Archives for May 2016

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Annuities with Fixed Cost of Living Adjustments Don’t Protect Against Inflation

A reader writes in, asking:

“I have been considering purchasing one of the “SPIA” annuities often recommended on Bogleheads. [Mike’s note: SPIA stands for single premium immediate annuity, and they are the most straightforward type of annuities — essentially just a pension that you purchase from an insurance company.]

I like the idea of inflation protection, but the ones linked to CPI are very expensive. What are your thoughts on buying one with an automatic 3% COLA [cost of living adjustment] every year as a compromise approach? It gives me some protection against inflation but not perfect protection.”

In short, I’m not a fan of annuities that use a fixed cost of living adjustment (rather than actually having the payout tied to the consumer price index) as a way to protect against inflation. The reason is that, as it turns out, they don’t actually protect against inflation! They just protect against a long life.

Let’s look at an example.

As of this writing the Income Solutions website (which I access via Vanguard) shows that a 65 year old male can get a fixed lifetime annuity paying 6.83%. Or, he can purchase an annuity with a 3% annual increase in the payout, with a payout that starts at 5.02%.* And, according to the SSA’s most recent period life table, a 65 year old male has a total life expectancy of nearly 83 years.

So, if the person buys $100,000-worth of each annuity, and there is no inflation over the person’s lifetime, then:

  • The fixed lifetime annuity will pay a total of $129,770 over the person’s expected lifetime, whereas
  • The annuity with the 3% COLA will pay a total of $126,087 (i.e., 97.2% as much as the annuity without the COLA) over the person’s expected lifetime.

But what if there is inflation? That’s what we really care about, after all.

If we assume annual inflation of 2% and we do the analysis in inflation-adjusted dollars:

  • The fixed lifetime annuity will pay a total of $108,859 over the person’s expected lifetime, whereas
  • The annuity with the 3% COLA will pay a total of $103,896 (i.e., 95.4% as much as the annuity without the COLA) over the person’s expected lifetime.

So in the scenario with higher inflation, the annuity with the COLA performs worse. (That is, it underperforms the non-COLA annuity by a greater amount than in the no-inflation scenario.)

But is that just a fluke? The table below shows other scenarios, with various ages at death along the left-hand side, and various rates of inflation along the top. The value in each cell shows the ratio of total inflation-adjusted dollars paid by the annuity with the COLA to total inflation-adjusted dollars paid by the annuity without the COLA.

So, for example, if the person lives to age 88 and there is 4% inflation over that period, the annuity with the COLA will have paid 99.5% as much as the annuity without the COLA.

0% inflation 2% inflation 3% inflation 4% inflation 5% inflation
73 83.0% 82.6% 82.5% 82.3% 82.1%
78 89.7% 88.8% 88.4% 88.0% 87.5%
83 97.2% 95.4% 94.6% 93.7% 92.9%
88 105.4% 102.5% 101.0% 99.5% 98.1%
93 114.6% 109.9% 107.6% 105.4% 103.2%

The key point here is that, the higher inflation is over this person’s lifetime, the worse the annuity with the COLA does as compared to the annuity without the COLA.

Why is this? It’s because the annuity with the COLA has a greater portion of its payout occurring later in the annuitant’s life (due to the fact that its payout starts lower, but climbs over time). And in a scenario in which dollars are declining in value over time due to inflation, the annuity that front-loads the payout (i.e., the annuity without the COLA) does better.

My point here isn’t that the COLA annuities are a bad idea. As you’ll notice, they do a better job of protecting against longevity than annuities without COLAs. (That is, the longer the lifetime, the better they perform.)

But annuities with fixed cost of living adjustments do not protect against inflation. Not only do they not keep up with high rates of inflation, they actually perform worse in the face of inflation than annuities without COLAs. If you want an annuity that provides true inflation protection, you have to buy one with payments that are tied to the actual rate of inflation.

*The payouts for females are slightly lower given longer life expectancies (6.35% for a fixed lifetime annuity and 4.58% for one with a 3% annual increase), but the analysis is essentially the same.

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  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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Should I Put Stocks in My Roth IRA and Bonds in My Traditional IRA?

A reader writes in, asking:

“If I have a Roth IRA and traditional IRA, is it better to put my stock funds in the Roth and the bond funds in the traditional IRA? That seems preferable, because as long as stocks do earn more than bonds it would leave me with more money down the road because the Roth is tax-free.”

Yes, it is often preferable to put your investments with higher expected returns in Roth accounts rather than tax-deferred accounts — but not for the reason you mentioned.

Loading up your Roth accounts (as opposed to tax-deferred accounts) with investments with higher expected returns will (assuming “expectations” pan out) leave you with more money to spend after taxes than if you had taken a different approach. But that’s simply because you took on more risk.

