Archives for April 2012

Is It Safer to Use Multiple Fund Companies?

One question I’ve been asked several times is whether it makes sense to diversify across multiple brokerage firms or fund companies. My wife and I do not diversify in this way — we keep all of our retirement savings at Vanguard. But I thought it would be helpful to turn directly to a mutual fund company to get a more behind-the-scenes look at the systems in place to protect fund investors so you can make your own evaluation.

Linda Wolohan from Vanguard’s public relations team was quite helpful, tracking down answers to every one of my questions. What follows are my questions (in bold), followed by her replies.

If Vanguard went out of business, what would happen to an investor who owned Vanguard mutual funds?

It is extremely unlikely that Vanguard would ever fail. Vanguard is owned by Vanguard mutual funds, and Vanguard mutual funds are owned by the funds’ shareholders. Because of this structure, we’re able to make every decision with only client needs in mind. [For example,] Vanguard is not engaged in the investment banking or underwriting businesses that have been in the news for suffering financial losses.

[In addition,] Vanguard is a distinct and separate legal entity from the funds in which you are invested. It is the service company that provides transfer agency services (recordkeeping, etc.) and administrative services (statements, client service, fund accounting, etc.). Because the funds and Vanguard are separate legal entities, if Vanguard were to enter bankruptcy, Vanguard’s creditors could not claim the funds’ assets to pay Vanguard’s obligations. Each fund’s assets would remain in the protective custody of the fund’s custodian bank. As a result, they would remain available to meet share redemptions and regular operating expenses.

Mike’s note: A mutual fund’s custodian is disclosed in its Statement of Additional Information. For Vanguard funds, you can find this report by clicking “view prospectus and reports” on a fund’s page on Vanguard’s site.

If the custodian bank for a Vanguard fund went out of business or became insolvent, what would happen to investors in the fund?

Vanguard has relationships with several independent custodian banks, which facilitates the efficient transfer of fund assets to a new custodian bank should a fund’s existing custodian bank experience financial stress.

Federal banking law generally provides that fund securities held in segregated custodian bank accounts are not assets of an insolvent custodian bank and are not subject to claims by the custodian bank’s general creditors. As a result, a fund’s securities and similar investments would not be subject to the liens or claims of creditors of the custodian bank or of the FDIC as receiver or conservator of the custodian bank.

Cash in a fund’s custodian bank account generally would be treated as a deposit obligation and become part of the custodian bank’s bankruptcy estate, accessible by its general creditors. For FDIC-insured custodian banks, FDIC insurance may provide limited protection to a fund’s cash deposits in the event of the bankruptcy of such bank. Generally, Vanguard funds hold only small amounts of cash in custodian bank accounts for liquidity purposes.

In a hypothetical failure of an FDIC-insured custodian bank, the FDIC would intervene, a receiver would be appointed, and custodied securities would be transferred to a stable FDIC-insured custodian bank. For example, upon the insolvency of Washington Mutual (which was not a custodian bank for any of the Vanguard funds), a transfer of assets to a stable bank took place within a 48-hour period with minimal disruption to clients.

If one of Vanguard’s custodian banks (including FDIC-insured custodian banks) were to show signs of financial instability, Vanguard would likely move assets to another of our solvent custodian banks well in advance of any imminent failure.

Does the SIPC provide any degree of protection here?

No. SIPC protects investors from the bankruptcy or insolvency of a brokerage firm. Neither Vanguard nor its custody banks are broker-dealers, so their clients do not receive SIPC protection.

Does it increase (or decrease) safety in any way to own ETFs rather than index mutual funds?

Assuming that the ETF is a 1940 Act vehicle and is therefore required to have an independent custodian, there is no meaningful difference between the two in terms of safety. As previously noted, the failure of a mutual fund’s service company or its custodian is extremely unlikely to result in a loss to the fund’s shareholders. For the same reasons, the failure of an ETF’s service company or custodian is extremely unlikely to result in a loss to the ETF’s shareholders.

