Archives for June 2012

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How Does Human Capital Affect Asset Allocation?

One of the major trends in finance in recent years is the increasing popularity of the “human capital” concept. In case you’re not familiar with the idea, your human capital is defined as the value (as measured today) of all of your future earnings from work.

In short, the ramifications are that:

  1. Over time, you must accumulate financial capital in order to make up for the fact that your human capital is being depleted as you move toward retirement (at which point it will be mostly, or entirely, depleted), and
  2. When considering how much risk to take on in your portfolio, you should consider how much risk you’re already taking on via your human capital.

How About a Few Examples?

Janelle is 24 years old, and she is employed by the federal government in a position with a great deal of job stability. In other words, she has a great deal of human capital (because she’s young, with many years of work ahead of her), and it is very low-risk. As a result, Janelle can afford to take on a good deal of risk with her portfolio.

Geoffrey is 28, and he’s self-employed in a business with an unpredictable income. Because Geoffrey’s overall economic picture is dominated by a large amount of high-risk human capital, he should probably take on very little risk with his portfolio.

Beth is 68 years old and retired, with no intention of going back to work. At this point, her human capital is depleted. Beth can afford to take on a moderate amount of risk with her portfolio.

(Important caveat: All of the above examples are extreme simplifications, ignoring numerous other factors that would typically affect a person’s risk tolerance.)

Human Capital and Investing Guidelines

Most often, when I see human capital brought up in a book or article, it’s as a rationale for why most investors should shift toward more conservative allocations as they age. The idea is that most people’s human capital is bond-like (because most people’s income is relatively stable), so as their bond-like human capital decreases, they should increase the allocation to bonds within their portfolio.

That’s fine, as broadly-applicable guidelines go. But I think the more useful application of the human capital concept is to use it as a tool for contrasting different people’s economic situations and considering how they should tailor their portfolios accordingly. If your human capital is high-risk, it’s not particularly relevant that most people’s human capital provides a nice, safe, bond-like income.

The common sense takeaway: The riskier your job, the less risk you should take on in your portfolio.

Taxes on Bonds and Bond Funds

A reader writes in with a question about taxes on bond funds:

“When I own a Treasury bond fund, I’m guessing I would be paying taxes on the interest through the term of the bond. When I sell, would there be additional tax consequences?

I get that other types of investments — stocks for example — have price changes that affect the tax consequences when I sell. But a Treasury bond would only have interest, right? No gains/losses, because it pays at a fixed rate?”

Before discussing how a bond mutual fund is taxed, it’s probably easier to back up a step and discuss the tax treatment of an individual bond.

If you buy a bond for when it’s originally issued, and you hold the bond until it matures, yes, you would only have to pay taxes on the interest along the way.

However, if you buy a bond and sell it prior to its maturity date, you would probably have either a capital gain or a capital loss, because the sale price would almost certainly be either higher or lower than what you paid for it. (Because, as we’ve discussed here before, bond prices move up and down in the opposite direction of market interest rates.)

If the bond is sold for a capital gain, it would work the same as selling a stock for a capital gain. That is, if you had held the bond for one year or less, it would be a short-term capital gain, taxed at your ordinary income tax rate. If you had held the bond for greater than one year, it would be a long-term capital gain, taxed at a maximum rate of 15%.

Taxes on Bond Funds

Owning a bond mutual fund works a bit differently. Each year, shareholders of mutual funds are responsible for paying taxes on:

  1. Their share of the interest and dividends earned by the fund’s holdings, and
  2. Their share of any net capital gains realized within the fund’s portfolio (that is, gains that occur when the fund sells investments within its portfolio for an amount greater than what it paid for them).

In other words, with mutual funds (including bond funds), you often have to pay capital gains taxes even while you still hold the fund.

Finally, when you do sell the fund, there will typically be a capital gain or loss on that transaction, calculated just like you’d expect: proceeds from the sale, minus your cost basis in the mutual fund shares that you sold.

