Archives for August 2017

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Should I Stop Contributing to Retirement Accounts if I’m Planning on Early Retirement?

A reader writes in, asking:

“The conventional wisdom of retirement saving is to put as much money as possible into retirement accounts rather than normal brokerage accounts. I’ve done this for years, but I’m considering if I should stop contributing to my 401 and IRA because I am planning on an early retirement. My employer does not offer a match, so I wouldn’t be missing anything there.”

As with any tax-planning question, the answer is, “it depends.” In most cases, however, it makes sense to continue contributing to retirement accounts, even if you’re planning on retiring early.

For people (unlike our reader) for whom a 401(k) match is available, it definitely makes sense to get that match, regardless of planned retirement age.

Accessing Your Money

A concern that many people have if they’re planning to retire prior to age 59.5, is that they will have to pay a 10% penalty to get to their money. But the 10% penalty can typically be avoided with sufficient planning.

For instance, any money that you contributed to a Roth IRA (as opposed to earnings in the account or amounts in the account as a result of Roth conversions) can be taken out of the account at any time, free from tax or penalty.

And if you retire in (or after) the year in which you turn age 55, money in your 401(k) with your most recent employer will be available penalty-free. (For public safety government employees, it’s age 50 rather than 55.)

Then there’s a whole list of other exceptions to the 10% penalty that you might be able to take advantage of. Most importantly, you can take money out of a retirement account penalty-free if you do it as part of a “series of substantially equal periodic payments” that lasts 5 years or until you’ve reached age 59.5, whichever comes later. (This rule is available to anybody, so it can be super helpful as part of an early retirement plan. It is, however, complicated. So it’s important to do your research and, most likely, work with a tax professional.)

Finally, it’s worth noting that if you’re planning to retire very early, it’s likely that you’re going to be saving more per year than you can contribute to retirement accounts anyway. So you’re going to have some savings in taxable accounts even if you continue contributing as much as possible to retirement accounts.

Other Considerations

All of the above deals with whether you would have tax-free/penalty-free access to the money. But that’s only part of the analysis.

Once you have a good idea of whether the penalty will be applicable or not for the money in question, you would want to consider the following factors:

  • What is my current marginal tax rate?* (That is, how much value would you get from having a smaller taxable income this year as a result of contributing to a tax-deferred account?)
  • What will be my marginal tax rate (including 10% penalty, if applicable) when this money comes out of the account?
  • How much value would I get as a result of having the money in a retirement account? (That is, how valuable is the faster rate of growth that will occur as a result of not having to pay tax each year on interest/dividends?**)

*As always, “marginal tax rate” might be something other than just your tax bracket. For instance, your current marginal tax rate could be greater than your tax bracket if making a contribution to a tax-deferred account would allow you to claim the retirement savings contribution credit — or if it reduces your adjusted gross income to a level such that you can claim some other deduction/credit.

**The longer your money is expected to be in the account, the more valuable this faster rate of growth. Also, a key point is that if you’re in the 15% tax bracket or below — and you expect to stay there — qualified dividends and long-term capital gains are already tax-free in a normal taxable account. So having the money in a retirement account won’t provide nearly the same benefit as it would for somebody in a higher tax bracket.

What Change Would I Make to My Portfolio?

A reader writes in, asking:

“If you were to change your portfolio, what would the change be?”

I began using the Vanguard LifeStrategy Growth fund for the entirety of our retirement savings back in 2011, and I have been super happy with the fund. I really appreciate the hands-off nature of an “all-in-one” fund.

Still, if I were to make a change, I know exactly what it would be. I would swap out my bond funds for CDs. Allan Roth has convinced me that active management is worthwhile in fixed-income — via shopping for CD rates. And because that means I would no longer be able to use an all-in-one fund, I would use Vanguard’s Total Stock Market Index Fund and Total International Stock Index Fund for my stock holdings (or possibly Vanguard Total World Stock ETF).

On the fixed-income side, there would be a significant increase in yield and a decrease in risk.

On the stock side, the risk would remain the same, but there would be a slight decrease in expense ratio.

In other words, it’s a strict improvement in terms of risk/return. Risk goes down slightly and expected return goes up slightly.

What isn’t an improvement is that the portfolio would require more ongoing work. I’d be shopping for CD rates occasionally. I’d be doing my own rebalancing. And (unless I want to stick exclusively to CDs available at Vanguard) I’d have to manage accounts across multiple providers. None of those tasks are challenging, but they do take a little time and occupy a bit of “mental space.”

