Archives for July 2013

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A Look Inside Vanguard’s International Bond Funds

Vanguard originally announced their two new international bond funds back in 2011. But things moved somewhat more slowly than anticipated, and the funds weren’t made available to investors until May and June of this year.

But now the funds are available, their portfolios are in place (i.e., the funds no longer hold just cash, as they did when they were brand new), and Vanguard’s website has all the standard information about the funds’ holdings. So let’s see what they look like, shall we?

Vanguard Total International Bond Index Fund (VTABX)

Vanguard’s Total International Bond Index Fund is the one that has been added to the LifeStrategy and Target Retirement funds. Here’s a quick breakdown of key facts:

  • Expense ratio: 0.20% for Admiral shares (with a $10,000 minimum), 0.23% for Investor shares.
  • Average duration: 6.7 years, meaning this fund should be slightly more volatile than Vanguard’s Total Bond Market Index Fund (with its average duration of 5.5 years).
  • SEC yield: 1.66%, which is slightly lower than the current SEC yield of 2.00% on Vanguard Total Bond Market Index Fund.
  • Credit risk: Slightly higher than Vanguard’s Total Bond Market Index Fund, with the largest part of its holdings being AA-rated bonds rather than U.S. Treasury bonds.
  • Currency risk and inflation risk: Because the fund will be currency-hedged, currency risk should be minimal, and inflation risk should be comparable to that of any dollar-denominated nominal intermediate-term bond fund.

In short, relative to the domestic “total bond” fund, the new “total international bond” fund is slightly more expensive, has slightly more interest rate risk, slightly more credit risk, and a slightly lower yield. When viewed as a stand-alone investment, it’s not exactly the sort of thing I’d be rushing to get my hands on.

On the other hand, similar arguments (higher costs, higher risk, and, at some points in time, lower yield) can be made about international stock funds relative to U.S. stock funds, yet most of us have decided to include international stocks in our portfolios because they offer diversification — diversification both in the sense of holding more total securities and in the sense of offering less-than-perfect correlation with U.S. stocks and bonds. And the same diversification-based arguments can be made for international bonds. (See this paper from Vanguard making that case, for instance.)

Vanguard Emerging Markets Government Bond Index Fund (VGAVX)

While the new Total International Bond Index Fund is, overall, fairly similar to the domestic Total Bond Market Index Fund, Vanguard’s new Emerging Markets Government Bond Index Fund is an entirely different beast due to its level of credit risk and its corresponding yield.

  • Expense ratio: 0.35% for Admiral shares (with a $10,000 minimum), 0.50% for Investor shares.
  • Average duration: 6.5 years.
  • SEC yield: 4.67%.
  • Credit risk: 80% of the portfolio is rated Baa or below. (For reference, Baa is the lowest credit rating that still qualifies as “investment-grade” rather than speculative/junk.)
  • Currency risk: None, because the fund invests in dollar-denominated bonds.
  • Inflation risk: Comparable to any intermediate-term nominal bond fund.

With a yield and credit quality breakdown like that, it’s just barely outside the range of a junk bond fund. (By way of comparison, Vanguard’s High Yield Corporate Fund has a yield of 5.08%.)

So, for those looking for a high-risk bond fund to act as a potential diversifier, how does this fund compare to a high-yield U.S. corporate bond fund? Based on the very limited information I’ve been able to find (namely, comparing the correlation figures in the Vanguard paper I linked to above to correlation figures I calculated for high-yield bonds), it looks like:

  • Emerging market government bonds have a slightly lower correlation to U.S. and international stocks than high-yield corporate bonds do (which makes some intuitive sense, given that emerging markets government bonds seem to have less of a natural connection to the U.S. stock market than high-yield U.S. corporate bonds do), but
  • Emerging market government bonds have a significantly higher correlation to U.S. investment grade bonds than high-yield U.S. corporate bonds do.

In other words, it’s not clear that this fund is a better or worse diversifier than a high-yield corporate bond fund for a typical U.S. investor. (Though it’s important to note that the data in the Vanguard paper on correlations is only for the brief period 2002-2010, so it doesn’t necessarily tell us much about the future.)

Choosing Among Pension/Annuity Options

A reader writes in, asking:

“My wife recently turned 65, and I am 66. Both of us are retired. My wife has a relatively small annuity that is now valued at approximately $46,800. She can take a lump sum or choose one of many annuitization options.

