Archives for April 2013

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A Question for You: Getting Changes in Your 401(k)

After watching last week’s Frontline documentary dealing with 401(k) fees, several readers wrote in to ask what they can actually do about the situation. They know the investment options in their employer-sponsored plans stink, but they don’t know how to go about persuading their employers to make any changes — either adding lower-cost funds or switching plan administrators.

Unfortunately, I don’t have any good input here. I’ve never lobbied an employer of mine to get better fund choices in a 401(k), nor have I seen any research on the topic.

So that’s my question for you: Have you ever tried to get your employer to make changes to your 401(k), 403(b) etc.? If so, what did you try, and what were your results? I’m interested in hearing stories of both successful and unsuccessful efforts — both are useful pieces of information.

I’ll share the results (anonymously of course) on Wednesday.

Thank you!

Which Bonds are Most Tax-Efficient?

A reader writes in, asking:

“I know that some stocks relative to other stocks are more efficient regarding taxes [eg foreign stocks being better because of the foreign tax credit] but what about bonds? If investing in a taxable account, are some bonds better than other bonds?”

Yes, there absolutely are differences in the relative tax-efficiency of different types of bonds.

Most obviously, municipal bonds are exempt from federal income tax, making them very tax-efficient.

After munis, Treasury bonds are the most tax-efficient for most investors because they’re exempt from state and local income taxes. This is true not only for plain-vanilla Treasury bonds (such as those held in a Treasury bond fund), but also for TIPS and savings bonds.

Because they generate less interest income, bonds with lower yields are generally more tax-efficient than bonds with higher yields. This makes shorter-term bonds more tax-efficient than longer-term bonds, and higher-credit-quality bonds more tax-efficient than lower-rated bonds.

The most obvious application here is for making asset location decisions — that is, for choosing which investments to tax-shelter when you have a limited amount of space in your tax-advantaged retirement accounts.

Example: Ben’s portfolio includes holdings of Vanguard High-Yield Fund, Vanguard Total Bond Market Index Fund, and Vanguard Intermediate-Term Treasury Fund, but he only has room for one of those funds in his retirement accounts. Ben stands to gain the most from tax-sheltering the high-yield fund and the least from tax-sheltering the Treasury fund.

But knowing about the relative tax-efficiency of different types of bonds can even be helpful when choosing an asset allocation.

Example: Due to having sold her business for a large sum, Jessica’s portfolio is almost entirely in taxable accounts. She knows that muni bonds make sense for her, given her tax bracket, but she’s not comfortable devoting her entire bond allocation to muni bonds, given the budget troubles that most state and local governments are facing. For the remainder of Jessica’s bond allocation, rather than using a typical “total bond market” type of fund, she could benefit by using short-term Treasuries and then simply using a slightly higher stock allocation.

By doing this, she keeps the overall level of risk and expected return the same (because she has shifted to safer bonds, but slightly decreased the total allocation to bonds), but more of her expected return comes in the form of qualified dividends and long-term capital gains than it would if she were using a “total bond” fund and a slightly larger bond allocation.

How Should I Count [Something] In My Asset Allocation?

I often receive questions about how (or whether) to count various things (e.g., Social Security, a pension, or an annuity) in your asset allocation. For example, a reader recently wrote in with the following question:

“I want an asset allocation of 50/50. $200,000 of my total portfolio is in a Vanguard variable annuity that is actually a Wellington managed mutual fund with the guaranteed withdrawal benefit rider in place. The Wellington fund has 65% in stocks and 35% in bonds.

When I figure the allocation, do I include the $130,000 in the stock allocation and the $70,000 in bonds in the allocation, or because I am taking the guaranteed benefit rider should I look at the $200,000 as fixed income? Or should I ignore it completely?”

I think it makes more sense to approach the question from the other direction. That is, rather than setting a desired overall allocation, then trying to figure out what the annuity should be counted as in order to reach that allocation, I would instead ask how you want the rest of the portfolio to behave.

Remember, the goal isn’t a specific allocation. The goal is a specific level of risk. So, given how the annuity works, how much volatility are you comfortable having in the rest of your portfolio? The answer to that question (rather than a desire to meet an allocation goal) should inform the decision of how you allocate the remainder of your portfolio.

For example, using the reader’s example from above, if we assume a $1,000,000 total portfolio, $200,000 of which is in the Vanguard variable annuity), if you:

  • Decided that the largest portfolio decline you could tolerate from the non-annuitized portion is, say, $200,000, and
  • You’re comfortable assuming stocks won’t fall by more than 50%,

…then you would want to limit your stock allocation (in the non-annuitized portion) to $400,000 (that is, twice the $200,000 maximum tolerable loss).

