Archives for May 2014

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Our Solo 401(k) with Vanguard

One of the most common topics readers ask about is what my wife and I do with our own portfolio. Admittedly, I derive some amusement from that fact, given that our own portfolio is as unexciting as a portfolio can be. As we’ve discussed here on a few occasions, we use a grand total of one mutual fund for the entirety of our retirement savings.

Our retirement account decisions aren’t especially exciting either: We max out our Roth IRAs every year, then we contribute as much as we can afford to contribute to a solo 401(k) with Vanguard.

Still, a handful of readers have asked about the decision process for why we use a solo 401(k) and why we went with Vanguard, so here goes.

Why Solo 401(k)?

We chose to use a solo 401(k) — alternatively referred to as an “individual 401(k)” or “self-employed 401(k)” — rather than a SEP IRA or SIMPLE IRA because a solo 401(k):

  • Allows for larger contributions each year, and
  • Can accept Roth contributions. (Of note: It is only the employee contributions to a solo 401(k) that can be designated as Roth contributions. The employer contributions must be tax-deferred.)

It is slightly more work to open a solo 401(k) — rather than opening the account online in just a few minutes, you actually have to fill out some on-paper forms and mail them in to Vanguard. But it’s not especially difficult.

Why Vanguard?

We opted to use Vanguard for two reasons:

  1. As mentioned above, we like their all-in-one funds, and
  2. We already had our other accounts with them, so it’s simpler to keep everything in one place.

That said, Vanguard’s solo 401(k) isn’t going to be a good fit for every self-employed person. For example, Vanguard’s plan does not allow for incoming rollovers. For us, this is a nonissue, but for other people it could be an important point. (Rolling money from a traditional IRA to a 401(k) can sometimes be helpful as a part of a backdoor Roth IRA strategy.)

Fortunately, there are several firms that offer no-fee solo 401(k) plans that do allow for incoming rollovers. For example, as of this writing:

  • Fidelity’s solo 401(k) and Schwab’s solo 401(k) both allow for incoming rollovers, but, unfortunately, they do not allow for Roth 401(k) contributions.
  • E*Trade’s solo 401(k) plan allows for incoming rollovers and Roth contributions. And if you have an incoming rollover of $25,000 or more, you may qualify for a new account bonus. On the other hand, you would probably end up spending some money each year on trade commissions (e.g., to buy low-cost ETFs from Vanguard or another fund family). 
  • TD Ameritrade’s solo 401(k) plan allows for Roth contributions and incoming rollovers, and you can buy many ETFs (including many popular ones from Vanguard) without paying commissions.

What’s the Big Deal with Vanguard’s Personal Advisor Service?

A reader writes in, asking:

“Why is there so much hoopla over the Vanguard advisory service? I thought that it was accepted wisdom that managing an index portfolio isn’t that hard. Are we all supposed to be using advisors now?”

The reason that Vanguard’s new Personal Advisor Service is a big deal is not that everybody should be using it. Plenty of people will continue to succeed with DIY portfolios; plenty of people (like me) will continue to be well served by a simple one-fund portfolio; and plenty of people will continue to find value in other advisors.

Rather, the reason Vanguard’s new service is a big deal is that it provides a clear benchmark against which other advisory services can be measured: 0.30% per year for portfolio management, an annual basic (investment-focused) financial plan from a CFP, and the ability to contact your CFP when you have questions.

For example, if we use Vanguard’s new advisory service as a point of comparison for a portfolio of actively managed mutual funds from an Edward Jones broker, we see that using Edward Jones means:

  • Paying roughly 0.2%-0.4% more each year (due to higher mutual fund expense ratios),
  • Paying commissions of up to 5.75% on each new investment (rather than paying no commissions at all), and
  • Having an advisor with just a brokerage license rather than a CFP credential.

Vanguard’s new service is noteworthy because it makes it more obvious than ever that the traditional “full-service brokerage” model is a poor value for investors.

Alternatively, for the many independent advisors who charge an annual fee of roughly 1% of assets under management, Vanguard’s new services makes it clear that these advisors must:

  1. Provide some very significant financial planning value over and above the basic financial plan that Vanguard provides with their service, and/or
  2. Provide some sort of investment management expertise that is likely to earn significantly better returns than a basic portfolio of Vanguard funds.

And, together, these value-added services must be worth at least 0.7% per year. That’s certainly possible — there’s a lot of room to provide value to clients via comprehensive financial planning (i.e., tax planning, insurance planning, Social Security planning, estate planning, etc.) — but the onus is now clearly on advisors to show that their services provide sufficient value to justify the additional cost.

