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Investing Blog Roundup: Pros and Cons of “Bucket” Strategies

This week Dirk Cotton continues his series looking at different strategies for retirement portfolios. (Prior articles: “Floor and Upside” and “Variable Spending from a Volatile Portfolio.”) This time he takes a look at the popular “bucket” strategies.

Other Recommended Reading

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An Ideal Retirement Spending Strategy?

Late last year, Steve Vernon, Joe Tomlinson, and Wade Pfau released a new piece of research (full version here, summary version here) that evaluated many different retirement income strategies according to several different criteria:

  1. Average annual real retirement income expected during retirement,
  2. Increase or decrease in real income expected during retirement (i.e., does the income go up for down over time),
  3. Average accessible wealth expected throughout retirement (liquidity),
  4. Rate at which wealth is spent down,
  5. Average bequest expected upon death,
  6. Downside volatility,
  7. Probability of shortfall relative to a specified minimum level of income, and
  8. Magnitude of such shortfall.

The report was pretty lengthy, so I put off reading it. But I recently had a long day of traveling (to the White Coat Investor conference), with plenty of time to read.

The report is primarily focused on discussing metrics for testing retirement income strategies, rather than recommending any particular strategy. And the authors repeatedly make the point that no strategy is perfect — it’s always a tradeoff between the different goals/metrics. That said, the authors do spend quite a bit of time discussing one particular strategy, essentially saying, “given our assumptions, this strategy is a pretty good one, when measured by the metrics discussed here.”

In short, the strategy works as follows:

  • Delay Social Security until 70.
  • For the part of the portfolio that is used to fund the delay, invest in something safe, such as a money market fund or short-term bond fund. (For example, if you are forgoing $150,000 of Social Security benefits by waiting from 62 until 70, set aside $150,000 in something safe in order to fund the extra spending necessary until age 70.)
  • For the rest of the portfolio, use IRS required minimum distribution (RMD) tables to determine the amount of spending each year.

And with regard to asset allocation for the rest of the portfolio, the authors write:

“Our metrics support investing the RMD portion significantly in stocks – up to 100% if the retiree can tolerate the additional volatility (which is modest because of the dominance of Social Security benefits). However, the asset allocation to stocks for a typical target date fund for retirees (often around 50%) or balanced fund (often ranging from 40% to 60%) also produces reasonable results.”

Overall, this is basically a combination of several findings that we’ve seen repeatedly from other research over the last several years (including research by these same individuals). Specifically:

  • Delaying Social Security is usually advantageous (especially for the higher earner in married couple);*
  • It’s good to have safe money set aside in order to fund such a delay;*
  • For the rest of the portfolio, a high stock allocation is reasonable (if you can tolerate the volatility) given that you have a significant “safe floor” of income from delaying Social Security;*
  • It’s usually wise to adjust spending over time based on portfolio performance, rather than spending a fixed inflation-adjusted amount each year of retirement;
  • It’s usually wise to adjust spending based on your remaining life expectancy (i.e., you can afford to spend a larger percentage of your portfolio per year when you are age 90 than when you’re age 60); and
  • Using the RMD tables to calculate a spending amount each year does a reasonably good job of achieving the two prior points.

The authors also note that it’s wise to keep a separate emergency fund that would not be used to generate retirement income but which would be used as necessary to pay for unforeseen one-time expenses (e.g., home repairs). And they note that some people may want to make adjustments based on differing goals. For example, retirees who wish to spend at a higher rate during early retirement may wish to carve out a separate piece of the portfolio to fund such spending (and such piece of the portfolio should likely be invested conservatively given that it will be spent over a short period of time).

Again, no retirement spending strategy is perfect, because there’s always a tradeoff between competing goals (e.g., a higher level of spending now, as opposed to a higher expected bequest for your heirs). But a strategy roughly like the one discussed above does appear to be “pretty good” according to a whole list of different metrics.

In his summary write-up, Steve Vernon even concludes with the following:

“I’ve been studying retirement for my entire professional career, and at age 64, I’ve been thinking seriously about my own retirement. This actuary will be using a version of [the strategy discussed above], based on my 30+ years of study. My life-long quest may just be coming to an end!”

*With regard to these three bullet points, I find that it can be helpful to think of them in combination. That is, as you move from 62 to 70, you’re spending down your bonds to buy more Social Security. In other words, you’re shifting your portfolio from “stocks and bonds” to “stocks, a little bonds, and a lot of Social Security” — which is an improvement for most people given that delaying Social Security is, on average, a better deal than you can get from regular fixed-income investments and given that it helps reduce longevity risk.

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Investing Blog Roundup: A New Tax Scam

This week a reader informed me about a new tax-related identity theft scam that I hadn’t yet heard of. Admittedly, it strikes me as pretty clever — the sort of thing many people might fall for.

Other Recommended Reading

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Which Shares Should I Sell When Using the Specific Identification Cost Basis Method?

A reader writes in, asking:

“With regard to selecting a ‘cost basis method’ for a brokerage account, Vanguard and others say that the specific identification method may allow for ‘greater tax efficiency’ than other methods. I get that the specific identification method lets me choose which shares to sell, so I have more control. But how should I actually decide which shares are the most tax efficient ones to sell?”

As a bit of background, selecting a cost basis method is important when investing in a taxable brokerage account, because it affects how your capital gains/losses are calculated whenever you sell shares of any of your holdings.