For example, there are some long term periods of withdrawal, almost 20 years, which we’re not interested in. There is a lifetime option that pays $277/month that also guarantees payment for at least 5 years. Then there is a straight 5-year payment option with nothing after that, which has payments of $860/month. I’m strongly leaning to this latter option.”

When you need to select one out of several annuitization options (or payout options on a pension), I think a helpful first step is to get quotes elsewhere to see if one of the options being offered is an unusually good (or bad) deal.

For example, using immediateannuities.com, as of today:

  • The annual payout for a 5-year annuity is 20.29%, and
  • The annual payout for a fixed lifetime annuity (with a 5-year guaranteed period) for a 65-year-old female is 6.51%.

With this information we can calculate that on the private market, it would cost $50,862 to purchase an annuity that pays $860 per month for 5 years. (That is, $860 per month x 12 months per year to get the required annual income, divided by a 20.29% annual payout ratio.)

Similarly, we can calculate that it would cost $51,060 to purchase $277 per month for life, with 5 years guaranteed. (That is, $277 per month x 12 months per year to get the required annual income, divided by a 6.51% annual payout ratio.)

In other words, it looks like the lifetime income option is an ever-so-slightly better deal than the 5-year option with no lifetime income (because it has a slightly higher market value). And they are both significantly better deals than the $46,800 lump sum option.

Given how close $51,060 is to $50,862 though, I probably wouldn’t pay much attention to which one is a slightly better bargain. Rather, I would choose based on which one fits better into my overall financial plan. In other words, do you want to further annuitize your portfolio — that is, turn it into lifetime income rather than liquid assets?

When making this decision, it’s helpful to remember that you already have some lifetime income via Social Security. And, in most cases, “buying” more Social Security by delaying benefits provides more bang for your buck, so to speak, than an actual annuity from an insurance company. So, for most investors, annuitizing via an actual lifetime annuity only becomes desirable if they still want more lifetime income than what they can get from Social Security.

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Getting Advice from the SSA

A reader writes in, asking:

“Does the Social Security Administration offer any form of counseling so that public employees can make informed decisions before it’s too late?  I can’t tell you the number of public employees I talk to that are clueless about all the twists that factor into their Social Security benefit calculation. The online statements aren’t much help.”

Regardless of your employment status (i.e., public employee, private employee, self-employed, or unemployed), you can always make an appointment to speak with an SSA representative so that they can explain your options. If you do that though, it’s important to be aware that SSA employees, like anyone, can make mistakes.

Even more importantly, it’s critical to try to minimize the likelihood of the miscommunications that are so common when discussing complex Social Security topics (e.g., married couple claiming strategies or claiming strategies when WEP/GPO are involved). For example, I’ve heard from numerous people with stories that go something like this:

  • Bob visits his local SSA office.
  • Bob meets with an SSA employee and asks the employee a question — let’s call it Question A.
  • The SSA employee thinks that Bob asked Question B (either because Bob used incorrect terminology when asking his question, because he did not explicitly state all the relevant assumptions underlying his question, or because the SSA employee simply misunderstood something that Bob said).
  • The SSA employee answers Question B.
  • Through the entire conversation, the miscommunication goes unnoticed by both people involved, and Bob walks away thinking that the answer to Question B is the answer to Question A — only to find out the truth later, when something goes wrong (e.g., he gets a check for less than he expected or he is told he’s ineligible for a benefit that he thought he’d be able to claim).

To avoid scenarios like the above, it’s important to be as explicit as possible about exactly what it is that you want to know. For example, if you want to know how much you or your spouse would receive per month if you followed a given claiming strategy:

  • Be sure to clearly state the age at which each person is retiring,
  • Be sure to clearly state the age at which each person is filing for any benefits, and
  • If somebody is filing a restricted application (i.e., an application after reaching FRA for just spousal benefits) or filing and suspending, be sure to state that clearly.

And when asking about a particular benefit, be sure to state clearly whether you are asking about your retirement benefit, your spousal benefit, your widow/widower benefit, or your total monthly benefit (e.g., your retirement benefit plus spousal or widow/widower benefit, if applicable).

Frankly, I think it’s a good idea to put your question on paper. That way you can plan it out thoroughly beforehand, you won’t forget to state anything important, and the SSA employee you meet with can read it and reread it as necessary.

