Archives for February 2012

Vanguard Spotlights Simplicity?

Mike’s note: This is a guest post from Nisiprius — a prolific, anonymous member of the Bogleheads forum from whom I (and many other investors) have learned a great deal. When he’s not sharing his wisdom with us, he is a semiretired software engineer who lives in the New England area.

John C. Bogle once wrote, “the key to whatever success I may have enjoyed… is that the Lord gave me enough common sense to recognize the majesty of simplicity.”

Recent changes in Vanguard’s website look to me as if Vanguard has tightened its focus on indexing and on simplicity for personal investors.

But isn’t “Vanguard advocates indexing” the non-story of all time?

Maybe not. Vanguard has always had a dual personality. It was clearly visible in the “core funds” web page as it appeared for many years:

Vanguard used to include nine funds in their “core” category. Besides Prime Money Market, the other eight were perfectly split between index funds (Total Bond Index, Balanced Index, Total Stock Market Index, and Total International Stock Index) and actively managed funds (Short-Term Investment-Grade Fund, Wellesley Income, Wellington, and Diversified Equity).

Vanguard’s New “Core”

Today, however, Vanguard names only four “core funds”: Prime Money Market, Total Bond, Total Stock, and Total International. They suggest a decision framework that calls for first choosing a stock/bond/cash asset allocation, then implementing it with these funds.

On Vanguard’s personal-investors’ website today, almost all roads lead to Total Bond, Total Stock, and Total International — either directly or via “all-in-one” funds-of-funds which are mostly simple three-fund portfolios of the core funds.

Actively managed funds are out of the spotlight.

Vanguard’s actively managed Wellington Fund used to be as famous as its Five Hundred Index Fund. (The Wellington Fund antedates the founding of Vanguard by quite a bit. Want a thrill? Go to Morningstar’s main page, type VWELX in the “quote” box, click on “more” above the growth chart, and then “maximum” on the expanded chart — and stand back. Seriously, take a look.)

Today, a retail investor who begins at Vanguard’s main page and starts exploring is probably not going to find Wellington unless she is looking for it. You can find it by searching by name or by looking at the “all funds” table, but you are not likely to stumble across it by clicking your way through Vanguard’s fund decision pathways.

A few years ago, Vanguard routinely issued nuanced statements about complementary roles for active and index funds. In 2007, Vanguard’s chief investment officer, Gus Sauter, published a paper entitled “A Framework for Developing the Appropriate Mix of Indexing and Active Management.” Using Modern Portfolio Theory and efficient frontier charts, he said “These analyses demonstrate the asset allocation advantages to an investor of combining index and actively managed funds. They also further the rationale for an overall core-satellite approach, comprising index funds for the core and actively managed funds as satellites.”

But now, Vanguard’s new core funds page does not invite investors to think in terms of “core” and “satellites.” In the Bogleheads forum, the phrase “three-fund portfolio” is used to refer to a portfolio which uses only basic asset classes — usually a domestic stock ‘total market’ index fund, an international stock ‘total market’ index fund and a bond ‘total market’ index fund. The core fund page is now an illustration of how to build exactly this kind of three-fund portfolio.

Vanguard’s All-in-One Funds

If we look elsewhere, we notice that (for example) Vanguard’s Target Retirement 2040 fund is, literally, a three-fund portfolio: Total Stock, Total Bond, and Total International. This is a stunning contrast to the complex compositions of other firms’ target-date funds:

T. Rowe Price Retirement 2040 uses 10 funds,
ARDVX American Century LIVESTRONG 2040 uses 13,
MFS Lifetime 2040 uses 16,
American Funds 2040 Target Date uses 17,
Schwab Target 2040 uses 19, and
Fidelity Freedom 2040 uses no less than 20 funds.

It’s worth noting that, until 2010, Vanguard’s Target Retirement funds were slightly more complex — owning three separate funds (Europe, Pacific, Emerging Markets) in the place of Total International.

The same theme is evident in recent changes to Vanguard’s LifeStrategy funds. These funds-of-funds are all-in-one portfolios for specific life stages or specific degrees of risk tolerance that hold a stable allocation over time. However, they used to include a significant slice of the Vanguard Asset Allocation fund, a “tactical asset allocation” fund that shifted back and forth between stocks and bonds in response to “quantitative models.” Because the LifeStrategy funds owned this Asset Allocation Fund, they also shifted stock exposure up and down. In late 2011 however, Vanguard revamped these funds and they are now, yes, simple three-fund portfolios with fixed allocations.

The retail website does have a path guiding the investor to Vanguard’s Managed Payout funds, which do not fit the pattern. They use a university-endowment-like strategy and employ nontraditional assets, and tactical allocation. Launched in 2008, they hit a perfect storm, and to date have attracted only $0.747 billion in assets. They are certainly not “simple three-fund portfolios.” Nevertheless, each invests over half of its portfolio in, you guessed it, Total Stock, Total Bond, and Total International.

How far does Vanguard’s emphasis on the four “core funds” go?

