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Investing Blog Roundup: Expected and Unexpected Returns

On Monday we discussed the expected return from the Vanguard Total Bond Market Index Fund.

This week I came across an article from esteemed economist Kenneth French discussing the expected and unexpected returns of Facebook, Amazon, Apple, Netflix, and Alphabet (i.e., Google).

A key point about expected returns is that, except for a few specific types of investments (e.g., Treasury bonds that we intend to hold to maturity), we don’t actually expect to get the expected return. That is, we will almost always get more or less than the expected return (i.e., there will be some level of positive or negative unexpected return — we just don’t know how much).

Recommended Reading

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Will a Total Bond Fund Keep Up With Inflation?

In reply to the previous article about fixed-income options in a low-yield environment, a reader wrote in with the following question:

“Would Vanguard’s Total Bond Market fund (or the equivalent) be expected to match inflation over time?”

For a bond (or bond fund), the best estimate for its expected return is its yield. Right now, the SEC yield for Vanguard Total Bond Market Index Fund is 1.19% You can find this on either the “Overview” or “Price & Performance” tab on the fund’s page on the Vanguard site.

But there are two important points of note here.

First point of note: that’s the expected return over the fund’s average duration. We can click over to the “Portfolio & Management” tab to find the fund’s average duration: 6.5 years. So what we’re seeing here is that the fund’s expected return over the next 6.5 years is 1.19%.

For periods shorter or longer than 6.5 years, there’s a greater degree of uncertainty about what the actual return will be.

For shorter periods, 1.19% is still probably the best expected return estimate, but the actual return is going to be primarily affected by price movements (i.e., whether the bonds’ prices move up or down as a result of interest rate changes). See any of the following articles for a discussion of how bond prices respond to changes in interest rates:

For longer periods, 1.19% is (again) likely the best guess, but we (again) have a lower degree of certainty. In this case, a major cause of the uncertainty is that, as we look at longer and longer periods, we simply don’t know what bonds are going to be in the fund’s portfolio. For example, imagine that we were concerned with the expected return over the next 20 years. Given the fund’s average effective maturity of 8.5 years, most of the bonds currently held by the fund will have matured before the 20-year period is even halfway over. In other words, the return earned by the fund over the next 20 years will be hugely affected by the yields on bonds that it hasn’t even bought yet — and which haven’t even been issued yet. And since those bonds don’t even exist yet, we have absolutely no way to know what their yields will be.

Second point of note: because this is a nominal bond fund, the 1.19% figure is a nominal yield (i.e., before inflation) and therefore a nominal expected return.

A good way to get a rough estimate of the market’s expectation for inflation over a given period is to find the difference in yields between TIPS and nominal Treasury bond for the period in question. For example, since our expected return is for a 6.5-year period, we could look at the yields for 7-year TIPS and 7-year Treasuries. Right now, the yield on 7-year TIPS is -1.10%, and the yield on 7-year Treasuries is 0.55%. That’s a difference of 1.65%, which tells us that the market is expecting inflation of roughly 1.65% over the next seven years.

So, in summary, with an expected nominal return of 1.19% over the next 6.5 years and expected inflation of roughly 1.65% over the next 7 years, we can say that the expected return for Vanguard Total Bond Market Index Fund is about 0.46% below inflation over the next 6.5 years.

But that’s just an expected return. The actual nominal return could be meaningfully different from the 1.19% figure. Or inflation could be meaningfully different from the 1.65% figure. And as discussed above, for periods shorter or longer than 6.5 years, there’s an even greater degree of uncertainty.

Investing Blog Roundup: Open Social Security Widow(er) Update

A quick announcement about the Open Social Security calculator: it now has full functionality for widow/widower scenarios (including mother/father benefits as applicable).

To be clear, the calculator has always accounted for survivor benefits, but it was not built to provide guidance to people who are already widows/widowers at the time they are using the calculator.

When I first created the calculator, my line of thinking was that such wasn’t necessary because the analysis for a surviving spouse is usually very straightforward. In fact, in the absence of complicating factors, there are only two options worth considering, as compared to the 96 options for a single person to consider or 9,216 options for a married couple.

But of course, that’s “in the absence of complicating factors.” And in real life, complicating factors do apply in many cases. (The earnings test is the complicating factor most likely to dramatically affect the analysis for a widow/widower.)

So, as of last week, the calculator now provides guidance for widows/widowers, with all of the same features as in other cases.

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6 Fixed-Income Options for a Low-Yield Environment

A reader writes in, asking:

“My wife and I are retired. I have approximately 50% of our savings in Vanguard’s Total Bond Market (TBM) fund. The remaining half is a mix of stock funds as well as a few individual stock holdings.

