Archives for January 2020

Investing Blog Roundup: Is Vanguard’s “At Cost” Model Even Good Enough?

Vanguard’s claim to fame is that it runs everything “at cost” because of its ownership structure (i.e., no external shareholders demanding a profit). And the benefit to Vanguard clients has been tremendous over the years.

In a recent article for Financial Planning, Allan Roth pointed out that Schwab is now basically able to run their entire asset management business below cost — offering what many would see as superior service, while charging fees as low or lower than Vanguard’s.

The key point is that Schwab simply has a different business model (most especially, a key other revenue source), so they are able to use their asset management business as a loss leader, whereas Vanguard must break even on theirs.

Does Schwab’s Growth Threaten Vanguard’s Domination? from Allan Roth

Can I Change the Beneficiary of My 529 Plan/Account?

A reader writes in, asking:

“Can I create a 529 account, contribute to it with my daughter named as the beneficiary, and then change the beneficiary to another family member if we end up wanting to help fund somebody else’s education?”

The short answer is: it depends on who exactly the family member is, but probably yes.

Naturally, Code section 529 is where we’d find information about 529 plans.

There, we find that there are no income tax consequences to changing the beneficiary of a 529 account, provided that you change the beneficiary to somebody who is a “member of the family” of the existing beneficiary. Members of the family include:

A child or a descendant of a child (i.e., a grandchild);
A brother, sister, stepbrother, or stepsister;
The father or mother, or an ancestor of either (i.e, grandparent);
A stepfather or stepmother;
A niece or nephew;
An aunt or uncle;
A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law;
An individual who, for the taxable year of the beneficiary, has the same principal place of abode as the beneficiary and is a member of the beneficiary’s household;
The spouse of any of the above people;
The spouse of the existing beneficiary; or
A first cousin of the existing beneficiary.

Reminder: When going through this list, remember that these relationships are with regard to the existing beneficiary — not with regard to you or to any other person(s) contributing to the account.

If you change the beneficiary to somebody who is not in one of the above categories, the distribution will be taxable as income and will be subject to a 10% penalty.

Finally, section 529 also notes that the gift tax and generation-skipping transfer tax shall apply unless the new beneficiary is:

In the same generation as (or a higher generation than) the existing beneficiary, and
A member of the family of the existing beneficiary (as described above).

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

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The difference between deductions and credits,
Itemized deductions vs. the standard deduction,
Several money-saving deductions and credits and how to make sure you qualify for them,
Click here to see the full list.

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January 20, 2020

Investing Blog Roundup: State-by-State Economic Insecurity Among Americans Age 65+

This week I came across a recent study that looks at economic insecurity among older Americans. The paper discusses the typical amount of income necessary in each state for a person age 65+ (or a couple age 65+) to maintain independence and meet daily living costs while staying in their own homes (providing separate figures for renters, homeowners with a mortgage, and homeowners without a mortgage). Then it shows what percentage of people in each state in that age range are below that necessary income figure.

What struck me most was not so much the differences between states, but rather the differences between single people and couples.

Economic Insecurity and Older Americans Insecurity in the States 2019 (pdf) from Jan Mutchler, Yang Li, and Nidya Velasco Roldán

Why Longer-Term Bonds Have Greater Price Volatility (Interest Rate Risk)

A reader writes in, asking:

“I am aware that bonds and bond funds with longer duration have greater price changes in response to interest rate moves than shorter-term bonds do. And given that, I understand that longer-term bonds generally have higher yields because of that higher risk. That makes perfect sense.

What I have never been able to wrap my head around is why do the prices of longer duration bonds fluctuate more severely?”

A bond’s market price is really just the result of a net present value calculation. That is, the price of a bond at any given time is the sum of the present values of each of the cash flows from the bond (i.e., the present value of each interest payment plus the present value of the payment upon maturity).

(See this article if you haven’t encountered the concept of present value before. It’s worth a read, as it’s one of the most fundamental concepts in finance.)

As a reminder, the present value of a given cash flow is calculated as follows:

PV = FV / (1 + r)^n

where:

PV = present value
FV = future value (i.e., the dollar amount of the cash flow in question)
r = annual discount rate
n = number of years before the cash flow is received

The greater the number of years, the greater the impact of the discount rate. Compare the two following examples.

Example 1: Given a discount rate of 2%, the present value of a $1,000 cash flow to be received one year from now is $980. If we raise the discount rate to 3%, the present value falls to $971, a change of $9.

Example 2: Given a discount rate of 2%, the present value of a $1,000 cash flow to be received five years from now is $906. If we raise the discount rate to 3%, the present value falls to $863, a change of $43.

