Archives for November 2011

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What to Do with a Windfall

A reader writes in to ask,

“Does it make sense to apply what I call the ‘retirement model’ to a large windfall — that is, spending a percentage of the windfall each year, while allowing the rest to grow? If so, what withdrawal rate do you recommend? The 4% rule, I gather, means that the money could likely run out after 30 years or so. Since I am 33 now, that means that it could run out just as I was hitting retirement. What withdrawal rate should I use to have the money last until I am 100?

And what about your readers? I’d be curious to see how other readers have dealt with this experience.”

Mike’s note: What follows is my answer to this question. If you’re comfortable sharing your own answer, please chime in via the comments section on this post.

You’re right that if you wanted the money to last for 60+ years, it would be wise to use a withdrawal rate lower than 4%.

To back up a step though, I doubt that’s the approach I’d apply at all. Rather than thinking about at what rate you can spend from this money, I’d simply incorporate the windfall into your existing plans. That is, now that you have this additional money, at what rate (if any) do you still need to be saving for retirement and other financial goals?

Matching Resources to Goals

To go about answering this question, I’d make a list of your financial goals in order of importance. For example:

  • Basic retirement living expenses,
  • A replacement for your aging car,
  • College for children,
  • “Fun” spending in retirement,
  • etc.

Then I’d make a list of resources available to meet those goals:

  • Your current and future work income,
  • Your existing savings (including the new windfall),
  • Social Security,
  • etc.

Then I’d play a matching game — allocating resources to satisfy your goals in order of importance. Once the highest priority goal is satisfied (using any combination of resources), you can start allocating resources to the next highest priority.

For example, if retirement is the #1 priority, are your existing savings (including the windfall) large enough that they would likely fund your retirement if you let them grow untouched between now and your planned retirement age? If so, then you no longer need to save for retirement every year, and you can begin allocating resources to other goals. (Of course, this decision should be revisited periodically based on how well the money is/isn’t growing over time.)

Tax-planning note: Even if you no longer have to save for retirement per se, it still likely makes sense to max out your retirement accounts every year. For example, contribute $16,500 to a 401(k) and $5,000 to a Roth IRA, while spending $21,500 out of the taxable windfall you received in order to effectively transfer as much of the windfall as possible to tax-advantaged accounts.

In short, my suggestion would be to make decisions from the broader perspective of how to meet as many of your goals as possible (in order of importance) using your total resources rather than trying to figure out what to do with just this one part of your resources.

Social Security Do-Over Options

Justine writes in to ask,

“I started taking Social Security as soon as I was eligible — age 62. The more I read though, the less sure I am that claiming early was the right choice. I recently read an article stating that at age 70 you can withdraw your application, repay all the benefits you’ve received, and they’ll treat it as if you didn’t claim benefits until age 70. Is that really possible? I can’t find anything about it on the Social Security website.”

It was possible. In December of 2010 though, the Social Security Administration changed the rules to prevent people from using this option to get a large, interest-free loan from the government.

However, there still might be some things you can do to increase the amount of your monthly benefit if you’ve filed for Social Security benefits early and since changed your mind.

12-Month Do-Over

The change in the rules didn’t completely eliminate the ability to withdraw your application and pay back benefits received. Rather, it limited the do-over option in two ways:

  1. It’s now only available once per lifetime, and
  2. It’s now only available to people who have only been entitled to benefits for less than 12 months. (Note: You’re not “entitled to benefits” until you actually apply for benefits.)

Example: Beth files for benefits on her 64th birthday. Nine months later, she changes her mind and decides she’d rather wait until age 70. By filing Form SSA-521 and paying back all the benefits she’s received so far, she can essentially undo her application, thereby allowing her Social Security benefit to grow until age 70.

I should warn you though: From what I’ve heard from readers, the withdrawal of application process is not as easy as that one-page form makes it look — reasons being that:

  1. Many SSA employees are not particularly familiar with the process, and
  2. There can be tax ramifications if you’re paying back any benefits that you received in a prior year.

Suspend Benefits at Full Retirement Age

If you’ve been receiving benefits for 12 months or more, it’s not possible to pay back your benefits and start over. You can, however, suspend benefits once you reach full retirement age and choose not to start them again until age 70.

Example: Greg begins claiming benefits at age 62. Three years later, he changes his mind and wishes he had waited. Once he reaches his full retirement age of 66, he can ask for his benefits to be suspended. If he waits until age 70 to start them again, he’ll earn 4 years’ worth of “delayed retirement credits,” which will help offset the fact that he originally claimed benefits prior to full retirement age.

Social Security Earnings Test

Finally, if you claim benefits early and change your mind after missing the 12-month do-over window but before reaching your full retirement age, there’s still one thing you can do that will help you offset the effect of claiming early: Work.