Important note: Your cost basis includes not only the amount you paid for the initial fund shares you purchased, but also any dividend/gain distributions that you chose to reinvest in order to purchase additional shares.

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Picking Bonds Based on Performance and Yield

Two readers recently wrote in with similar questions about selecting the type(s) of bonds to use for the bond portion of your portfolio.

Long-Term vs. Short-Term Bonds

Reader #1 asks:

“As of today, Vanguard’s Treasury bond funds have the following performance figures:

  • Vanguard Long Term Treasury: 1-year return = 31.6%, 10-year average annual return = 9.08%
  • Vanguard Intermediate Term Treasury:  1-year return = 8.7%, 10-year average annual return = 6.2%
  • Vanguard Short Term Treasury: 1-year return = 1.45%, 10-year average annual return = 3.54%.

Based on that information, why isn’t everyone buying long term Treasury funds?”

Bond prices and market interest rates are inversely related. When one goes up, the other goes down. And that makes perfect sense if you consider an example.

Arthur buys a 10-year Treasury bond paying 2% interest. Five years later (when his Treasury bond is now effectively a 5-year bond), market interest rates have risen, and new 5-year Treasury bonds are yielding 3%. The result: Because of the rise in rates, nobody would be willing to buy Arthur’s 2% bond unless he offers to sell it at a discount. (That is, interest rates have gone up, so the price of his bond has gone down.)

And the longer a bond’s duration, the more severely its price will change as a result of market interest rate changes. Specifically, the size of the price change will be approximately equal to the change in interest rates, multiplied by the bond’s duration. So, for example, a bond with a 5-year duration would lose approximately 5% of its price if the applicable market interest rate increased by 1%.

In other words, the reason that long-term bond funds currently have higher past performance records than shorter-term bond funds is simply that:

  1. They have a longer duration, and
  2. Interest rates have been falling fairly steadily over the last few years (thereby pushing bond prices up, with the prices of longer-term bonds going up the most).

As far as the question of “why doesn’t everybody buy the long-term fund,” the answer is simply that the opposite phenomenon can happen as well. That is, in a rising-rate environment, bond prices fall, and it would be the longer-term bonds whose prices would fall most severely.

Nominal Treasuries or TIPS?

Reader #2 writes in asking:

“Currently all TIPS with a maturity of less than 20 years have a negative yield. And even with 20-year TIPS the yield is just 0.09%. In contrast, 20-year normal Treasuries currently yield 2.28%. Even a 3 month normal Treasury (yield = 0.10%) beats a 20-year TIPS. I don’t understand why experts still talk about TIPS as a useful tool when normal Treasury bonds look so much better.”

What makes TIPS unique is that their principal adjusts upward with inflation, and their interest payments are based on the inflation-adjusted principal. In contrast, both the principal and interest payments on nominal Treasury bonds are fixed. As a result, comparing the yield on TIPS to the yield on nominal bonds does not tell you which one will actually earn a greater return.

For example, when we see that a 20-year TIPS has a yield of 0.09%, we know that (as measured in nominal dollars), its return will be 0.09%, plus any inflation that occurs over the 20 years. So by comparing that to a nominal 20-year Treasury with a 2.28% yield, we can see that if inflation is more than 2.19% per year (that is, 2.28%, minus 0.09%), the TIPS will provide a greater return. (And conversely, if inflation is less than 2.19%, the nominal Treasury bond will provide a greater return.)

So the answer to the question of why anybody would use TIPS is simply that many people are worried about the possibility of inflation that’s greater than the difference between nominal Treasury yields and TIPS yields.

Why Annuitizing Reduces Risk

In Friday’s roundup I briefly mentioned that annuitizing part of a retirement portfolio not only reduces the probability of running out of money, but also makes the oops-I-ran-out-of-money scenario not nearly as bad. Several readers asked how both of those things work.

Reducing Portfolio-Depletion Probability

The reason that inflation-adjusted lifetime annuities reduce the risk of portfolio depletion is that they provide a higher payout rate than you can safely take from a stock/bond portfolio. For example, even with today’s super-low interest rates, a 65-year-old female can purchase an inflation-adjusted lifetime annuity with a 4.4% payout.