So in short it’s just a question of how much I’m willing to pay (in the form of forgone earnings) for the simplicity of an all-in-one fund. As our portfolio gets bigger, the amount we’re paying for that simplicity each year grows. It’s likely — though not certain — that at some point I’ll decide that the price is sufficiently high that I no longer want to pay it.

How Much Does Simplicity Cost?

On the stock side of the portfolio, the weighted-average expense ratio would decrease by 0.094% (due to switching to Admiral shares rather than the Investor shares held by the LifeStrategy fund). So for every $100,000 that’s invested in stocks via a DIY allocation rather than a LifeStrategy fund, there would be annual savings of $94. Not a big deal, but not nothing either.

Much more significant is the improvement on the bond side of the portfolio. As of this writing, Vanguard Total Bond Market Index Fund has an SEC yield of 2.25%, with an average maturity of 8.3 years and average duration of 6.1 years. And Vanguard Total International Bond Index Fund has a yield of 0.77%, with an average maturity of 9.2 years and average duration of 7.8 years. So, given the US/international breakdown of the bond holdings in a LifeStrategy fund, the current weighted-average yield is 1.81%.

By way of comparison, via Vanguard Brokerage you can currently get a 5-year CD yielding 2.35% or a 7-year CD yielding 2.5%. If you’re willing to look elsewhere (e.g., shop around on bankrate.com or depositaccounts.com) you can often find slightly better yields. And CDs have no default risk (provided you stay under FDIC limits) and in many cases less interest rate risk (because if you buy directly from a bank you can often find some with very low penalties for early redemption).

So for every $100,000 invested in CDs rather than in bonds via a LifeStrategy fund, that’s an increase of $690 in expected interest per year (assuming a 2.5% yield on the CDs) — and a slight reduction in risk.

I don’t know exactly how high the annual cost would have to be before I make the switch. But I think it’s reasonably likely that it will happen at some point.

Do Dividend Stock Funds Belong in Your Portfolio?

A reader writes in, asking:

“What do you think of dividend funds? Do they have a place in a portfolio for a hands-off investor who is nearing retirement?”

The most important question here is what would be removed to make room for the dividend funds?

For the last several years, with interest rates stubbornly staying at low levels, some people have asserted that high-dividend stock funds can be used as a substitute for bond funds. To put it plainly, that idea is nuts.

For instance, the following chart (made via the Morningstar website) shows the performance over the last 10 years of Vanguard Dividend Growth Fund (in blue), Vanguard High Dividend Yield Index Fund (in orange), and Vanguard Total Bond Market Index Fund (in green).

Dividend and Bond Funds

There’s no question that the two dividend funds are much riskier than the bond fund. Dividend stock funds are simply not a suitable substitute for a bond fund. Bonds can play the role of the “mostly safe” part of your portfolio. Dividend stocks cannot.

But using dividend-oriented funds as a part of your stock holdings (i.e., in order to give high-dividend stocks a greater weight in your portfolio than other stocks) is a reasonable position. It’s not a position I plan to take with my own portfolio, but I wouldn’t tell somebody else that it’s a mistake to do it with their portfolio.

Before diving into dividend-stock strategies though, it’s important to be very clear on one point: it’s total return that matters, not income. A dollar of dividends is no better than a dollar of capital appreciation — even for a retiree. (And if we’re talking about holdings in a taxable account, a dollar of dividends is worse than a dollar of capital appreciation, because you have no control over when it will be taxed.)

So, when viewed from a total-return perspective, how have dividend-stock strategies performed relative to “total market” strategies? It depends what period we look at, and it depends what we use as our measure of dividend stock performance.

For instance, a piece of Vanguard research from earlier this year found that from 1997-2016, global high dividend yielding stocks and U.S. dividend growth stocks both earned higher returns with less volatility than a global “total market” collection of stocks (primarily due to dividend stocks not being hit as hard as the market overall during the decline of tech stocks in 1999-2000).

As another example, the following chart compares the performance of Vanguard High Dividend Yield Index Fund (in blue) since its inception in 2006 to the performance of Vanguard Total Stock Market Index Fund (in orange). Over this particular period, it was basically a tie. (The total market fund ends up with a very slightly higher value.) And you can see that the two index funds have tracked each other super closely.