In years prior to full retirement age during which you work while claiming benefits, the Social Security earnings test will reduce your annual benefit by $1 for every $2 by which your annual earnings exceed a certain amount ($14,160 in 2011).

Then, after you reach full retirement age, your benefit will be recalculated to account for the benefits you didn’t receive earlier. For example, if the earnings test reduced the total benefit you received by an amount equal to ten months of benefits, your benefit after full retirement age will be calculated as if you’d claimed ten months later than you actually did.

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Implementing a Withdrawal Rate Strategy

A reader writes in to ask,

“My sister is 63 and recently retired. She has a pension that pays her basic living expenses, and she has not yet started taking Social Security.

Last year she withdrew 4% from Vanguard Target Retirement 2015 Fund (VTXVX). But over the last year, the fund only earned a return of 1.48%. Since this is generally her sole source of “extra money” beyond her pension, my conclusion is that she should scale back on the 4% withdrawal due the lack of a “keep even” return.

But with less money in her hand I fear she will feel strapped. She loves her travel.”

SWR: Safe-ish Withdrawal Rates

The original studies showed that a 4% inflation-adjusted withdrawal rate was successful over most historical 30-year periods for a balanced stock/bond portfolio in the United States. But mostly safe in the past is a long way from completely safe in the future. In addition, your sister might live longer than 30 years. Both of those points would suggest that perhaps a withdrawal rate of less than 4% would be wise.

That said, one year of a slightly-negative real return (1.48% nominal return, minus 3.9% inflation over that period) isn’t necessarily a catastrophe.

Indeed, during the historical period on which the 4% guideline is based, there were plenty of years when the return of a balanced stock/bond portfolio would have been less than the amount withdrawn (and plenty of years when the real return would have been worse than -2.42%), yet the 4% guideline was still mostly safe.

In other words, it’s not typically one year of slightly-negative real returns that spells disaster for a 4% withdrawal rate. Rather, it’s a market collapse right at the beginning of the period or several years of slightly negative returns that you have to watch out for.

Is Portfolio Depletion a Problem?

For this particular investor though, I’m not sure that we need to be worried about portfolio depletion at all. She has a pension that pays all of her basic living expenses, so income from her portfolio will be used purely for discretionary spending.

And she hasn’t started claiming Social Security benefits yet, so if she keeps her discretionary spending constant throughout retirement, the amount she’ll need to withdraw from her portfolio each year will decrease after a few years once she starts claiming Social Security.

In addition, some experts argue in favor of intentionally front-loading discretionary spending in the early years of retirement when:

  1. You’re most able to enjoy it, and
  2. You’re most likely to be alive to enjoy it.

As you can see, this question doesn’t have a right or wrong answer. It’s a lifestyle decision. Different people would make different choices here, and either choice (cutting back or not) could be perfectly reasonable.

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Lump Sum vs. Dollar Cost Averaging

A reader writes in to ask:

How would you advise someone with a lump sum to invest for a 15-20 year time horizon? It’s really hard for me to invest a lump sum in this current environment, when tomorrow I could wake up and have lost a substantial portion of my investment. Is it advisable to dollar cost average into the market over a period of time in order to slowly switch into one’s appropriate asset allocation?

I chose to adopt passive investing with an asset allocation that mirrors my age so that I would not have to worry about the markets on a daily basis. Yet here I find myself STRESSING about how and when to take the plunge and invest this lump sum.

Regarding dollar cost averaging, I’ve always found this brief interview with academic finance hotshot Kenneth French to be helpful.

French’s position — which I agree with — is that, from a technical standpoint, if you know your ideal asset allocation, it’s usually best to switch to that allocation as soon as possible rather than use any other (and therefore non-ideal) allocation for any period of time.

From an emotional/psychological standpoint though, dollar cost averaging is less frightening for many people than investing the entire lump sum all at once. And the expected return you forgo by dollar cost averaging over a few months is relatively slim.

Is Your Asset Allocation Appropriate?

I think it’s worth noting, however, that if the idea of having your entire portfolio invested according to what you think is your target allocation causes you to experience the degree of stress that you indicated, then perhaps that shouldn’t be your target allocation at all. Perhaps your target allocation should be more conservative.

Remember, the “age in bonds” rule of thumb is just a rough guideline. It often makes sense to adjust it one way or the other based on an individual investor’s needs.

Stock Market Volatility is Normal

Finally, I think it’s also worth noting that, if measured by monthly or annual returns, the market hasn’t actually been significantly more volatile over the last 10 years than over the previous 30. This isn’t to say that the market hasn’t been volatile. It has been. But that’s normal.

And while the recent market volatility has been accompanied by a whole list of frightening economic events, that’s normal too.

I think the best approach is to find an allocation that you could use today (without having to coax yourself into it) that would let you sleep well at night even with an unpredictable market and frightening economic news.

