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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

Thanks for reading!

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).

Can I Retire (2020 edition), Investing Blog Roundup

Another book announcement for today: the 2020 edition of Can I Retire? is now available. Of the 2020 editions I’ve done this year, this is the book that received the most significant update. Some of the changes include:

  • The discussion of annuities has been adjusted, given the new environment in which inflation-adjusted SPIAs are no longer available;
  • There’s a new brief chapter on Social Security and how that fits into a broader retirement plan, especially in a “creating a floor of safe income” sort of context;
  • There’s a new chapter on retirement spending strategies; and
  • The discussion of asset location has been condensed somewhat, given its reduced importance in a consistently-low-yield environment.

You can find the print edition here and the Kindle edition here.

Other Recommended Reading

Thanks for reading!

How Do Social Security Inflation Adjustments Work?

A reader writes in, asking:

“I’d be interested in an article on the specifics of Social Security inflation adjustments. I have a vague awareness that my wages are indexed so that my wages from early years count for more than just the actual dollar amount earned. And I also know that the SSA publishes a COLA figure every year for people already receiving benefits. Are those the same thing? And does a person have to file for benefits in order to start getting the COLA?”

The indexing of prior-year earnings is completely separate from the annual cost-of-living adjustments. Let’s discuss how each works.

Wage/Earnings Indexing

Wage indexing occurs at one point in time: in the year you turn 62 — or the year in which you die or become disabled if such happens before you reach age 62.

All of your wages (and net earnings from self-employment) up to 2 years prior to the year in question are indexed based on the national average wage index (NAWI) — sometimes just referred to as the average wage index (AWI). This can be roughly thought of as adjusting your old earnings for “wage inflation” up to age 60.

Example: Bob (alive and not disabled) turns 62 in 2020. All of Bob’s historical earnings up to 2018 are indexed based on the ratio of NAWI in 2018 to NAWI in the year of the earnings in question. So for example if Bob’s earnings in a given earlier year were exactly twice the NAWI figure for that year, then his earnings for that year would essentially “count for” twice the 2018 NAWI.

In the year 2000, NAWI was $32,154.82. If Bob earned twice that amount (i.e., $64,309.64) in the year 2000, then his 2000 earnings would be adjusted to twice the 2018 NAWI when originally calculating his benefit. In 2018, NAWI was $52,145.80, so Bob’s year-2000 earnings would count for $104,292 in 2018 dollars.

Earnings after age 60 are not indexed. In most cases this means that earnings after age 60 actually count for more than they would if they were indexed — because if they were indexed, they’d have to be indexed downward to age-60 dollars, given that NAWI usually grows over time. (There are exceptions of course. NAWI shrank in 2009 with the recession, and it’s certainly going to be lower for 2020 than it was for 2019.)

Another relevant point here — one you may have seen discussed in the news lately — is that your Social Security benefit is ultimately rather dependent on the NAWI figure in the year you turn age 60. If NAWI is low in that year, all of your prior earnings will be multiplied by the low age-60 NAWI. While we won’t know 2020 NAWI until (roughly) September 2021, it’s clear that the figure will be unusually low, given the dramatic amount of earnings loss this year. This is not a good thing for people born in 1960. (And to the extent that it doesn’t recover by 2021, this is not a good thing for people born in 1961.)

Cost-of-Living Adjustments (COLA)

The second type of indexing is the annual cost-of-living adjustment based on actual price inflation. Beginning with the year you turn 62 (or, if earlier, the year you die or become disabled), each year, your primary insurance amount is indexed upward based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

Specifically, the COLA for a given year is based on the average of the CPI-W for the third quarter of the prior year, divided by the average of the CPI-W for the third quarter of the year before that. For example, the average CPI-W from July-Sept of 2019 was 1.6% higher than the average CPI-W from July-Sept of 2018, which is why we had a 1.6% COLA in 2020.

