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What Does an Investment Portfolio Need?

I recently encountered a conversation about the characteristics of a good portfolio. The person speaking (whom I didn’t know) had a long list, but it got me thinking about what I would include on such a list.

I came up with only three things. (That is, only three characteristics that make a portfolio strictly better than a portfolio that does not have those characteristics.)

  1. Diversification,
  2. Low costs (including tax costs, if applicable), and
  3. An appropriate overall level of risk.

With regard to diversification, the most critical thing is diversification among individual holdings (unless we’re talking about FDIC-insured CDs or Treasury bonds, for which diversification isn’t needed). Point being: Don’t set yourself up for financial catastrophe if a single company goes out of business. Also helpful, but less important, is diversification among asset classes — have some stocks and some fixed-income.

With regard to costs, the lower you can get the better. But it’s important to think in dollars rather than proportions. For instance, the difference between an expense ratio of 0.8% and an expense ratio of 0.2% is much greater than the difference between 0.2% and 0.05%, even though in each case the less expensive option is 1/4 as costly as the more expensive option. On a number of occasions I’ve heard from people considering changing fund companies in order to shave just a few hundredths of a percent off their average expense ratio. It would be rare for such a change to be worth the hassle for anything other than a very large portfolio.

When it comes to choosing an appropriate level of risk, it’s important to know that this is a very rough thing. Your risk tolerance isn’t something that can be measured precisely. In addition, your risk tolerance will change over time. (And the riskiness of different combinations of investments changes over time too!) Finding something that feels “approximately right” for you is as good as you’re ever going to get here.

The reason I’m such a big fan of index funds (and/or ETFs) is that, in most cases, it’s easier to achieve each of the three goals above by using index funds. Index funds are typically very well diversified, with very low costs. And it’s easy to achieve any particular level of risk with index funds. But the above goals certainly can be achieved with actively managed funds. Vanguard, for instance, has a long list of actively managed funds with super low costs.

For many investors — myself included — “simplicity” would also be on the list of characteristics that improve a portfolio. And simplicity is also aided by the use of index funds or ETFs. But I’ve left it off the list because some people truly do not care about it. They’re perfectly happy to manage portfolios with 10 different funds across several different accounts. And there’s nothing wrong with that.

When Are Variable Annuities Useful?

This is the final article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the second article discussed how variable annuities are taxed.

To recap, a variable annuity is essentially one or more mutual funds (or other similar investment options) wrapped in an insurance policy. The insurance aspect of the product creates some unique characteristics:

  • A death benefit,
  • The ability to “annuitize” the policy (i.e., convert it into a guaranteed stream of income),
  • Various optional riders that provide other insurance characteristics, and
  • Unique tax treatment.

Death Benefit

As a reminder, the death benefit is the fundamental insurance aspect of a basic variable annuity. The most common death benefit says that if you die while holding the policy and the account value at that time is less than your net contributions, your beneficiary will receive an amount equal to your net contributions rather than the (lower) account value.

The problem here is that this is such a strange sort of insurance. It doesn’t protect you against loss. Nor does it protect your loved ones in the event of your death as life insurance would. Instead, it only protects if both of those events occur at the same time (i.e., you die and at the time of your death the account value is less than your net contributions to the policy). And even then the insurance only provides enough money to “top them off” (i.e., bring the amount they receive back up to the net contribution), whereas a simple term life policy could provide a much larger death benefit per dollar of premium.

Another key point is that the death benefit is most likely to pay off in the first few years you own the policy, because at least in theory after several years the account value will have gone up. So you can eventually (sometimes quickly) reach a point where it becomes clear that the death benefit will have no value at all, and yet you’re stuck paying for the death benefit (via the “mortality and expense risk fee”) every year for the rest of the time you hold the policy.

It’s not that the death benefit doesn’t have any value. The problem is that there’s nobody who needs exactly this sort of insurance. It’s not an especially good fit for anybody.

A general financial planning guideline is that it doesn’t make sense to buy insurance that you do not need. And the death benefit on a variable annuity is insurance that most people do not need.