To see the impact annuitizing would have, let’s look at an example.

Susie is 65 years old and recently retired with a $400,000 portfolio. She expects to need $30,000 of income per year in retirement, and her annual Social Security benefit will be $14,000. In other words, she hopes to spend $16,000 per year from her $400,000 portfolio.

If Susie does not annuitize any of her portfolio, she’d have to use a 4% withdrawal rate ($16,000 ÷ $400,000) to provide the desired level of income.

If Susie uses half of her portfolio ($200,000) to purchase a single premium immediate inflation-adjusted lifetime annuity, the annuity (given a 4.4% payout) would provide  $8,800 of income per year. As a result, she would only need another $7,200 of income from the non-annuitized part of her portfolio. That works out to a 3.6% withdrawal rate.

Naturally, Susie is less likely to deplete her portfolio with a 3.6% withdrawal rate than with a 4% withdrawal rate.

Improving the Worst-Case Scenario

And possibly even more importantly, if Susie does end up depleting her portfolio, she’ll be left with an income of $22,800 per year ($14,000 Social Security + $8,800 from the annuity) rather than the $14,000 per year she’d be left with if she didn’t annuitize any of her portfolio.

Don’t Forget About Delaying Social Security

As we’ve discussed before, delaying Social Security benefits is economically equivalent to purchasing an inflation-adjusted lifetime annuity — one with lower credit risk and a higher payout than you can get from an insurance company.

For example, for somebody with a “full retirement age” of 66, if your Social Security benefit would be $18,000 per year at age 62, it would be approximately $31,680 per year if you waited until age 70. By giving up eight years of $18,000 in benefits, you’ve effectively spent $144,000 ($18,000 x 8) to purchase $13,680 ($31,680 — $18,000) of annual inflation-adjusted income. That’s much higher than the 4-5% payout you can get from an inflation-adjusted annuity.

In other words, delaying Social Security has the same two risk-reducing effects as annuitizing part of your portfolio (i.e., reducing the probability of depleting your portfolio and protecting you somewhat in the event that you do deplete your portfolio), and on a per-dollar-spent basis, it provides more of those risk reductions than an annuity from an insurance company would.

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Should Asset Allocation Change with Age?

Conventional wisdom says that as you age, you should shift your asset allocation steadily toward bonds — perhaps via the “age in bonds” guideline or via a target date fund that steadily becomes more conservative as the named retirement date approaches.

But there’s at least some degree of evidence suggesting that this commonly-recommended shift might not be entirely necessary. For instance, Wade Pfau’s research (see charts here and here) shows that for retirement portfolios using withdrawal rates of 5% or less, there’s startlingly little difference in success rates for allocations anywhere from 30% stock to 70% stock.

In other words, from a U.S. historical data standpoint, a retirement portfolio with a typically-conservative allocation of just 30% in stocks isn’t convincingly better than a more aggressive allocation of 70% stocks (i.e., something you’d see more often in an accumulation stage portfolio).

Still, I think there’s a perfectly good, common sense reason for most people to want their asset allocation to become more conservative over time.

As we’ve discussed before, risk tolerance is a function of both:

  1. The degree of flexibility you have with regard to your financial goals, and
  2. Your personal comfort level with volatility in your portfolio.

From what I’ve seen, for many investors, that second factor really takes a nosedive as their portfolio grows and they approach and enter retirement.

Let’s Look at a Few Examples

Allison is 27 years old. Her retirement savings are currently equal to 6 months of her salary. She also has a good-sized emergency fund, so she knows she probably won’t have to touch her savings for many years.

Phil is 59 years old. His retirement savings are equal to 10 years of his income. He’s starting to think seriously about retirement sometime in the next year or so.

Dorris is 70 years old. Her portfolio is sizable (about 15 years-worth of expenses), but it’s significantly smaller than it was 8 years ago when she retired. Dorris has absolutely no desire to return to work — not to mention the fact that she’s worried she’d have a heck of a time finding a job if she did have to return to work.

