Zero Income Tax in Retirement

cut-taxesThere was a discussion on Bogleheads.org started in late 2011 about how a married couple with 6-figure expenses in retirement could pay zero income taxes. I also recently read an article at Forbes, titled, “How Retirees Pay Zero Taxes.”

A member of Bogleheads.org named Livesoft posed the following scenario:

Married, filing jointly, ages 55.

They need $100,000 a year after-tax to pay for expenses. Typical rule of thumb is that the sustained withdrawal rate from a portfolio is 4%, but they also have the possibility of Social Security benefits that would go towards that $100K, so give the couple $2 million in a portfolio split half in taxable and half in tax-advantaged. Of the tax-advantaged, 94% is in tax-deferred 401(k), 403(b), traditional IRA accounts and 6% in Roth IRAs.

They have been diligently tax-loss harvesting and the stock market had large losses in the recession, so their net gains in the taxable assets are essentially zero. That is, they have enough carryover losses to deduct $3,000 from ordinary income each year for quite a while. If they sell any taxable assets, the net capital gain will be essentially zero for a number of years. Their taxable portfolio generates 2% in qualified dividends each year. They get a foreign tax credit as well. They live in a state with no state income taxes.

They have a kid in college and one in high school who will go to college, thus they will get education credits, but they pay for college partially out of 529 plans (not included in portfolio described above).

They have no debts and own their home mortgage-free. They take the standard deduction in odd years and bunch property taxes and charitable contributions into even years.

They will delay taking SS until age 70 while converting their tax-deferred assets to Roth IRAs between ages 55 and 70.

Using the Optimal Retirement Planner calculator, with inputs outlined above, ORP gives the following withdrawal report. The columns are

Age: Age in years of the retiree.

TaxDef: The amount of money withdrawn from the Tax-deferred Account; investments on which taxes have not been paid. The amounts shown are before taxes have been paid. Withdrawals are assumed to be made at the first of the year.

If you begin Tax-deferred account withdrawals before the age of 59½ ORP’s optimal withdrawal level honors the IRS requirement to fix all withdrawals before the age of 59½ at the same level.

AfterTax: The amount of money withdrawn from the After-tax Account, investments on which taxes are paid annually. Withdrawals are assumed to be made at the first of the year. There are no additional taxes on After-tax account withdrawals.

RothIRA: The amount of money distributed from the Roth IRA Account. No tax is paid on Roth IRA withdrawals. For IRA to Roth IRA rollovers there is a 10% penalty charged for the withdrawal of the increase in account value within five years of the deposit in a Roth IRA. ORP conservatively assumes that the 10% applies to all of the early distribution. This will cause ORP to assess a larger than necessary economic penalty on early distributions and will cause ORP to prefer to avoid early distributions.

IRA2Roth: The amount of money to be rolled over from the Tax-Deferred Account into the Roth IRA during the year. This will occur when there is sufficient money in the After-tax Account to live on for the year without paying significant income taxes on the rollover. Then tax-deferred money can be rolled over to a Roth IRA while paying a low tax rate on the tax-deferred distribution. Remember that tax has to be paid on all tax-deferred distributions, even when rolling them over into a Roth IRA. There may be a significant tax advantage in rolling over at a low tax rate early in retirement and then distributing out of the Roth IRA tax free at a later year when Tax-deferred distributions put taxes into a higher bracket.

SocSec: The amount of before-tax Social Security benefits, after adjusting for inflation.

Taxes: The amount Federal and state income tax paid in each year. These are taxes paid on Tax-deferred Account withdrawals, Social Security income, earned income, and pension income. It does not include taxes paid each year on the After-Tax account returns.

Spending: During retirement the spending values show the after-tax, inflation adjusted money available each year of retirement to live on.

