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Financial Planning Priorities

A reader writes in, asking:

“I am getting my financial house in order for the first time. I have no debt and a good income, but have not paid much attention to investing until now. A friend directed me to your blog and to the bogleheads website, but I am finding it all to be overwhelming. Do you have any suggestions for which topics to read about/focus on first?”

The Bogleheads forum is filled with investing enthusiasts. As such, there are several advanced topics that get a lot of discussion there, which most people can safely ignore. For example:

  • Should you use international bonds?
  • Should you use “smart beta” funds?
  • Should you tilt toward small/value/momentum/profitability?
  • Should you include corporate bonds in the portfolio? A TIPS fund?
  • Should the bonds be short-term, intermediate-term, or long-term?
  • How often should you rebalance to your target allocation?

When getting started, most people should ignore all of the above topics and simply start with a “three fund portfolio,” or possibly even a low-cost “all-in-one fund” (e.g., a Vanguard Target Retirement fund).

In fact, most people should never spend any time thinking about the above topics, because:

  1. There’s a limited amount of time that they’re willing to devote to financial planning, and
  2. There are other financial planning topics that are much more important.

For example, all of the following financial planning to-do items are more important than the asset allocation questions listed above.*

  • Basic insurance planning (i.e., making sure you have appropriate health insurance, life insurance if anybody is dependent on you for income, disability insurance unless you’re retired, etc.)
  • Budgeting (i.e., selecting a spending/saving rate that’s appropriate relative to your income/assets)
  • Basic portfolio allocation (i.e., stock/bond allocation, as well as making sure there isn’t too much in one single stock)
  • Basic estate planning
  • Basic tax planning
  • Social Security planning (if near retirement)
  • Minimizing portfolio costs (i.e., making sure to use funds with low expense ratios)

It’s only after taking care of all of these items that it would make any sense to think about things like whether or not your portfolio should include “smart beta” mutual funds. And even for people who have taken care of these other financial planning to-do items, there’s still no need to spend time thinking about all of those advanced asset allocation questions. In nearly all cases, it’s perfectly fine to stick with that simple “three fund portfolio” — or even the single all-in-one fund in some cases.

*I’ve attempted to order this list roughly from highest to lowest priority. The exact order of priority will vary from one person to another though. For example, if you’re unmarried and have no kids, estate planning would be a lower priority than it would be for somebody with children. And estate planning would be an especially high priority for a married couple who each have children from a prior marriage.

Investing Blog Roundup: Planning for Tax Changes

While we still don’t know what the final law will look like, one thing that seems very likely is that many people who currently itemize will be claiming the standard deduction going forward (because many itemized deductions are likely to go away, while the standard deduction is likely to be increased considerably). As a result, one thing that likely makes sense for many people will be to accelerate itemized deductions, if possible.

The following article has more information. But again, it’s key to keep in mind that nothing is set in stone yet.

Other Money-Related Articles

Thanks for reading!

How Do Long-Term Care Annuities Work?

A reader writes in, asking:

“I do not have long term care insurance, and likely will not be able to buy any in the future due to a pre-existing medical condition. An acquaintance recently recommended that I consider purchasing a long term care annuity. I’ve been reading about them, but they appear to be complicated products. And I have learned the hard way that it’s wise to be skeptical of complicated insurance products. Could you shed some light on how they work, and perhaps some thoughts on whether they’re worth buying?”

Long-term care annuities are deferred annuities, in the sense that they have an accumulation stage and a distribution stage.

Background for readers who aren’t familiar with those concepts: With a deferred annuity, during the “accumulation stage” you have an account that grows at either a fixed rate of return (if you have a fixed annuity) or a variable rate of return (if you have a variable annuity). Then, if you want to, you can shift to the “distribution stage” (this is known as “annuitizing” the annuity). When you do so, you give up the account, and in exchange you get a guaranteed stream of income (e.g., a stream of income that is guaranteed to last for your life).

With a long-term care annuity, you purchase a rider that provides a degree of long-term care protection during the accumulation stage. Because this protection disappears when you shift to the distribution stage (i.e., when you “annuitize” the annuity), the typical plan when purchasing a long-term care annuity is actually to never annuitize it at all (i.e., to stay in the accumulation stage indefinitely).

The long-term care annuities I have looked at are either fixed or fixed-indexed annuities, meaning they provide a guaranteed rate of return during the accumulation stage. For the annuities I’ve looked at, a 1% guaranteed rate of return (or somewhere in that ballpark) was typical.

And you have to pay a cost for the long-term care rider. The cost is usually in the ballpark of 1% per year for somebody age 65 (higher if you’re older, lower if you’re younger).

When you consider the ~1% fixed rate of return together with the ~1% annual cost for the rider, we’re talking about a product that has roughly zero expected growth.

How Does the Long-Term Care Protection Work?

Firstly, it’s important to know that the details vary from one policy to another. But the general way the long-term care rider works is that, if you deplete your account value by paying for long-term care over a specified period of time, you get access to some additional funds that you can spend on long-term care over another specified period of time.

For example, a policy may require that you spend down your account value over two years by paying for long-term care. And if you do so, then an additional sum of assets (which would be a specified amount, such as 2x your account value as of the date that you started needing long-term care) would be released to you to spend on long-term care over another period (e.g., four years).

So with such a policy, you would get no benefit from the rider at all if you need less than two years of long-term care (because during the first two years of care you’re just spending your own assets). And you would only get the full benefit from the rider if you need at least six years of long-term care.

Are Long-Term Care Annuities a Good Idea?

Whether or not you should buy a long-term care annuity depends on your circumstances.

First and most obviously: the more likely you are to need long-term care (and, specifically, a long period of long-term care), the more valuable a long-term care annuity might be.