If I’ve added the right things, the “total assets” numbers for Prime Money Market + Total Bond + Total Bond II + Total Stock + Total International add up to $510 billion. That’s a huge number, but it’s only 30% of Vanguard’s total holdings of $1,700 billion. And by one count Vanguard offers more actively managed funds (67) than index funds (53).

But Vanguard, at least as it presents itself to retail investors on its website, seems to be shining the spotlight on their huge “core” index funds, and on three-fund portfolios made from them. It looks like a rededication to “the majesty of simplicity.”

February 13, 2012

Do Annuities Make Sense in a Low-Rate Environment?

A reader writes in to ask,

“In your book Can I Retire you wrote about single premium immediate annuities being useful as a way to increase the amount a retiree can spend each year relative to a portfolio without annuities. But with the way annuity rates have declined over the last year, has that advice changed at all? Do annuities still make sense?”

It’s true that lifetime annuities have lower payouts than they did when I wrote the book. But the yields on other low-risk investments have declined as well.

So, overall, the same basic analysis still applies: Lifetime inflation-adjusted annuities allow you to safely spend more money than a diversified stock/bond portfolio does.

In fact, because of the way lifetime annuities work (that is, with annuitants who live beyond their life expectancy getting to spend the money of those who don’t make it to their life expectancy), they should always allow you to safely spend more money than a non-annuitized portfolio — regardless of current interest rates.

Some people might bring up the “4% rule” here, arguing that historically a 4% withdrawal rate has been mostly safe from a non-annuitized portfolio, whereas, depending on your age and gender, lifetime inflation-adjusted annuities aren’t even paying that much. (For example, according to Vanguard’s quote system, a 60-year-old female would only get 3.9% from a single premium immediate inflation-adjusted lifetime annuity today.)

But the problem with that argument is that when interest rates are well below their historical norms, a withdrawal rate based on historical returns isn’t exactly a safe bet. Said differently, it’s true that depending on your age and gender, a lifetime inflation-adjusted annuity may not even pay out 4% right now, but the flip side is that, with today’s low bond yields, a 4% inflation-adjusted withdrawal rate strategy from a non-annuitized portfolio is currently looking more dangerous than it has in the past.

Should You Delay Purchasing an Annuity?

And, for those who think an annuity does make sense for part of their portfolio, the same general analysis I provided for when to buy a lifetime annuity still applies. That is, the answer still depends on:

The rate of return you think you can get from safe non-annuity investments while you delay your annuity purchase, and
What direction you think interest rates will move while you delay your annuity purchase.

The more quickly and the more dramatically you expect interest rates to rise, the more sense it makes to delay purchasing an annuity. (In other words, if you expect rates to rise sharply in the near future, locking in currently-low rates for the rest of your life is probably not a great idea.)

Personally, I have no predictions as to how rates will change over any particular period of time.

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February 6, 2012

Is a Nondeductible IRA a Good Idea?

A reader writes in, asking:

“Because of our income level and because my wife and I both have qualified plans at work, we can neither contribute to Roth IRAs, nor make deductible contributions to traditional IRAs. But for years we have been following what I’ve always seen as the accepted wisdom of making maximum contributions to our IRAs anyway, in order to get the value of tax deferral on the growth and earnings within the IRA.

But I’m now questioning whether we’ve been doing the right thing. When we take distributions, the growth on our nondeductible IRA will be taxed as ordinary income (at rates that will likely be 25% or more given the magnitude of our distributions at retirement age), whereas the capital gains and dividends on the assets we purchase would be taxed at only a 15% rate if we kept them in a taxable account instead.”

Is the “Back Door Roth” an Option?

First, I think it would be a good idea to back up a step and ask if the “back door Roth” strategy is a good option here. In brief, under that approach, you make a nondeductible IRA contribution, then do a Roth conversion.

If you don’t have any IRAs that include deductible contributions or earnings, the conversion would be nontaxable — essentially allowing you to make a Roth contribution even though you’re over the income limit. If, however, you do have IRAs that include deductible contributions or earnings, the conversion will be at least partially taxable, thereby making the strategy less appealing.

Nondeductible IRA or Taxable Account

If the back door Roth is not suitable, I think the question of whether to use a nondeductible IRA or a taxable account depends largely on what will be held in the account. If the account will hold tax-efficient stock index funds or ETFs, then I think I would usually opt for a taxable account for the reasons you mentioned (i.e., the advantageous tax rates on long-term capital gains and qualified dividends as compared to ordinary income tax rates).

But if the account will hold something less tax-efficient (REITs or taxable bonds, for instance), then I think a nondeductible IRA can make a lot of sense.

From what I’ve seen though, for most investors, there’s enough space in other tax-advantaged accounts (employer-sponsored retirement plans, rolled over IRAs, etc.) to tax-shelter all of tax-inefficient asset classes — thereby making it possible to arrange the portfolio so that the only thing that would have to go into a taxable account would be something that’s already tax-efficient.

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February 1, 2012