Ability to Annuitize

The second insurance aspect of a variable annuity is the option to annuitize the policy (i.e., convert it from a somewhat-liquid asset into a guaranteed stream of income). But that’s not necessarily valuable in itself, because with any other liquid asset you always have the option to sell it and simply buy an immediate annuity with the proceeds.

In other words, the ability to annuitize a deferred variable annuity only ends up being helpful if it helps you avoid a meaningful tax cost on that exchange or if the variable annuity has a meaningfully higher payout than what would be offered on the market for immediate annuities.

Optional Annuity Riders

A variable annuity could be a useful part of a financial plan when a particular rider provides a high value to you relative to its cost. The trouble here is that the value of a rider is usually super difficult to determine.

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. This doesn’t mean that you should never purchase a variable annuity, nor does it mean that you should never purchase a rider on a variable annuity. It does, however, mean that you should be very skeptical about whether or not you’re getting good value for your money.

Tax Planning Uses

As we discussed last week, the circumstances in which a variable annuity’s tax treatment would be most beneficial would be something like this:

  • You have a high marginal tax rate,
  • You want to invest in an asset that a) has a high expected return (as measured in nominal dollars rather than inflation-adjusted dollars) and b) does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

This is uncommon, but it’s not unheard of. Also, this situation would be significantly more common if interest rates were higher because the annual tax cost of holding regular “total market” bond funds in a taxable account would be greater than it is at the moment.

The most common financial planning use of variable annuities is simply as a replacement for worse (i.e., more expensive) variable annuities that a person has already purchased. As we discussed last week, if you liquidate a variable annuity, there can be undesirable tax consequences. If, however, you exchange that variable annuity (via a “1035 exchange“) for another variable annuity (or a qualified long-term care contract) then you do not have to pay any tax on the transaction.

As a result, for people who have purchased very expensive variable annuities, it is often advantageous to exchange them for variable annuities with lower ongoing costs (e.g., the Vanguard Variable Annuity or the Monument Advisor variable annuity from Jefferson National/Nationwide). A key point, however, is that a 1035 exchange only gets around adverse tax consequences. It does not get you out of paying surrender charges.

How Are Variable Annuities Taxed?

This is the second article in a three-part series about variable annuities. The first article discussed how variable annuities work. And the final article will discuss cases in which they do/don’t make sense as a part of a financial plan.

How a variable annuity is taxed depends on where it is held.

Variable Annuities within Retirement Accounts

If the variable annuity is held in a retirement account, the variable annuity is taxed (almost*) like anything else within that account. For instance, if one of the investment options in your 403(b) plan is a variable annuity, when you defer salary to contribute to the annuity within that plan, those deferrals will reduce your taxable income — and when you take money out of the plan it will be taxable as income.

Taxation of Nonqualified Variable Annuities

If the variable annuity is not held in a retirement account (i.e., it is a “nonqualified” annuity) it has unique tax characteristics.

First, earnings that occur within the account are not taxable while they remain in the account. That is, the account is tax-deferred much like a traditional IRA (but without the opportunity for a tax deduction when you make contributions).

This tax deferral is, generally speaking, a good thing, because it allows the account to grow more quickly. And the greater the expected return, the bigger this benefit is. (Because the greater the return, the greater the annual tax cost that you get to avoid via tax deferral.)

However, when earnings are distributed from the account they are taxable as ordinary income. If you’re using the variable annuity to invest in stocks, this is a big drawback relative to a taxable account, because it means that dividends and long-term capital gains that would have otherwise received beneficial tax treatment are instead taxed at a higher rate as ordinary income.

When your original investment is distributed from the account, it is not taxable. However, all distributions from the account are considered to come from earnings until there are no more earnings left in the account. (In other words, distributions are considered to come in the least favorable order.)

Also, earnings distributions that occur prior to age 59.5 are subject to a 10% penalty, unless you meet one of a few exceptions:

  •  You (the owner of the annuity) have died,
  • You (the owner of the annuity) are disabled,
  • The distributions are part of a “series of substantially equal periodic payments” over your life or life expectancy (or the joint lives/life expectancies of you and a joint annuitant), or
  • The distribution is allocable to your investment in the contract that occurred before August 14, 1982.