Dividend and Total Market

Or as one final example (in the international category this time), the following chart compares Vanguard Total International Stock Index Fund (in blue) to iShares International Dividend Select ETF (in orange) since the inception of the dividend ETF in 2007. This one is essentially a tie as well. (Again, the “total market” fund ends up very slightly ahead, and the two tracked each other fairly closely over the period.)

International Dividend vs Total Market

Every time I look into this question I come to the same conclusion: if you want to hold dividend stock funds because you see that dividend strategies outperformed total market strategies over some particular period and you think the same thing will occur over your particular investment horizon, go for it. But, as always, be sure to diversify broadly and keep costs low (i.e., don’t bet your financial future on just a few dividend stocks, and don’t pay a fund manager or advisor a pile of money to pick dividend stocks for you).

And finally and most importantly: dividend stocks are not a substitute for bonds.

Are Guaranteed Living Withdrawal Benefit (GLWB) Riders a Good Idea?

A reader writes in, asking:

“What do you think of the ‘Secure Income’ rider product for the Vanguard Variable Annuity? I find the combination of safety and flexibility to be very appealing, yet I have learned from bogleheads that a 1.2% fee is not something to be taken lightly.”

As we discussed earlier this year, in general I think that deferred variable annuities are most useful either as:

  1. A tax planning tool in uncommon circumstances, or
  2. A tool to get out of an even less desirable insurance product via a 1035 exchange.

What is a Guaranteed Living Withdrawal Benefit (GLWB)?

For those who are unfamiliar with the product, the “Secure Income” rider for the Vanguard variable annuity is a “guaranteed living withdrawal benefit” (GLWB) rider. With a GLWB rider, you agree to pay an extra annual expense, and in exchange you are guaranteed to be able to withdraw a certain amount per year from the account for the rest of your life.

In other words, a GLWB is kinda-sorta like having the benefit of a regular lifetime annuity, without having to annuitize the account (i.e., without having to turn over the assets). But you pay a significant annual cost for that benefit.

In the case of Vanguard’s GLWB, the annual cost is 1.2% of the “Total Withdrawal Base.” And the amount you are guaranteed to be able to withdraw per year is also a percentage of the Total Withdrawal Base (e.g., 4% for an individual who starts taking withdrawals between ages 59 and 64).

The Total Withdrawal Base starts out as the account value when you activate the GLWB rider. And each year it is recalculated as the greater of either 1) the existing Total Withdrawal Base or 2) the current account value. In other words, the Total Withdrawal Base will not go down as a result of poor investment performance — which means that your annual guaranteed withdrawal will also not decrease as a result of poor investment performance.

Are GLWB Riders a Good Idea?

Relative to simply owning the same variable annuity (without purchasing a rider) and taking the same size distribution each year as would be provided by the rider, the rider’s overall effect is to:

  1. Accelerate the likelihood and rate of account depletion (because of the additional cost), but
  2. Guarantee that income will still continue to be paid in the event that the account is depleted (because the TWB is locked in at a higher value).

Increasing the annual withdrawal rate from a portfolio by 1.2% (as would be the case when the Vanguard GLWB is activated) significantly increases the rate at which the portfolio will be depleted. In addition, if/when the account value does fall at some point, because the TWB is “locked in” (i.e., it doesn’t fall), the GLWB fee (1.2% of the TWB) will actually be more than 1.2% of the account value, which will cause the account to deplete even faster.

In short, the GLWB rider has the effect of guaranteeing some level of income, at the cost of reducing the amount that is ultimately left to heirs. Of course, that in itself isn’t necessary a bad tradeoff. Plain-old lifetime SPIAs involve the same tradeoff, and they’re broadly considered to be a useful tool in financial planning.

So the question is primarily: is the GLWB a good deal? That is, is the safety added by the guarantee worth the cost? Or would there be a more cost-effective way to get the same level of safety?

For instance, for a 62 year old male, the Vanguard GLWB rider guarantees a 4% income stream. So a $100,000 account would produce $4,000 of annual income (to start with — it could go up if the portfolio performs well soon after activating the rider).

Conversely, based on a quote from immediateannuities.com, $64,620 would be enough for a 62 year old male to purchase a lifetime SPIA that guarantees $4,000 of annual income. And that would leave $35,380 to be invested as desired to leave to heirs, provide for spending increases later, or some combination thereof.