Point being, a 1% increase in the discount rate had a much larger effect on the cash flow that was further in the future.

When we’re calculating the present value of a bond, the discount rate is the return that investors could expect to earn from other bonds with similar risk (i.e., other bonds with the same credit rating and same duration).

So when interest rates change, the discount rate changes. And the further in the future the cash flow is to be received, the greater the change in present value (i.e., market price).

So, the longer the duration of a bond (i.e., the further in the future its cash flows will be received, on average), the greater the change in present value (i.e., market price) when interest rates change.

January 6, 2020

Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

The following is an excerpt from my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less.

Most annuities are a raw deal for investors. They carry needlessly high expenses and surrender charges, and their contracts are so complex that very few investors can properly assess whether the annuity is a good investment.

That said, one specific type of annuity can be a particularly useful tool for retirement planning: the single premium immediate annuity (SPIA).

What’s a SPIA?

A single premium immediate annuity is a contract with an insurance company whereby:

You pay them a sum of money up front (known as a premium), and
They promise to pay you a certain amount of money periodically (monthly, for instance) for the rest of your life.

A single premium immediate annuity can be a fixed annuity or a variable annuity. With a single premium immediate fixed annuity, the payout is a fixed amount each period. With a single premium immediate variable annuity, the payout is linked to the performance of a mutual fund. For the most part, I’d suggest steering clear of variable annuities. They tend to be complex and expensive. And because they each offer different bells and whistles, it’s difficult to make comparisons between annuity providers to see which one offers the best deal.

In contrast, fixed SPIAs are helpful tools for two reasons:

They make retirement planning easier, and
They allow for a higher withdrawal rate than you can safely take from a portfolio of stocks, bonds, and mutual funds over the course of a potentially-lengthy retirement.

Retirement Planning with SPIAs

Fixed SPIAs make retirement planning easier in exactly the same way that traditional pensions do: they’re predictable. With such an annuity, you know that you will receive a given amount of income every year, for the rest of your life — no matter how long you might live. With a traditional stock and bond portfolio, retirement planning is more of a guessing game.

SPIAs and Withdrawal Rates

Fixed SPIAs are also helpful because they allow you to retire with less money than you would need with a typical stock/bond portfolio. For example, even with the low interest rates that prevail as of this writing, according to immediateannuities.com (a website that provides annuity quotes from various insurance companies), a 65-year-old male could purchase an annuity paying 5.88% annually.

If that investor were to take a withdrawal rate of 5.88% from a typical stock/bond portfolio (and continue spending the same dollar amount each year going forward), there’s a meaningful chance that he’d run out of money during his lifetime—especially given the current environment of low interest rates and high stock valuations. That risk disappears with an annuity.

How is that possible? In short, it’s possible because the annuitant gives up the right to keep the money once he dies. If you buy a SPIA and die the next day, the money is gone.* Your heirs don’t get to keep it — the insurance company does. And the insurance company uses (most of) that money to fund the payouts on SPIAs purchased by people who are still living.

In essence, SPIA purchasers who die before reaching their life expectancy end up funding the retirement of SPIA purchasers who live past their life expectancy.

But I Want to Leave Something to My Heirs!

For many people, it’s a deal-breaker to learn that none of the money used to purchase an annuity will go to their heirs.

The relevant counterpoint here is that, depending on how your desired level of spending compares to the size of your portfolio, choosing not to devote any portion of your portfolio to an annuity could backfire. That is, there’s a possibility that, rather than resulting in a larger inheritance for your kids, the decision results in you running out of money while you’re still alive, thereby causing you to become a financial burden on your kids.

Inflation Risk

Another important downside of single premium immediate annuities is that they are exposed to inflation risk. That is, the amount of income that the annuity pays each year is fixed, thereby leaving you with a purchasing power that will be eroded over time via inflation.

It is possible to purchase an annuity with a cost-of-living adjustment (COLA) each year. But that naturally requires paying a higher initial premium. Also, the COLA is a fixed percentage (e.g., the income increases by 2% annually), so you are still exposed to the risk of high inflation eating away at your purchasing power.

Not too long ago, it was possible to purchase a SPIA that had a COLA that was linked to the consumer price index (i.e., the actual rate of inflation), thereby eliminating inflation risk. But in 2019, the last insurance company offering such products decided to stop selling them. Will they be available again in the future? It’s possible, but I wouldn’t count on it.

