Archives for September 2020

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6 Fixed-Income Options for a Low-Yield Environment

A reader writes in, asking:

“My wife and I are retired. I have approximately 50% of our savings in Vanguard’s Total Bond Market (TBM) fund. The remaining half is a mix of stock funds as well as a few individual stock holdings.

I am worried how that TBM fund will do going forward, especially over what we hope will be a long retirement.

The Federal Reserve says they’ll keep rates low until at least 2023 unless inflation gets above 2%. But 2% annual inflation still adds up over a few decades. And with US government debt exceeding 20 trillion dollars, inflation over 2% can’t be ruled out. What’s the solution here? Low yields abound, inflation risk still a problem, stocks as risky as ever. Is it time to try something other than TBM for fixed-income? Is it time to increase the equity percentage, even though we are conservative investors?”

There are several reasonable options here. And we’ll discuss them.

But the reality is that (with the exception of option #5, in some cases), none of the options are great. In a low-yield environment, there’s no way to get anything other than low expected returns without taking on significant risk. You basically have to accept that fact and conduct your personal financial planning accordingly. In most cases the best response to low expected returns is to change your expectations rather than change your portfolio.

Trying to find ways around this risk/return relationship is how you end up buying complicated/expensive insurance products you don’t understand or buying esoteric investments with risks you don’t understand. (That is, in a low-yield environment, if an investment appears to be offering you a decent expected return and low risks without any other significant downside, you are misunderstanding some aspect of the product in question. Either the expected return is not what you think it is, or the risks are not what you think they are.)

Option #1: Shop for CD Rates

As long as you stay under the FDIC coverage limit, CDs have no more credit risk than Treasury bonds, and they can provide higher yields, if you’re willing to shop around. For instance, as of this writing, 5-year Treasury bonds are yielding 0.26%, while you can find plenty of 5-year CDs with yields of 1.3%.

The primary downside in my opinion is that it’s somewhat of a hassle — not so much the shopping, but moving money from one financial institution to another. And, when each CD matures, if you’re not willing to shop around again and move the money if necessary (i.e., you simply roll the maturing CD into a new CD at the same bank), you’re going to be missing out on potential yield.

Option #2: Take on More Credit Risk

Another option is to take on more credit risk with the fixed-income part of your portfolio, for instance by switching from a “total bond” fund to an investment-grade corporate bond fund. As an example, as of this writing, Vanguard Intermediate-Term Investment-Grade Fund has a yield of 1.51%, as compared to a 1.18% yield from Vanguard Total Bond Market Index Fund.

But there’s no reason to think that this is a “free lunch.” Yes, it means higher expected returns, but with correspondingly higher risk — not necessarily very different from simply shifting your overall allocation slightly toward stocks.

Option #3: TIPS

Treasury Inflation-Protected Securities (TIPS) offer a given after-inflation yield, as compared to most bonds which provide a given nominal (before-inflation) yield. If, like the reader above, you are concerned that an unexpected high level of inflation will consume most of your purchasing power over time, TIPS alleviate that risk.

Today though, TIPS yields are negative (e.g., -0.55% for 20-year TIPS). In other words, if you buy TIPS right now and hold to maturity, your purchasing power won’t keep up with inflation. But at least it won’t lag it by very much per year. (Point being: if inflation turns out to be very high, lagging inflation by just a little bit per year is actually a relatively decent outcome.)

Option #4: SPIAs

For a household concerned about outliving their money in retirement, a single premium immediate annuity (SPIA) is worth considering. As we’ve discussed elsewhere, it’s basically just a pension you purchase from an insurance company.

And because of the risk-pooling aspect of annuitization (i.e., the fact that the income ends when the annuitant dies, and therefore annuitants who live beyond their life expectancy essentially get to spend the money of annuitants who did not live to their life expectancy), they allow you to spend more per year than you could safely spend from a normal fixed-income portfolio.

An important downside of SPIAs is that they carry inflation risk. Because they pay a fixed nominal amount of income, the purchasing power will decline over time — and would decline dramatically in the event of very high inflation.

Some people make the case that buying a lifetime annuity (i.e., a fixed-income product with a very long duration) is not a good idea when interest rates are low. But as others (e.g., Wade Pfau, David Blanchett) have pointed out, the payout from lifetime annuities is actually most attractive relative to other fixed-income products when yields are low — because the portion of the annuity payment that comes from risk pooling (i.e., the “mortality credits”) is not affected by low interest rates.

