Archives for July 2022

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Investing Blog Roundup: Investors Do Well with “All-in-One” Funds

Morningstar recently released the latest edition of their “Mind the Gap” study, which looks at how investor’s actual returns compare to the returns of the funds in which they are invested.

Again, investors in “allocation” funds (which includes balanced funds, target-date funds, and things like the Vanguard LifeStrategy funds) had the smallest gap. To me this is entirely unsurprising. When you use a fund like that, there’s less temptation to jump around from one fund to another. The whole point is to just put it on autopilot. So that’s what people do. And it works.

And investors in sector-specific funds have a huge gap. Again not really surprising. A lot of people buying those funds are likely buying them just because of a recent bout of great performance, which is often exactly the worst time to buy. (And of course if we’re considering a naive investor like this — somebody who is just looking at the x-year return figures and picking the fund with the highest — they probably aren’t the person who is going to stick around, if ensuing performance isn’t so great.)

If you’re trying to make bets about this sector or that sector being a better bet than the market overall,

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Asset Allocation and Asset Location for LTC-Dedicated Dollars

A reader writes in, asking:

“We have decided against long term care insurance and have allocated a portion of our portfolio for long term care expenses.

First question, what are your thoughts on the best asset location for these funds – Roth or Traditional IRA? Currently, we have allocated half in Roth and half in Traditional.

Second question, thoughts on where to invest this money, do you put in all into Vanguard Total Stock Market and let it ride, or do you do a more conservative approach?”

I don’t think there’s a clear-cut answer to either of those questions. The primary issue here is that, in order to implement a typical asset-dedication strategy, you have to know (at least roughly) when the dollars are going to be spent. With long-term care, we don’t know that information. We don’t even know if that cost will arise.

With regard to asset location, the theoretical goal would be to try to incorporate it into the broader retirement distribution plan (i.e., which dollars to spend each year), with the idea always being to spend tax-deferred dollars when your marginal tax rate is lowest. That is, we would create a year-by-year plan. For each year, we first ask how many dollars need to be spent in the year in question. Then we determine which dollars to spend to get to that level. First we spend from current income and taxable-account dollars where cost basis is at least equal to the current value. Then we spend from tax-deferred dollars, to use up relatively-low-tax-rate space (if any). Then Roth or possibly taxable.

But the practical reality is that meaningfully incorporating long-term care costs into such a plan is pretty much impossible, because, again, we don’t know when these dollars will be spent.

Similarly, for investment selection/asset allocation, in theory it would depend on your risk tolerance for these specific dollars. How much can you afford for them to decline — and by how much? The younger you are (i.e., the further away a long-term care need is likely to be), the greater the risk you can afford to take with these dollars — and the more return you might need in order to try to keep up with rising LTC costs.

At least in this case, depending on your age, you might be able to make some useful decisions. For example, if you’re age 50, you could say, “it will probably be at least 15 years, likely even longer.” And that’s enough to tell us something about the appropriate asset allocation. But if you’re in your 60s or beyond, it could be a few years from now, 20 years from now, or never.

Given those practical challenges resulting from the high level of uncertainty, I’m not sure how much is to be gained from making asset allocation or asset location decisions specifically for these dollars. If it were me, I think my personal approach would be:

  1. Consider them part of the overall portfolio and continue making overall-portfolio level decisions for asset allocation and asset location.
  2. If the desire is still to have dollars set aside specifically, do that via the “how much to spend” each year decision. For example if, in a given year, the plan calls for you to spend X% of the portfolio balance, instead spend X% * (portfolio minus LTC-dedicated amount).
  3. If/when the LTC need does arise, make the decision at that time as far as which specific dollars to spend (i.e., stocks/bonds and Roth/tax-deferred/taxable).

With regard to that last step though, there is admittedly a potential problem in that, depending on the reason why you need care, you may not be in a position to actually make such decisions. If you’re married, making sure your spouse understands the household finances and the plans is important. Giving a trusted loved one (or trusted professional fiduciary) authority to act for you via a durable power of attorney can help. And keeping the portfolio as simple as possible is helpful to make it easier for another person to implement your plans.

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Investing Blog Roundup: “Bogleheads Live”

For the last few months, financial planner Jon Luskin has been hosting weekly interviews via Twitter Spaces with various guests — Rick Ferri, William Bernstein, Christine Benz, etc. And for people who are interested but who miss the live event, he’s making them available as podcast episodes.

The episode in which Jon interviews me about Social Security was published this last week:

You can find the full list of available episodes here.

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Bequest Allocation and Bequest Location

In financial planning we talk a lot about asset allocation — what portion of your portfolio is allocated to US stocks, international stocks, bonds, etc. And we talk about asset location as well, which is the idea that you can achieve tax savings by making sure your least tax-efficient assets are in retirement accounts rather than in taxable accounts where they’ll generate considerable tax costs each year. (For example, if you own a high-yield bond fund or actively managed stock funds with high turnover, it’s best not to own them in taxable accounts.)

I would like to propose the terms bequest allocation and bequest location as well.

Your bequest allocation is what portion of your assets will go to which parties, upon your death (or upon the second death of you and your spouse).

And the bequest location concept is analogous to asset location. That is, after deciding your bequest allocation, it’s wise to take some time to think about which assets should be used to satisfy which parts of your bequest allocation.

For example, imagine that you are a grandparent and you have decided that you want your bequest allocation to be 40% to your children, 10% to your grandchildren, 50% to charity.

And imagine that your assets are roughly broken down as: 40% tax-deferred accounts, 25% taxable accounts, 15% Roth IRA, 20% real estate (your home).

How should you divvy up those accounts to meet the desired bequest allocation? Many people might default to simply taking a pro-rata approach, but there’s a much better solution.

First things first: tax-deferred accounts are the ideal asset for giving to charity, because the charity doesn’t have to pay any tax on the money, whereas any individual would have to pay tax as distributions are taken from the account.

And for the opposite reason, the Roth accounts should go to a human rather than to charity. That is, a charity has no reason to prefer Roth dollars over tax-deferred dollars, whereas your kids (or grandkids) definitely would prefer Roth dollars.

So should the Roth IRA go to your kids or grandkids? Back when Roth IRAs could be stretched over a beneficiary’s lifetime, it often made sense to leave them to the youngest people, to get tax-free growth for as long as possible. Today though, they often have to be distributed over 10 years regardless of whether they’re going to kids or grandkids. So now it often makes sense to leave the Roth dollars to the generation that has the highest marginal tax rate. (Note though that if the grandkids are under 18 or under 24 and full-time students, the kiddie tax could cause your grandkids to have a marginal tax rate that’s the same as their parents’ rate anyway.)

Taxable assets work well for either party. Again, any assets are tax-free to a tax-exempt charity. And any humans who inherit taxable assets will receive a step-up in cost basis, thereby allowing them to sell the assets immediately (if desired) and incur little to no tax.

So in the above example, the ideal bequest location would probably be:

  • The tax-deferred assets (40% of the total assets) go to charity,
  • A portion of the taxable assets (10% of the total assets) goes to charity,
  • Another portion of the taxable assets (10% of the total assets) goes to your grandkids,
  • The rest of the taxable assets (including the home) as well as the Roth IRA go to your kids (40% of the total assets).

In short, the idea is: prioritize Roth for humans, prioritize tax-deferred for charity. And to the extent possible, especially prioritize Roth assets for humans with the highest tax rates.

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