It’s only natural that Allison would be the least concerned about volatility in her portfolio. For example, imagine that each of our three investors has the same asset allocation (70% stocks, 30% bonds) and that the stock market takes a 50% plunge.

  • Allison sees a small loss (when measuring the loss in dollars, as most people do), and her daily life isn’t really impacted in any way.
  • Phil sees a very large loss, and he may begin to worry about having to work for a few more years than he’d planned.
  • Dorris sees a large loss, and she may begin to worry about whether she needs to cut back on her spending.

There’s nothing terribly tricky going on here. And it’s got nothing to do with Monte Carlo simulations or academic studies. For many investors it makes sense to shift toward more conservative investments over time simply due to the fact that the bigger your portfolio and the closer you are to having to spend from that portfolio, the worse a loss of a given percentage feels.

What Record to Keep for Taxes (I’m Self-Employed)

When running a business, good recordkeeping is essential. As you probably already know, keeping detailed records helps you to more accurately track how well your business is doing. Records allow you to see what expenses could likely be cut, what expenditures are producing results and should be increased, which customers are your most profitable, and so on.

Recordkeeping is also essential for tax purposes. First, it makes the job much easier for the person preparing your taxes, whether you’re doing it yourself or getting professional help. You can save yourself a nightmare at tax time by keeping an organized list of your taxable receipts and deductible expenditures.

Equally important is the need to have sufficient records in case of an audit. If you’re audited and cannot produce evidence of an expense you claimed as a deduction, the deduction is almost certain to be disallowed. There are several recordkeeping software products (e.g., Quicken) on the market that are both affordable and fairly easy to use. The financial risk you incur by not keeping records far outweighs the cost of such software.

What Records to Keep

The first step, if you haven’t done so already, is to get a business checking account. Being able to separate your business expenses from your personal expenses will prove invaluable both for evaluating your success and for doing your taxes.

The most important record to keep is a ledger. This is a record of all of your business transactions. (Your personal ledger is the little booklet that accompanies your checks in your checkbook.) You can find paper versions of these at business supply stores, but it’s strongly recommended to find software to help you with this. However, if you do use a software package to help you, be sure to backup your file regularly. Losing this information due to something as simple as a computer failure would be quite unfortunate.

For tax purposes, you will also be required to maintain supporting documents for your ledger. For your income items, these will be things such as invoices, bank deposit slips, and so on. (If you run a business with lots of cash sales, an important record to keep is a daily log of the amount of cash received.) For expenses, your supporting documents will be receipts, credit card statements, bank statements, invoices, etc.

How Long to Keep Your Records

For tax purposes, the general rule is that you want to keep records until the applicable “statute of limitations” runs out. The statute of limitations is the period during which a) you can amend your return to claim a refund, or b) the IRS can assess an additional tax. For the most part, this is three years after the date the return was filed or the date the return was due, whichever is later.

There are two major exceptions to this three-year period. First, if you file a fraudulent return or do not file a return, the IRS has an unlimited amount of time to assess additional tax. Second, if you do not report income that you should have reported, and it is more than 25% of your gross income for the year, the applicable statute of limitations is six years.

So for the most part, three years is the length of time required to keep records for tax purposes. However, there are several reasons you may want to keep records (at least some of them) for far longer than that. Generally you will want to keep at least your ledger of revenues and expenses (although not the actual receipts) more or less indefinitely. This information will continue to be valuable for tracking your business’s progress. Also, your insurance company or creditors will quite possibly require you to maintain your records for longer than three years. Finally, your state law may require recordkeeping for longer than three years.

In Summary

  • The most important thing you can do to make preparing your taxes simpler is to get a separate checking account for your business.
  • In case of an audit, you want to have both a canceled check (or credit card statement) and a receipt to prove each of your claimed deductions.
  • Generally, you want to make sure to keep your records for three years for tax purposes, but you may be required to keep records for longer for your bank or insurance company.

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