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Evaluating a Financial Advisor’s Client Investment Performance

A reader writes in, asking:

“How can you measure, and verify, a financial adviser’s performance for the sake of comparing one prospective adviser to another?”

While this is a common question for people to ask, it’s not really a useful way to evaluate a financial advisor — for a few reasons.

First, an advisor doesn’t recommend the same portfolio to everybody. The investment portfolio that is appropriate for you as a client may be wholly inappropriate for another client with very different circumstances.

If an advisor or advisory firm were to calculate something like the average annualized return earned by their clients over a given period, that figure wouldn’t provide a meaningful point of comparison to another advisor’s such figure. For example, if one advisor has a clientele that is primarily middle class retirees, while another advisor’s clientele is primarily super-high-earners in their 30s or 40s, the clients of the first advisor would probably have, on average, lower returns over the last several years than clients of the second advisor — and that would simply be the result of the first advisor recommending appropriately low-risk portfolios for his/her clients.

In short, there’s no single figure that can be calculated to meaningfully measure how well the investment recommendations of a given financial advisor have performed over a given period.

Second, an advisor shouldn’t really be trying to do anything clever with respect to client portfolios. If an advisor is putting together a portfolio for you, a simple, boring portfolio of index funds/ETFs that approximately match the market’s return is your best bet. Intentionally seeking out an advisor who shows you a backtested, market-beating portfolio is setting yourself up for disappointment.

Finally, an advisor who engages in actual financial planning does a whole lot more than just make investment recommendations for clients.

A financial planner can also provide advice about tax planning or estate planning. They can help you evaluate your insurance coverage to see if there’s anything important you have missed (e.g., disability insurance). They can help with Social Security planning, and retirement planning in general. They can provide assistance with budgeting if that’s something you struggle with. They can provide advice with regard to your employee benefit options (e.g., help determine which health insurance is the best fit for your family).

And frankly, investment management is quickly becoming the least valuable part of financial planning. While there are still plenty of people whose investment performance would be improved by working with a financial advisor, the list of tools available for DIY investors to create a low-maintenance portfolio has grown dramatically over the last decade. Investors can now choose from Vanguard’s LifeStrategy funds, low-cost indexed target retirement funds at various providers, a smorgasbord of total market index funds/ETFs, or low-cost services like Betterment or Vanguard Personal Advisor Services.

Investing Blog Roundup: The Bogleheads’ Guide to the Three-Fund Portfolio

Taylor Larimore — nonagenarian, World War II vet, and co-author of the Bogleheads’ Guide books — recently released a new book: The Bogleheads’ Guide to the Three-Fund Portfolio.

The “three-fund portfolio” (subject of a long-running discussion thread on the Bogleheads forum) is made up of three index funds: a total US stock market index fund, a total international stock index fund, and a total bond market index fund. With just three holdings, it manages to be far simpler than most people’s portfolios, while also being extremely diversified (including thousands of stocks from around the world, as well as thousands of bonds).

Larimore’s new book is very brief — in the spirit of Bill Bernstein’s If You Can. For those who are already well versed in the Bogleheads literature (e.g., having already read the original Bogleheads Guide to Investing, and other books by Bernstein, Roth, Ferri, etc.) the book will be unlikely to provide new information, but it will likely be an enjoyable read nonetheless, as it was for me. (I always enjoy reading about Taylor’s lessons accumulated via many years of experience.)

I think where the book will really shine is as a gift for new investors. Because of the book’s brevity (easy to read in an afternoon), it is more likely to actually be read than the typical book about investing. And because of the book’s singular focus, it will be easy for new investors to internalize the message.

Other Recommended Reading

Thanks for reading!

Building a Safe Floor of Retirement Income — in Advance

A reader writes in, asking:

“I’ve been reading about the safety first school of retirement planning because I think that appeals to me more than the probability method of just spending from risky investments and assuming everything will ‘probably’ be okay. My question is how to start putting such a plan into action in advance.