I am worried how that TBM fund will do going forward, especially over what we hope will be a long retirement.

The Federal Reserve says they’ll keep rates low until at least 2023 unless inflation gets above 2%. But 2% annual inflation still adds up over a few decades. And with US government debt exceeding 20 trillion dollars, inflation over 2% can’t be ruled out. What’s the solution here? Low yields abound, inflation risk still a problem, stocks as risky as ever. Is it time to try something other than TBM for fixed-income? Is it time to increase the equity percentage, even though we are conservative investors?”

There are several reasonable options here. And we’ll discuss them.

But the reality is that (with the exception of option #5, in some cases), none of the options are great. In a low-yield environment, there’s no way to get anything other than low expected returns without taking on significant risk. You basically have to accept that fact and conduct your personal financial planning accordingly. In most cases the best response to low expected returns is to change your expectations rather than change your portfolio.

Trying to find ways around this risk/return relationship is how you end up buying complicated/expensive insurance products you don’t understand or buying esoteric investments with risks you don’t understand. (That is, in a low-yield environment, if an investment appears to be offering you a decent expected return and low risks without any other significant downside, you are misunderstanding some aspect of the product in question. Either the expected return is not what you think it is, or the risks are not what you think they are.)

Option #1: Shop for CD Rates

As long as you stay under the FDIC coverage limit, CDs have no more credit risk than Treasury bonds, and they can provide higher yields, if you’re willing to shop around. For instance, as of this writing, 5-year Treasury bonds are yielding 0.26%, while you can find plenty of 5-year CDs with yields of 1.3%.

The primary downside in my opinion is that it’s somewhat of a hassle — not so much the shopping, but moving money from one financial institution to another. And, when each CD matures, if you’re not willing to shop around again and move the money if necessary (i.e., you simply roll the maturing CD into a new CD at the same bank), you’re going to be missing out on potential yield.

Option #2: Take on More Credit Risk

Another option is to take on more credit risk with the fixed-income part of your portfolio, for instance by switching from a “total bond” fund to an investment-grade corporate bond fund. As an example, as of this writing, Vanguard Intermediate-Term Investment-Grade Fund has a yield of 1.51%, as compared to a 1.18% yield from Vanguard Total Bond Market Index Fund.

But there’s no reason to think that this is a “free lunch.” Yes, it means higher expected returns, but with correspondingly higher risk — not necessarily very different from simply shifting your overall allocation slightly toward stocks.

Option #3: TIPS

Treasury Inflation-Protected Securities (TIPS) offer a given after-inflation yield, as compared to most bonds which provide a given nominal (before-inflation) yield. If, like the reader above, you are concerned that an unexpected high level of inflation will consume most of your purchasing power over time, TIPS alleviate that risk.

Today though, TIPS yields are negative (e.g., -0.55% for 20-year TIPS). In other words, if you buy TIPS right now and hold to maturity, your purchasing power won’t keep up with inflation. But at least it won’t lag it by very much per year. (Point being: if inflation turns out to be very high, lagging inflation by just a little bit per year is actually a relatively decent outcome.)

Option #4: SPIAs

For a household concerned about outliving their money in retirement, a single premium immediate annuity (SPIA) is worth considering. As we’ve discussed elsewhere, it’s basically just a pension you purchase from an insurance company.

And because of the risk-pooling aspect of annuitization (i.e., the fact that the income ends when the annuitant dies, and therefore annuitants who live beyond their life expectancy essentially get to spend the money of annuitants who did not live to their life expectancy), they allow you to spend more per year than you could safely spend from a normal fixed-income portfolio.

An important downside of SPIAs is that they carry inflation risk. Because they pay a fixed nominal amount of income, the purchasing power will decline over time — and would decline dramatically in the event of very high inflation.

Some people make the case that buying a lifetime annuity (i.e., a fixed-income product with a very long duration) is not a good idea when interest rates are low. But as others (e.g., Wade Pfau, David Blanchett) have pointed out, the payout from lifetime annuities is actually most attractive relative to other fixed-income products when yields are low — because the portion of the annuity payment that comes from risk pooling (i.e., the “mortality credits”) is not affected by low interest rates.

Allan Roth recently performed an analysis that found that, when using himself as an example, a lifetime annuity actually provided a higher expected rate of return than AAA-rated corporate bonds. (And therefore a considerably higher expected return than a “total bond” fund that includes a substantial allocation to lower-yielding Treasury bonds.) And that’s while also reducing longevity risk, relative to a bond portfolio.