It’s worth noting that for some people the lack of inflation protection may not be a problem at all. Some people explicitly desire to spend more per year in early retirement than in late retirement. A fixed nominal dollar amount may actually be a good fit for people with such a preference (because it has the effect of front-loading spending, when we measure spending in terms of actual purchasing power).

Annuity Income: Is It Safe?

Because the income from an annuity is backed by an insurance company, financial advisors and financial literature usually refer to it as “guaranteed.” But that doesn’t mean it’s a 100% sure-thing. Just like any company, insurance companies can go belly-up. It’s not common, but it’s certainly not impossible. However, if you’re careful, the possibility of your annuity provider going out of business doesn’t have to keep you up at night.

Check Your Insurance Company’s Financial Strength

Before placing a meaningful portion of your retirement savings in the hands of an insurance company, it’s important to check that company’s financial strength. I’d suggest checking with multiple ratings agencies, such as Standard and Poor’s, Moody’s, or A.M. Best. (Note that each of these companies uses a different ratings scale, so it’s important to look at what each of the ratings actually means.)

State Guaranty Associations

Even if the issuer of your annuity does go bankrupt, you aren’t necessarily in trouble. Each state has a guaranty association (funded by the insurance companies themselves) that will step in if your insurance company goes insolvent.

It’s important to note, however, that the state guaranty associations only provide coverage up to a certain limit. And that limit varies from state to state. Equally important: the rules regarding the coverage vary from state to state.

For example, the guaranty association in Connecticut provides coverage of up to $500,000 per contract owner, per insurance company insolvency. But they only provide coverage to investors who are residents of Connecticut at the time the insurance company becomes insolvent. So if you have an annuity currently worth $500,000, and you move to Arkansas (where the coverage is capped at $300,000), you’re putting your money at risk.

In contrast, the guaranty association in New York offers $500,000 of coverage, and they cover you if you are a NY state resident either when the insurance company goes insolvent or when the annuity was issued. So moving to another state with a lower coverage limit isn’t a problem if you bought your annuity in New York.

Minimizing Your Risk

In short, annuities can be a useful tool for maximizing the amount you can safely spend per year. But to maximize the likelihood that you’ll receive the promised payout, it’s important to take the following steps:

Check the financial strength of the insurance company before purchasing an annuity.
Know the limit for guaranty association coverage in your state as well as the rules accompanying such coverage.
Consider diversifying between insurance companies. For instance, if your state’s guaranty association only provides coverage up to $250,000 and you want to annuitize $400,000 of your portfolio, consider buying a $200,000 annuity from each of two different insurance companies.
Before moving from one state to another, be sure to check the guaranty association coverage in your new state to make sure you’re not putting your standard of living at risk.

*There are some exceptions. For example, you can buy a SPIA that promises to pay income for the longer of your lifetime or a given number of years. But purchasing such an add-on reduces the payout, thereby reducing the ability of the SPIA to do what it does so well—provide a relatively high payout with very little risk.

Simple Summary

If you desire a larger “floor” of safe income than you will receive from Social Security (and pension, if applicable), a single premium immediate fixed annuity may be a good idea.
Such annuities allow for a higher level of spending than would be safely sustainable from a typical portfolio of other investments.
In exchange for this safety, you give up control of the money as well as the possibility of leaving the money to your heirs.
Another drawback of single premium immediate annuities is that they leave you exposed to the risk that inflation will significantly erode your purchasing power over time.
Before buying an annuity, check the financial strength of the insurance company and make sure you’re familiar with the rules and coverage limits for your state’s guaranty association.

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Topics Covered in the Book:

How to calculate how much you’ll need saved before you can retire,
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How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
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January 1, 2020

When Should I Take Social Security Benefits? (Single Investor)

The following is an excerpt from my book Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less.

Even if you are married, the place to start when trying to figure out when to claim Social Security is with a solid understanding of the (less complicated) analysis for unmarried retirees.

And before we go any further, let’s make sure we’re on the same page about an important point: the decision of when to retire is separate from the decision of when to claim Social Security benefits. For example, depending on circumstances, you might find that it makes sense to retire at a given age, yet hold off on claiming Social Security until a later date — maybe even several years later.

The earlier you claim Social Security, the less you’ll receive per month. For example, the following table shows how retirement benefits are affected by the age at which you first claim them:

Age when you claim retirement benefits	Amount of retirement benefit
5 years before FRA	70% of PIA
4 years before FRA	75% of PIA
3 years before FRA	80% of PIA
2 years before FRA	86.67% of PIA
1 year before FRA	93.33% of PIA
at FRA	100% of PIA
1 year after FRA	108% of PIA
2 years after FRA	116% of PIA
3 years after FRA	124% of PIA
4 years after FRA	132% of PIA

Background: your “primary insurance amount” (PIA) is the amount you would receive per month if you claimed retirement benefits at your “full retirement age” (FRA).