Age TaxDef* AfterTax* RothIRA* IRA2Roth* Savings* SocSec* Taxes* Spending*
55 $36 $102 $0 $34 $0 $0 $2 $102
56 $37 $106 $0 $35 $0 $0 $2 $106
57 $28 $109 $0 $28 $0 $0 $0 $109
58 $29 $112 $0 $29 $0 $0 $0 $112
59 $30 $115 $0 $30 $0 $0 $0 $115
60 $31 $119 $0 $31 $0 $0 $0 $119
61 $31 $122 $0 $31 $0 $0 $0 $122
62 $32 $126 $0 $32 $0 $0 $0 $126
63 $33 $130 $0 $33 $0 $0 $0 $130
64 $34 $134 $0 $34 $0 $0 $0 $134
65 $41 $96 $0 $0 $0 $0 $0 $138
66 $43 $76 $23 $0 $0 $0 $0 $142
67 $44 $0 $102 $0 $0 $0 $0 $146
68 $45 $0 $105 $0 $0 $0 $0 $150
69 $47 $0 $108 $0 $0 $0 $0 $155
70 $65 $0 $62 $0 $0 $40 $8 $160

*Dollar values are in thousands.

The i-orp output suggests that they will pay $2K in taxes in the 1st and 2nd years of retirement, and zero income taxes until age 70. It also suggests that those $2K in taxes are at the 10% marginal income tax rate and that the couple is never above the 15% marginal tax bracket. Conversions to Roth IRA are between $28K and $34K a year. Of course, all this is an estimate and makes no use of some of the initial details, so let’s go use TaxCaster and put in some of those details.

Give the couple $20K in qualified dividends, the two kids, the college expenses and a $3K capital loss. This gives them some tax credits which are very helpful. I will ignore any foreign tax credit for now, but they may be eligible for $600 foreign tax credit though I am not sure about this since they won’t be paying any taxes for a while. Maybe the FTC can be carried over to the future? TaxCaster says that they can convert about $58,400 to a Roth IRA and pay no income taxes. That’s quite a bit different than the $34K calculated by I-ORP and there is no $2K tax. 

That was all with the standard deduction (say an odd year). For even years, give them $12K in property taxes and $16K in charitable donations ($6K and $8K per year). With itemizing these deductions, TaxCaster says that they can convert about $74,500 to a Roth IRA and pay no income taxes.

That sets the stage for a more detailed analysis with TurboTax itself. Can the couple get all their tax-deferred assets converted to Roth IRAs by age 70? Maybe. Maybe not. The average conversion in the first few years is more than $66K per year. It is true that the youngest kid will graduate from college in 6 to 7 years. Also do not forget that their taxable assets have no net gains that will eventually be used up. Hopefully, the value of those assets will increase, but at the same time withdrawals may diminish the amount of qualified dividends received.

Livesoft added,

Just a reminder: That money that went into the tax-deferred 401(k) and traditional IRAs was tax-free going in and it appears to be tax-free coming out. That’s way better than a Roth IRA and a Roth 401(k). This thread should put to rest which is better: Roth 401(k) or Traditional 401(k).

Living mostly off taxable investment income for the first 11 years of retirement helps to keep the couple within the 15% income bracket. That means that they pay zero Federal tax on qualified dividends and capital gains. They could also use their tax loss carry forward of $3,000/year to zero out taxes on any interest in their taxable accounts. As the table shows, they were also able to convert quite large amounts of tax deferred savings to Roth savings with no taxes. (Taxcaster says they could convert even more.) Being able to convert from tax deferred to tax exempt savings is a huge benefit of this retirement withdrawal strategy.

It sounds pretty good to me.

 

Asset Location in Various Accounts

asset-allocationLast July, I wrote Asset Allocation Across Multiple Accounts, an article discussing what type of asset (stocks, bonds, REITs, etc.) should be stored in what type of account (taxable or tax sheltered).

Tax efficiency is the main reason to treat all accounts as one large account. You want to have tax inefficient holdings, like REITs and taxable bonds in your tax sheltered accounts, such as your 401(k) and IRAs, and tax efficient holdings, like the Total Stock Market index fund, in your taxable investment account.