Then there’s the question of your assets. If you have enough assets that you could pay out of pocket for long-term care without too much of a challenge, it’s usually undesirable to buy insurance against LTC risk (because, on average, insurance is a losing proposition for the purchaser, given that the insurance company prices it so that it will be profitable to them).

And on the other side of the spectrum, if your assets are low enough that Medicaid would kick in after just a couple years of long-term care, it’s probably not a good idea to buy insurance against LTC risk, because doing so isn’t protecting you from financial risk so much as protecting the government against financial risk.

In other words, it’s people in the middle asset range who are more likely to benefit from insuring against LTC risk (either through buying traditional LTC insurance or a long-term care annuity).

One potentially important point regarding LTC annuities is that they often have less thorough underwriting than regular LTC insurance. That is, a person who wouldn’t qualify for regular LTC insurance due to a medical condition might be able to qualify for a LTC annuity.

Another difference relative to traditional LTC insurance is that long-term care annuities (or life insurance products with LTC riders) can work as a sort of “high deductible” LTC policy, in that they don’t start paying until you’ve needed years of long-term care.

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Investing Blog Roundup: GOP Tax Legislation

It’s likely (though not entirely certain) that we’ll see the Senate pass its version of the GOP tax bill today. We still have to wait and see what the finalized version will look like though.

On an unrelated note, several people made suggestions regarding the solo 401(k) contribution calculator I released a couple of weeks ago. I believe they’ve all been implemented by this point.

Other Money-Related Articles

Thanks for reading!

Investing Blog Roundup: State-wide Automatic Enrollment

I hope you all enjoyed the holiday yesterday. There will be no article this upcoming Monday, as we’ll be spending time with family visiting from out of town. The regular publishing schedule will resume on Friday 12/1.

One of the biggest personal finance success stories in recent years is the implementation of automatic enrollment in employer-sponsored retirement savings plans (i.e., retirement plans that automatically enroll new employees unless they opt out of the plan). The state of Oregon is implementing a similar concept on a large scale, to cover employees whose workplaces do not offer retirement plans. It will be interesting to see how everything plays out.

Investing Articles

Thanks for reading!

Rebalancing, with an Eye on Tax Costs

A reader writes in, asking:

“How do you balance tax considerations with portfolio rebalancing? For example, one can have long-term equity holdings in taxable accounts, with large capital gains baked in. To rebalance from them might help one stay on an asset allocation target, but at the cost of a sizable tax bill. Is there a way to think about this trade off, based on some analysis?”

You’ve likely already thought of these, but just to make sure:

  • Rebalancing with new money (if you’re in the contribution stage) can bring your allocation back toward the target without tax costs.
  • Rebalancing by changing the allocation within tax-advantaged accounts can bring the overall allocation back toward the target without tax costs.
  • If you have plans for charitable giving, donating appreciated shares can bring your overall allocation back toward the target without tax costs.

Assuming that none of the above points is sufficient to get your allocation back to your target allocation, then it’s usually a process of liquidating the specific shares with the smallest built-in gain until you’ve achieved an allocation that is again acceptable.

[Brief tangent/exception: If the gain would fall within the 15% bracket or below, there would be no tax on the gain. So if the additional income does not cause other undesirable tax consequences (e.g., making you ineligible for a particular credit or deduction), realizing a gain on purpose could be a good thing ]

When going through the above process (i.e., liquidating shares with the lowest gains until you’re back at an acceptable allocation), there are a two primary factors that I would think about.

How Off-Target Is Your Allocation?

First, how dramatic is the difference between your current allocation and your desired allocation? For instance, is a huge part of the portfolio in one single stock? If so, tax considerations usually take a distinct back seat to risk considerations.

Conversely, if your portfolio consists entirely of holdings that you do indeed want to hold, and they’re simply off-target by a few percentage points here and there, the analysis is very different.

For example, below is a chart comparing the performance of Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX, in blue) with Vanguard’s LifeStrategy Conservative Growth Fund (VSCGX, in orange) over the last 10 years. While their allocations have changed somewhat over the period, the conservative fund has pretty consistently had about 20% more in bonds and 20% less in stocks than the moderate fund.

LifeStrategy funds

You’ll notice that, as expected, the moderate fund fell by a greater amount during the 2008-2009 crash than the conservative fund, and in recent years (with good market performance) it has grown somewhat more quickly. But an investor in one fund would not have had too wildly different an experience than an investor in the other fund. And that’s with a big (20%) difference in the most important part of the allocation (i.e., the stock/bond allocation).

So it’s safe to say that if something is a few percent out of whack, it’s not usually an urgent problem. And that’s especially true if the difference is within one asset class (e.g., you have too much international stock relative to domestic stock, but your overall stock allocation is about right).

Is Waiting Worthwhile?

The second consideration is whether you actually gain anything by waiting to rebalance.

For example, in the case of a person who is well into retirement or who is in very poor health, it would be worth thinking about whether the holdings with built-in-gains could simply be held until they’re eventually left to heirs (who would get a step-up in basis, thereby being able to avoid the tax cost completely).

Or, in some cases, rebalancing over two or three years rather than all at once might keep your tax rate lower (either because it keeps you in a lower tax bracket the whole time or because it keeps your adjusted gross income below some threshold, such that you stay eligible for a given credit/deduction).

Conversely, if you know that:

  1. You’ll have to rebalance at some point (i.e., the market isn’t going to rebalance for you, and your allocation is too far out of whack to consider simply holding it indefinitely),
  2. In order to rebalance you’ll have to liquidate shares with gains, and
  3. You don’t actually gain very much by waiting…

…then it often makes sense to just bite the bullet and incur the tax cost of fully rebalancing.

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