Finally, there’s no step-up in cost basis when you die.

Taxation of Nonqualified Annuities, after Annuitization

After annuitizing a nonqualified annuity (i.e., after you convert it from a liquid asset into a guaranteed stream of income, as discussed last week), payments from the annuity are taxed in the same way as payments from any other nonqualified immediate annuity. That is, part of each payment is nontaxable because it is considered to be a return of your basis (i.e., the amount that you put into the annuity), while the remaining portion of each payment is taxable as ordinary income. Eventually, if you live long enough to receive all of your basis back (i.e., the sum of the nontaxable portions of the payments eventually totals your basis), further payments will be entirely taxable.

Tax Planning Considerations

In summary, relative to investing in a retirement account, investing in a nonqualified variable annuity provides only tax disadvantages. It’s essentially the same as nondeductible traditional IRA contributions (i.e., the least desirable type of retirement account contribution) but with two big disadvantages:

  1. Distributions are considered to happen in a less favorable order, and
  2. There’s no opportunity for Roth conversions.

Relative to investing in a taxable account, investing in a nonqualified variable annuity has one tax advantage (tax deferral) and a list of tax disadvantages (distributions of earnings are taxed at ordinary income tax rates when otherwise they might be taxed at lower rates, there’s no step-up in cost basis when you die, and there’s the possibility of a 10% penalty on early distributions).

So when would a nonqualified variable annuity offer a net tax benefit relative to simply investing in a taxable account? The ideal set of circumstances would be something along the lines of:

  • You have a high marginal tax rate,
  • You want to invest in an asset with high expected return and which does not receive very favorable tax treatment (e.g., high-yield bonds or REITs),
  • You do not have room for that asset in your retirement accounts,
  • You expect to hold the asset for a long time (such that the tax-deferral has many years to create significant value), and
  • You expect to deplete the asset during your lifetime rather than leaving it to your heirs (otherwise you’d want a taxable account so they could receive a step-up in cost basis).

Suffice to say, that situation is very uncommon. Most people have plenty of space in their retirement accounts to hold any high-return, tax-inefficient assets they want to own.

*I say “almost” here because a qualified variable annuity that has been annuitized has slightly different tax treatment than other things within a retirement account. Specifically, after reaching age 70.5, there is no need to calculate an RMD for the annuity. Instead, each year the payment from the annuity is simply considered to be the RMD amount.

How Do Variable Annuities Work?

This article is the first in a three-part series. The second article will discuss how variable annuities are taxed, and the third article will discuss when variable annuities are/aren’t helpful.

A variable annuity can be roughly thought of as a mutual fund wrapped in an insurance policy. That insurance policy creates a few new characteristics, relative to a mutual fund:

  • Unique tax treatment (which we’ll discuss in the next article in the series),
  • Additional expenses, and
  • Some insurance benefits that you get in exchange for those additional expenses.

The insurance benefits include:

  1. A death benefit,
  2. The ability to annuitize the account/policy at a later date (i.e., convert it from a somewhat-liquid account into a stream of income that is guaranteed to last for a certain length of time), and
  3. (Often) one or more riders that introduce other insurance features.

A key point to understand is that all of the above insurance benefits, as well as their associated costs, vary from one policy to another.

The Anatomy of a Variable Annuity

The premium that you pay to the insurance company (whether in one lump-sum or in many payments over time) is invested in one or more “subaccounts,” which are the investment options you’re allowed to choose from (e.g., stock funds, bond funds, or various cash-like options).

Your account value then rises or falls in keeping with the performance of the subaccount(s) that you have chosen.

Variable Annuity Expenses

Variable annuities come with several expenses. First, there are the normal costs of the mutual funds/investment options in the subaccount(s) you choose to use. As with any other time you pick mutual funds, it’s a good idea to seek investment choices with low costs.

The mortality and expense risk fee pays for the insurance aspects of the basic policy (i.e., the death benefit and any guaranteed income options that are included in the basic policy).