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Social Security Strategies with a Government Pension

A reader writes in, asking:

“For those of us with government pensions, it’s difficult to know how to modify the most common bits of Social Security advice to fit our own situations, given the WEP and GPO.”

For those unfamiliar with what this reader is asking about: If you receive a government pension from work for which you did not pay Social Security taxes:

  • The Windfall Elimination Provision (WEP) changes the calculation of your primary insurance amount (PIA) in a way that, in most cases, reduces it by a significant amount (details here), and
  • The Government Pension Offset (GPO) reduces any benefits you can receive on your spouse’s work record (i.e. spousal benefits or widow/widower benefits) by an amount equal to 2/3 of your government pension.

Unmarried Retirees

If you’re unmarried (and have never been married), the answer is easy: There’s little to change with regard to the conventional when-to-claim-benefits advice. That’s because, while the Windfall Elimination Provision does reduce your benefit, it does not change the break-even math, because your benefit still grows at the same rate for each month you hold off on claiming benefits.

Married Retirees

For married retirees, as with unmarried retirees, the WEP’s effect is straightforward: It reduces the spouse with the pension’s PIA, which is no different from a situation in which that spouse simply had a lower retirement benefit to begin with (i.e., due to a lower earnings history). The effect of the GPO is more complicated though. Because of the GPO, the options available to the couple will vary depending upon the size of the government pension in question.

In short, because of the complexity added by the GPO, it’s difficult to make any broadly-applicable rules of thumb. Instead, it’s probably easier to run through a few different examples to give an idea of how things can play out.

Example #1: Melissa and Eric are married. Melissa has worked for her state government for her entire career. So a) she has never paid into Social Security and therefore doesn’t qualify for a retirement benefit of her own and b) her state pension is large enough to completely eliminate any Social Security benefits she could receive as Eric’s spouse or widow.

In this case, things are pretty straightforward. Melissa has no Social Security-related decisions to make. And Eric’s decisions are essentially the same as they are for an unmarried person (at least in terms of break-even math) because the only benefit in question is his retirement benefit — no spousal benefits of any kind are available.

Example #2: Michelle and James are married. Michelle worked in private industry for 10 years (just long enough to qualify for a Social Security retirement benefit), then worked for the rest of her career for the state government. Her government pension is large enough that the GPO will completely eliminate any spousal or widow’s benefits she could otherwise receive based on James’s work record. She does qualify for a retirement benefit of her own. But because of the WEP and because her average-indexed monthly earnings includes 25 years of zeros, her retirement benefit will be quite small.

This situation is similar to the common married couple situation in which one spouse simply has a much higher retirement benefit than the other. The primary difference is that Michelle cannot get a spousal benefit at any point, which means that:

  • Claiming strategies that involve Michelle receiving a spousal benefit (i.e., the typical “file and suspend” strategy, with James being the one filing and suspending) are not applicable, and
  • Having James delay his retirement benefit is not as advantageous as it normally is for the spouse with the higher benefit, because delaying his benefit only increases the amount the couple will receive as long as James is alive (whereas in most married couples, delaying the higher of the two retirement benefits increases the amount the couple receives as long as either spouse is still alive).

Because Michelle cannot receive a spousal benefit at any point, the only clever strategy Michelle and James can use is for James to get four “free” years of spousal benefits (between FRA and age 70) based on Michelle’s work record, by filing a restricted application for spousal benefits once he reaches his FRA of 66. But, given that Michelle’s PIA is so small, James’s Social Security benefit as Michelle’s spouse will be very small.

Example #3: Martha and Paul are married. Martha worked in private industry for 20 years (and therefore qualifies for a significant Social Security benefit), then worked for her local government for 20 years. Her government pension is large enough to eliminate any spousal benefits she could receive based on Paul’s work record, but it is not large enough to completely eliminate the benefit she could receive as Paul’s widow, if that ever becomes applicable.

This scenario works out much like example #2 above, with the exception of the facts that:

  • It is now more advantageous for Paul to delay claiming his retirement benefit, because doing so would result in an increased widow’s benefit for Martha, should she outlive him, and
  • It is now even more advantageous for them to use the restricted application strategy in which Paul gets 4 years of free spousal benefits, because those benefits will be based on a higher earnings history than were James’s spousal benefits in the previous example.