Example: You have a taxable brokerage account in which you own 1,000 shares of Vanguard Total Stock Market Index Fund, purchased over several years, at various prices. Now you place an order to sell 200 shares. For the purpose of reporting capital gain or loss on the sale, which 200 shares (out of the 1,000 that you own) will be sold? It depends on which cost basis method you are using.

The three options for cost basis method are:

  • Specific identification, in which you tell the brokerage firm which specific shares you are selling;
  • First-in-first-out, in which it is always assumed that you are selling your oldest shares of the holding in question; and
  • Average cost, in which, for each holding, the total cost basis of all of your shares is added together, then divided by the number of shares you own, for the sake of calculating an average basis per share. And then each share is considered to have that average basis. (In other words, for a given holding, all of your shares are considered to be the same as each other.)

The specific ID method requires the most work, because you have to choose which shares to sell. In addition, you have to keep records of all of your purchases and sales in order to track the basis for each of the shares you own. (For shares purchased after 2011 the brokerage firm will track this for you, as long as you have told them you want to use the specific identification method. But it’s wise to keep records yourself as well.)

But the upside of the specific ID method is that whenever you sell shares, you can sell the shares that are most tax-efficient to sell at that time.

In most cases, that means selling the shares with the highest cost basis — with the reasoning being that doing so results in the smallest capital gain (and therefore the lowest tax cost) or the largest loss (and therefore the greatest tax savings).

However, there are two important exceptions.

First, if selling the shares with the highest cost basis would mean realizing a short-term capital gain (because you’ve held those shares for 1 year or less), then you might want to sell other shares instead. Short-term capital gains are taxed at ordinary income tax rates, whereas long-term capital gains are taxed at lower tax rates. So instead of selling your highest-basis shares, you might want to sell your highest-basis shares out of the shares that you’ve held for longer than one year.

Second, if your taxable income including capital gains is below (for 2018) $38,600 if single or $77,200 if married filing jointly, long-term capital gains have a 0% tax rate. So you may want to sell the shares with the lowest cost basis. That is, you may want to “harvest” the largest gain possible.

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Investing Blog Roundup: Taxes Made Simple, 2018 Edition

The 2018 edition of Taxes Made Simple is now available (print version here, Kindle version here).

The book has been updated to include many of the topics we’ve been discussing here on the blog over the last couple of months: the larger standard deduction, the new version of the home mortgage interest deduction, the new version of the deduction for state/local taxes, the new version of the child tax credit, and so on.

Recent Recommended Reading

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Worrying about Market Declines and High Valuations

A reader writes in, asking:

“The stock market’s tumble over the last week combined with the fact that stock valuations are still so high makes me wonder about the appropriate way to respond. Time to take some money off the table? I suspect I know what you’ll say, but I’m interested to hear anyway.”

The total U.S. stock market (as measured by the Vanguard Total Stock Market Index Fund, VTSMX) fell by less than 10% last week. If that made you super nervous, that’s a good indication that your stock allocation is too high. A 10% decline should not be a big deal — especially when it comes after a 9-year bull market during which the value of U.S. stocks rose by roughly 400%.

If a decline of less than 10% makes you nervous at all, imagine how you’ll feel about a 30%, 40%, or 50% decline. The goal of asset allocation is to craft a portfolio with which you’d be able “sit tight” (or possibly even rebalance into stocks) during a full-blown bear market.

Making Use of Market Valuations

It’s true that the stock market is still highly valued relative to historical norms. (This should not be a surprise, given the huge returns over the last 9 years.)

But how useful is that information for the purpose of predicting returns going forward?

The following chart shows the correlation between the S&P 500’s valuation (as measured by PE10) and its inflation-adjusted returns for periods of various lengths from 1926-2017. As you would expect, the correlation is always negative, which means that the higher the market’s valuation at any time, the lower we should expect returns to be going forward.

Valuations and Returns

But the correlation between PE10 and ensuing short-term returns has been pretty weak. For instance, the correlation coefficient between PE10 and 1-year returns is just -0.22. The correlation is quite a bit stronger if we look at 10-year real returns (-0.63 correlation) or 20-year real returns (-0.75 correlation).

In other words, valuation levels are not very good at predicting short-term market returns. They are much better at predicting longer-term returns.

But even if we have good reason to suspect poor returns over the next, say, 10 years, a 10-year period of poor returns could come in a lot of forms. The market could be roughly stagnant, with inflation taking a toll. Alternatively, we might see another 7 years of gangbuster returns, followed by a super bad bear market for 3 years. Or we might see a 2-year bear market, followed by 4 years of good returns, then another 4-year bear market. And so on. (Or, the next 10 years could be a period for which valuation isn’t even predictive in the first place! A negative 63% correlation is still far from perfect.)

Point being, we never know what’s about to happen in the near term. So valuations aren’t very useful for trying to “dodge” a bear market, so to speak.

But because they do have decent predictive power over the long-term, valuations are useful for questions such as, “how much should I be saving per year?” And, “how much can I afford to spend per year in retirement?”

And with today’s high valuations, we should expect pretty modest returns — suggesting that high savings rates (for those in their accumulation years) and low spending rates (for those in their retirement years) are probably prudent. This was true a year ago, and it’s still true today.

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