By putting your high-risk investments in a Roth, you expose yourself to more risk than you would if you had an equal allocation in both tax-deferred and Roth. The reason for this is that you feel the full effect of fluctuations in the balance of your Roth IRA, whereas you only feel a portion of the effect of fluctuations in the balance of tax-deferred accounts.

For example, imagine that you expect to have a marginal tax rate of 25% during retirement. If your Roth IRA’s value changes by $20,000, that changes the amount of money you have available to spend by $20,000. In contrast, if your traditional IRA’s value changes by $20,000, the amount of money you have available to spend only changes by $15,000 (because $20,000 in the traditional IRA is only worth $15,000 to you, given a 25% marginal tax rate).

In other words, using your Roth IRA entirely for high-risk investments is very similar to just bumping up your allocation to high-risk investments in the first place — it will likely result in more money in the end, but at the cost of higher risk.

Now, having said that, it does typically make sense to prefer to use the Roth for investments with higher expected returns.

Why?

Because Roth IRAs Have No RMDs

As long as a Roth IRA is owned by its original owner (as opposed to being owned by a beneficiary after the death of the original owner), RMDs do not have to be taken from the account at any point.

So, in that sense, you would prefer to have a Roth IRA of a given size rather than a proportionally-larger traditional IRA, because the Roth gives you better control over your money.

For example, you would rather have $75,000 in a Roth IRA than $100,000 in a traditional IRA with a 25% marginal tax rate, despite the fact that the two amounts are functionally equivalent in terms of how much they leave you with after taxes.

For that reason, it does typically make sense to use your Roth accounts for the investments with the highest expected return. But you should be aware that in doing so, you increase your overall risk, so you may want to compensate by reducing risk slightly in some other manner.

Social Security is a Year-by-Year (or Month-by-Month) Decision

For simplicity’s sake, writers and financial advisors often compare claiming Social Security at 62 to claiming at 70, in order to show the difference between the two extreme strategies. But in reality, the decision should be made step-by-step along the way. (“Do I want to wait a year? Do I want to wait another year?” And so on.)

This is important because many people look at waiting until age 70, decide that 70 is too far in the future, and therefore default to claiming as early as possible at 62. That’s unfortunate because, even for people for whom claiming at 70 doesn’t make sense, claiming at 62 is still usually a mistake.

For example, if you are an unmarried person, currently age 61 and trying to decide whether or not to claim Social Security ASAP at 62, you don’t want to compare claiming at 62 to claiming at 70. You want to compare claiming at 62 to claiming at 63. When we do that, we can calculate that the breakeven point is age 78. (That is, if you live to age 78, you are better off having claimed at 63 than having claimed at 62.) Using the 2011 actuarial tables from the SSA, we can calculate that for an average 62 year old male, there is a 67% probability of living to age 78. For a 62 year old female, there is a 76% probability. Conclusion: For most unmarried people, it makes sense to wait at least until 63, because there is a much greater than 50% probability of living to the breakeven point.

Then, at age 63, we would want to see if it makes sense to wait until 64. The breakeven point between claiming at 63 and claiming at 64 is age 76. Using the same actuarial tables, we can calculate that for an average 63 year old male, there is a 74% probability of living to age 76. For a 62 year old female, there is an 82% probability. Conclusion: It probably makes sense to wait another year.

And then you would repeat this analysis every year. (In theory, you should actually do the analysis every single month to see if it makes sense to wait one more month. But that would be a heck of a lot of work. In my opinion, it makes sense to reassess annually — or whenever you get new information about your life expectancy.)

For somebody with a full retirement age of 66, the year-by-year breakeven ages would be as follows:

Claiming Ages
Breakeven Age
62 vs. 63 78
63 vs. 64 76
64 vs. 65 78
65 vs. 66 80
66 vs. 67 79.5
67 vs. 68 81.5
68 vs. 69 83.5
69 vs. 70 85.5

And for somebody with a full retirement age of 67, the year-by-year breakeven ages would be as follows:

Claiming Ages
Breakeven Age
62 vs. 63 77
63 vs. 64 79
64 vs. 65 77
65 vs. 66 79
66 vs. 67 81
67 vs. 68 80.5
68 vs. 69 82.5
69 vs. 70 84.5

To be clear, the above discussion is a simplification, meant to illustrate the general concept that the decision should be made year-by-year rather than simply asking “Should I claim at 70 or at 62?” A real-life analysis of your personal situation should ideally include a few other factors:

  • Investment return earned on early-received benefits. In the above discussion, we’re assuming that early-received benefits earn a 0% real return (i.e., they precisely match inflation). Given that the yields on TIPS (i.e., the investment with a risk level most similar to that of Social Security) are currently at or near zero, that’s a pretty reasonable assumption. If real interest rates were higher, the breakeven points would be pushed back somewhat.
  • Tax planning. The specifics vary from person to person, but in most cases tax planning is a point in favor of waiting to claim benefits, because of Social Security’s tax-advantaged nature.
  • Spousal and survivor benefits for married couples. (As we’ve discussed before, for married couples, at least one spouse usually should be using one of the “extreme” strategies of filing at 62 or at 70.)
  • Longevity risk. For anybody who is concerned about running out of money due to a very long retirement, delaying Social Security is often a good decision, even if there is a less than 50% probability that they will live to the breakeven point in question.