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Topics Covered in the Book:
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  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Tax Planning for a Bequest

A reader writes in, asking:

“Because of a generous pension, we expect to spend from our portfolio at a rate of just 1-2% per year, meaning that most of the portfolio will probably be left to our children. Do you have suggestions for how to prioritize our accounts for spending? Portfolio is mid six figures, so estate tax is not a concern…unless they change the rules again.”

Step-up in Cost Basis

A common piece of retirement tax planning advice is to spend from taxable accounts before spending from IRAs and other retirement accounts, so as to maximize the length of time that your money is allowed to grow tax-free. Depending on circumstances, however, that advice may need to be turned on its head when you know you’ll be bequeathing most of your holdings.

The key fact here is that when your children inherit your taxable holdings, they will receive a “step-up” in cost basis. That is, their cost basis will be the market value of the assets as of (in most cases) the date of your death. As a result, any unrealized capital gains that had built up over your lifetime will go entirely untaxed. Therefore, for taxable holdings in which you already have significant unrealized capital gains, it often makes sense to avoid liquidating those holdings and paying tax on the gain, given that it’s possible to avoid paying tax on the gain at any point in time.

The older you are — or, to be more blunt, the shorter your remaining life expectancy — the more likely it is that it makes sense to avoid selling taxable holdings with unrealized gains, because there will be fewer years in which you have to pay taxes on dividend and interest income before your heirs get to take advantage of the step-up in basis.

Your Marginal Tax Rate vs. Their Marginal Tax Rate

For most retirees, when choosing whether to spend from tax-deferred accounts or Roth accounts, the question is primarily a function of how your current marginal tax rate compares to the marginal tax rate you expect to have in the future. (If you expect a higher marginal tax rate later, it’s best to spend from tax-deferred now and preserve Roth accounts for later when you have that higher marginal tax rate.)

But when you expect to leave most of your assets to heirs, it becomes a question of how your current marginal tax rate compares to the marginal tax rate you expect your heirs to have while they’re taking money out of the accounts. If you expect your heirs to have a higher marginal tax rate than you have now, preserving the Roth account (by spending from the tax-deferred accounts) generally makes most sense.

In addition, Roth conversions can be a useful tool in years in which you find that, even after taking sufficient distributions from tax-deferred accounts to satisfy your living expenses, you still have a marginal tax rate that is lower than the marginal tax rate you expect your heirs to have when they’re taking money out of the inherited IRA.

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Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
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  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Determining Your Marginal Tax Rate

A reader writes in, asking:

“I’m a recent grad, with my first real job and am learning about taxes for the first time. I understand that knowing my ‘marginal tax rate’ is very important for many decisions. But from what you’ve written recently, it sounds like there’s a lot more to it than just tax brackets, correct? And do you have any tips for determining what my actual marginal tax rate is other than just looking at my tax bracket?”

You’re right that there are many factors that can cause your marginal tax rate to be something other than just the tax bracket you’re in. For example (and, to be clear, this is not an exhaustive list):

In other words, there are a number of taxes that appear and tax credits/deductions that disappear as your income crosses various thresholds or travels through certain ranges, thereby causing your marginal tax rate to be higher than just your tax bracket as your income travels through those ranges or across those thresholds.

Unfortunately, this is not the sort of thing that lends itself to fast and easy modeling in a spreadsheet, given that these various calculations aren’t all based on the same measurement of income. That is, some are based on taxable income. Some are based on adjusted gross income. Some are based on varying definitions of modified adjusted gross income. One is based on “combined income.” And one is based on “household income.”

One of the best methods for figuring out your marginal tax rate is to plug your information into your favorite tax prep software and try fiddling with the numbers a bit. For example, try bumping your income up or down in increments of $500 or $1,000 and see if your total tax changes by something other than just your tax bracket multiplied by the change in income.

Unfortunately, even this isn’t perfect, because tax laws change from year to year. For example, plugging your current information into a 2012 edition of a tax preparation product will not necessarily give you your correct marginal tax rate for 2013, given that the software doesn’t apply the various new rules that have come into effect in 2013 (e.g., the 3.8% net investment income tax). So to be really sure about your analysis, you need to keep abreast of tax law changes each year so that, if necessary, you can make manual adjustments to what the software is telling you.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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