There’s also typically an administrative fee, which can be a flat amount per year or a percentage of the account value.

Then, there’s often a surrender charge that applies if you withdraw your money within the first several years of purchasing the policy. For example, I recently reviewed a policy that had a 7% surrender charge for the first two years of the policy’s life, a 6% charge for the next two years, a 5% charge for the next three years, and no surrender charge beyond that point.

The sum total of these fees can vary dramatically from one policy to another. For instance, it’s super common to see variable annuities with total annual fees of 2-3%, plus surrender charges if you take your money out within the first several years. In contrast, the total annual fees for Vanguard’s Variable Annuity are roughly 0.45-0.75% (depending on which funds you choose to use), and it has no surrender charge.

Optional riders (which we’ll discuss momentarily) come with additional costs, which also vary dramatically from one type of rider to another.

Death Benefit

The most basic death benefit guarantees that, if you die prior to annuitizing the annuity (which we’ll discuss in a moment), your beneficiary will get the greater of:

  • The account value (i.e., the value of the underlying investments), or
  • The premiums you paid into the policy, minus any withdrawals you had taken from the policy.

This would be relevant if the account value goes down during the time you own the policy due to poor investment performance.

Income Options

The second insurance benefit that a variable annuity offers is the option to convert the account/policy into a guaranteed stream of income (i.e., to “annuitize” the policy).

When you annuitize the policy, you lose control of the assets. That is, you no longer have the option to take your money out whenever you want.

Most variable annuities come with several income options. Typical options would include:

  • A life annuity that pays out for as long as you live,
  • A joint life annuity that pays out for as long as either of two named people (e.g., you or your spouse) is still alive, or
  • A life annuity with period certain that pays for the longer of your lifespan or a fixed period of time (e.g., 20 years).

A key point is that you do not have to annuitize the annuity in order to start using it for income. Prior to annuitizing, you can take money out whenever you want (though you may have to pay surrender charges and tax costs). You have to annuitize in order to activate the various income guarantees (e.g., to turn the annuity into a life annuity that is guaranteed to pay out for as long as you’re alive).

Optional Riders

Riders are the optional “bells and whistles” that you can add to a variable annuity. They can be just about anything. A few common types of riders are:

  • Features that increase the death benefit in one manner or another (for instance, “locking in” a new value for the death benefit on a certain anniversary date each year if your account value is at a new high),
  • Features that guarantee that you can withdraw a certain amount per year, no matter how long you live, without having to actually annuitize the annuity, or
  • Features that provide a payout if you need long-term care.

Riders naturally have a wide range of costs given the wide range of insurance benefits that they can provide.

Next week we’ll take a look at how variable annuities are taxed. And the week after that we’ll discuss how and when they might be a useful part of a financial plan.

Free Lunches in Investing

“There’s no such thing as a free lunch.”

It’s a basic economic principle. But from the perspective of an individual investor, it isn’t true.

Diversification is a Free Lunch

Imagine that your portfolio consists of 10 randomly selected stocks. If, instead, you held 20 randomly selected stocks, the expected return of your portfolio would be the same, but you would be exposed to less risk. And if you held hundreds or thousands of randomly selected stocks, the expected return would still be the same, but you would be exposed to even less risk.

Point being: as long as there is no (or minimal) cost to actually achieve the diversification, you get a free lunch — risk reduction with no downside.

A counterpoint is that if you own just 10 stocks, they probably aren’t randomly selected. You probably picked them because you have reason to think they’ll earn above-average returns, and therefore if you switch to a more diversified portfolio, yes, your risk will go down, but your expected return will decrease as well.

That’s true of course — if you are one of the few people who can successfully pick winning stocks. Most investors, myself included, have no reason to think that we are smarter than the collective wisdom of the market. For most of us, even if we think we’ve selected 10 great stocks, our results are not likely to be any better than random selection. (And we might as well just diversify instead, in order to get the risk reduction.)

Reducing Costs is a Free Lunch

When it comes to mutual funds, a reliable phenomenon is that funds with lower expense ratios tend to outperform funds with higher expense ratios. Even if you’re dead-set on trying to outperform the market via actively managed mutual funds, you dramatically improve your chances by using funds with low costs.