Allan Roth recently performed an analysis that found that, when using himself as an example, a lifetime annuity actually provided a higher expected rate of return than AAA-rated corporate bonds. (And therefore a considerably higher expected return than a “total bond” fund that includes a substantial allocation to lower-yielding Treasury bonds.) And that’s while also reducing longevity risk, relative to a bond portfolio.

Option #5: Delaying Social Security

Another option for people in the applicable age range is to effectively sell some bonds to “buy more” Social Security (i.e., spend down fixed-income holdings in order to delay filing for Social Security).

This is the only option on this list that is an exception to the above discussion about risk and expected return. The expected return from delaying Social Security does not change based on current interest rates. So when rates are low, delaying Social Security becomes relatively better.

Option #6: Move Some Money to Equities

Finally, there’s always the option to increase your stock allocation. Stocks do tend to earn more than fixed-income. But as with shifting to riskier bond holdings, shifting from bonds to stocks is not a free lunch. And it tends not to really even increase the amount you can safely spend — at least not at the outset of retirement. (Rather, it provides more of an option for increasing spending later in retirement, if stocks do end up providing good returns over the first part of your retirement.)

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:

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Investing Blog Roundup: The Annuity Puzzle (Again)

Most people really don’t like lifetime annuities. At the same time, most people really do like pensions. An interesting fact, given that they’re the same thing.

This week David Blanchett, Michael Finke, and Timi Jorgensen took a look at a recent survey by The American College. The survey assessed people’s knowledge and attitudes about retirement income planning and financial products — looking specifically at people age 50-75 with at least $100,000 of non-housing wealth.

There are a number of interesting findings, including that people’s appetite for risk declined during the COVID-related downturn, yet demand for annuities declined as well.

Recommended Reading

Thanks for reading!

When Are IRAs Aggregated?

A reader writes in, asking:

“I have read that your traditional IRAs are all considered one IRA as far as the IRS is concerned. But I recently found another article that explicitly indicated otherwise. Maybe it depends on circumstances? Could you elaborate on this in an article?”

The issue is not so much that it depends on circumstances, but rather that IRAs are aggregated for some purposes and not for other purposes.

Traditional IRAs Aggregated for RMDs

For RMD purposes, all of your traditional IRAs will be treated as if they are one collective traditional IRA. Specifically, each traditional IRA will have its RMD calculated separately, but then you can total up all your necessary traditional IRA RMDs for the year and take that total amount out of any one traditional IRA or any combination of traditional IRAs.

Note that SEP IRAs and SIMPLE IRAs count as traditional IRAs here, so they are aggregated as well.

Employer-sponsored plans are not aggregated with your IRAs though (nor are they aggregated with each other). For example, a distribution from your 401(k) will not count toward satisfying your traditional IRA RMD for the year.

Traditional IRAs Aggregated for Distribution/Conversion Taxability

Similarly, when you take a distribution from a traditional IRA — or do a Roth conversion from a traditional IRA — whether or not it is taxable will depend on an aggregated calculation.

Example: Joan has made $20,000 of nondeductible contributions to her traditional IRA at Vanguard. During 2020, Joan makes a $40,000 Roth conversion from that IRA. At the end of the year, the balance in Joan’s Vanguard traditional IRA is $100,000. She also has a traditional IRA at Schwab with a year-end balance of $60,000. She has taken no other distributions (or done any other conversions) from these IRAs.

The nontaxable portion of Joan’s conversion is calculated as her basis in traditional IRAs (i.e., the amount of nondeductible contributions she has made), divided by the sum of her year-end balances and distributions or conversions from traditional IRAs over the course of the year. (And again, we’re counting all of her traditional IRAs here.)

Joan’s basis is $20,000. The sum of her year-end traditional IRA balances is $160,000. And the sum of her conversions and other distributions from traditional IRAs for the year is $40,000. So the nontaxable portion of Joan’s conversion is calculated as: $20,000 / ($160,000 + $40,000) = 10%. In other words, 90% of Joan’s conversion will be taxable.

IRAs Not Aggregated for “SEPP” Distributions

IRAs are not aggregated for the “series of substantially equal periodic payments” rule, sometimes referred to as 72(t). For that purpose, each traditional IRA is treated as its own separate account.

Aggregation for Roth IRA 5-Year Rule

With regard to the 5-year rule for distributions of earnings from Roth IRAs, once you have satisfied the 5-year rule for one Roth IRA, you have satisfied it for all Roth IRAs.

