Archives for January 2012

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REITs Are Stocks

A reader writes in, asking:

“I noticed that you no longer include REITs in your portfolio. [Mike’s note: See here for the post explaining the portfolio change he’s discussing.] Do you feel that you’re giving up some degree of diversification? And, for those of us who do include REITs, how would you suggest we count them toward an overall stock/bond allocation?”

I liked this question because it gives us a chance to address a couple common misconceptions about REITs.

What is a REIT?

Real estate investment trusts (REITs) are companies that invest in real estate — sometimes commercial real estate, sometimes residential estate, sometimes both.

REITs are unique because of the way they’re taxed. Specifically, they are not subject to corporate income tax, provided that they satisfy a few requirements. For example, REITs must distribute at least 90% of their taxable income to shareholders every year.

Should REITs Be Counted as Stocks or Bonds?

Despite their unique tax treatment and their high yield, shares of ownership in a REIT are still, by definition, equity investments. In other words, when considering your overall stock/bond allocation, a REIT fund should be counted as a stock fund because it is a stock fund — a sector-specific one, much like a health care fund, for example.

REITs Are Included in Total Market Funds

While my portfolio does not include a REIT-specific fund, it does still include REITs. REITs are included in broad “total stock market” index funds in proportion to their market weight — just like stocks from every other market sector.

REITs are included in many other stock index funds as well. For instance, as of last year, the S&P 500 included 15 different REITs.

REITs as a Diversifier

Because of their high-yield characteristic and because of the fact that REITs are often more closely correlated to real estate prices than to the stock market, REITs are often thought to be a good diversifier for a typical stock portfolio — the idea being to overweight them relative to their market weight in the hope of reducing overall portfolio volatility.

Personally, I’ve found the “REITs as a diversifier” argument (just barely*) convincing enough to include a REIT fund in the index fund portfolio my wife and I were using until recently. That said, having now moved to an all-in-one LifeStrategy fund that does not overweight REITs, I’m not worried that we’re missing out in any way that’s likely to meaningfully impact our long-term success as investors.

*It’s useful to remember that imperfect correlation doesn’t in itself make something a useful diversifier — otherwise you could take a total stock market index fund and overweight any stock in it (on the basis that each individual stock has an imperfect correlation to the rest of the portfolio) and thereby reduce the portfolio’s volatility.

Using REITs to Save for a Down Payment

A reader writes in, asking:

“What do you think about using Vanguard’s REIT ETF rather than CDs or a savings account as a way to save up money for a down payment on my first home? My line of thinking is that a REIT fund would likely outperform such low-risk investments, and if the fund has a loss, it might not even be a problem because it’s likely that real estate prices will be falling as well.”

There’s certainly a degree of common sense appeal to such a strategy.

  • Like any stock fund, it’s true that a REIT fund will earn higher returns than CDs or savings accounts over most periods.
  • And it’s true that a REIT index fund or ETF would usually be more closely correlated to home prices than other stock investments would.

But it’s still a risky way to save because you can’t count on a high correlation between the price of the home you want to purchase and the performance of a REIT index fund or ETF.

Commercial Real Estate vs. Residential Real Estate

Most REIT index funds have the majority of their assets invested in commercial REITs rather than residential REITs. (See, for example, the holdings of Vanguard’s REIT index fund.) As a result, there’s a real possibility that home prices could be rising (making your desired home purchase more expensive) at the same time that the price of your REIT fund is falling due to a poorly-performing commercial real estate market.

Real Estate is Local

It’s also important to remember that home prices don’t move in lock-step across the country. Home prices could be falling overall, while home prices in your area are holding steady or even climbing. If your REIT fund’s price falls along with most home prices, saving for a home in your area will be a challenge in such a scenario.

To pick two examples off the top of my head: Asheville, North Carolina and Hot Springs, Arkansas — two places we had considered moving to last year — both saw home prices increase through 2007 and 2008. Trying to save for a down payment in one of those cities would have been rather difficult if you were using an investment that, like Vangaurd’s REIT index fund, lost almost half of its value (47%) over those two years.

It’s Not Crazy. But It’s Not Safe Either.

Using a REIT fund to save for a home down payment probably would make more sense than using something like a total stock market index fund, because the REIT fund probably would have higher correlation to home prices in your area. But again, that correlation isn’t going to be very reliable.

And a REIT fund will likely earn you greater returns than a savings account would. But when I say “likely” here, all I mean is “greater than 50% probability.” It’s not at all something you can count on. And it makes the worst-case scenario significantly worse (home prices increasing while the value of your savings is decreasing — something that can’t happen with a savings account).