With the old school probability method, I would just keep building my mutual fund holdings, possibly rebalancing to hold more bonds instead of stocks. The ‘safety first’ method focuses on delaying social security or buying an annuity. But I can’t delay social security until I’m 62. And I can’t, or shouldn’t, buy an annuity in my 50’s either. So what should I, as a safety first investor in my 50’s, be doing right now in the years leading up to retirement?”

As a bit of background for readers unfamiliar with the terms, there are two broad schools of thought with regard to retirement planning. The first school of thought plans to finance retirement spending primarily via liquidating a mutual fund portfolio (or a portfolio of individual stocks/bonds) over time. This approach relies heavily on historical studies and/or Monte Carlo simulations to calculate how safe a certain level of spending is, given various assumptions. This approach is sometimes referred to as the “probability” school of thought, because it focuses on metrics such as “probability of portfolio depletion.”

The second approach essentially says, “I don’t want to bet my retirement on the validity of such studies/assumptions. I’d rather lock in sufficient safe income (e.g., via annuities, pension, Social Security) to satisfy my needs and only use mutual funds to finance my discretionary spending.” This school of thought it sometimes referred to as the “safety first” or “safe floor” method of retirement planning.

The answer to the reader’s question about how to start implementing a “safety first” plan in advance is that you start building a TIPS ladder (or other bond ladder, or CD ladder) that you will use to fund your spending while you delay Social Security, or to fund your annuity purchase.

To plan in advance for delaying Social Security, you would allocate a portion of the portfolio to a bond ladder that will provide the necessary cash each year for 8 years. For example, if you’re passing up $1,500 per month ($18,000 per year) for 8 years, you could start building an 8-year bond ladder, with roughly $18,000 maturing each year.

If Social Security at age 70 still doesn’t give you a sufficient “safe floor” of income to meet your needs/satisfy your risk tolerance, then you should start thinking about a lifetime annuity.

To start planning in advance for an annuity purchase, you’d do something similar — build up bond holdings that you would eventually use to fund the purchase. What’s different about this, relative to delaying Social Security, is that you don’t know how much the annuity will cost. For example, if you anticipate buying a lifetime annuity at age 70 that pays $10,000 per year, there’s no way to know right now (in your 50s) how much that annuity will cost, because you don’t know how high or low interest rates will be when you turn 70.

The solution, rather than buying a bunch of bonds that mature when you turn 70, would be to work on building bond holdings that, when you turn 70, will still have a duration roughly equal to that of the annuity you expect to purchase. This way, the market value of your bonds will rise/fall along with the cost of such an annuity, helping to offset the interest rate risk that you face with the annuity purchase. (Here’s a great Bogleheads thread on that topic.)

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Can I Retire Cover

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  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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Investing Blog Roundup: Keeping Up With the Joneses, When the Joneses Won the Lottery

A recent study from the Federal Reserve Bank of Philadelphia looked at the effect of (small-to-medium-size) lottery winnings on the neighbors of the winners. They found that, on average, neighbors of the winners increase their spending and are more likely to become bankrupt the larger the size of the winnings. It’s hard to ignore the spending of the people around you.

Other Recommended Reading

Thanks for reading!

How Long Will You Collect Social Security Survivor Benefits?

Today I just wanted to give you a quick heads-up about some updates to the Open Social Security calculator, as well as address a question many people have asked about it. I promise we’ll discuss something other than Social Security next time.

  • The calculator now reflects withholding (and eventual benefit adjustment) for the earnings test (i.e., for people receiving benefits and working while under full retirement age).
  • The default mortality table has been updated for the newly-released 2015 SSA period table. (It previously used the 2014 table, as that was the newest available until this month.)
  • The calculator now allows for the selection of a specific “I will die at” age rather than using a mortality table.
  • The calculator now allows for situations in which one of two spouses has already filed, in order to get a suggestion for the other spouse. (Important caveat: It does not currently have “voluntary suspension” functionality, so if the ideal solution is for the spouse who has already filed to suspend benefits at/after full retirement age, the calculator won’t know to suggest that.)
  • Now, when you load the page, the calculator automatically looks up the yield on 20-year TIPS to use as the default discount rate.

In the last two weeks, a common question about the calculator has been why it uses mortality tables (to calculate a probability of being alive in each given year) rather than simply assuming the user will die precisely at their life expectancy. The answer has to do with survivor benefits for married couples.