In short, the “big deal” about Vanguard’s Personal Advisor Service is that it provides an obvious, credible point of comparison against which other advisors can be evaluated.

Why Most Experts Suggest Delaying Social Security

You buy homeowners insurance in order to shift money from financially non-scary scenarios (e.g., those in which your house doesn’t burn down) to financially scary scenarios (e.g, those in which your house does burn down).

And you buy life insurance in order to shift money from financially non-scary scenarios (in which you live long enough to enjoy a normal-length career) to financially scary scenarios (in which you die at a young age, leaving your dependents with insufficient sources of income).

And the same thing goes for several other similar decisions: buying health insurance, buying auto insurance beyond that mandated by law, including low-risk asset classes in your portfolio, etc.

A key point about each of these decisions is that they actually worsen your average outcome. That is, on average, you will collect less money from an insurance policy than you pay in premiums (because insurance companies have costs as well as profit margins). Yet such decisions are generally regarded as prudent, because they protect you from a significant financial risk.

What This Has to Do With Social Security

Delaying Social Security is a choice that shifts money from financially non-scary scenarios (i.e., short retirement due to early death) to financially scary scenarios (i.e., long retirement due to living longer than average). What’s so compelling about this decision, however, is that in most cases it doesn’t actually worsen the average outcome. In fact, for more than half of retirees (namely, most people other than lower-earning spouses in married couples) the decision to delay actually improves the average outcome.

To state that again: For most retirees, delaying Social Security simultaneously reduces risk and improves the average outcome (i.e., the amount of dollars you can spend over your lifetime). That type of opportunity is very rare in finance. And that’s why you see so many experts saying that it’s a good idea to hold off on taking benefits, if you have the ability to do so.

Point of explanation #1: Delaying Social Security improves the average outcome for unmarried people because the system includes a built-in interest rate that exceeds current market interest rates. That is, in order for taking benefits at 62 to be as good on average as taking benefits at 70, an unmarried person would have to be able to invest his/her early-received benefits at a roughly 2% real interest rate — which you cannot safely do right now, with interest rates as low as they are.

Point of explanation #2: When the higher-earning spouse in a married couple delays claiming Social Security, it dramatically improves the average outcome because (in addition to the above point about interest rates) the increased monthly payout that comes from delaying will be applied for as long as either spouse is still alive.

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Laddering Life Insurance Policies

For most people, the need for life insurance decreases over time. During your working years, the need for life insurance typically decreases because your savings are increasing, the balance on your mortgage (and other debt) is decreasing, and the number of years for which your children will be financially dependent upon you is decreasing.

Similarly, for a person who needs life insurance during retirement (e.g., a married person with a defined benefit pension that provides insufficient survivor benefits), the amount of insurance needed declines over time because the number of remaining years of retirement that must be funded declines over time.

For example, a person’s life insurance needs might look something like this:

  • A current need for $1,500,000 of death benefits,
  • A projected need for $1,000,000 of death benefits for the period 10-20 years from now,
  • A projected need for $500,000 of death benefits for the period 20-30 years from now, and
  • No projected need for death benefits after 30 years.**

For this person, rather than buying a $1.5 million 30-year policy, there’s an opportunity to save some money by “laddering” life insurance policies. That is, break the coverage up into a few policies of varying terms: a $500,000 10-year policy, a $500,000 20-year policy, and a $500,000 30-year policy.

Using term4sale.com, I get the following premium estimates for a hypothetical male non-tobacco user, 30 years old, living in St. Louis, Missouri, with average health status:

  • $1,500,000 30-year policy: $2,050 annual premium,
  • $500,000 30-year policy: $730 annual premium,
  • $500,000 20-year policy: $465 annual premium, and
  • $500,000 10-year policy: $310 annual premium.

In other words, the ladder of three smaller policies results in a savings of $545 per year for the first 10 years, which increases to $855 of savings per year after 10 years, and $1,320 of savings per year after 20 years. Not the sort of thing that will dramatically change a person’s life, but enough to add up to a very meaningful amount over time.

An additional advantage to using a life insurance ladder is that, if you want to, you can get the policies from different companies, thereby diversifying credit risk and taking better advantage of the (limited) protection offered by your state guarantee association.

**When projecting how much life insurance you will need at some point in the future, be sure to include a guesstimate for inflation. $500,000 of death benefits 25 years from now will surely be worth meaningfully less than it would be worth tomorrow.

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