Inherited IRAs Not Aggregated

Inherited IRAs are not aggregated with other IRAs for RMD purposes, nor are inherited IRAs aggregated with other IRAs for the purpose of calculating what portion of a distribution (or conversion) is taxable.

Inherited IRAs can be aggregated with each other for RMD purposes if the inherited IRAs in question a) were originally owned by the same person and b) are being distributed over the same period (i.e., if the inherited IRAs are being distributed over somebody’s life expectancy, it must be the same life expectancy that is being used for each inherited IRA if you want to aggregate them with each other for RMD purposes).

Can I Retire (2020 edition), Investing Blog Roundup

Another book announcement for today: the 2020 edition of Can I Retire? is now available. Of the 2020 editions I’ve done this year, this is the book that received the most significant update. Some of the changes include:

  • The discussion of annuities has been adjusted, given the new environment in which inflation-adjusted SPIAs are no longer available;
  • There’s a new brief chapter on Social Security and how that fits into a broader retirement plan, especially in a “creating a floor of safe income” sort of context;
  • There’s a new chapter on retirement spending strategies; and
  • The discussion of asset location has been condensed somewhat, given its reduced importance in a consistently-low-yield environment.

You can find the print edition here and the Kindle edition here.

Other Recommended Reading

Thanks for reading!

Corporate Finance: Excel Examples

The following discussion is intended as a companion to my book Corporate Finance Made Simple: Corporate Finance Explained in 100 Pages or Less.

Click any of the links below to jump to the applicable part of this page.

Future Value

The “future value” of an asset is the amount that the asset will be worth at some specific point in the future, given a particular rate of return.

Example: We want to calculate the future value of a 7-year CD with an initial deposit of $1,000 and a 6% rate of return compounded annually.

We calculate present value as follows:

FV = PV x (1 + r)n

where:

  • FV is future value,
  • PV is present value,
  • r is the rate of return (as a decimal), and
  • n is the number of periods.

So you could calculate the future value manually by typing the following equation into a given cell:

= 1000*1.06^7

If you’ve done everything correctly, Excel should provide the result: $1,503.63.

Or you could enter the appropriate input values in cells in Excel, such as in the image below. (The text in column B isn’t necessary for the formula. Its purpose is simply to make it easier for you to remember what the number in each cell refers to.)

Then you could enter the following in a new cell, thereby calculating the FV by referencing your input cells rather than manually entering the values in your equation.

= A1*(1+A2)^A3

The above approach is often convenient, because it makes it easy to see how the result changes as you adjust one or more of the inputs. For instance if you change the cell that contains your rate of return from 6% to any other number, your calculated future value will immediately change accordingly.

Alternatively, you could use Excel’s built-in “FV” function, which requires the following parameters:

  • Rate (the rate of return)
  • Nper (the number of periods)
  • Pmt (the periodic payment)
  • PV (present value)
  • Type (either a zero or a one, to indicate the timing of any periodic payment; 1 indicates payment at the beginning of the period; 0 or leaving the field blank indicates payment at the end of the period)

You can access the FV function by clicking Insert -> Function -> FV. Then in your formula builder window, enter the following:

  • Rate = A2
  • Nper = A3
  • Pmt = 0 (We’re dealing with a CD for which there are no periodic payments at all.)
  • PV = -A1 (We enter a negative value here, because in Excel’s financial functions, a negative value indicates a cash outflow. We’re paying $1,000 to buy the CD in the first place, so we need a negative value in order to represent this outflow.)
  • Type = left blank

Click “done,” and you should see the appropriate future value ($1,503.63) appear in the cell.

If you click on the cell and look in your formula bar, you should see the following formula:

=FV(A2,A3,0,-A1)

Of note: If you prefer, you can enter the applicable values directly into the formula builder window rather than entering them by reference to cells. (For example, instead of entering A2 for the rate, you could enter 0.06.)

Present Value

The “present value” of a future cash flow is the amount that that future cash flow is worth today.

Example: How much would you be willing to pay for an investment that will pay you $10,000 five years from now, if you could earn a 9% rate of return per year, via other investments with similar risk? (That is, what is the present value of a $10,000 cash flow five years in the future, with a 9% discount rate?)

We calculate present value as follows:

PV = FV / (1 + r)n

where again:

  • PV is present value,
  • FV is future value,
  • r is the discount rate (as a decimal), and
  • n is the number of periods.

So you could calculate the present value manually by typing the following equation into a given cell:

= 10000/1.09^5

If you’ve entered your equation correctly, Excel should provide the result: $6,499.31.