I generated a table showing the least tax efficient asset classes to the most tax efficient asset classes with corresponding types of accounts that they should be held in. I have reproduced the table, below.

Least tax efficient High-yield bonds Best held in tax-sheltered accounts
High-turnover active stock funds
REITs
Active stock funds
Taxable bond funds
Target-date funds (contain both stocks and bonds)
Cash Can be held in either taxable or tax-sheltered accounts
Value index funds
Small or mid-cap index funds
Total international index funds
Total US market index funds
Most tax efficient Tax-managed funds

The reason I am looking at this again, is that Rick Ferri recently wrote an article asking, “Does Asset Location Make Sense?”

Rick wrote,

This strategy sounds correct on the surface and it’s often heralded in the media as a smart way to invest. I agree with the concept in general, but that doesn’t mean there aren’t drawbacks. Here are some of the problems I see with asset location for tax purposes:

  1. Tax-favored account capacity: you may not have enough room in your non-taxable or tax-deferred accounts to accommodate enough bonds to have the overall asset allocation that you desire.
  2. Taxable account capacity: the same limited capacity issue may occur in your taxable accounts and the amount of stocks you wish to own.
  3. The choice may not be yours: your employer-sponsored 401(k) may have poor bond choices and good stock fund choices, or there may not be any REITs available.
  4. Accounting across accounts: maintaining a portfolio to a target asset allocation becomes more difficult when you’re monitoring an allocation across several accounts rather the same allocation among accounts.
  5. Rebalancing across accounts: rebalancing a portfolio becomes more difficult when several adjustments need to be made across different account types. Settlement dates may be different, or you may be restricted on when you can trade one account versus another.
  6. Tax rates in the future cannot be known: the tax strategies we employ today tend to be focused on the situation today rather than in the future. A tax-saving strategy today might cost more in taxes than anticipated as your tax rates changes in the future.
  7. Liquidity becomes expensive: your situation is bound to change over the years as your life changes. There may be a time you need liquidity to buy a home or for another purpose and you find yourself selling the only thing you have in your personal account – stocks. This could mean paying a lot in capital gains taxes when you need the most liquidity.

The alternative to an asset location strategy across accounts is to hold the same asset allocation among accounts. Assuming you have one taxable and one non-taxable account of the same value, you would hold the same asset allocation in both accounts.

He goes on to argue that perhaps people ought to do both strategies: divide some asset classes into different accounts based on tax efficiency, and also put some of the same asset classes into all accounts.

My concern with putting the same mix of asset classes in each account you own is that you will pay more taxes during asset accumulation, and not have as much money in retirement.

I think Rick’s concern, which he mentioned above, is that using a location-based strategy is too complicated for most people. Putting the same asset class mix in each account is certainly easier. Doing a mix of both strategies, however, is more complicated than either strategy by itself.

Personally, my wife and I will stay the course with a location-based strategy. I also know of several people who are more happy having the same asset allocation in each account, even though it is less tax efficient. I doubt, however, that many people will follow Rick Ferri’s advice to combine the strategies across all accounts.

Our New Plumber

plumberOur washing machine drain backed up last weekend and created a minor flood in the garage. My wife moved the stuff that could get damaged away from the water and then told me about the problem. I looked at it and figured it would take a power snake to clean out the drain pipe.

Some years ago, we had this drain pipe that’s located in the garage snaked the last time it backed up. Another clogged drain incident in the kitchen forced me to go to the tool rental place and run a power snake through the main drain line to clear the house and toilet drains — something I hoped to never do again.

When I saw all the water on the garage floor, I quickly calculated in my head that I could save around $50 if I snaked the garage line myself. I immediately decided against doing that because I just didn’t want to get down and dirty with all the stuff that you will typically find in a main drain pipe.

So, my wife got on Yelp and looked for a 5-star plumber. She found a local plumber and gave him a call. This was mid-Saturday morning. She left a message, hoping they would call back.

