Archives for March 2011

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Taking Social Security Early and Investing the Money

After last week’s post about when to take Social Security benefits, a few people contacted me to ask what I think about taking the benefits early and investing them. [Quick note: This post is also regarding unmarried investors. I’m attempting to cover the simpler scenarios before moving on to the more complex ones.]

My answer was that it makes sense in some cases. Specifically, it depends on four factors (two knowable, two unknowable):

  • How long you’ll live,
  • What rate of return you’d earn if you invested the money,
  • What withdrawal rate you expect to need to use from your portfolio, and
  • Whether you care more about increasing the possibility of leaving a large inheritance or about reducing the possibility of outliving your money.

Let’s Try an Example

For a person born in 1950, for every $12,000 0f annual benefits at full retirement age, you could instead choose to get:

  • $9,000 per year (adjusted for inflation) at age 62, or
  • $15,840 per year (adjusted for inflation) at age 70.

So how does it play out if we compare the two following strategies?

Strategy 1: Delay benefits until age 70, at which point you claim benefits and spend the entire amount ($15,840) each year.

Strategy 2: Claim benefits at age 62 ($9,000 per year) and invest the money. Beginning at age 70, start spending $15,840 per year ($9,000 of benefits and $6,840 from the savings that have accumulated from claiming benefits early).

Using Low-Risk Investments

If we assume a 2% after-inflation return (approximately what you could expect to earn from low-risk investments like TIPS), the break-even point occurs shortly after turning 83.* That is, if you live past age 83, you’d be better off delaying benefits. If you die prior to age 83, you’d have been better off taking benefits early.

For reference, according to the Social Security Administration, the total life expectancy at age 62 is 81.2 for a male and 84.1 for a female. In other words, for very low risk investments, the break-even point is approximately the same as the average life expectancy.

What If We Use Riskier Investments?

If we assume, for example, a 4% after-inflation return, the break-even point occurs shortly before age 87. The takeaway here is that with a 4% real return, most investors would end up benefiting from claiming benefits early and investing them.

And indeed, a 4% after-inflation return does sound reasonable (to me, at least) for a moderately-allocated stock/bond portfolio.

But it’s not exactly a slam-dunk. Even if the investments in your portfolio earn a (time-weighted) average 4% annual after-inflation return, it’s possible that your return will be less due to sequence of returns risk.

The conclusion here is rather common sense: If you take something with very little risk (Social Security payments) and replace it with higher-risk investments (stocks and bonds), you will on average, end up with more money. But that comes at the cost of a higher risk (specifically, a higher risk of running out of money–depending on your withdrawal rate).

In Summary

As we discussed before, delaying Social Security retirement benefits is very much like buying an inflation-adjusted lifetime annuity (one with an unusually high payout and unusually low credit risk).

And much like buying an annuity, it makes a lot of sense if your goal is to maximize the amount you can spend per year while minimizing the risk of running out of money.

However, also like buying an annuity, it doesn’t make a lot of sense if a) you care a great deal about maximizing the size of the inheritance you leave to your heirs and b) you have enough savings to get by using a safe withdrawal rate from a portfolio of higher-risk investments (stocks, bonds, etc.).

*If you’d like to check my math (never a bad idea), here’s the spreadsheet I used.

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Questions for New Investors

Mike’s note: I get a lot of questions from new investors. Often, the person is somewhat bewildered about investing in general and is having trouble figuring out where to start.

To that end, I invited my friend Matt–who was in a similar position just a few years ago–to share some of the questions he had when he was new, as well as the answers that he’s settled on as he’s gotten started investing.

Should I pay off debt or invest?

As a general rule of thumb, if the interest rate on your debt is higher than what you expect to earn by investing, pay off that debt as your first investment. Eliminating high-interest debt is a no-risk, high-return investment.

In fact, it might even be reasonable to work on wiping out all debt ASAP. For example, I consider myself to be particularly debt averse: I look at paying off debt as an investment in security. If I lose my income, the less debt I have, the less pressure I’m under. I’m willing to accept somewhat lower returns in exchange for that security.

Should I contribute to my 401(k) while in debt?

Contributing toward your employer-matched retirement plan is a special circumstance when it comes to investing. Think about it this way: If someone approached you on the street and offered to match the dollar amount currently in your wallet if you promise to save it, would you let them do it or would you tell them you can’t because that money is going toward debt?

It’s good to pay yourself first, but it’s even better to let others pay you first.

After you’ve contributed enough to get the maximum employer match, then go ahead and use any surplus to get out of debt. (Paying off debts in order from highest to lowest interest rate.)

Should I buy individual stocks?

Investing in individual stocks is tempting. There’s the possibility of striking it rich–a possibility that just doesn’t exist with broadly diversified index funds.