In other words, by waiting until age 70 rather than claiming as early as possible at age 62, you can increase your monthly benefit amount by roughly three-quarters. Of course, by waiting, you decrease the number of months in which you’ll be receiving a Social Security check.

So how can you tell if the trade-off is worth it? One way to compare two possible ages for claiming benefits is to compute the age to which you would have to live for one strategy to become superior to the other strategy. Another way to analyze the decision is to compare the payout you get from delaying Social Security to the level of income you can safely get from other retirement income sources.

Computing the Breakeven Point

EXAMPLE: Alex and Bob are both retired and unmarried. Both are age 62, both have a full retirement age of 67, and both have exactly the same earnings history. In fact, the only difference between the two is that Alex claims his retirement benefit at age 62, while Bob waits all the way until 70. Even though Alex claims benefits at age 62, he doesn’t need to spend the money right now, so he keeps it in his savings account, where it earns a return that precisely matches inflation.

By age 70, because he has been receiving benefits for eight years, Alex is far better off than Bob. However, starting at age 70, Bob starts to catch up (because he’s receiving a monthly benefit equal to 124% of his primary insurance amount, as compared to Alex who is receiving a monthly benefit equal to 70% of his primary insurance amount).

In the end, Bob’s cumulative benefit surpasses Alex’s cumulative benefit at age 80 and 5 months. From that point onward, Bob’s lead over Alex continues to grow.

The takeaway: for an unmarried retiree, from a breakeven perspective, if you live to roughly age 80.5, you will have been better off claiming benefits at age 70 instead of claiming as early as possible at age 62.

According to the Social Security Administration, the average total life expectancy for a 62-year-old female is 85.1. For a male, it’s 82.3. In other words, from a breakeven perspective, most unmarried retirees will be best served by waiting to take their retirement benefit.

Comparing Social Security to Other Income Options

When you delay Social Security, you give up a certain amount of money right now (i.e., this month’s or this year’s benefits) in exchange for a stream of payments that will increase with inflation for the rest of your life.

Take, for example, somebody with a full retirement age of 67. If her benefit at full retirement age would be $1,000 per month, her benefit at age 62 would be $700 per month, and at age 63 it would be $750 per month.

Therefore, waiting from age 62 to age 63 is the equivalent of paying $8,400 (that is, $700 forgone per month, for 12 months) in exchange for a source of income that pays $600 per year (that is, a $50 increase in monthly retirement benefit, times 12 months per year), adjusted for inflation, for the rest of her life.

Dividing $600 by $8,400 shows us that delaying Social Security retirement benefits from age 62 to 63 provides a 7.14% payout. Let’s see how that compares to other sources of retirement income.

A single premium immediate lifetime annuity is essentially a pension that you can purchase from an insurance company. With such an annuity, you pay the insurance company an initial lump-sum (the premium for the policy), and they promise to pay you a certain amount of income for the rest of your life. In other words, such annuities are a source of income similar to Social Security.

As of this writing, according to the website immediateannuities.com (which provides annuity quotes from multiple insurance companies), the highest payout available to a 63-year-old female on such an annuity is 5.38%. For a male, the highest available payout would be 5.62%. As you can see, the 7.14% payout that comes from delaying Social Security from 62 to 63 is a higher payout than you can get from annuities of this nature. An even more important difference is that the income from Social Security gets adjusted upward over time to keep up with inflation, whereas the income from these annuities would be fixed.

Alternatively, we can compare the payout from delaying Social Security to the income that you can safely draw from a typical portfolio of stocks and bonds. Several studies have shown that, historically in the U.S., retirees trying to fund a 30-year retirement run a significant risk of running out of money when they use inflation-adjusted withdrawal rates greater than 4%. And it’s worth noting that even a 4% withdrawal rate isn’t a sure bet going forward, given that the studies show 4% to be mostly safe in the past, which is a far cry from completely safe in the future.

In other words, for each dollar of Social Security you give up now (by delaying benefits), you can expect to receive a greater level of income in the future than you could safely take from a dollar invested in a typical stock/bond portfolio.

A similar analysis can be performed for each year up to age 70, and the conclusion is the same: delaying Social Security benefits can be an excellent way to increase the amount of income you can safely take from your portfolio.