By using funds with lower expense ratios, you increase the expected return of your portfolio, without any downside. (That is, you get a free lunch in that you’re no longer paying for somebody else’s lunch.)

That said, it’s important to keep costs in perspective. The savings from reducing the costs of your portfolio from, say, 1% per year to 0.2% per year are dramatic when compounded over a few decades. In contrast, the savings from trying to pick the very least expensive index funds or ETFs (e.g., worrying about the difference between a 0.05% and 0.06% expense ratio), are slim to nonexistent.

CDs Are a Free Lunch (Sort of)

As author/advisor Allan Roth has pointed out repeatedly over the last several years, CDs are often a free lunch relative to bond funds.

By shopping around for yields, you can find a meaningfully higher yield than you’d get from Treasury bonds, despite having no additional risk of default (as long as you stay within FDIC insurance limits). And in some cases you can even have less interest rate risk too, if you find CDs that allow for early redemption with only a small penalty.

This extra yield persists because the FDIC limit keeps large institutional investors from scooping CDs up in huge amounts and driving yields back down to match Treasury yields.

Point being: if you’re going to try to actively manage your portfolio, you’re more likely to find a free lunch by imitating your grandparents — shopping around for CD rates — rather than trying to imitate Warren Buffett.

That said, there is a time cost involved, so it’s not truly a free lunch. But for anybody with significant fixed-income savings, the payoff relative to time spent can be super high.

When Does It Make Sense to Prepay a Mortgage?

A reader writes in (in reply to last week’s article about calculating the after-tax interest rate on a mortgage), asking:

“I get that the point of calculating an after-tax interest rate is to determine whether it’s better to prepay your mortgage instead of investing. But where do you draw the cut-off? How high does the interest rate have to be in order for it to be better to pay it down rather than invest? Would looking at historical returns for the funds I own would be useful here?”

Prepaying a mortgage provides a safe rate of return. That is, you know that the return you’ll get from paying down the mortgage is equal to the after-tax interest rate on the mortgage.

As such, generally speaking, what you want to do is compare the after-tax interest rate on your mortgage to the after-tax expected return on the safe investments (e.g., bonds or CDs) that you hold or that you are considering buying.

For example, if your mortgage has an after-tax interest rate of 3%, and you are holding fixed-income investments that have an after-tax expected return of 2%, you’re essentially borrowing money at 3% in order to lend it back out at 2%. In most cases, that doesn’t make sense.

Conveniently, it’s fairly easy to get a decent estimate of the expected return for a fixed-income investment. In most cases, just look at the yield.*

Look at After-Tax Expected Returns

A key point here is that, just like we looked at the after-tax interest rate on the mortgage, we have to look at the after-tax expected return for the investments in question.

In the case of tax-sheltered retirement accounts, the calculation is easy. Specifically, if you would be liquidating assets from retirement accounts (or choosing not to contribute to retirement accounts) in order to prepay the mortgage, the return on the investments in question wouldn’t be taxed, so the after-tax rate of return is the same as the before-tax rate of return.

In a taxable brokerage account, however, determining the after-tax return can be somewhat trickier. It’s simply calculated as the before-tax expected return multiplied by (1 – your marginal tax rate). But your marginal tax rate will depend on your tax bracket, what type of investment we’re talking about (taxable bond? muni bond?), and on other factors such as whether or not you’re subject to the 3.8% tax on net investment income.

A Reason Not to Prepay

Regardless of the above comparison of rates of return, it definitely does not make sense to prepay your mortgage if doing so will cause you significant liquidity problems.

For instance, if you have an “emergency fund” sitting in a savings account earning little to no interest (and you truly would need that money in the event of a large unexpected expense), it’s not a good idea to use that money to pay down your mortgage, despite the fact that doing so would earn you a higher rate of return than the savings account is earning.

*Specifically, you’ll want to look at the yield to maturity for most bonds, the yield-to-worst for callable bonds, and the SEC yield for bond funds.

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