A short time later, someone called saying they would be at our house at around 3:00 PM. At 3:00 PM, she received a text message that the plumber would be late, because the previous work was taking a lot more effort than originally thought. We shrugged and waited.

The plumber eventually showed up with a helper at 6:00 PM. We were a bit upset that they were 3 hours late, but this was a Saturday, after all. We were happy that anyone showed up.

When the plumber talked to my wife, he said he would take 50% off our bill for being so late. He did all the snaking and cleared the drain. He also said we had a 60-day warranty against any clogging on that line. If it clogs in the next 60 days, they will come back and re-snake it.

After having them move the washer out and then back in, as well as running their power snake down the drain as far as it would go, we decided to pay the plumbers their full bill of $95, which is actually very cheap for a plumber on the weekend.

We now understand why these guys were so highly rated on Yelp. They did what we wanted, and were prepared to charge us less than $50. You better believe that the next time we have a plumbing problem, we are going to call these same people again.

How have your experiences with plumbers been? Did you rely on personal recommendations, Yelp, or throw a dart at a phone book?

What I Did With an Older Mac Mini

intel_mac_miniOne of my brothers gave me his old Apple Mac Mini that he had replaced with a newer version. I thought I could perhaps replace my current web server with the Mac Mini and save some money on electricity. The current server, which runs 24/7, has an Intel Core 2 Duo with 4 GB RAM and 4.5 TB of hard disk storage.

I bought a 3 TB USB disk for $120, and a USB keyboard and mouse for $30. The server needs two Ethernet ports, one to connect to the WAN, and one to connect to the house LAN. The Mac Mini has a single built-in Ethernet port and a wireless Ethernet chip. Using wireless is not really good for a server, so my brother gave me a USB-to-Ethernet adapter to get the second wired Ethernet port. He also put a 750 GB disk inside the Mini to replace the original 60 GB disk. That gave me 3.7 TB of disk storage, which was less than the current sever, but enough.

So, for $150, I had my new low-power server.

The web server hosts

  • five separate websites, of which saveandconquer.com is one
  • a mail server for the five web domains
  • an incremental backup server to backup all computers on our house LAN. (That’s the reason I need so much disk storage.)
  • a streaming music server sending music and podcasts to three stereos in the house.

I installed Ubuntu Linux on the Mini, and cloned all the data from the old server. I wired the Mini in the old server’s place and let it rip. It turns out the load was just too much for the Mini. The Mini is one of the first Mac Minis to have an Intel CPU in it. The computer’s official designation is a Mac Mini 1,1. It contains an Intel Core chip, but it’s not anywhere near as powerful as current Intel CPUs.

So, now the question is what to do with the Mac Mini. It turns out that it does have enough power to feed video streams to our HDTV. I removed of a bunch of server software that I wouldn’t need, like the email server, the web server, the SQL database software, WordPress, and the music server. I then installed XBMC.

From the XBMC website, “XBMC is an award-winning free and open source (GPL) software media player and entertainment hub that can be installed on Linux, OSX, Windows, iOS, and Android. It allows users to play and view most videos, music, podcasts, and other digital media files from local and network storage media and the internet.”

XBMC on the Mac Mini looks great. I have been working to put our collection of DVDs on the Mini, as well as all of our digital photos. (I actually just pointed it at the photos that are stored on our old server.) Now, where’s the popcorn? Mystery Science Theater 3000, anyone?


What do you do with old computers? Have you ever repurposed an old computer?

