Archives for August 2015

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Should I Still Contribute to a 401(k) if I Plan to Retire Early?

A reader writes in, asking:

“If I plan to retire well before age 59.5, should I still be contributing to my 401-K? In case it matters, I am in my late 20’s and the goal is to retire around age 40.”

For a few reasons, even if you plan to prior to age 59.5, it is still probably a good idea to contribute to a 401(k) account.

First, in order to retire very early, you’re probably going to have to save more per year than your maximum 401(k) contribution limit, so you will probably also have money in a Roth IRA and in taxable brokerage accounts, each of which can be accessed prior to age 59.5 without penalty. (At least, contributions made to the Roth IRA can be accessed prior to age 59.5 without penalty. For earnings, one of several exceptions to the penalty would have to be met.)

Second, there are several ways to get money out of a 401(k) account prior to age 59.5 without having to pay a penalty. For example, there is an exception to the 10% penalty for any distributions that are part of a “series of substantially equal periodic payments” taken over your life expectancy. The rules are complicated, and I would urge you to work with a tax professional if you plan to take advantage of this option. But if you follow the rules correctly, you can get access to (some of) the money as early as you want.

Finally, even if you retire at age 40, there will still (most likely) be many years after 59.5 for which you will need savings. According to the Social Security Administration, the average total life expectancy for a 40-year-old is approximately 80.5 years. In other words, on average, there would still be more than two decades of post-age-59.5 spending that must be funded.

In short, the 10% additional tax that applies to certain early distributions from 401(k) accounts shouldn’t necessarily be a big problem, even for somebody who plans to retire early. And it is unlikely that that drawback overwhelms the benefits of contributing to a 401(k) account (i.e., tax-deferred growth, potential for shifting income from high-tax-rate years to low-tax-rate years, and potentially an employer match).

What to Do about a Bad Day (or Week) in the Stock Market

On Thursday the U.S. stock market (as measured by Vanguard’s Total Stock Market ETF) went down by 2.17%. And on Friday it went down by 2.88%. The week’s market performance (down approximately 5.5% in total) has received quite a bit of news coverage, and if my email inbox and Facebook feed are any indication, many people are nervous — or even downright scared.

This Could Be No Big Deal

According to Yahoo Finance, in the last 5 years (i.e., during a roaring bull market) there have been 8 other days worse than Friday and 28 days worse than Thursday.

You might say, but this was two bad days in a row, surely this is a problem! Well, those 8 days worse than Friday? Two of them were in a row as well (9/21/11 and 9/22/11). In fact, all 8 of the days that were worse than Friday occurred within the August-November window of 2011. Perhaps, like me, you have already forgotten about that brief little period of not-so-great returns. Until looking at the data just now, I had forgotten about that period because it turned out to be no big deal. The market continued to climb for another (so far) nearly 4 years after that.

In other words, this sort of thing is normal, and it can even happen right in the middle of a period of great market returns. It doesn’t necessarily mean the bull market is over.

But Maybe We Are in for a Crash

On the other hand, maybe this is the beginning of the next bear market. We could be in for a much greater decline. In the 2007-2009 decline, for instance, the market fell by more than 50%.

If last week’s not-that-big-of-a-deal performance has you in near panic mode already, you have learned an important lesson. Specifically, you have learned that you overestimated your risk tolerance and chose a portfolio that is probably too risky for you. If a decline of less than 10% has you scared, imagine how you’d feel if the market fell another 40%.

The point of strategic asset allocation is to give up on guessing where the market is going next and instead craft a portfolio that will allow you to sleep well at night, regardless of whether we’re in for another 4 years of great returns (as we were after that little blip in late 2011) or a further decline of 40% or more.

What to Do Now?

Evaluate. How are you feeling about your portfolio and its risk level right now?

If you’re feeling perfectly comfortable, this week could be a great time to rebalance your portfolio back to its target allocation, which likely means buying more stocks. (It may also be an opportunity to tax-loss harvest.)

On the other hand, if you’ve been stressing about this modest decline, you may want to scale back your stock allocation somewhat. Yes, that means selling immediately after a decline, which isn’t ideal. But chalk it up as a lesson — one that could have been much more expensive.