Specifically, assuming that each person will die at their expected date often results in an underestimation of the total amount of survivor benefits that are likely to be received — and that could cause the calculator to suggest a suboptimal strategy.

As one quick example, consider a husband and wife, each born 4/15/1960. The husband has PIA of $1,800, and the wife has PIA of $1,000. And let’s assume that they are in average health.

The calculator as it’s written now suggests that the husband files at 70 and the wife files at 62 and 3 months. The total present value of this strategy (i.e., the total amount of spending it can be expected to fund over their lifetimes) is $549,164, of which $102,742 comes from survivor benefits.

Now what if we instead do the analysis using fixed “death date” assumptions?

Well, if we look at the SSA 2015 period life table to find their life expectancies at age 62, we see that:

  • The husband has a life expectancy of age 82, and
  • The wife has a life expectancy of age 84.81.

If we used those as the fixed “death dates,” the calculator would be calculating for 2.81 years of survivor benefits.

If filing at 70 the husband has a retirement benefit of $2,232 per month. If filing at 62 and 3 months the wife has a retirement benefit of $712 per month. The difference between $2,232 and $712 is $1,520, which tells us that if the wife outlives the husband, she’ll get a survivor benefit of $1,520 per month — or $18,240 per year.

Multiply $18,240 by the “expected” 2.81 years, and we get a total survivor benefit of $51,254, before discounting for time value of money.

When we discount that back to age 62 with the 0.89% real rate the calculator is currently using, we get a PV of $42,399.

In other words, with this particular set of inputs, by assuming fixed dates of death, the calculator would only assign about 41% of the value ($42,399 rather than $102,742) to survivor benefits that it really should.

In some cases (depending on difference in ages, PIAs, etc) this might not matter much in terms of the suggested strategy. But in other cases it will be important. Accepting and accounting for uncertainty in death dates is, in general, useful.

Why Is There Such a Difference?

Even though each approach (year-by-year mortality, or fixed death date assumption) is using the same “expected” date at death, the year-by-year mortality approach accounts for scenarios in which there’s a long length of time where survivor benefits are relevant. For example, it accounts for a scenario in which the husband dies at 71 and the wife lives until 84. And a scenario in which the husband dies at 72 and the wife lives until 83. And a scenario in which the husband dies at 82 and the wife lives until 96, etc.

Each such scenario is unlikely, but when taken together they add up to a nontrivial probability. And in such scenarios, the payout for strategies that maximized survivor benefits is quite a bit higher than for strategies that did not do so. It would usually be a mistake not to take that into account.

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Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
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.

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Investing Blog Roundup: Lessons from the Past 25 Years

Christine Benz is likely the most well-rounded personal finance expert I’ve met. At the drop of a hat, she can talk about the nitty-gritty details of any personal finance topic — and communicate the concepts in a clear way.

Benz recently celebrated her 25-year anniversary at Morningstar, and wrote an article to share some of the most important lessons she’s learned in that time. It’s an excellent read.

Other Recommended Reading

Updates on the “Open Social Security” Project/Calculator

There’s been a huge amount of feedback this week, which has been very helpful. Thank you all for the input!

I started a Bogleheads thread for feedback/bug reports, and to keep people updated as to my “to do” list with the project. I’ve spent most of this week working on adding “earnings test” functionality, and frankly it’ll probably require most of next week also.

For anybody who couldn’t get the calculator to run, it appears to be one of two things:

  1. Please don’t use anything other than digits/decimals in the input boxes (i.e., no dollar signs, percent signs, or commas)
  2. If you’re 70 or over, unfortunately the calculator doesn’t (yet) know what to do with you. I designed it so that it won’t suggest a claiming date that’s in the past. (I was thinking that, for example, somebody age 64 doesn’t want to be told that they should file at age 62.) But for somebody age 70 or over, there are no possible filing dates in the future. A high priority on my to-do list is giving users the option to input a date on which they already filed for benefits. (For example, “Spouse A already filed 6 years ago at age 67. Given that, when should Spouse B file?”)
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My new Social Security calculator (beta): Open Social Security