Grok’s Tip #15: You’re doing it wrong: Figuring your stock/bond split

grokGrok’s Tip #15: You’re doing it wrong: Figuring your stock/bond split

Figuring your asset allocation or stock/bond split may seem like pretty simple math. Let’s say your investment accounts total $100 k with $60 k in stocks and the other $40 k in bonds/cash. So your stock/bond split is just 60/40 right? Not so fast. To better calculate your TRUE stock/bond split I would argue for considering these 3 things:
1) Tax deferred vs. taxable (i.e. after-tax) accounts
2) Social Security
3) Your mortgage

1) Tax-deferred vs. taxable (i.e. after-tax) accounts. Let’s say the $60 k in stocks is in a taxable account whereas the $40 k in bonds is in a traditional 401k. The trouble is the $40 k in bonds are pre-tax funds whereas the $60 k in stocks was created out of after-tax funds. So if you had to liquidate everything today and your tax rate was 25% then you would net $90 k after tax, with $60 k from stocks (assuming no capital gains were realized) and $30 k from bonds (i.e. $40,000*75%). That works out to a 67/33 stock/bond split.

So the idea is to put all your accounts on the same tax basis. Personally I like to work with pre-tax figures so I gross up my taxable accounts to a pre-tax basis. Staying with the above example the $60 k taxable stock account is really $80 k (=$60k/75%) on a pre-tax equivalent basis. The adjusted total is then $120 k of which $80 k stocks and $40 k bonds, giving the same 67/33 split. I like working on a pre-tax basis for 2 reasons:

a) It’s easier to compare the amounts to your salary (which is of course pre-tax)
b) I think for most people, most of their money is in pre-tax accounts.

Now some may argue that it is your future tax rate in retirement that should be used and that this is too uncertain to estimate. It’s a valid concern. But be aware that just adding up your accounts ignoring their tax basis is equivalent to assuming you will have a 0% tax rate in retirement-that hardly seems realistic.

The Bogleheads wiki has some perspective on this as well:
http://www.bogleheads.org/wiki/Tax-adju … allocation

2) Social Security: Many (young) investors decide to simply ignore social security. It is too far off and they think the trust fund may be depleted by then anyway. But older investors often find Social Security to be a very meaningful part of their retirement picture. Let’s say you are in mid-career with retirement on the horizon and you want to start factoring social security into your asset allocation- what should you do? Well the idea is to somehow estimate the present value of your future social security benefits and count that towards your bond allocation (pre-tax).

It sounds tricky but this is one of those issues that I think just being in the ballpark is good enough-at least for mid-career asset allocation purposes. Here’s a quick and dirty way to factor in Social Security: Just add up your (and your employers) contributions over your working career to date. The basic assumption here is that the current value of your earned social security benefit is equivalent to the government having invested these contributions over time at a 0% nominal return. That may be pessimistic, but then again it may be realistic and it certainly makes the math easy!

It used to be easy to find your contribution history when SS mailed you a statement every year. If you have an older SS statement to work from you can keep the total up to date by looking at your more recent W2s. In case you can’t find the info easily or can’t be bothered, here is a table by age of what the contributions would total assuming: 1) you started work at age 22, and 2) you earned the maximum social security wage each year ($113.7 k for 2013).

As of 7/1/2013
Age…start work year….Sum of Max SS contributions through end 2013 ($k)
25……2010……………………$40.55 k
30……2005……………….……103.45
35……2000…………………….156.74
40……1995…………………….199.56
45……1990…………………….235.31
50……1985……….……………262.72
55……1980………………….…282.08

Most people would want to make 2 adjustments to use this table. First: interpolate based on your age or year you started work. Say you are 42.5 years old. Then you would average the figures for 40 and 45 and get $217.4 k. Or say you are 45 now but didn’t start work till age 26, i.e. in 1994. Then you would interpolate between the $199.56k and $235.31k figures to get $206.7k [=199.56 + (235.31-199.56)*(1/5)].

