Archives for September 2012

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Retirees: Should You Get Rid of Your Bonds?

Retirement researcher Wade Pfau recently released a paper titled “An Efficient Frontier for Retirement Income” (summary here) in which he compared different allocations of stocks, bonds, fixed lifetime annuities, inflation-adjusted lifetime annuities, and variable annuities with “guaranteed lifetime withdrawal benefit” riders to see how each combination plays out in terms of meeting two competing retirement goals:

  1. Minimizing the shortfall between desired spending and actual spending, and
  2. Maximizing the amount of money you leave to your heirs.

The results were rather shocking. So shocking, in fact, that there’s a good chance you’ll read about it elsewhere (which is why I’m hoping to prepare you for what you’ll hear).

What Wade found was that, given the assumptions he used, the ideal allocations for retirees involved only stocks and fixed lifetime annuities. That is, the ideal allocations included no bonds, no inflation-adjusted lifetime annuities, and no variable annuities (although I don’t think many people will find that last part to be particularly shocking).

What’s important to understand, however, is that Wade’s paper is not about showing you how to allocate your money — at least not directly. Rather, it’s about creating a new method for analyzing various allocations — by looking at how well each allocation meets those two goals above, rather than looking at, say, the allocation’s probability of running out of money within 30 years.

The specific results that Wade provides in his paper are only an example of one such analysis. And they use a very specific (though mostly reasonable) set of assumptions (about stock and bond returns, correlations between them, rates of inflation, and so on). When those assumptions are changed, the results might look very different.

In other words, for individual investors, the takeaway is not that you should dump all your bonds in favor of stocks and/or fixed lifetime annuities. Rather, the takeaway is simply that a portfolio completely eschewing bonds in favor of lifetime annuities might not be completely-off-the-wall-crazy. And, given how far such a portfolio would be from conventional retirement recommendations, that’s very interesting.

I hope we’ll see more research along these lines in the near future.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less
Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
September 26, 2012

Asking the Advisors: How to Pay for Investment Advice

When looking for a financial planner and/or investment advisor, one of the most important things to decide is what type of compensation agreement will be the best fit for you. Would you rather pay an hourly fee? A fee calculated as a percentage of your portfolio? Or a flat monthly/quarterly/annual fee?

Rather than sharing my own thoughts yet again, I thought it would be more interesting to hear from three different advisors — one for each of the three business models. So I reached out to three people whose opinions I’ve come to value:

Under what circumstances would an investor be best served with an hourly fee model?

Allan Roth: When someone needs help in moving from complexity to simplicity and is willing to be a hands on manager of their own portfolio. If the client will let me design the portfolio simply enough, I can give them rebalancing rules they can follow and they may never need me again. That is the goal.

[In addition], non-investment related advice such as tax, insurance, financial independence, and estate planning coordination works better on the hourly model as need varies greatly.

Rick Ferri: That’s a two part answer:

Investor 1: Someone who wants investment advice but doesn’t want ongoing investment management. They pay hourly or by the project for a portfolio review and investment recommendations, and then it’s up to the investor to implement. Often investors who have a large amount of wealth in a company 401(k) fall into this category. The adviser doesn’t have access [to the account], so the investor has to DIY.

Investor 2: Someone who has an investment manager but who also needs other financial services. Perhaps they need a full financial plan, or estate planning help, or insurance review, or tax planning. In my opinion, these services should be paid for hourly or by the project even if they’re provided by the same adviser who does the investment management. I believe it’s unethical to lump these other services under a higher AUM (assets under management) fee because that links tax planning to the value of an investment portfolio, which makes no sense. In addition, often the investor only needs occasional extra advice, so why should they pay for it continuously with AUM?

Dylan Ross: An investor seeking specialized help when facing a complex decision with significant consequences may be best served with an adviser that charges by the hour. Some examples might be deciding when to begin Social Security, getting a second opinion before a major purchase, or general guidance on how to best structure their investment portfolio.

While hourly advice is frequently touted as great for one-time or the occasional as-needed help, it doesn’t have to stop there. It can also work well for ongoing, pay-as-you-go services. However, for general, less complex advice, it may be more expensive than paying flat periodic fee. For someone considering purchasing any kind of an annuity with their life savings, hiring a fee-only hourly advisor to look everything over would be a very, very wise choice.

