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Investing Blog Roundup: Equifax Fallout Continues

It’s been two weeks since the announcement of the Equifax data breach, and people are still scrambling to take the appropriate protective actions. Personally, I hope we see some regulatory changes — or at least changes to common security practices in order to account for the fact that our identifying information (i.e., combination of name/DoB/SSN) is no longer a secret.

Other Money-Related Articles

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RMDs and Retirement Spending Strategies

After last week’s article about retirement spending strategies, several readers wrote in with questions about the interaction between required minimum distributions (RMDs) and such strategies.

The most common question was whether RMDs would get in the way of implementing a retirement spending strategy.

To be clear, the RMD rules say that you have to take money out of the account in question, but they do not force you to actually spend the money. Nor do they force you to change your asset allocation in any way. (That is, after taking the money out of your retirement account, you can re-buy the very same asset in a taxable brokerage account, if you want to.)

That said, there is some interaction between RMDs and spending, simply in the fact that if your RMDs are going to cause your tax bill to increase over time, that’s something you have to budget for — much as you might budget for, say, increasing health care expenses over time.

In other words, if increasing RMDs cause your tax bill to make up a larger and larger portion of your annual spending amount, it can force you to cut other expenses in order to stay within the spending range you’ve set for yourself.

RMDs Affecting Spending by Reducing Returns

One reader asked whether RMDs would eventually have a downward effect on portfolio returns (because more of the portfolio will be in a taxable account as time progresses) and whether that should be factored in when determining an initial spending rate.

It’s true that once the money is reinvested in a taxable account, the rate of growth will (generally) be lower than it would have been in a retirement account. But this would have a very minor effect on a person’s achievable level of spending through an entire retirement, given that:

  • RMDs have no effect whatsoever until age 70.5,
  • RMDs only affect a portion of your money (i.e., accounts that require RMDs have pretty small RMDs in the first several years, and RMDs have no effect at all on money that was already in a taxable account or a Roth IRA),
  • Even once the money is in a taxable account, you will still get to keep most of the earnings (especially with stock holdings, given the favorable tax treatment of dividends and long-term capital gains), and
  • Much of your ability to spend in retirement comes from the fact that you can spend principal as well as earnings.

RMDs as a Spending Strategy

One reader asked about the strategy of using RMD tables as a means of calculating your spending each year (i.e., each year, calculating what the RMD would be if your entire portfolio were in a traditional IRA, and using that amount as your annual spending amount).

A study by David Blanchett, Maciej Kowara, and Peng Chen found that such a strategy was more efficient than either the “percent of portfolio each year” strategy or the “inflation-adjusted spending” strategy that we discussed last week. And a study by Wei Sun and Anthony Webb had similarly positive findings for an RMD-based spending strategy. In other words, based on what I’ve read, I think that’s one of several reasonable approaches to selecting an annual spending amount.

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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,
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Investing Blog Roundup: Equifax Security Breach

The big personal finance news of the last week has been the Equifax security breach, affecting as many as 143 million people. To put that number in perspective, there are approximately 249 million adults in the U.S. In other words, it’s more likely that your data was stolen than not stolen.

Security journalist Brian Krebs has a piece answering the most common questions you might have. Ron Lieber of the New York Times has also been covering the incident in a series of articles.

Other Money-Related Articles

Thanks for reading!

There is No Perfect Retirement Spending Strategy

Lately a few readers have written in asking about strategies for determining how much to spend each year from a retirement portfolio.

Personally, I think there are many parallels between selecting a spending strategy and selecting an asset allocation. That is, in each case you have an endless list of options, and there’s a ton of research on the topic. But no matter how sophisticated the research, nothing can actually tell you the future. Nothing can give you certainty about the best strategy.

In short, as with asset allocation, there is no perfect spending strategy, but there are many perfectly fine spending strategies. So the goal is to understand the pros and cons of each strategy, then pick one that suits you and move on with your life.

The Spectrum of Spending Strategies

I like to think of a spectrum of retirement spending strategies. At one end of the spectrum is a strategy in which you simply spend a fixed percentage of your portfolio balance each year (e.g., spending 4% of your portfolio balance each year). The advantage of this strategy is that you’ll never fully deplete your portfolio. The disadvantage is that your spending can vary dramatically from one year to the next.