Second: estimate what percentage, on average, your salary has been relative to the maximum taxable social security wage. You can find the historical maximums here:

http://www.ssa.gov/planners/maxtax.htm
(note: in working out this average you shouldn’t take any credit for the years your salary is above the max). So again if you are now 42.5 and figure your salary over your career has been roughly 60% of the social security max salary then your estimated contributions (including those of your employer) would be 60%*217.4 or $130.4k

3) Mortgage: Opinions vary on how to figure your mortgage into your asset allocation. Some argue to ignore it all together and some to treat it like a negative bond. My position is more middle of the road- basically I think its usually safe to ignore it early in life but as you get close to retirement you should start treating a mid-to-large mortgage like a negative bond. So how do we translate that intuition into a working rule of thumb? Let’s lay out some assumptions and then work some examples:

Assumptions:
a) goal: payoff or defease mortgage before you retire. Let’s assume the (now) standard SS retirement age of 67 & then drop that to age 64 to build in a 3 year margin of safety (note: if you are targeting early retirement for other than health reasons, you may have less of a need to build in a margin of safety).

b) house to be paid off pro-rata over a 30 year period (i.e. standard mortgage period)
c) assume you just bought your house yesterday at fair market value (check Zillow http://www.zillow.com/).

So let’s look at some examples:

d) Let’s say you bought a house 3 years ago for $400k. It’s now worth $500k and you are age 40. Your current mortgage balance is $275k. So basically your house is 45% paid off (again you calculate using the current $500 k market value, and thus the unpaid amount is $275k/$500k = 55%). Your goal is to pay off your house prorata over the 30 years before age 64. So based on that, since you have 24 years to go, you would need to have only 20% of your house paid off (= 1 -24/30). So you are ahead of the game and your mortgage can be safely ignored. Note that according to the logic here, the $400k purchase price and the fact that you bought your house 3 years ago are basically irrelevant. Only the current market value of the house, your age, and your mortgage balance matter.

e) Now let’s tweak that example and say that instead you are aged 55. So now you have only 9 years to go until the target payoff age of 64. So your house should be 70% paid off (=1-9/30) but as before your house is only 45% paid off. So you are 25% short or in dollar terms $125k (=25%*$500k). I would argue you should treat that $125k as a negative bond in your asset allocation. And moreover that $125k shortfall is an after-tax amount. Pre-tax it is $167 k (again assuming a 25% tax rate).

4) Putting it all together: Let’s stay with part 3e) above and put that together with the info from 1) and 2). To sum up:

Taxable stocks = $60 k = $80 k pre-tax
401k bonds = $40 k = $40 k pre-tax
SS (est.) = $282 k pre-tax bonds (assuming your salary was at the yearly SS max taxable salary on average)
Mortgage = negative $125 k = negative $167 k pre-tax bonds

So putting it all together, on a pre-tax basis you have:

Stocks = $80 k
Bonds = $40 k + $282 k – $167 k = $155 k
Total pre-tax = $235 k
Stock/bond split = 34/66

What Grok is saying in the example is that the investor who thought they had a stock/bond spit of 67/33 actually has a 34/66 split. So, he is advocating for a much higher equity holding to account for the bond value of SS, as well as the outstanding balance of loans such as your mortgage as a negative bond. John Bogle has also said this on http://www.morningstar.com/cover/videocenter.aspx?id=339534

Having said that, I want to quickly add that you’ve got to take all of your assets into account, when you figure that asset allocation, because for example, your Social Security investment, when you’re say 60 or 65, has a capitalized value of something like $300,000, and it’s going to continue to pay. It may pay a little bit less. I hope we can solve that problem, but it’s not going to go away.

And so if you have a $100,000 to invest, I don’t see why you would not put it all in stocks at that stage of your life. That would be 25 percent then in equities and 75 percent in effect fixed income with an inflation hedge. It’s a good investment.

My take on this is that SS has bond-like characteristics, but it has zero liquidity and can’t be rebalanced. It should be handled separately from your asset allocation, as an income source that reduces the amount of money you will have to draw out during retirement. I do not agree with placing the future value of your SS benefits into your current asset allocation. So I have to disagree with both Grok and Mr. Bogle on this one.


What side do you come down on? Treat SS future benefits as a bond holding in your current asset allocation, or treat the benefits as an income source?