Under what circumstances would an investor be best served with a fee based on assets under management?

Rick Ferri: There are two types of AUM fee advisors — wealth managers and investment managers. The first wraps all financial services under an AUM fee and the second charges a lower AUM fee for investment managing services. [Mike’s note: This second type of service is what Rick’s firm does.]

Many individuals and small institutions do not desire to manage their investment portfolio directly or cannot manage them for legal reasons. They delegate this duty to a legal fiduciary, such as Portfolio Solutions. We work with these clients to come up with a sensible long-term plan for their needs or the needs of beneficiaries, implement their plan with discretionary authority, maintain the plan day-to-day including cash flows, and report on performance versus appropriate benchmarks periodically.

I believe the difference between the DIY investor and adviser investor return is discipline. DIY is the best option from a fee perspective because there is no extra adviser fee. That being said, very often DIY investors don’t stay disciplined. Procrastination and inconsistency in management are common and this lowers long-term returns. An adviser is paid to be disciplined. This keeps a portfolio strategy on course and often leads to higher returns.

If you decide to hire an advisory firm, make sure they have the same strategy ideas that you do. This way your thinking is aligned and there is no confusion on what the adviser is trying to accomplish. Also, fees matter. The more an investor pays an adviser, the lower their returns.

Dylan Ross: I have formed the opinion that charging a fee based on assets under management is only really appropriate for asset management services like portfolio management or mutual funds. So it would be most appropriate for an investor seeking only to have their investment portfolio managed in accordance with a particular investment strategy or philosophy, not for household financial management or financial planning.

Tying the fee to the value of an account almost seems as if the account, not the person, is the client. If you don’t want to manage your own investments or haven’t been capable of doing so, paying a fraction of a percent of your assets to a low-fee advisor like Portfolio Solutions for disciplined investment management would be money well spent.

Allan Roth: [An AUM-based fee is best] when someone does not want to be a hands-on manager of their own money and wants someone else to handle the portfolio. Fees matter, so a great manager for a low price like Rick is right for those clients. I nearly always recommend Rick for those who want someone to do the investing for them.

Under what circumstances would an investor be best served by a flat annual/quarterly/monthly fee?

Dylan Ross: Flat periodic fees are best for folks who want/need general ongoing advice or regular access to advice at a predictable, fixed cost. It’s similar to a level-pay plan from your utility company, or health club membership. It can be a less conflicted solution for those seeking an advisor to manage assets and provide planning advice. For those seeking ongoing help with general personal finances such as cash management, debt liquidation, credit, saving and investing, low-fee access to a financial planner or an automated online service may be the best fit.

Allan Roth: I don’t see a big difference between this model and the AUM model. In reality, most fees I’ve seen in this matter are based on asset size. It does give more flexibility, like the hourly model, to advise on assets such as employer 401(k), pensions, etc.

Rick Ferri: I believe all investors who have smaller accounts and wish to have account managed under a discretionary relationship should pay a flat fee in lieu of an AUM fee. This is fair to the adviser and fair to the client. The flat fee will vary from adviser to adviser as does the adviser’s account minimums. Investors should choose an adviser that meets their needs.

Finally, Dylan Ross provided this summary, which I mostly agree with: “In a nutshell, I think that that folks are best served to pay a financial planner that is a generalist (not a Jack-of-all-trades, but a true generalist like a family doctor is a generalist) a low, periodic fee. Pay financial planners that are specialists by the hour, as-needed for specialty advice. And for specific services like investment account management, pay a portfolio manager or mutual fund company based on assets under management.”

September 24, 2012

Is Rebalancing Market Timing?

A reader writes in, asking:

“Some people rebalance once a year, others rebalance either more times a year, or when a particular fund goes up or down more than a certain percentage. When, if ever, does rebalancing become a form of market timing, or is all rebalancing, regardless of when it is done, a different name for market timing?”

Personally, I dislike the term “market timing.” It includes so many different things that I don’t think it’s very helpful as a descriptor. For example, market timing could include:

  • Day trading back and forth between cash and a total market ETF (which is clearly unwise for most people), or
  • A one-time decision to move a portion of one’s portfolio to an inflation-adjusted lifetime annuity because recent returns have been good and interest rates are high (which, depending on circumstances, could be a perfectly wise decision).