Of course, because ETFs must be held in a brokerage account, owning an ETF introduces a third entity that could fail—i.e., the broker. However, this does not make ETFs less safe than mutual funds. If a brokerage firm holding an ETF in a customer account were to fail, the ETF’s shareholders would be protected by SIPC. In most cases, SIPC’s role is to ensure that customer cash and securities are still in the brokerage account and to organize an orderly transition of those assets from the failed brokerage firm to a solvent one. In the unusual case where some or all of a customer’s cash and securities are missing, SIPC insurance covers losses up to $500,000 (maximum of $250,000 for cash losses).

Does it increase (or decrease) safety in any way to own Vanguard funds at a separate brokerage firm (e.g., owning Vanguard ETFs in an account at Schwab)?

No. Investors’ assets are separate from the brokerage firm and are solely theirs. Consequently, a brokerage firm’s failure should not result in loss of customer assets. If in an extremely unlikely circumstance a client’s assets are lost (i.e., the Vanguard fund shares owned by the client have been removed from the client’s account), investors would be protected by SIPC up to the limits discussed above.

What prevents the fund custodian from committing fraud (e.g. siphoning off fund assets, but continuing to report that they’re all there)?

Many processes and controls are in place that would make it difficult for a custodian to commit fraud or for any fraud to go undetected.

Vanguard performs a rigorous due diligence review on each prospective custodian in order to understand its internal policies and procedures, including those intended to prevent fraud.
Vanguard and our custodians work closely on an ongoing basis to identify and address opportunities to improve the custody services that are provided, including fraud prevention.
A custodian may only act upon authorized instructions from an approved Vanguard officer or representative. Because Vanguard reconciles its internal accounting system for each fund with those of the custodian every day, any unauthorized trades or differences in securities positions or cash balances would be readily apparent to Vanguard and trigger immediate follow-up.
It would be difficult for a custodian to report that assets are in the fund if they are not. For example, the counterparty on the other end of a Vanguard buy or sell instruction for 100 shares of a stock would report a failed trade if the cash or shares did not settle as expected under the typical market practice of “delivery versus payment.” As a result, Vanguard would be aware that something was amiss at the custodian almost immediately.

If somebody at the custodian somehow committed fraud and the auditor didn’t notice it, would investors have any recourse?

Each Vanguard fund’s contract with its custodian provides that the custodian will be liable to the fund for any losses attributable to fraud. The fund — on behalf of its investors — would pursue a recovery against the custodian for these losses.

Would investors be meaningfully safer in any way if, rather than holding their entire portfolio at Vanguard in Vanguard funds, they held half at Vanguard and half at another brokerage firm with low-cost index funds (at Fidelity in their Spartan funds, for example)?

From a fund custody perspective, there is no meaningful advantage to an investor holding assets in that manner. Non-Vanguard funds are subject to the same custody requirements as Vanguard funds. It is reasonable to assume that other large, well-respected asset managers have similar controls and processes as Vanguard to prevent potential fraud by their fund custodians. Further, they are likely to want to appoint the most sophisticated and stable custodians for their funds, so there is the potential that certain fund assets will be custodied at the same bank.

Given the protections from creditors for mutual fund assets at custodian banks under applicable banking and contract laws, and assuming the funds in question have an industry standard custody contract in place, it is unlikely that splitting assets in this manner to diversify “custodial risk” would be particularly effective.

What prevents Vanguard from committing fraud in some way (e.g., taking a buy order and taking an investor’s money, but never sending the money or information of the order to the custodian)?

Vanguard has many controls in place to ensure that the funds it receives are handled properly and that it complies with all aspects of the law. One of those numerous controls includes spreading responsibilities across multiple roles in separate areas of Vanguard to, in part, protect against a single person being able to commit fraud.

If somebody at Vanguard somehow did commit such a fraud and the auditor didn’t notice it, would investors have any recourse?

Clients should certainly contact us directly, but they also can contact the funds’ boards of trustees or the funds’ primary regulator, the SEC.

April 30, 2012

Social Security Strategies with a Reduced Life Expectancy

The decision of when to claim Social Security involves a break-even analysis. By waiting to claim benefits, you give up something now (this month’s benefit) in exchange for an increased benefit in future months. As a result:

The longer you expect to live, the more attractive delaying benefits becomes (because you’ll receive the increased benefit amount for many years), and
The shorter you expect to live, the less attractive delaying benefits becomes. (Obvious example: If you have a medical condition such that you don’t expect to make it past age 64, deciding to wait until age 70 to claim benefits usually wouldn’t make sense.)