Still, I’ve chosen to build my portfolio using index funds and ETFs. Two good reasons for choosing index funds and ETFs over individual stocks are:

  • Easy diversification: Just a few funds gives me a diversified portfolio. With individual stocks, diversification requires many more holdings.
  • Less work: There’s no need to watch for news about the companies I own.

But what about stock tips?

If the tip is legit, unless you’re a market insider, chances are pretty good that the info has already been exploited by the time it gets around to you. I advise leaving individual stock ownership to day traders and professionals and sticking to something simpler and easier to understand.

Should I buy bonds?

Given that stocks have historically earned higher returns than bonds, many new investors wonder whether it makes sense to hold any bonds at all. The answer: Yes. Bonds are more secure than stocks, and even a small amount can significantly reduce volatility in a stock-heavy portfolio.

Because I am 35 I hold a fairly aggressive portfolio: 80% stock index funds, 10% bond index funds, and 10% physical precious metals. For my bond position I’ve chosen to use a Treasury bond fund because Treasury bonds are very secure. Using a Total Market bond fund would also be a reasonable choice. Just understand that if you do that, you will be investing in some higher-risk bonds as well.

If you are closer to retirement or more risk averse, it’s probably wise to hold a greater percentage of bonds than the 10% position I presently hold.

Should I buy precious metals?

Precious metals look quite appealing given the returns they’ve earned over the last couple years. But past isn’t always prologue when it comes to investing.

That said, I do actually hold physical silver with a small portion of my portfolio. But it’s not because I’m hoping to get lucky with amazing returns. Rather, I own silver as a sort of insurance policy against a collapse scenario for our debt-based fiat currencies. I prefer physical silver to precious metal ETFs or gold, neither of which would be as useful in such a scenario.

In closing…

If there is something I missed–and I’m sure there is–leave your question in the comments. I’ll answer to the best of my ability.

Matt Jabs set out on a passionate adventure to get out of debt back in January of 2009. He writes about personal finance at and about healthy self-reliance at Subscribe to his blog here.

Investing Blog Roundup: CPA Exam Update

Happy Friday, Dear Readers.

For those following along, I got my score on the first of four sections of the CPA exam this week. Result: I’m 1/4 of the way there! 🙂 Next up: Auditing (in mid- or late April, most likely).

Investing Articles

Other Money-Related Articles

Thanks for reading!

Where to Open Your First IRA

I recently received this question from a reader:

“I’m about to get started investing, and I’m trying to figure out where to open my first Roth IRA. I know that you like Vanguard, but I don’t have the $3,000 that it takes to invest in any of their funds. What’s your suggestion for a new investor?”

My answer: It depends. Specifically, it depends on how much money you do have. But first, we need to back up a step.

Do You Have an Emergency Fund?

For most investors, building an “emergency fund” is a higher priority than saving for retirement. Unexpected expenses (car repairs, medical expenses, etc.) come along often enough that it’s important to plan for them. You don’t want to end up in debt just because you were eager to get started investing and your investments declined in value right before you needed to access them.

So if the cash in question is nearly all of your money, keep it in something safe (a savings or money market account, for instance), and continue working on saving. Eventually, you’ll get to the point where you can invest while still maintaining an emergency fund.

$1,000-$3,000: Vanguard STAR Fund

For investors with between $1,000 and $3,000 (outside of their emergency fund), I’d usually suggest opening an IRA at Vanguard and investing in the STAR Fund. Unlike other Vanguard funds, the STAR fund’s minimum investment is $1,000 rather than $3,000.

With a 0.34% expense ratio, it’s slightly more expensive than a low-cost index fund. But with $2,000 in the STAR fund, you’re still only paying $6.80 per year in expenses–hardly a catastrophe for your long-term investment success. And if you keep socking money away, you’ll soon be able to move it over to your favorite index fund(s) of choice.

Note: If you expect to spend the money within the next few years (on a first-time home purchase, for instance), the STAR fund’s ~62% stock allocation is too risky. CDs would likely be more appropriate. (Many brokerages and banks offer CDs inside an IRA account.)

$0-$1,000: Savings or Money Market

For new investors who haven’t yet managed to come up with the $1,000 necessary for the STAR fund, I would usually suggest just sticking with a plain-old savings or money market account–for now, anyway.

The first step to becoming a successful investor is to be a successful saver. So focus on saving until you’ve got it down to a science. If you can save just $20 each week, in less than a year you’ll have that $1,000.

(Just to be clear for any new readers: Vanguard is not the only good place to invest. There are plenty of other brokerage firms where you can build a low-cost diversified portfolio using index funds or ETFs. I’m just particularly keen on Vanguard because of their unique ownership structure.)