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Investing in Healthcare Stocks to Offset Healthcare Risk

A reader writes in, asking:

“What would you think about buying a healthcare mutual fund to reduce the risk of healthcare costs rising as I age? Or in a similar vein, what about buying stock in long term care facilities to reduce the financial risk of needing long-term care?”

In short, I would say that that idea makes no sense.

There is no particular reason to think that the performance of a healthcare mutual fund will be highly correlated to your personal healthcare costs. Nor is there any reason to think that the performance of a collection of long-term care stocks will be highly correlated to your personal need for long-term care.

In other words, neither one can function anything like an actual insurance product that directly reduces your out-of-pocket costs for care.

A line of thinking that I’ve seen from many investors is that healthcare stocks are in for several years of excellent performance because our aging population will cause healthcare companies to experience strong profits over the next couple of decades. And such stocks are therefore a safe holding for retiring baby boomers.

But as we’ve discussed here in the past, the performance of a given stock is determined by how that company’s earnings compare to the market’s expectations for that company’s earnings. So a company (or industry) can have good earnings growth over a given period, yet experience poor stock performance if the earnings growth isn’t as good as the market expected it to be.

For example, Morningstar reports that Vanguard Health Care Fund has a P/E ratio that’s about 25% higher than that of Vanguard Total Stock Market Index Fund. In other words, based on their current earnings, the Health Care fund is significantly more expensive — presumably because the market already expects the stocks owned by the healthcare fund to have higher earnings growth than the average stock in the U.S. stock market. So it’s entirely possible that healthcare stocks experience high earnings growth yet still perform poorly because the earnings growth isn’t as high as expected.

In summary, healthcare stocks — like stocks in general — are risky. And holding them as a way to reduce risk (including the risk that your personal healthcare costs will rise) is nonsensical.

When Does it Make Sense to Do a Roth Conversion?

A reader writes in, asking:

“I have read that a Roth conversion is a good idea if I am currently in a lower tax bracket than the tax bracket I will be in during retirement. But real life appears to be more complicated than that, as we will be in differing tax brackets from one year to another during retirement. And I don’t think our situation is particularly unusual.

I expect to retire about 4-5 years from now, which will cause us to move into a lower tax bracket. My wife anticipates retiring a few years after that, which may cause us to move into an even lower tax bracket, where we will be for a few years, until we start taking Social Security and move back up into a higher tax bracket. At what point(s) would Roth conversions be favorable?”

Firstly, just to be clear on one point, we are more concerned with how your marginal tax rate will change over time, rather than how your tax bracket will change over time. (While they are often the same, they can differ due to things such as the way Social Security is taxed or due to ACA subsidies — or other tax breaks — phasing out over certain income ranges.)

With Roth conversions — and tax planning in general — the goal is often to “smooth out” your marginal tax rate, to the extent possible.

Overall, the planning process typically looks something like this:

  1. Forecast your future income on a year-by-year basis using a simple “dummy” scenario, in which you do no particular tax planning. (For example, no Roth conversions at any point, and each year’s spending in retirement comes proportionately from each type of account — Roth, tax-deferred, and taxable.)
  2. Calculate your marginal tax rate in each year going forward under the dummy strategy.
  3. Look for years in which your marginal tax rate is projected to be at its lowest point.
  4. Attempt to shift income from high-marginal-tax-rate years to low-marginal-tax-rate years (e.g., by spending more from tax-deferred accounts or doing Roth conversions in a given year in order to increase taxable income in that year and reduce it in future years).
  5. Repeat steps 3 and 4 until a) your marginal tax rate is projected to be fairly steady going forward (such that you would not benefit from further shifting income from one year to another) or b) you are out of options for income-shifting.

So, for example, in the case of our reader above, his marginal tax rate will likely be at its lowest point in the years after his wife retires and before they start receiving Social Security. So it would likely be advantageous to increase taxable income in those low-tax-rate years (by spending from tax-deferred accounts and likely doing Roth conversions) in order to reduce taxable income in laters years in which they would otherwise have a higher marginal tax rate.

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."
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