At the other end of the spectrum is the strategy used by the classic “4% rule.” According to this strategy, you spend a certain percentage of your portfolio balance in the first year of retirement (e.g., 4%), then you adjust your spending upward each year in keeping with inflation, regardless of how your portfolio has performed. The advantage of this inflation-adjusted spending strategy is that it keeps your spending predictable. The downside is that it can lead to portfolio depletion, if your initial withdrawal rate turns out to have been too high relative to how long you end up living and how well your portfolio ends up performing.

And in the middle of the spectrum are an assortment of hybrid strategies that either:

  • Start with the “percent of portfolio each year” strategy, but then add a provision that attempts to control the variation in spending, or
  • Start with the “inflation-adjusted spending” strategy, but then add a provision that allows for a modest degree of adjustment based on portfolio performance.

For instance, Vanguard’s Managed Payout Fund uses a “percent of portfolio” strategy, but it smoothes the variation in spending by basing the payout on the average share price over the last three years.

Similarly, Colleen Jaconetti of Vanguard recently wrote about a “dynamic retirement spending strategy” that is essentially the “percent of portfolio” strategy, but with “floor” and “ceiling” amounts that are based on the prior year’s spending level, so as to limit the variation from year to year.

Yet another alternative is to use an inflation-adjusted spending strategy, but with a provision that “ratchets” spending slightly upward or downward if the portfolio grows/falls by a certain percentage.

Broadly speaking, the two principles that are always true are that:

  1. Regardless of which spending strategy you choose, selecting a lower annual spending amount at the outset makes you safer.
  2. A strategy that adjusts spending downward when portfolio performance is poor is safer than one that does not.

And by “safer” I mean, “less likely to lead to portfolio depletion.” The flip side, of course, is that the safer your spending plan, the more likely you are to die with a pile of unspent money — which may be acceptable or unacceptable to you, depending on how motivated you are by the idea of leaving a bequest to heirs/organizations.

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:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: How Much International Diversification?

This week Morningstar’s John Rekenthaler addresses one of the most common investing questions: what’s the right amount of international diversification? As Rekenthaler explains, the most honest answer isn’t terribly far from “we don’t really know.”

Other Money-Related Articles

Thanks for reading!

The Cost (to an Index Fund) of Turnover in an Index

A reader writes in, asking:

“When stocks enter or leave an index, an index fund is forced to sell the leaving stocks and buy the entering ones. I have heard that this results in a cost to the index fund. Is this cost big enough to matter much?”

There are two types of costs imposed on an index fund when stocks move in or out of the index that the fund tracks: transaction costs and front-running costs.

Transaction costs are the brokerage costs and bid/ask spreads incurred by buying and selling shares of a stock.

Indexes themselves, unlike index funds, have no transaction costs. As such, transaction costs would show up in the form of “tracking error” (i.e., the amount by which an index fund trails the performance of its respective index). As it turns out though, most index funds from reputable providers (e.g., Vanguard, Fidelity) don’t often trail their indexes by amounts significantly more than their expense ratios. In other words, the total transaction costs for such funds are often sufficiently small that they typically don’t even make an observable impact on fund performance.

Given the above, and given that transaction costs from stocks entering/leaving the index are only a part of an index fund’s overall transaction costs, we can confidently conclude that the transaction costs specifically resulting from changes in the index must be very small.

The second type of costs, front-running costs, are the reduction in performance that results from other parties bidding up the price of a stock by buying shares after the announcement that the stock will be added to a given index but before index funds buy it. It’s difficult to estimate such costs because they don’t show up as tracking error, because such costs affect the performance of the index itself as well as the performance of index funds.

In the last decade, two studies estimated the cost of front-running to be in the 0.2-0.3% per year range for index funds that track the S&P 500. That would certainly be a significant cost over time. However, other parties have argued that the cost has likely declined (and will continue to decline) as front-running opportunities are largely eliminated due to the idea becoming so well known.

In addition, you’re largely unaffected by such costs if you stick to “total market” funds, because your fund would already hold such stocks well before the bidding up that happens when the stock is announced for inclusion in something like the S&P 500.

So in short, yes, costs are imposed on an index fund when stocks are added to or removed from the index that it tracks. However, such costs (both transaction costs and front-running costs) tend to be very small, especially for the most diversified index funds.

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