In short, unless you’re very flexible with regard to when you purchase the home (such that you wouldn’t mind waiting several years for your REIT fund to bounce back after a decline), I’d suggest sticking with the normal advice: Use something safe for short-term savings.

Social Security Benefits for Divorced Spouses

A reader writes in to ask:

“It seems to me that most personal finance discussions overlook divorced people. For example, as a divorcee, I have different tax planning and retirement planning considerations than other people. Would you mind writing an article discussing how Social Security benefits work for people who have been divorced?”

There are two types of benefits that can be claimed based on an ex-spouse’s earnings record:

  1. Divorced spouse benefits, or
  2. Surviving divorced spouse benefits.

The rules for both types of benefits are actually pretty similar to those for still-married couples.

Qualifying for Divorced Spouse Benefits

To qualify for spousal benefits on behalf of an ex-spouse’s earnings record, you must:

  • Have been married for at least 10 years,
  • Be age 62 or older, and
  • Not currently be married.

In addition, either a) your ex-spouse must have already claimed his/her own retirement (or disability) benefit, or b) he/she must be eligible to claim such a benefit and you have been divorced for at least 2 years.

For the most part, divorced spouse benefits are calculated the same way as regular spousal benefits. That is, if you claim at full retirement age, your benefit will be equal to 50% of your ex-spouse’s primary insurance amount (i.e., the amount of retirement benefits he/she would receive if he/she claimed at full retirement age). Also like regular spousal benefits:

  • If you claim prior to your FRA, your divorced spouse benefit will be reduced, and
  • You do not get any additional benefit for waiting beyond full retirement age.

Important note: If you claim divorced spouse benefits prior to full retirement age, you will be deemed to have filed for your own retirement benefit as well. If, however, you wait until full retirement age to claim divorced spouse benefits, it will not be treated as filing for your own benefit — thereby allowing you to receive divorced spouse benefits for a few years while you allow your own retirement benefit to grow until age 70.

Qualifying for Surviving Divorced Spouse Benefits

If your ex-spouse has passed away, you may be eligible for surviving divorced spouse benefits on his or her behalf. In order to qualify:

  • You must have been married for at least 10 years,
  • You must be age 60 or older (or disabled and at least age 50),
  • You must not currently be married,
  • Your ex-spouse must be deceased, and
  • Your ex-spouse must have been “fully insured” at the time of his/her death.

In general, surviving divorced spouse benefits are calculated the same way as regular surviving spouse benefits. That is, if you have reached full retirement age by the time you claim surviving divorced spouse benefits, your benefit will be 100% of your deceased ex-spouse’s benefit. If you claim surviving divorced spouse benefits prior to FRA, the benefit you receive will be reduced.

Important note: If the (now deceased) ex-spouse claimed benefits earlier or later than full retirement age, your surviving divorced spouse benefits will be based on the benefit that the deceased ex-spouse was receiving rather than on his/her primary insurance amount.

If You’ve Remarried

If you get remarried, you will not be eligible for benefits on your prior spouse’s record — unless your new spouse dies or you get divorced (that is, divorced from your second spouse), in which case you will again be eligible for benefits on your first spouse’s record. If you second marriage also lasted 10 years, you can claim benefits on behalf of either ex-spouse.

Exception to the rule: For surviving divorced spouse benefits, if your remarriage occurs after age 60 (or after age 50 if you’re disabled), it will not prevent you from claiming benefits on behalf of your prior spouse.

How About An Example?

Anne is married to Bob for 15 years. Then they get divorced, and Anne marries Christopher. After 15 years of marriage to Christopher, they too get divorced. When Anne reaches age 62, she can claim spousal benefits on behalf of either spouse. Because Bob made significantly more than Christopher over the course of his career, Anne chooses to claim spousal benefits on behalf of Bob.

A few years later, Christopher dies. Anne is now eligible for surviving divorced spouse benefits on his behalf. Despite Christopher’s lower earnings, surviving divorced spouse benefits on his behalf are greater than divorced spouse benefits on Bob’s behalf (because divorced spouse benefits are based on 50% of the ex-spouse’s benefit, whereas surviving divorced spouse benefits are based on 100% of the deceased ex-spouse’s benefit). So Anne switches to claiming surviving divorced spouse benefits on Christopher’s behalf.

A few years later, Bob dies too. Anne can now switch to receiving surviving divorced spouse benefits on Bob’s behalf (which, because of Bob’s higher earnings, should be greater than the surviving divorced spouse benefits on Christopher’s behalf that Anne had been receiving).

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