And take note of the stress you’ve been feeling. Literally. Make a note of it. Record how you are feeling right now. Then sign and date that document. You want something that you can refer back to the next time things are looking rosy and you are tempted to bump up the risk level of your portfolio (to a level that you have already proven is too risky for you).

Why Use Actively Managed Bond Funds?

A reader writes in, asking:

“I saw an article on your blog about passive funds beating active ones. But then why do Jack Bogle and Rick Ferri use the actively managed Vanguard funds? For example, wouldn’t a muni ETF be a better option if it beats the active manager 95% of the time? I’m a full time indexer but I don’t understand why these legends use active bond funds. Can the same be said for corporate bond funds?”

The key point about indexing isn’t that there’s anything magical about the indexing itself but rather that it is a very low-cost way to run a diversified mutual fund. Or, to look at it from the other direction, most actively managed funds have a very difficult time overcoming their much higher costs.

In some cases, however, the actively managed funds have costs that are approximately as low as (or sometimes even lower than) the costs of index funds (or ETFs) in the same category. This is especially common with Vanguard’s bond funds. Many of them are not technically index funds, because they do not specifically track an index. But they have low expense ratios because the fund’s investment strategy is still very passive. That is, the fund isn’t trying to do any of the (expensive) things that many actively managed funds do in their attempts to outperform their benchmarks.

For example, Vanguard’s Intermediate-Term Investment-Grade Fund is technically actively managed. But the Vanguard website describes the fund’s investment strategy as follows: “This fund provides diversified exposure to medium- and high-quality investment-grade bonds with an average maturity of five to ten years.” Nothing about trying to pick bonds with unusually high performance. Nothing about trying to predict interest rate movements. It’s basically just, “We’re going to buy a bunch of bonds with investment-grade credit ratings and maturities of 5-10 years.” Very boring and, importantly, inexpensive to implement.

Similarly, in the muni bond category, Vanguard’s funds are technically actively managed. And their expense ratios range from 0.12% (for Admiral shares) to 0.2%. By way of comparison, if you take a look at a list of muni bond ETFs (here or here, for example), you’ll notice than none are less expensive than Admiral shares of Vanguard’s non-index muni funds.

The triumph of index funds is really a triumph of inexpensive funds over expensive funds. When an actively managed fund has very low costs (and there’s no reason to think that the manager is going to do something stupid with your money), such a fund can be a perfectly good option for inclusion in a low-cost, diversified portfolio.

With Similar Earnings History, Which Spouse Should Delay Social Security?

A reader writes in, asking:

“My husband and I plan for one of us to file for Social Security at age 70 and for the other to file early, probably at age 62. You have stated that the spouse with the higher benefit should be the one to wait, in order to maximize survivor benefits, but what should we do if we have nearly identical benefits? Is there rhyme or reason for one of us as opposed to the other being the one who should wait?”

In cases in which:

  1. Both spouses have very similar primary insurance amounts,
  2. Neither spouse expects his/her primary insurance amount to grow meaningfully as a result of future earnings (i.e., neither PIA is expected to become meaningfully larger than the other in the future), and
  3. The couple plans for only one spouse to wait to claim retirement benefits

…the question of who should wait is often a function of age.

Specifically, if one spouse is more than 4 years older than the other spouse, that older spouse is the one who should file early. The reason for this recommendation is that this is the strategy that will allow for the most total years of “free” spousal benefits.

How About an Example?

Mario is 62 years old, and his wife Christina is 56. Their PIAs are approximately identical.

Scenario A: The couple decides for Mario (the older spouse) to file at age 62 and for Christina (the younger spouse) to wait until age 70. With this strategy, once Christina reaches her full retirement age, she can file a “restricted application” to receive just spousal benefits. This way, she can receive 4 years of drawback-free spousal benefits while allowing her own retirement benefit to continue growing until age 70.

Scenario B: The couple decides for Christina (the younger spouse) to file at age 62 and for Mario (the older spouse) to wait until age 70. This strategy is not as good, because Mario won’t be able to file a restricted application for spousal benefits until Christina has reached age 62 and filed for her own retirement benefit — by which point Mario will be age 68, meaning the couple only gets 2 years of “free” spousal benefits rather than 4 years.