In other words, I don’t think it’s particularly useful to ask whether rebalancing is a form of market timing. I think it’s more useful to get right to the point and ask if you should rebalance your portfolio and, if so, when you should do so.

What Would Happen if You Never Rebalanced?

In my view, the primary goal of rebalancing is to keep the risk level of your portfolio approximately where you want it to be. If you never rebalanced, it’s likely that stocks would eventually dominate your portfolio because of their higher long-term returns, thereby causing your portfolio to get riskier and riskier as you age. For most people, that would not be a good thing.

And if you’re going to be rebalancing, you obviously have to settle on some plan as far as when to do it. And you have to choose between the various options somehow.

When to Rebalance

One way to choose between rebalancing methods would be to select based on ease of implementation. That might lead you to rebalance, for example, every year on your birthday (woohoo! rebalancing party!) or to use an “all-in-one” fund that rebalances for you automatically.

Or, you could go about the risk-control directly, checking your portfolio on a regular basis and rebalancing any time your asset allocation is out of whack by more than a certain amount. For example, in his Only Guide You’ll Ever Need for the Right Financial Plan, Larry Swedroe suggests rebalancing when a holding is off by an amount equal to 5% of your portfolio balance or 25% of the holding’s intended balance.

Alternatively, you could choose based on some rationale for why a given method might earn slightly better returns than another method. For example, you might note that stocks have historically shown momentum over periods of less than one year, so you choose to rebalance every two years rather than rebalancing more frequently.

I think any of the above rebalancing strategies would be perfectly reasonable — even if they could be referred to as market timing. Most important, in my opinion, is to pick a method and stick with it so that you know your asset allocation (and therefore, the risk level of your portfolio) will not get too far out of whack.

September 19, 2012

Using Taxable Holdings to Fund IRA Contributions

A reader writes in, asking:

“My wife and I have a variable income. In previous years, our income has been high enough to max out our retirement accounts and still have money left over to invest for retirement in a taxable account.

This year, however, our income has been lower than in previous years, so we were not able to max out our Roth IRA contributions. Do you think it would make sense to sell some investments from our taxable account in order to raise cash to contribute to retirement accounts?”

If There Are No Capital Gains Taxes to Pay

If there’s little or no capital gains tax to pay from selling the holdings (because your cost basis is approximately the same as the current market value, because you have a capital loss carry-forward from a prior year, or because you have a capital gain but are in the 15% or lower tax bracket such that long-term capital gains would be taxed at a 0% rate), then there is no downside to selling the taxable holdings.

In such cases, the question is basically the same as if the money was already in cash: Would you contribute the money to your retirement accounts? In most cases, of course, the answer to this question would be yes. (And the question of whether the money should be used for Roth contributions or tax-deferred contributions would be much the same as always. That is, it would depend primarily upon how you expect your retirement tax bracket to compare to your current tax bracket.)

And if there’s an unrealized capital loss, then you would actually get some tax savings this year by selling the taxable investments and claiming the loss on your taxes. Any additional tax savings you get from having the money in a retirement account going forward would be a bonus. [Important note: If you’re selling something at a loss in a taxable account, be sure to steer clear of the wash sale rule when using the cash to purchase something in your retirement accounts.]

If There Would Be Capital Gains Tax to Pay

If you would have to pay tax on a large capital gain, the question is somewhat trickier. In a case like this, you would want to consider how your current capital gain tax rate compares to the capital gain tax rate you expect to face in the future.

For example, if you have a 15% tax rate on capital gains right now, and you don’t expect that tax rate to be any lower in the future, then you (usually) might as well go ahead and pay the tax now, contribute the money to a retirement account, and get tax-free growth going forward.

In contrast, let’s say you expect to retire within a couple years, and you expect to have a 0% tax rate on long-term capital gains in retirement (e.g., because you expect the current tax structure to continue, and you expect to have little taxable income in retirement). In such cases, it would probably be best to keep holding the taxable investments in order to take advantage of that lower rate in the future.

September 17, 2012

Investing for Non-Retirement Savings Goals

A reader writes in, asking:

You’ve written before about viewing all your accounts as one portfolio. What about when you have some money that’s not intended for retirement?

For example, I use an 80% stock, 20% bond allocation for my retirement savings, but I also have a good amount of money, currently in savings, that I expect to use somewhere between 5-20 years from now. What would be a good allocation for that money? And should that money be counted in my overall “one-portfolio” asset allocation? For example, if I put the money in CDs or a bond fund, would that have an impact on the allocation I should use for my retirement money?”