Which is likely to work out better? That depends on investment performance as well as how long the person lives. In short, it’s not an easy question to answer.

And this, to me, is one of the reasons why I think most people (not necessarily everybody) should stay away from riders (and to a lesser extent, variable annuities in general) — it’s quite hard to analyze whether a specific guarantee is worth the cost. Earlier this year I wrote the following about variable annuity riders in general, and I think it’s applicable here:

The insurance company has a team of actuaries, financial analysts, and attorneys working together to create the product in such a way that they believe it will be profitable for them. The consumer, on the other hand, doesn’t have nearly the same level of information or analytical ability.

And when a financial services company has a significant information advantage over the client (that is, when the client can’t really tell whether they’re getting a very good deal, a very bad deal, or somewhere in the middle), it is not usually the financial services company that gets the short end of the stick.

As far as analyses that have already been done by smart, qualified people, here are a few that may be of interest:

One thing we can say with a high degree of confidence is that if our hypothetical 62 year old male has a desire for safe lifetime income, one thing he should definitely be doing before purchasing either type of annuity is delaying Social Security. With interest rates as low as they are right now, the deal offered by delaying Social Security is meaningfully better than the deal any insurance company would offer on an annuity.

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Direct Costs vs. Indirect Costs

The following is an adapted excerpt from my book Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less.

“Direct costs” are those that can be directly traced to a specific cost object. (As a reminder, a cost object is typically a product.) “Indirect costs” are those that cannot be directly traced to a single cost object. Because they cannot be traced directly to a specific cost object, indirect costs must instead be allocated to all of the products they are used to produce.

EXAMPLE: For a manufacturer of rock climbing gear, the cost of nylon for climbing ropes can be directly traced — it’s obviously a cost of producing the ropes. It is a direct cost. Similarly, the aluminum used for carabiners is a direct cost because it can be directly traced as a cost of producing the carabiners.

But what about the electricity that’s used to power the company’s manufacturing facility? The facility produces several different products, including climbing ropes, carabiners, and climbing harnesses. As a result, the cost of electricity cannot be directly traced to a single product. It is an indirect cost. The firm will have to use some sort of system to allocate the cost of electricity among the various products that the electricity is used to produce.

To recap: Direct costs get directly traced. Indirect costs have to be allocated.

Direct Materials and Direct Labor

Direct manufacturing costs are further divided into two categories: “direct materials” and “direct labor.” Direct materials include all materials that eventually become part of the finished product and that can be directly traced to a given product in an economical manner (e.g., the nylon used in a climbing rope). Direct labor includes the compensation for any labor that can be directly traced to a cost object. Of note: This includes not only wages/salary, but also other types of compensation such as health insurance, retirement benefits, and so on.

Indirect Manufacturing Costs (Manufacturing Overhead)

Indirect manufacturing costs — also referred to as manufacturing overhead costs — includes three types of costs: indirect materials, indirect labor, and other manufacturing overhead costs.

“Indirect materials” include all materials used in manufacturing which cannot be traced to specific cost objects in an economically feasible manner. Common examples of indirect materials would be cleaning supplies and lubricants for machinery. Screws, nuts, and bolts would often be included in indirect materials as well, because while it would be possible to directly trace them to specific products, it would not be cost-effective to do so. (That is, because screws, nuts, and bolts are so inexpensive, it doesn’t often make sense to spend much time/money tracking them.)

“Indirect labor” includes costs for labor that is used in manufacturing but which cannot be directly traced to a specific cost object. Supervisors for a plant (who oversee production for all of the company’s products) would be categorized as indirect labor. The cleaning crew that cleans the plant would also be indirect labor, as would the maintenance crew that handles repairs for the plant.

“Other manufacturing overhead costs” — also referred to as “other indirect manufacturing costs” — is just what it sounds like: any other costs of manufacturing that cannot be traced to a specific cost object. For example, if a manufacturing facility is used to produce multiple products, most costs applying to the entire facility (e.g., rent, insurance, utilities) would be in the other manufacturing overhead category.

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Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.

What is a Business’s Contribution Margin?

The following is an adapted excerpt from my book Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less.