Option #5: Delaying Social Security

Another option for people in the applicable age range is to effectively sell some bonds to “buy more” Social Security (i.e., spend down fixed-income holdings in order to delay filing for Social Security).

This is the only option on this list that is an exception to the above discussion about risk and expected return. The expected return from delaying Social Security does not change based on current interest rates. So when rates are low, delaying Social Security becomes relatively better.

Option #6: Move Some Money to Equities

Finally, there’s always the option to increase your stock allocation. Stocks do tend to earn more than fixed-income. But as with shifting to riskier bond holdings, shifting from bonds to stocks is not a free lunch. And it tends not to really even increase the amount you can safely spend — at least not at the outset of retirement. (Rather, it provides more of an option for increasing spending later in retirement, if stocks do end up providing good returns over the first part of your retirement.)

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Investing Blog Roundup: The Annuity Puzzle (Again)

Most people really don’t like lifetime annuities. At the same time, most people really do like pensions. An interesting fact, given that they’re the same thing.

This week David Blanchett, Michael Finke, and Timi Jorgensen took a look at a recent survey by The American College. The survey assessed people’s knowledge and attitudes about retirement income planning and financial products — looking specifically at people age 50-75 with at least $100,000 of non-housing wealth.

There are a number of interesting findings, including that people’s appetite for risk declined during the COVID-related downturn, yet demand for annuities declined as well.

Recommended Reading

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When Are IRAs Aggregated?

A reader writes in, asking:

“I have read that your traditional IRAs are all considered one IRA as far as the IRS is concerned. But I recently found another article that explicitly indicated otherwise. Maybe it depends on circumstances? Could you elaborate on this in an article?”

The issue is not so much that it depends on circumstances, but rather that IRAs are aggregated for some purposes and not for other purposes.

Traditional IRAs Aggregated for RMDs

For RMD purposes, all of your traditional IRAs will be treated as if they are one collective traditional IRA. Specifically, each traditional IRA will have its RMD calculated separately, but then you can total up all your necessary traditional IRA RMDs for the year and take that total amount out of any one traditional IRA or any combination of traditional IRAs.

Note that SEP IRAs and SIMPLE IRAs count as traditional IRAs here, so they are aggregated as well.

Employer-sponsored plans are not aggregated with your IRAs though (nor are they aggregated with each other). For example, a distribution from your 401(k) will not count toward satisfying your traditional IRA RMD for the year.

Traditional IRAs Aggregated for Distribution/Conversion Taxability

Similarly, when you take a distribution from a traditional IRA — or do a Roth conversion from a traditional IRA — whether or not it is taxable will depend on an aggregated calculation.

Example: Joan has made $20,000 of nondeductible contributions to her traditional IRA at Vanguard. During 2020, Joan makes a $40,000 Roth conversion from that IRA. At the end of the year, the balance in Joan’s Vanguard traditional IRA is $100,000. She also has a traditional IRA at Schwab with a year-end balance of $60,000. She has taken no other distributions (or done any other conversions) from these IRAs.

The nontaxable portion of Joan’s conversion is calculated as her basis in traditional IRAs (i.e., the amount of nondeductible contributions she has made), divided by the sum of her year-end balances and distributions or conversions from traditional IRAs over the course of the year. (And again, we’re counting all of her traditional IRAs here.)

Joan’s basis is $20,000. The sum of her year-end traditional IRA balances is $160,000. And the sum of her conversions and other distributions from traditional IRAs for the year is $40,000. So the nontaxable portion of Joan’s conversion is calculated as: $20,000 / ($160,000 + $40,000) = 10%. In other words, 90% of Joan’s conversion will be taxable.

IRAs Not Aggregated for “SEPP” Distributions

IRAs are not aggregated for the “series of substantially equal periodic payments” rule, sometimes referred to as 72(t). For that purpose, each traditional IRA is treated as its own separate account.

Aggregation for Roth IRA 5-Year Rule

With regard to the 5-year rule for distributions of earnings from Roth IRAs, once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for all Roth IRAs.

Inherited IRAs Not Aggregated

Inherited IRAs are not aggregated with other IRAs for RMD purposes, nor are inherited IRAs aggregated with other IRAs for the purpose of calculating what portion of a distribution (or conversion) is taxable.

Inherited IRAs can be aggregated with each other for RMD purposes if the inherited IRAs in question a) were originally owned by the same person and b) are being distributed over the same period (i.e., if the inherited IRAs are being distributed over somebody’s life expectancy, it must be the same life expectancy that is being used for each inherited IRA if you want to aggregate them with each other for RMD purposes).

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