Cameras, Computers, and Mutual Funds

My wife writes a food blog.* For years, she used a simple “point & shoot” digital camera for all the photos. But as she learned more about photography, she realized that she would have to upgrade her camera in order to reach the level of photo quality to which she aspired.

While we were researching the purchase, I visited the Digital-Photography-School forums to ask the experts for their input. Before I knew it, I was looking at a $2,400 camera, a $380 lens, and a few hundred dollars of accompanying gear.

I had a similar experience shopping for a new laptop early last year. Any new computer would have beaten the pants off our 2004 vintage MacBook, but after reading several articles and reviews, I found myself leaning toward a rather high-end machine.

In both cases, I found that it was helpful to take a step back and think about our needs. After all, a feature that someone else considers an absolute necessity might end up going entirely unnoticed in our hands.

What This Has to Do with Investing

When researching a purchase–especially in a field in which you’re not an expert–it’s easy to get overwhelmed or talked into something you don’t really need.

The same thing goes for building a portfolio. While researching the decision, you’re going to get a whole list of varying suggestions, even from those of us who agree that a low-cost, passively managed portfolio is the way to go. For example:

  • Some people will say it’s important to rebalance annually. Others will say every 2 years. Others will say to do it every time your asset allocation is out of whack by a specific percentage.
  • Some people will insist that you’re better off if you overweight small-cap stocks and/or value stocks.
  • Some people will insist that you need to have a certain portion of your portfolio in emerging markets, REITs, gold, commodities, or any of 100 other things.
  • Some people will insist that you need to include corporate bonds in your portfolio. Others will argue that it’s better to stick to Treasuries.

The result I see over and over is that an investor will end up with a portfolio that has so many moving parts he/she isn’t entirely sure how to operate it. That is, a portfolio that made perfect sense in the hands of the person recommending it (an investing aficionado) ends up being a poor fit for the person who’s new to the field or who simply takes less interest in managing his/her portfolio.

Simplifying Your Portfolio

My advice is to simplify your portfolio until it reaches the point where you understand all your holdings, why they’re in your portfolio, and how/when you’re supposed to move money between them. If that means using ten funds, super. If it means using just two or three funds (or even just one), that’s perfectly fine too.

*Shameless plug: She writes at Wheat Free Meat Free, where she shares gluten-free vegetarian recipes.

Roth 401(k) vs. Traditional 401(k)

Conventional investment wisdom says that when choosing between tax-deferred accounts [like a traditional 401(k) or IRA] or tax-free accounts [like a Roth IRA or Roth 401(k)], it’s primarily a question of how you expect your tax bracket in retirement to compare to your current tax bracket:

  • If you expect your retirement tax bracket to be higher, go for the Roth.
  • If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
  • If you have no idea, do some of both.

I recently received a related question from a reader about choosing between a regular 401(k) or a Roth 401(k):

I can contribute approximately $1,000 each month to my 401(k). The plan allows me to make either Roth or regular contributions.

I’m in the 25% tax bracket, so the $1,000 deduction I’d get every month from making regular 401(k) contributions would give me an extra $250 to contribute. Would that extra $250 monthly investment, compounded from now until I retire, be enough to overcome a higher tax bracket in retirement?

Good question. The short answer is, “No, because that’s already factored into the normal advice.”

How About an Example?

Annie invests $500 in a traditional 401(k) and $500 in a Roth 401(k). Each investment goes into the same fund. When Annie retires:

  • The Roth contributions will come out tax-free, but
  • The traditional 401(k) contributions will be taxable as ordinary income.

In other words, the $500 Annie invests in her Roth 401(k) will end up being worth more than the $500 she puts in her traditional 401(k) unless her tax rate during retirement is zero percent.

Takeaway: You have to invest more in a tax-deferred account than in a Roth account in order to have the same amount left after taxes.

For example, if you expect to be in the 25% tax bracket in retirement, you have to invest $1,333 ($1,000 ÷ 0.75) in the tax-deferred account each month for it to be as valuable as investing $1,000 in a Roth.

What Role Does an Employer Match Play?

In a follow-up email, the reader asked about how an employer match factors into the decision. For the most part, it doesn’t. Any employer contributions will be made to a “traditional” 401(k) account, regardless of whether the employee makes Roth or regular contributions.

Is Conventional Wisdom Right This Time?

When people say that the question of Roth vs. traditional is primarily about how your current tax bracket compares to your future tax bracket, they’re right. Again:

  • If you expect your retirement tax bracket to be higher, go for the Roth.
  • If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
  • If you have no idea, do some of both.

Just remember that when investing via tax-deferred accounts, you have to contribute more money.

*This is obviously not a scientific survey, but my correspondence with investors indicates that the majority of retirees are in a lower tax bracket in retirement than they were in for most of their careers.

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