But there’s one big exception.

When It Makes Sense to Wait

If a married couple has one person who is the primary earner, it can make a lot of sense for that person to delay claiming Social Security for as long as possible, even if he/she has a reduced life expectancy.

The reason it likely makes sense to wait is that doing so increases not only the benefit received by the higher-earning spouse, but also the survivor benefit that the lower-earning spouse will receive once the higher-earning spouse passes away.

To show how surviving spouse benefits work (and how they’re affected by the age at which the deceased spouse filed for benefits) let’s run through a few examples.

To keep things simple, we’ll assume that:

Spouse A would receive an annual benefit of $15,000 if he/she claimed benefits at his/her full retirement age (FRA) of 67, and
Spouse B never had any earnings of his/her own.

Example 1: Spouse A files for benefits as early as possible at age 62. Due to claiming benefits 5 years prior to full retirement age, Spouse A’s benefit will be reduced by 30% to $10,500 per year rather than $15,000. Spouse A then dies at age 64. Upon reaching his/her own FRA, Spouse B claims survivor’s benefits. Spouse B’s annual benefit is equal to the $10,500 that Spouse A had been receiving (plus any applicable cost-of-living-adjustment for inflation).

Example 2: Spouse A dies at age 64, having never filed for benefits. Upon reaching his/her own FRA, Spouse B claims surviving spouse benefits. Spouse B’s annual benefit is equal to the $15,000 that Spouse A would have received upon claiming at full retirement age (again, plus any applicable cost-of-living adjustment).

Example 3: Spouse A dies at age 69, having never filed for benefits. Upon reaching his/her own FRA, Spouse B claims surviving spouse benefits. Spouse B’s annual benefit is equal to the benefit that Spouse A would have received, had he/she claimed at age 69 on the date of death (again, plus any applicable cost-of-living adjustment). Ignoring the inflation adjustments, that works out to approximately $17,400 per year (that is, $15,000 with an increase of 0.66% for each month that Spouse A lived past his/her FRA).

Note that in each of the above examples, if Spouse B had claimed surviving spouse benefits prior to his/her own full retirement age, the benefit would be reduced.

In short, if you have a reduced life expectancy and you’re unmarried or you’re the lower-earning spouse of a married couple, it likely makes sense to claim Social Security as early as possible. If, however, you’re the higher-earning spouse, putting off your claim for benefits might be wise, because it increases the survivor’s benefit that your spouse will receive for the rest of his/her life after you’re gone.

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April 25, 2012

The Problem with Planning to Retire Later

Retiring later is a great way to reduce the chance that you’ll run out of money during retirement. The math behind it is straightforward and foolproof: Each additional year you work is one more year to accumulate savings and one less year of spending from your savings.

That said, there’s some danger in creating a financial plan that relies on a later-than-average retirement. The problem, as you’ve probably guessed, is that retirement isn’t always a choice.

In fact, in a recent survey from the Employee Benefits Research Institute, 50% of retirees surveyed indicated that they left the workforce earlier than they had planned. And of those who retired earlier than planned, only 8% cited exclusively positive reasons. In other words, 46% (almost half!) of retirees surveyed said that they retired earlier than planned, and negative reasons played a role in their leaving the workforce.

Job Security Only Goes So Far

The survey found that:

21% of retirees who retired earlier than planned cited changes at their company (e.g., downsizing or closure) as a reason for retiring,
34% cited other work-related factors, such as a change in the required skills to do their job,
51% cited health problems or disability, and
19% cited having to care for a spouse or other family member.

When I read this, I was surprised to see that the biggest factor wasn’t job related at all. Health — both your health and the health of your loved ones — appears to be the biggest factor. The takeaway: Even if your job security is ironclad, you still might not want to assume that you’ll be able to continue working as long as you would like.

Other Ways to Avoid Running Out of Money

If your retirement savings are not what they should be, it makes perfect sense to adjust your plans to include a late retirement. But it would be wise to take others steps as well. For example:

Find ways to cut your spending so you can save more per year,
Hold off on claiming Social Security benefits so as to increase your guaranteed, inflation-adjusted income, or
Annuitize part of your portfolio once you reach retirement in order to increase the amount you can safely spend per year.