Or you could enter the appropriate input values in cells in Excel, such as in the image below.

Then you could enter the following equation in another cell, thereby calculating the present value by referencing your input cells:

= A1/(1+A2)^A3

Or you could use Excel’s built-in “PV” function, which requires the following parameters:

  • Rate
  • Nper
  • Pmt
  • FV
  • Type (again, either a zero or a one; 1 indicates payment at the beginning of the period; 0 or leaving the field blank indicates payment at the end of the period)

You can access the PV function by clicking Insert -> Function -> PV. Then in your formula builder window, enter the following:

  • Rate = A2
  • Nper = A3
  • Pmt = 0 (In our example there are no periodic payments at all.)
  • FV = A1
  • Type = left blank (Again, there are no periodic payments, so the timing of the nonexistent payments doesn’t matter. We could enter a one, a zero, or leave it blank, and we’d get the same answer regardless.)

Click “done,” and if you’ve done everything correctly, you should see the present value (-$6,499.31) appear in the cell. (Note that it’s a negative value, simply to indicate a cash outflow again. That is, you’d have to pay $6,499.31 today, in order to have $10,000 after five years, given a 9% rate of return.)

If you click on the cell and look in your formula bar, you should see the following formula:

=PV(A2,A3,0,A1)

Again, if you prefer, you can enter the applicable values directly into the formula builder window rather than entering them by reference to cells. (For example, instead of entering A2 for the rate, you could enter 0.06.)

Net Present Value (NPV)

The “net present value” of an investment is the sum of the present values of each of the cash inflows, minus the sum of the present values of each of the cash outflows.

Example: We want to calculate the NPV for a project with an initial cost of $1,000, which is projected to provide the following annual cash inflows, given a 7% discount rate.

  • End of year 1: $200,
  • End of year 2: $300,
  • End of year 3: $400,
  • End of year 4: $500.

We could manually calculate the net present value, by calculating the present value of each individual cash flow, then summing those present values. But that would be inconvenient, to say the least. (And with more complex streams of cash flows, it becomes thoroughly impractical.)

A much faster approach is to use Excel’s “NPV” function. The NPV function requires the following parameters:

  • Rate (the discount rate)
  • Value1 (the future value of the first cash flow)
  • Value2 (the future value of the second cash flow)
  • etc

We begin by entering our relevant inputs:

Then we choose Insert -> Function -> NPV.

An important point about the NPV function is that it assumes that cash flows happen at the end of each period. So if you have any cash flow that occurs at the beginning of the first period, you have to exclude it when using the NPV function, then manually add/subtract the initial cash flow in question. So in our example, we will not be including the value in cell A2 in our NPV function. Rather, we’ll calculate the NPV without it, then we will manually subtract $1,000 from the calculated NPV to arrive at the actual NPV for our investment.

In the formula builder window, you can manually enter A3 for Value1, A4 for Value2, A5 for Value3, and so on. A faster approach, however, is to enter a range of cells for Value1. That is, for Value1 you would select (highlight) the entire range from A3 to A6. Or you could type A3:A6 as the value for Value1.

When you click “done,” the NPV for the cash inflows should appear: $1,156.91. But remember, that does not account for the present value of the cash flow at the beginning of the first period. We have to subtract that manually. When we do so, we see that the NPV for the investment is $156.91.

Internal Rate of Return (IRR)

The “internal rate of return” (IRR) for an investment is the discount rate at which net present value of the cash flows is zero (i.e., it is the discount rate at which the present value of the cash outflows is equal to the present value of the cash inflows).

Example: We want to calculate the IRR for a project with an initial cost of $1,000, which is projected to provide the following annual cash flows:

  • End of year 1: $200,
  • End of year 2: $300,
  • End of year 3: $400,
  • End of year 4: $500.

There’s no practical way to calculate IRR manually, as the only way to do it is by trial and error. Fortunately, Excel can do the math instantly via the IRR function, which takes in the following parameters:

  • Values: (the range of cells that contain the cash flows in question)
  • Guess: (your guess as to the IRR — basically you’re telling Excel where to begin the trial and error process. If you leave this blank, Excel will start with 0.1 (i.e., 10 percent)).