EXAMPLE: Daniel is retired at 62 years old. His full retirement age is 67. He has $50,000 of annual expenses and a $600,000 portfolio. He is trying to decide between claiming benefits as early as possible at age 62 or spending down his portfolio while he holds off on claiming benefits until age 70.

Daniel’s primary insurance amount (the amount he’d receive per month if he claimed his retirement benefit at full retirement age) is $2,500, which means he would receive:

$1,750 per month ($21,000 per year) if he claimed benefits at age 62, or
$3,100 per month ($37,200 per year) if he claimed benefits at age 70.

If Daniel claims his retirement benefit at age 62, he’ll have to satisfy $29,000 of expenses every year from his portfolio (because Social Security will only be satisfying $21,000 out of $50,000). That is, he’ll be using a 4.83% withdrawal rate ($29,000 divided by his $600,000 portfolio) starting at age 62. That’s a higher withdrawal rate than most experts would recommend.

Alternatively, if Daniel delays Social Security until 70, he’ll have to satisfy annual expenses of $12,800 (i.e., $50,000, minus $37,200 in Social Security benefits), plus an additional $37,200 for each of the eight years until he claims Social Security.

If Daniel allocates $297,600 (that is, $37,200 x 8) of his $600,000 portfolio to cash or something else very low-risk (in order to satisfy the additional expenses for those eight years), that leaves him with a typical stock/bond portfolio of $302,400. With a portfolio of $302,400 Daniel can satisfy his remaining $12,800 of annual expenses using a withdrawal rate of just 4.23%.

In effect, Daniel is spending down a portion of his portfolio in order to purchase additional Social Security benefits in the amount of $16,200 per year, starting at age 70. By doing so, he’s reduced the withdrawal rate that he’ll need to use from his portfolio for the remainder of his life, thereby reducing the probability that he’ll run out of money. In addition, if Daniel’s portfolio performs very poorly and he does run out of money, he’ll be much better off in the wait-until-70 scenario than in the claim-at-62 scenario, because he’ll be left with $37,200 of Social Security per year rather than $21,000.

Reasons Not to Delay Social Security

Of course, there are circumstances in which it would not make sense for an unmarried person to delay taking Social Security.

First and most obviously, if your finances are such that you absolutely need the income right now, then you have little choice in the matter.

Second, if you have reason to think that your life expectancy is well below average, it may be advantageous to claim benefits early. For example, if you have a medical condition such that you don’t expect to make it past age 64, it would obviously not make a great deal of sense to choose to wait until age 70 to claim benefits.

Third, the higher market interest rates are, the less attractive it is to delay Social Security. For example, if inflation-adjusted interest rates (such as those on inflation-protected Treasury bonds known as TIPS) were 2-3% higher than they are as of this writing, the payout from inflation-adjusted lifetime annuities might be higher than the payout from delaying Social Security.

Simple Summary

For unmarried retirees, from a breakeven perspective, you’ll be best served by waiting until age 70 to claim benefits if you expect to live to age 80 and 5 months. (And, for reference, the average total life expectancy for a 62-year-old female is 85.1. For a male, it’s 82.3.)
For unmarried retirees, on a dollar-for-dollar basis, the lifetime income you gain from delaying Social Security is generally greater than the level of income you can safely get from other sources. As a result, delaying Social Security can be a great way to increase the amount you can safely spend per year. (Or, said differently, it can be a great way to reduce the likelihood that you will outlive your money.)
The shorter your life expectancy and the greater the available yield on inflation-protected bonds, the less desirable it is to delay claiming Social Security benefits.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less

See it on Amazon.

Topics Covered in the Book:

How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
How to decide the best age to claim your benefit,
How Social Security benefits are taxed and how that affects tax planning,
Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

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January 1, 2020

Archives for January 2020

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Investing Blog Roundup: Is Vanguard’s “At Cost” Model Even Good Enough?

Other Recommended Reading

Can I Change the Beneficiary of My 529 Plan/Account?

For More Information, See My Related Book:

Investing Blog Roundup: State-by-State Economic Insecurity Among Americans Age 65+

Other Recommended Reading

Why Longer-Term Bonds Have Greater Price Volatility (Interest Rate Risk)

Single Premium Immediate Annuity: Why They’re Useful and When to Buy Them

What’s a SPIA?

Retirement Planning with SPIAs

SPIAs and Withdrawal Rates

But I Want to Leave Something to My Heirs!

Inflation Risk

Annuity Income: Is It Safe?

Check Your Insurance Company’s Financial Strength

State Guaranty Associations

Minimizing Your Risk

Simple Summary

Retiring Soon? Pick Up a Copy of My Book:

Welcome

Recommended Reading

My Latest Book