In my opinion, the easiest way to choose investments is on a goal-by-goal basis. For example, money intended for retirement savings has one asset allocation, money intended for your kids’ college education has another asset allocation, money intended for a home downpayment in a few years has another allocation, and your emergency fund has yet another allocation.

And (for the most part) those allocations are chosen independently of each other.

In other words, I would select an asset allocation for my retirement savings (using the all-one-portfolio idea to minimize costs and complexity), then I would separately select an appropriate asset allocation for each significant non-retirement savings goal.

How to Allocate for Shorter-Term Goals?

In general, the more near-term the goal you’re saving for, the less risk you can afford to take. I often use a very rough mental guideline that looks like this:

  • 0-5 years: 0% stock (e.g., CDs, savings account, money market),
  • 5-10 years: 20% stock (e.g., Vanguard LifeStrategy Income Fund),
  • 10-20 years: 40% stock (e.g., Vanguard LifeStrategy Conservative Growth Fund).

In other words, for any goals less than 5 years away, my personal inclination is to stick with things that are very safe, such as CDs. And for goals in the 5-20 year range, I think it starts to make sense to consider a modest stock allocation. But that comes with two huge caveats.

First, as we’ve discussed before, asset allocation is not a precise science. That’s every bit as true in the short-term as it is in the long-term.

Second, asset allocation should be determined by risk tolerance, and risk tolerance is about much more than just time frame. For example, there are additional economic factors to consider:

  • Is the dollar amount of your goal flexible, or is it absolutely crucial that you have at least as much money at the end of the period as you have at the beginning?
  • Is the time frame itself flexible? (For example, a home downpayment can often be put off for a few years without a terrible problem. But when your child reaches age 18, putting off college for a few years might not seem like a viable option.)

Then there’s the emotional component of risk tolerance as well: Could you take a 10% loss in stride, or would it cause a great deal of mental distress? What about a 20% loss? 30%? You’ll want to choose an allocation that accounts not only for the economic impact of a loss, but the emotional impact as well.

September 12, 2012

Retirement Planning: Focus on Covering Expenses Rather Than Replacing Income

I’m currently reading Charles Farrell’s book Your Money Ratios. In the book, Farrell suggests that once your retirement savings reach 12-times your annual salary, you should be able to retire. Interestingly, just a few weeks ago, I encountered an article in The New York Times stating that you need 20-times your annual salary in order to be able to retire.

That’s a huge discrepancy! The NYT writer (Teresa Ghilarducci) is suggesting you need 67% more money than Farrell says you need. So who is right?

Neither. (Or maybe both, depending on how you look at it.)

When we talk about retirement planning, there’s always a great deal of uncertainty: investment returns, how long you’ll live, how your tax rate will change over time, etc. But, by basing the how-much-do-I-need number on the reader’s pre-retirement level of income rather than spending, the writers above are adding yet another source of uncertainty and imprecision.

For example, the higher your income level, the greater the portion of your pre-retirement income that you’ll have to satisfy with your portfolio, because Social Security will replace a smaller portion of your pre-retirement income than it would for somebody with a lower earnings history.

Or, if you expect to pay off your mortgage shortly after retiring, you’ll be able to get away with replacing a much lower portion of your pre-retirement income than somebody who plans to rent throughout retirement.

Or, if you started saving very early, such that you’ve been able to use a low savings rate throughout your career, you’ll have to replace a higher portion of your pre-retirement income than somebody who was late to the game but who adjusted to living on just 60% of her pre-retirement income in order to catch up on retirement savings.

When expressed as a multiple of end-of-career salary, the multiple one person needs to reach in order to retire could be twice as high as the multiple another person needs to reach.

Focus on Expenses Rather than Pre-Retirement Income

If you want to get a good idea of how much you need saved in order to retire, it makes more sense to go about it directly — by looking at the expenses you hope to satisfy.

  1. How much will you be spending per year in retirement, and
  2. How large a lump sum will it take to finance that spending?

Even when you base your retirement calculations on your actual expenses, there are numerous uncertainties left in the planning. There’s no need to use a rule of thumb that adds yet another layer of potentially-wrong assumptions.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less
Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."
September 10, 2012
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