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).

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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 an older edition of my book Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less. (Newer edition here.)

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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