What If There’s Less than 4 Years Difference in Age?

If there’s less than 4 years difference in ages, then the couple will be able to receive drawback-free spousal benefits for the same number of months regardless of which spouse waits and which spouse files early. (Reason being that, if there’s less than 4 years difference, by the time the waiting spouse –regardless of which spouse that is — reaches full retirement age, the non-waiting spouse will already be age 62 and will have started receiving retirement benefits.) As a result, in these cases, whoever’s PIA is even slightly larger should generally be the person who waits.

Important Exception

There is one especially important exception to the above recommendations. Specifically, if one spouse is in particularly poor health such that he/she isn’t expected to make it to age 70, that spouse should not be the one who waits.

Example: Wallace and Gina are both age 61 and retired. Wallace’s primary insurance amount is slightly larger than Gina’s. Wallace, however, has a serious heart condition, which, his doctors have told him, makes it likely that he only has another 3-7 years left to live.

If the couple decide that Wallace will wait until age 70 for his retirement benefit and Gina will claim early, but then Wallace dies at, say, age 68, Gina will be left with an age-68 benefit for the rest of her life, as opposed to the age-70 benefit that she could have gotten if she (i.e., the healthy spouse) had been the one to wait.

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Where Can You Get Unbiased Financial Information?

A reader writes in, asking:

“I’m a bit of a late starter, financially speaking. I am in my late 30’s but only now beginning to learn in earnest about personal finance. One challenge I have run into is that I cannot tell who is giving good information and who is just selling me something. Where would you recommend looking for unbiased financial and investing information?”

The short answer is that nobody in the financial services industry (or financial publishing industry) is an unbiased source of information.

With regard to advisors, the most obvious conflicts of interest are created by a commission pay structure. Commission-paid advisors have a strong incentive to steer you toward insurance products and mutual funds that pay a commission, rather than low-cost index funds that do not pay a commission.

But other advisors have conflicts of interest too.

  • Advisors paid as a percentage of assets under management have an incentive to maximize your portfolio size, even when doing something else (e.g., spending the portfolio down to pay off your mortgage, delay Social Security, or buy a lifetime annuity) may be in your best interest;
  • Advisors who charge a fixed periodic retainer (e.g., a flat $X quarterly fee) have an incentive to gather a lot of assets while doing the least work possible on each portfolio, even when it may be beneficial to the client to pay somewhat more attention to it; and
  • Advisors who charge an hourly fee have an incentive to make things more complicated than they really need to be. (And all advisors have an incentive to make investing appear more complicated than it really is.)

Financial publications (and their writers) have conflicts of interest as well.

  • Most financial publications make the majority of their revenue from advertising. As a result, they’re often reluctant to publish articles explaining exactly how bad certain financial products are.
  • And every financial publication (including this one!) has an incentive to convince you of the importance of each topic being discussed. We need you to keep visiting our sites, buying our books, paying subscription fees, etc.

Even academic research can’t be assumed to be conflict-free. In many cases, the research is funded by a company with a product to sell. (For instance, many pieces of research regarding annuities have been funded by insurance companies.)

Of course, this doesn’t mean that none of these sources are helpful. Advisors, financial publications, and academic studies can all be very helpful. But it’s critical to be aware of the conflicts involved so that you know how the information you are encountering might be slanted.

So Where Can You Get Unbiased Information?

About the only way to get truly unbiased information is to get it from somebody who makes their living in a completely different field. For example, your neighbor who works as a software developer has little reason to convince you to make one investment decision as opposed to another. Of course, the problem is that, in most cases, such sources not only lack conflicts of interest, they also lack expertise.

As far as unbiased sources that are still knowledgable, something like the Bogleheads forum is about the closest you can get. Most people there do not work in the financial industry at all and therefore have nothing to gain from convincing you of one course of action over another. That said, even there it is important to be careful. Most people are anonymous, so it can be hard to know how much faith to put in any one person’s information or opinions. Also, some people there do actually have conflicts of interest (specifically, those of us who work in any of the types of positions mentioned above).

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