(Note that I did not mention increasing the risk level of your portfolio as a solution. While it might work, it’s not something I would recommend because it can backfire in a dramatic way.)

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April 23, 2012

Can a “Run on the Bank” Occur with Mutual Funds?

A reader writes in, asking:

“What happens when an investor in a fund sells their shares? Who buys the shares? And what happens if more people want to sell than buy? Is it possible to have something like a ‘run on the bank’ in which the fund crashes because many investors pull their money out at the same time?”

What happens when you sell a fund depends on whether it’s:

an ETF (or closed end fund) or
a traditional (“open-end”) mutual fund.

When you sell an ETF or closed-end fund, the transaction is between you and a third-party buyer. And the price of the fund will be determined by what the buyer is willing to pay for it. (The share price of the fund, however, is typically very close to the value of the underlying investments because institutional investors perform arbitrage trading in order to capitalize on — and eliminate — any such discrepancies.)

When you place a sell order for an open-end fund (e.g., Vanguard’s ordinary mutual funds), the transaction is between you and the fund company. The fund simply pays you cash equal to the NAV of the share you sold.

Background: At the end of trading each day, the total value of the assets the fund holds is divided by the number of shares outstanding. The result is the Net Asset Value (NAV), which is the price at which buy and sell orders of the fund will be executed that day.

In other words, as a fund shareholder, the value of your fund shares will be determined primarily (or exclusively) by the value of the underlying assets held by the fund. And, for the most part, the value of the underlying investments won’t be strongly affected by the actions of other investors in the fund, because most funds own only a small percentage of the total market value of each of their holdings.

For example, Vanguard’s Total Stock Market Index Fund — an absolutely massive fund — owned $5.63 billion of Exxon stock as of the end of 2011, according to Morningstar. Given Exxon’s total market capitalization of $401 billion, that’s just 1.4% of the company. Obviously the actions of the other 98.6% of the stock’s shareholders will be the dominant factor in the stock’s performance. And the same sort of analysis applies for most holdings in mutual funds.

Conclusion: When you own a mutual fund, the bulk of the risk you take on is the result of factors outside of the fund itself, not the result of actions by other shareholders in the fund.

April 18, 2012

How Much Do I Need to Save Per Year?

A reader writes in asking:

“I’m 26, and I recently enrolled in my company’s 401k. I know to contribute at least enough to get the maximum match. But how much should I contribute to be on track to retire comfortably? I’ve read numbers anywhere from 10% on up.”

This is one of the most frustrating questions I ever receive. It’s frequently asked, and it’s super important, but I don’t have a very good answer.

The reason the question is so difficult to answer is that it spans such a lengthy period of time. It’s like the already-difficult-to-answer “how much money do I need to retire?” question, but with an additional 3-4 decades of uncertainty tacked on at the beginning of the analysis.

Safe Savings Rates

The best research I’ve seen on the topic is Wade Pfau’s study of “safe savings rates.” Pfau analyzed U.S. historical data (starting in 1926) to determine what percentage of salary an investor had to save per year in order to meet a certain income goal in even the worst-case historical scenario.

For example, Pfau found that for an investor who:

Uses a fixed 60% stock, 40% bond allocation,
Has 40 years to save,
Expects retirement to last 30 years, and
Wants to replace 70% of his/her pre-retirement income,

…a 12.27% savings rate would have gotten the job done in each historical scenario. (Table 1 of the article I linked to above shows the “safe savings rate” for various sets of inputs.)

Applying This Concept to Real Life

Unfortunately, applying this “safe savings rate” concept to your real-life finances is a bit tricky.

One complicating factor is the fact that safe savings rates are simultaneously:

Probably higher than necessary (because in all historical U.S. outcomes except one, they resulted in excess savings), and
Potentially not high enough (because the historical worst-case scenario is not in fact the worst-case scenario).

This is not a fault of Pfau’s work in any way. It’s simply the nature of using historical data to answer questions about the future. But how does one deal with such uncertainty? Should you adjust your savings rate upward (relative to the historical safe savings rate) just to be on the safe(r) side? Or should you plan for a more historically-normal scenario and adjust your savings rate downward?

