, meaning that if yesterday was a down day, today is just barely more likely to be a down day. Profiting from this information, however, is rather difficult given how slight the effect is.

Should You Add International Bonds to Your Portfolio?

In November of 2011, Vanguard announced plans to create two new bond index funds: a Total International Bond Index Fund and an Emerging Markets Government Bond Index Fund. Then, for whatever reason, things got put on hold.

Last week, however, Vanguard announced that their Total International Bond Index Fund is going to be open to investors sometime in the second quarter of this year.

In addition, they announced that the new fund will be added to all of their Target Retirement and LifeStrategy funds. (Specifically, 20% of the bond allocation of each fund-of-funds will go to the new international bond fund.)

Costs

For the new Total International Bond Index Fund, Vanguard anticipates a 0.20% expense ratio for Admiral shares and ETF shares and a 0.23% expense ratio for investor shares.

In other words, international diversification for your bonds will cost you approximately 0.10% per year (calculated as the new fund’s 0.20% expense ratio, minus the 0.10% expense ratio of the domestic Total Bond Market Index Fund). That’s roughly on par with the cost of international diversification for stocks (given a 0.12% difference in expense ratios between Vanguard’s Total International Stock Index Fund and Total Stock Market Index Fund).

Do International Bonds Improve a Portfolio?

The following is what I wrote when the funds were first announced. I think it’s still applicable.


My initial thought — and please note that this is just average-Joe commentary here, as I am not an economist — is that international bonds could offer a diversification benefit, with the simple reason that interest rates in the U.S. are largely affected by the actions of the Federal Reserve, whereas rates in other countries are going to be more heavily impacted by the actions of their own respective governments.

A 2011 research paper from Vanguard offers us some historical data that supports the idea that international bonds offer a bit of a diversification benefit.

The paper showed that the monthly returns of international bonds (as measured by the Barclays Capital Global Aggregate ex-USD Hedged Index) had a 60% correlation to the monthly returns of U.S. bonds (as measured by the Barclays Capital U.S. Aggregate Bond Index) from 1988-2010. That’s significant correlation, but it’s still low enough to suggest that international bonds could be helpful.

The paper also showed that from 1985-2010, for a 60% stock, 40% bond portfolio, as you move more of the bonds from domestic to international, the portfolio’s overall monthly volatility decreases very slightly.

While these two data points do give some indication that holding international bonds is likely helpful, they’re not exactly overwhelming. And as always when using historical data, we must remember that it’s just that — historical. We don’t know whether international bond diversification will be more helpful, less helpful, or even detrimental going forward.

Currency Hedging

One important point about the fund is that it will be currency-hedged. That is, the fund will use currency exchange contracts to reduce the volatility that would otherwise be caused as a result of the U.S. dollar fluctuating in value as compared to the various currencies in which the fund’s international bond holdings are denominated.

The result of this hedging is that currency risk for this fund should be minimal.

So Should You Buy The New Fund?

The flip side of the decision to currency-hedge the Total International Bond Index Fund is that its performance will be much more closely correlated to the performance of U.S. bond funds than would be the case if the fund were not currency-hedged. In other words, the decision of whether or not to include this fund in your portfolio will probably not be on the list of most important investing decisions you’ll ever make.

As a general rule, I think it’s wise to watch something for a few years — long enough to have a good handle on how it tends to behave — before putting a large portion of your portfolio into it.

Because my wife and I currently use the Vanguard LifeStrategy Growth fund (with its 80% stock, 20% bond allocation) for our retirement savings, that means 4% of our retirement portfolio (20% of the 20% bond allocation) will be put into this new fund. That’s a pretty modest allocation — not enough to cause me any worry whatsoever.

That said, if we instead used a DIY portfolio of individual index funds, I would probably be inclined to wait and watch the fund for some years before moving anything into it.

There’s no need to rush.

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