If the calculated figure is negative (i.e., CPI-W went down), then there is no COLA rather than there being a negative COLA. And in the following year, the denominator in the calculation will be the third quarter CPI-W from the last year for which there was an inflation adjustment. For example, in 2015, the third quarter average CPI-W was lower than in 2014. So there was no COLA for 2016. Then, in 2017, the COLA was calculated based on the ratio of average CPI-W from third quarter 2016 relative to third quarter 2014 (rather than being compared to 2015 as would typically be the case).

Finally, to answer the reader’s second question, a critical point about Social Security cost-of-living adjustments is that they do not depend on whether or not you have claimed your retirement benefit. That is, you will get the applicable COLAs beginning age 62 onward, regardless of the age at which you file for your retirement benefit.

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Investing Blog Roundup: Downsizing, How to Get Rid of Stuff

Over a lifetime, we accumulate a lot of stuff. If you’ve lived in the same home for many years — and it’s therefore been quite a while since you’ve gone through the forced purge of moving — it’s probably a lot of stuff.

At some point, all of that stuff will have to go. Maybe that job will be yours if you do end up moving, or maybe the job will ultimately fall to your children or some other designated party. But, eventually, none of your stuff will remain in (what is currently) your home.

This week I encountered an interview of David Ekerdt about the findings from his new book, Downsizing: Confronting Our Possessions in Later Life. For the book Ekerdt conducted extensive interviews with people ages 50+ about their experiences getting rid of their stuff. The interview below shares many of the lessons and insights gained from that research.

Other Recommended Reading

I hope you’re well, and thanks for reading!

How Does the Fed “Prop Up” the Stock Market? (Interest Rates and Stock Prices)

A reader writes in, asking:

“I’ve read over and over this year that the Fed is ‘propping up’ the stock market by keeping interest rates low. How does that work?”

Broadly, there are two ways in which low interest rates help to keep stock prices high.

Firstly, to the extent that corporations are borrowers, keeping interest rates low reduces their costs and therefore directly improves their profitability, which of course helps keep their share prices higher. In the case of a struggling corporation, having access to low-cost capital can even make the difference between declaring bankruptcy or not. And of course avoiding bankruptcy proceedings is good for shareholders.

The second effect has to do with the way stocks are priced. (I think it’s actually easier to understand this effect from the perspective of increases in interest rates. So we’ll start with that.)

Stocks are quite a bit riskier than Treasury bonds. So why do you own stocks at all, rather than just buying Treasury bonds with all of your savings? Presumably, you own stocks because you hope to earn additional returns beyond what Treasury bonds earn. That additional return that you hope to earn is known as a risk premium (i.e., additional return to compensate you for the additional risk).

The price of a stock reflects the (market’s consensus as to the) present value of the future cash flows from the stock. And the discount rate used in that present value calculation is usually something along the lines of “whatever we could earn from bonds, plus a risk premium.”

So when interest rates go up, the necessary discount rate goes up. A higher discount rate means a lower present value, which means stock prices go down.

Or you can think of it this way: imagine that TIPS yields suddenly went way up to 3%, rather than the roughly -1% range where they are right now. Maybe you had been estimating that stocks would earn a 4% real return going forward. Before, that was a 5% risk premium. But with TIPS yielding 3%, a 4% real return would only be a 1% risk premium. Maybe you decide that a 1% expected risk premium isn’t high enough to justify the additional risk from owning stocks, so you sell your stocks to buy TIPS.

Collectively, lots of people would be selling stocks to buy bonds in such a scenario. So the price of stocks would fall. When the price falls, the expected return going forward goes up (because a new buyer is paying a lower price for a given amount of dividends/earnings). And the price would continue to fall (i.e., people would keep selling stocks) until the price was low enough that the expected return was high enough to earn whatever the market collectively decided was a sufficient risk premium over bonds.

So that’s what happens when interest rates go up: it has a downward effect on stock prices.

When governments or central banks make efforts to keep interest rates low, the opposite occurs: it exerts an upward pressure on stock prices. That is, low interest rates make the alternatives to stocks not look very appealing — and that helps keep stock prices high.

To be clear though, while low interest rates have an upward effect on stock prices (i.e., they make stock prices higher than they would otherwise be, all else being equal), they do not prevent stock prices from falling. When events occur that worsen the outlook for corporate profitability, stock prices will still fall.

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