Your first step would be to enter each of the cash flows, including the initial outflow (which, again, must be negative to indicate that it’s an outflow). Like so:

Then you can select another cell (wherever you want the IRR to appear) and click Insert -> Function -> IRR. Then in your formula builder window, provide the following inputs:

  • Values = A1:A5
  • Guess = left blank

When you click “done,” Excel should give you the calculated IRR (in this case, 12.8%, which may appear as 13% depending on how many decimals you currently have it set to show).

If you click on the cell and look in your formula bar, you should see the following formula:

=IRR(A1:A5)

Excel’s XIRR Function

One limitation of Excel’s IRR function is that it only works if the cash flows occur at regular intervals (e.g., monthly or annually).

If you have a series of cash flows in which there is no regular interval, you can use Excel’s XIRR function to calculate the internal rate of return for the series.

The XIRR function requires the following parameters:

  • Values (the dollar amounts of the cash flows in question)
  • Dates (a range of cells with the dates on which the cash flows will occur)
  • Guess (your guess as to the IRR)

Example: We want to know the IRR for the following series of cash flows:

  • $5,000 outflow on 1/1/2021
  • $1,000 inflow on 10/15/2021
  • $1,500 inflow on 3/10/2022
  • $3,000 inflow on 8/20/2022
  • $2,000 inflow on 6/15/2023

You would begin by typing the relevant inputs into cells, like so:

Then you can select another cell (wherever you want the IRR to appear) and click Insert -> Function -> XIRR. Then in your formula builder window, provide the following inputs:

  • Values = A1:A5
  • Dates = B1:B5
  • Guess = left blank

When you click “done,” Excel should give you the calculated IRR (in this case, 28.6%).

If you click on the cell and look in your formula bar, you should see the following formula:

=XIRR(A1:A5,B1:B5)

Yield to Maturity (YTM)

Yield to maturity (YTM) is the rate of return that a bond buyer would earn if he/she buys the bond at today’s price, holds the bond to maturity, and receives all the promised payments on time (i.e., there is no default).

Example #1: A three-year bond has a $1,000 par value and a 6% coupon rate, with interest paid annually ($60 every 12 months). The bond is currently selling for $960. What is the bond’s YTM?

To find the YTM, we can use Excel’s “Rate” function. The Rate function requires the following parameters:

  • Nper (the number of periods)
  • Pmt (the periodic payment)
  • PV (present value)
  • FV (future value — in this case, the face value of the bond)
  • Type (either a zero or a one, to indicate the timing of any periodic payment; 1 indicates payment at the beginning of the period; 0 or leaving the field blank indicates payment at the end of the period)
  • Guess (your guess as to the YTM. If you leave this blank, Excel will start with 0.1 (i.e., 10 percent))

We could provide our inputs in a spreadsheet as follows:

Then you would select another cell (wherever you want the YTM to appear) and click Insert -> Function -> Rate. Then in your formula builder window, provide the following inputs:

  • Nper = A2
  • Pmt = A3
  • PV = -A4 (Again, we use a negative value here to reflect the fact that purchasing the bond would reflect a cash outflow.)
  • FV = A1
  • Type (zero or left blank to indicate that coupons are paid at the end of each period)
  • Guess (left blank)

When you click “done,” Excel should give you the calculated YTM (in this case, 7.54%).

Things are slightly more complicated in a case in which interest payments are made more often than annually. And this is important, because most bonds in the US pay interest semiannually — every six months. When a bond pays interest more often than once per year, the quoted YTM represents the actual rate per payment period, multiplied by the number of payment periods per year.

Example #2: A three-year bond has a $1,000 par value and a 6% coupon rate, with interest paid semiannually ($30 every 6 months). The bond is currently selling for $960. What is the bond’s YTM?

In this case we could provide our inputs as follows:

And in our formula builder window for the Rate function, we would provide the following:

  • Nper = A2*2 (i.e., six semiannual periods)
  • Pmt = A3
  • PV = -A4 (Again, we use a negative value here to reflect the fact that purchasing the bond would reflect a cash outflow.)
  • FV = A1
  • Type (zero or left blank to indicate that coupons are paid at the end of each period)
  • Guess (left blank)

When you click “done,” Excel should give you the calculated rate (in this case, 3.757%). But this is the semiannual rate. To annualize it, we would multiply this figure by two (to reflect that there are two semiannual periods per year). The result would be the bond’s YTM: 7.514%.

To Learn More, Check Out the Book:

Corporate Finance Made Simple: Corporate Finance Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between finance and accounting
  • Raising capital by borrowing or by selling equity
  • Cost of capital
  • Net present value, IRR, and other capital budgeting metrics
  • Click here to see the full list.
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