In addition, we must remember that Pfau’s calculations involved a number of simplifying assumptions.

For example, he assumed that the investor’s inflation-adjusted income is constant throughout his/her working years. In real life, there are raises, promotions, layoffs, career changes, etc. For most people, the constant-real-income assumption is a conservative one — most people’s inflation-adjusted income increases over time. But it’s certainly possible that a particular investor could have the opposite experience. So, how should you adjust the “safe savings rate” to apply it to your own life? Again, there’s no easy answer.

And the calculations ignore taxes completely too. In real life, taxes will play a role in determining:

The net rate of return that your investments earn (if you’re investing in a taxable account), and
The amount that you’ll have to withdraw from the portfolio per year in order to have a given level of after-tax income.

Of course, it’s difficult to predict with any meaningful degree of certainty how your personal tax rate will change over the next 6-7 decades.

Pfau’s research is helpful in that it gives us something to work with. But once we account for all the different types of uncertainty involved (e.g., investment returns, tax rates, changes in your income over the course of your career, changes in Social Security, the age at which you’ll retire, and the age at which you’ll die) it’s simply not possible to get any more than a very rough idea of how much a young person should be saving for retirement each year.

While I admit it sounds like a total cop-out, I think the most honest answer I can give to somebody early in her career is, “save what you can (hopefully 10% or more), and make sure to reassess the situation every few years.”

April 16, 2012

Where Should I Open an IRA?

One of the most common questions I receive from readers is where to open an IRA. But the last time I directly addressed that question here on the blog was more than two years ago, and much has changed since then. (Most importantly: A number of companies have improved their low-cost offerings.)

My Favorite: Vanguard

As we’ve discussed several times, I personally prefer to invest with Vanguard because of their ownership structure. This structure (where the company is owned by the funds it runs rather than by outside shareholders) reduces costs and minimizes conflicts of interest between the company and its clients.

In addition, Vanguard’s all-in-one funds — both Target Retirement and LifeStrategy — are the best hands-off solutions I’ve found for most retail investors. (It’s important to note, however, that for people investing via taxable accounts rather than IRAs, all-in-one funds are generally not the most tax-efficient choice.)

Other Low-Cost Brokerage Firms

But, as great as Vanguard is, there are several other good choices, any of which could be a better fit for you depending on circumstances. For example, you may want to open an IRA with one of the following brokerage firms if you care about having an office nearby or if you already have an existing brokerage/checking/savings account with one of them.

Fidelity: Their Spartan index funds are super cheap and can be used to easily build a low-cost diversified portfolio. Alternatively, if you’re just getting started and cannot meet the $10,000 minimum initial investment for the Spartan funds, you can put together a portfolio using a few of the low-cost iShares ETFs that Fidelity offers on a commission-free basis.

Charles Schwab: Their relatively new line of ETFs have very low expense ratios and can be bought in a Schwab account without paying any commissions.

TD Ameritrade: They offer commission-free trades of more than 100 ETFs, including most of my favorites from Vanguard. And for investors just getting started, TD Ameritrade has the advantage of having no minimum initial investment for opening an IRA.

Wells Trade (Wells Fargo’s discount brokerage operation): They offer 100 commission-free stock/ETF trades per year if you link your brokerage account to their “PMA Package,” which as far as I can tell is basically a checking account that has a $30 annual fee unless you have a combined balance of $25,000 between 1) the checking account, 2) your brokerage account(s), and 3) 10% of your outstanding Wells Fargo mortgage.

Opening an IRA with a Bank or Credit Union

Alternatively, the best place to open an IRA may not be a brokerage firm at all. If you plan to have your Roth IRA do double-duty as your emergency fund (because Roth contributions can be withdrawn free from tax and penalty at any time), you’ll want to keep it in something very safe. The offerings from banks and credit unions are a natural fit for such a situation.

For example, writer Allan Roth recommends using Ally Bank’s 5-year CDs for this purpose because they usually offer a relatively high rate of interest, and you can get your money out at any time prior to the 5-year maturity date with just a small penalty (60 days’ interest).

April 11, 2012