But that decision could be stated in any of a few ways:

  • You could choose not to count the annuity as part of your allocation, and say that you want a 50/50 allocation (that is, half of the $800,000 portfolio being in stocks).
  • You could choose to count the annuity as fixed income, and say that you want a 40% stock, 60% bond allocation (that is, 40% of the $1,000,000 portfolio being in stocks when you count the annuity as a bond).
  • Or you could choose to count the annuity based on its underlying (65% stock) allocation, and say that you want a 53% stock, 47% bond allocation (that is, 53% of the $1,000,000 portfolio being in stocks when you count $130,000 of the $200,000 annuity as stocks).

Those are all the same portfolio, just expressed in different ways.

Personally, I think the easiest approach is to count things like annuities, pensions, and Social Security (i.e., everything other than plain-old investments like stocks, bonds, and mutual funds) as factors affecting your ideal allocation rather than as a part of your allocation. But what matters is not whether you count these things or how you count them. What matters is what is actually in the portfolio, and whether or not that results in a level of risk that is suitable for your needs.

Fixed-Maturity Bond ETFs

A reader writes in, asking:

“I would be interested in hearing your thoughts on building a laddered portfolio of bonds using the Guggenheim Bulletshares Corporate Bond funds as opposed to a general corporate bond ETF or mutual fund to generate income and reduce risk.”

For readers who have not yet encountered them, the Bulletshares funds are ETFs that hold collections of bonds that mature within (or near) a given year. For example, if you look up the Bulletshares 2019 Corporate Bond ETF on Morningstar and click over to the “portfolio” tab, you’ll see that more than 99% of the portfolio is invested in bonds with maturities in the 5-7 year range. When the date in the name is reached, the plan for the fund is to distribute all of its assets (which should mostly just be cash at that point) back to fund shareholders.

This is in contrast to the typical passively managed bond fund, which is more akin to a bond ladder that perpetually renews itself.

If your investment horizon is indefinite (or just very long, as it is for most investors prior to retirement), a perpetually-renewing bond ladder (i.e., a normal bond fund) is a good fit. But if you are planning to satisfy specific expenses at specific points in time (e.g., $X of living expenses each year for the next Y years), you would prefer a bond ladder that does not constantly renew itself. For that purpose, fixed-maturity bond funds such as the Bulletshares ETFs could potentially be helpful.

I like that the Bulletshares funds have a fairly modest expense ratio of 0.24%. That’s somewhat higher than what you’d pay with a simple bond index fund, but it’s still within reason in my opinion.

In addition, I like that they don’t include Treasury bonds — not because I think Treasury bonds are bad to own, but because it’s relatively easy to build a bond ladder on your own with Treasury bonds given that (unlike with corporate bonds) there is no need to diversify among borrowers. In other words, if I were going to create a ladder out of Bulletshares ETFs, I would probably supplement it with a Treasury (likely TIPS) ladder that I build on my own.

Unfortunately, the fact that the funds’ maturity dates only go out to 2020 significantly limits their usefulness. For most investors, retirees included, there’s clearly a need to plan more than 7 years into the future. Of course, you can create a rolling bond ladder with these fixed-maturity ETFs. But if you do that, you’ve basically just built a conventional corporate bond fund — one that requires extra work and that has higher costs than necessary.

In short, I think fixed-maturity bond funds like these are useful in certain situations (namely, when you want to plan for specific expenses in the not-so-distant future). But as a general retirement planning tool, they don’t become particularly helpful until well into retirement for most people.

The Best (Low-Cost) Index Funds

When choosing between companies for constructing an index fund portfolio, my primary considerations would be:

  • Cost of funds,
  • Minimum investment per fund, and
  • Selection of funds (Does this company have enough funds for me to build a diversified portfolio?).

What follows is a comparison of index funds from Fidelity, Schwab, and Vanguard. (I also took a look at T. Rowe Price’s index funds. Conclusion: Their selection is limited, and their funds cost more than any of the other three companies. Not particularly enticing, in my opinion.)

As a point of comparison, I’ve specifically mentioned funds from each company that could be used to construct Allan Roth’s “Second Grader Portfolio,” which consists of three basic asset classes: U.S. stocks, international stocks, and bonds. This is not to suggest that these are necessarily the only funds a person might want to use.

Fidelity Index Funds

  • Spartan Total Market Index Fund (expense ratio: 0.06%)
  • Spartan International Index Fund (expense ratio: 0.12%)
  • Spartan U.S. Bond Index Fund (expense ratio 0.10%)

Minimum Investment: $10,000 minimum initial investment per fund for the “Advantage” share class, for which I’ve listed the expense ratios. There’s also an “Investor” share class (which has slightly higher — though still low — costs), for which the minimum investment is $2,500 per fund.