Thoughts on Becoming a Financial Advisor

My post last week encouraging you not to hesitate to ask questions resulted (not at all surprisingly) in a great many questions from readers.

What did surprise me was that the most frequently asked-about topic wasn’t investing at all — at least not directly. People had lots of questions about working as a financial advisor. Specifically, they wanted to know:

  • Why I left the field despite still being very interested in investing,
  • How much of an advisor’s time is spent on sales work as opposed to actually working with clients, and
  • What I thought about working at Edward Jones as opposed to other firms.

Why I’m No Longer an Advisor

In short, the reason I quit working as an advisor is that I was not very successful at it. It didn’t take long for me to realize that I had a lot more fun when I was researching and learning about investing and tax planning than when I was networking, knocking on doors, or making phone calls.

But, as it turns out, reading books doesn’t bring in very many clients. And not-many clients means not-much income.

Are Advisors Salespeople?

As far as Edward Jones goes, yes, it’s definitely a sales position. Back when I went to work for them (2006), their website stated this fact very clearly, and the people involved in the recruiting process made sure to point it out as well. I’m not entirely sure why they’ve changed that.

To be clear though, the same thing applies to new financial advisors at other firms. When you’re new in the business, you have no existing clients. So, naturally, most of your time is spent trying to bring in clients. And that means sales-work.

[Exception: If you’re able to find a position at a firm that currently has more clients than it can handle, your time would obviously be spent differently. My understanding, however, is that these positions are not exactly abundant.]

The difference between brokerage firms (like Jones) and fee-only firms is that at a brokerage firm your job is to sell investments (specifically, ones that pay a commission), whereas at a fee-only firm your job would be to sell the service — the planning itself.

Which Firm to Work For

Personally, I think the fee-only model does a better job of preventing conflicts of interest between the advisor and the client. Unfortunately, the biggest recruiters in the industry (i.e., large brokerage firms, banks, and insurance companies) use the commission-paid model for most of their business.

That leaves you with three options, each of which presents its own challenges:

  1. Look for a position at a fee-only firm. (The challenge here being that such positions are more difficult to find.)
  2. Start your own independent practice. (The challenge being that you have to pay the start-up expenses and you’ll be earning very little while you find clients.)
  3. Go to work at a bank, brokerage firm, or insurance company, building your business in the most ethical way possible within that firm’s constraints, possibly with the intention of going independent later once you’ve built your client base.

Of course, all of the above comes with the caveat that this is the viewpoint of somebody who was only in the industry for approximately one year, worked for only one firm, and wasn’t particularly successful there. So if being a financial advisor is a career path you’re seriously considering, I’d definitely suggest getting other opinions as well.

I’m Afraid of a Bond Bubble

Karl writes in to ask,

“The old ‘age in bonds’ rule would have me put approximately one fourth of my portfolio in bonds. But I’m reluctant to put anything in bonds because I’m afraid that bonds (Treasuries especially) are in a bubble much like tech stocks in the late 90s. Assuming the bubble pops and interest rates come back up to more normal levels, bond prices will fall, right?”

It’s true, of course, that interest rates are very low right now. And it’s true that when rates come back up, bond prices will fall.

But Stocks Are Still Riskier

If risk of loss is what you’re concerned about — and saying you’re afraid of a bubble suggests that’s the case — then moving more money into stocks doesn’t make one bit of sense. Even with interest rates at historical lows, stocks are still riskier and more likely to have a large drop in price at any given time.

For example, from its peak in 2007 to its trough in 2009, Vanguard Total Stock Market Index Fund fell approximately 50%. For Vanguard’s Total Bond Market Fund (with an average duration of 5.1 years) to fall by that much, market interest rates would have to increase by almost 10%. In other words, interest rates would not just have to come back up to normal levels, they’d have to go shooting far beyond that.

And if you decided to stick with a short-term bond fund, the risk of significant loss due to a rise in interest rates would be even smaller.

Asset Allocation Based on Risk Tolerance

If the idea of incurring a significant loss in your portfolio really scares you, you need to be thinking about limiting your stock allocation.

My own personal favorite rule of thumb for asset allocation is to spend some time thinking about your maximum tolerable loss, then limit your stock allocation to twice that amount — with the line of thinking being that stocks can (and sometimes do) lose roughly half their value over a relatively short period. For example, if the idea of a 30% decline really scares you, I wouldn’t go higher than 60% stocks.

As far as your bond allocation, if you really are convinced that rates will be increasing soon, using a relatively short-term bond fund will minimize your exposure to interest rate risk.

I’d add the caution, however, that just because rates are low right now doesn’t necessarily mean they’re likely to be increasing any time soon. And by sticking with shorter-term bonds, you’ll be earning a lower rate of interest while you wait for rates to come back up.

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