Revenue and total variable costs are the two things that change as a business’s sales/production volume changes. The difference between a business’s revenues and total variable costs is referred to as its “contribution margin.” That is:

Contribution margin = Sales – Variable costs

EXAMPLE: Joe has a food truck from which he sells tacos. In the month of July, his fixed costs were $900, his total variable costs were $4,000, and his revenue was $10,000. Joe’s contribution margin is $6,000 (i.e., his revenue minus his variable costs).

Contribution margin is particularly helpful when looked at on a per-unit basis. The per-unit contribution margin for a product is the difference between the product’s selling price and the per-unit variable costs necessary to produce the product.

Contribution margin per unit = Selling price – Variable cost per unit

In other words, the per-unit contribution margin for a product is the amount that each unit of sales contributes toward the company’s profits.

EXAMPLE: Joe sells his tacos for $5 each. His variable cost per taco is $2. His contribution margin per taco is $3 (i.e., $5 selling price minus $2 variable costs). Each taco sold contributes $3 toward covering his fixed costs. And after his fixed costs are covered for the period, each taco sold contributes $3 of profits.

Breakeven Analysis

One common way to use contribution margin per unit is to find a business’s “breakeven point”—the number of units the business would have to sell in order to precisely break even in a given period.

EXAMPLE (continued): What is Joe’s breakeven point? That is, how many tacos does he have to make and sell in order to break even in a given month?

Again, we know that Joe’s fixed costs are $900 per month. And we know that his contribution margin is $3 per taco. (That is, each taco sold contributes $3 toward covering his fixed costs.) We can calculate his breakeven point by dividing his fixed costs by his contribution margin per unit.

Breakeven point (in units) = Total fixed costs
Contribution margin per unit
Breakeven point (in units) = $900
$3 contribution margin per taco

Breakeven point = 300 tacos

Reaching a Target Operating Income

We can also calculate how many units of a product must be sold in order to achieve a given level of operating income (i.e., profit before interest and income tax expenses).

As we discussed previously, a company’s contribution margin is equal its revenue minus variable costs. Another way to state that would be to say that a company’s contribution margin is essentially its profit before considering fixed costs.

For example, if Joe wants to earn a profit of $5,100 in a given month with his taco truck business, and his fixed costs are $900 per month, how much contribution margin would be required? That is, how much contribution margin would be necessary to cover Joe’s fixed costs and still provide the desired level of profit?

Required contribution margin = Target operating income + Fixed costs

Required contribution margin = $5,100 + $900

Required contribution margin = $6,000

If Joe’s contribution margin per taco is $3, how many tacos will he have to sell in order to reach his desired level of operating income for the period?

Required units sold = Required contribution margin
Contribution margin per unit
Required units sold = $6,000
$3 contribution margin per taco

Required units sold = 2,000 tacos

Contribution Margin Income Statement

In managerial accounting, businesses will often prepare an income statement (such as the one below) formatted in a way that highlights contribution margin.

Contribution Margin Income Statement
  Total Per Unit
Sales (2,000 units) $10,000 $5
Variable costs ($4,000) ($2)
Contribution margin $6,000 $3
Fixed costs ($900)
Operating income $5,100

With a traditional income statement, you begin with revenue, then subtract cost of goods sold (which includes both variable and fixed production costs) to arrive at gross profit. Then you subtract selling and administrative expenses (both fixed and variable) to arrive at operating income.

In contrast, with a contribution margin income statement, all variable costs (i.e., variable production costs as well as variable selling and administrative costs) are grouped together and subtracted from revenue to arrive at contribution margin. Then, all fixed costs (both production-related ones as well as selling and administrative ones) are grouped together and subtracted from contribution margin to arrive at operating income.

Simple Summary

  • Contribution margin refers to a business’s revenue minus variable costs.
  • Contribution margin per unit is equal to the per unit selling price minus the per unit variable costs. In other words, it’s the amount that each unit of sales contributes toward the business’s profits.
  • When you know the contribution margin per unit, you can find a business’s “breakeven point” — the number of units the business would have to sell in order to precisely break even in a given period.

To Learn More, Check Out the Book:

Cost Accounting Made Simple: Cost Accounting Explained in 100 Pages or Less

Topics Covered in the Book:
  • Cost accounting terminology (fixed costs vs. variable costs, product costs vs. period costs, direct costs vs. indirect costs, etc.)
  • Cost-volume-profit analysis
  • Job order costing, process costing, activity-based costing
  • Budgeting and variance analysis
  • Click here to see the full list.
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