Selection: Fairly limited. For example, investors looking to tilt their portfolios toward growth stocks or value stocks won’t find the tools to do so, as there are no value-specific or growth-specific Spartan index funds.

Related note: Fidelity has a lot of “enhanced index funds.” I wouldn’t bother with them. Their costs are low for active funds, but still usually significantly higher than decent index funds.

More information about Fidelity’s index funds can be found here.

Schwab Index Funds

Schwab’s selection of  actual index funds leaves much to be desired. (For example, they don’t even have a single bond index fund.) Schwab does, however, offer commission-free trades on their own ETFs, many of which are low-cost, index-tracking ETFs.

  • Schwab U.S. Broad Market ETF (expense ratio: 0.04%)
  • Schwab International Equity ETF (expense ratio: 0.09%)
  • Schwab U.S. Aggregate Bond ETF (expense ratio: 0.05%)

Minimum Investment: As ETFs, the minimum investment is simply the cost to purchase one share of the fund. As a result, most Schwab ETFs can be accessed with amounts as small as $50.

Selection: Somewhat limited. For example, Schwab has growth/value domestic large-cap ETFs, but no such offerings in the small-cap or international categories.

More information about Schwab’s ETFs can be found here.

Vanguard Index Funds

  • Vanguard Total Stock Market Index (expense ratio: 0.05%)
  • Vanguard Total International Stock Index (expense ratio: 0.16%)
  • Vanguard Total Bond Market Index (expense ratio: 0.10%)

Minimum Investment: $10,000 minimum initial investment per fund for the “Admiral” share class, for which I have listed the expense ratios. There’s also an “Investor” share class, with slightly higher (though still low) expenses, for which the minimum investment per fund is $3,000. (As yet another alternative, if you have an account at Vanguard, you can get commission-free trades on the ETF versions of Vanguard’s index funds, which carry the same expense ratios as their Admiral Shares funds.)

Selection: Very broad. Vanguard has more than 30 different index funds, covering pretty much every asset class you can think of.

More information about Vanguard’s index funds can be found here.


In short, which company to use depends upon your situation. If you intend to build a somewhat more complicated portfolio — such as one that overweights value or small-cap stocks — go with Vanguard. But if that’s not a concern for you, any of the three companies could be a perfectly good choice (though Fidelity will be less desirable if you cannot meet the minimum investments on their index funds).

Portfolio Risk Levers

People often ask what I think about one proposed asset allocation as opposed to another. More often than not, my answer is indifference — I have no reason to think that either proposed allocation is markedly better than the other.

I like to think of a portfolio as having several levers that you can adjust upward or downward in order to increase or decrease the level of risk.

  • There’s the stock-vs-bond lever.
  • There are the bond-related levers for adjusting interest rate risk, credit risk, and inflation risk.
  • And there are the stock-related levers for adjusting small-cap risk, value risk, and emerging market risk.

In my view, it’s OK to position those levers in any number of different ways, so long as you end up with an overall risk level that is appropriate for your personal risk tolerance.

For example, on the bond side of the portfolio, some experts recommend sticking to only very safe bonds such as short-to-intermediate-term Treasuries. Other experts (e.g. John Bogle and Rick Ferri) take a different approach. Not only do they like the corporate bond allocation included in a “total bond” fund, they suggest going further and including additional corporate bonds as well.

Either approach seems perfectly reasonable to me. The point is simply that, if you choose to increase the risk you take with your bonds, it’s important to adjust the risk level downward in some other way (by using a smaller stock allocation, for instance).

On the stock side, one common strategy is to adjust the levers in some way (most often by increasing the weighting of value stocks and small-cap stocks) with the hope of creating a portfolio that is greater than the sum of its parts, because the various pieces have sufficiently low correlation to each other for you to achieve a bit of extra return via rebalancing between them.

I think such an approach is perfectly fine, so long as the portfolio is adjusted in some other way to bring the overall risk level back to where it should be — by switching to less risky bonds or by increasing the bond allocation, for instance. (I would also caution against putting yourself in a position where you’re relying on a “bonus” diversification-driven return. Investment correlations are not entirely stable, so the fact that something has worked as a diversifier in most historical periods does not mean it will necessarily do so when you need it to.)

Which Risks Are Most Problematic for You?

There are some situations, however, in which it makes sense to be concerned not just about overall risk level, but also about exposure to a specific risk. Generally, these situations are the result of non-portfolio factors in your life.

For example, if you’re a retiree who has a government pension instead of Social Security, and that pension is not inflation-adjusted (or there is a cap on the inflation adjustment), then you’re more exposed to inflation risk than other retirees. And as a retiree in general, you’re more exposed to inflation risk than working investors. As such, you have a good reason to keep the inflation risk in your portfolio low (by using TIPS and I Bonds) and use your other levers to achieve your desired level of overall risk.

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