Carnival of Money Pros — April 13, 2014

Chicken-Little-classic-disney-218743_1280_1024Welcome to the Carnival of Money Pros — April 13, 2014.

It’s been a bad couple weeks in the market. We might be headed for a 10% correction. The S&P 500 closed the week at 1815.69. The closing high for the S&P 500 was 1897.28 on April 4. The S&P is down over 4% in this month, alone. Lots of big-name tech stocks have sold off. Big bank profits are down. US producer prices rose 0.5 percent in March. What will we do?

Continue reading

Grok’s Tip #14: Avoid long-term corporate bonds

grokGrok’s Tip #14: Avoid long-term corporate bonds

It’s a tough fixed income investing environment out there, no question. Bond yields are brutally low with the 10 year treasury yield under 2% and t-bills yielding 0%. There has been a lot of talk about corporate bonds, and in particular some may think that long-term corporate bonds, with yields of around 4.5%, might be worth a look. Apple for example recently sold 30 year corporate bonds at a yield of 3.88% which was a spread over treasuries of 100 bps. Investors were so excited about the offering that it was 3 times oversubscribed.

http://www.fool.com/retirement/general/ … stors.aspx

Vanguard introduced a long term corporate bond ETF in late 2009 and the returns have been very good, averaging 12% annual return since inception. So should you dive in?

My advice: stay away!

To understand why, let’s look at the long term returns. Over the past 40 years, the average annual return since inception of the Barclays long term corporate bond index was 8.88%.  Not too shabby. But wait- what was the return over the same period of the long-term treasury index? You guessed it, almost exactly the same, it clocked in at 8.78%. And of course you can buy and hold treasuries directly at no cost. Whereas even the ultra-low cost Vanguard ETF charges 12 bps annually- so after costs the corporate bonds lagged by 2bps.

So basically, over this long 40 year period investors received no compensation for bearing all the extra risks of corporate bonds, credit risk, liquidity risk, etc.

So why is investing in long-term corporate bonds a mug’s game? Who knows? My own view is that it may have something to do with the limited life-span of corporations. See this link for example

http://www.innosight.com/innovation-res … al2012.pdf

The chart shows that the average lifespan of a company in the S&P 500 index has declined from around 30 years in the mid ’70s to less than 15 years today. It’s a volatile uncertain world out there and getting more so.

But wait, you say, doesn’t the same argument apply to equity index investing? The difference I think is a fundamental one between stock and bond investing. With stocks you have unlimited upside. So if a few companies fail, that can be more than compensated for by the companies whose value skyrockets like Google, and well, I guess Apple! But on the bond side, your upside is capped. When you are only getting a measly 1% per year over treasuries it only takes one Enron to ruin the return for your whole bond portfolio.

So skip long-term corporate bonds! Take your risk on the equity side!

We don’t own any corporate bonds other than the small amount that is in the Vanguard total bond market fund. And these are certainly not long-term bonds.

As an interesting aside, John Bogle has been espousing the need to hold more corporate bonds. Here is a new interview with John Bogle by Olly Ludwig of ETF.com. It is titled, “Bogle: Tilt To Corporates For More Yield.” This is the introduction:

John Bogle, Vanguard’s founder who built a second career as an author and the conscience of American capitalism, is still vigorous and relevant at the age of 84. As always, Bogle counsels investors to keep their focus on the long term, and to try to look past the near-term distractions in markets.

Total returns will always be the sum of earnings growth and dividend yield, plus whatever yield the bond market is serving up. Regarding the paltry bond yields that still prevail since markets crashed five years ago, Bogle reckons investors would be wise to work around the overweight in government debt that now characterizes the Total Bond Market Index.

He stressed that even ardent indexers like himself should always be focused on improving indexes, and he does that in the bond market by taking on a bit of extra risk and yields by including corporate debt in his retirement account and tax-free municipal debt in his non-retirement account.

Personally, I agree with Grok on this one. Corporate bonds are just so much more risky than treasuries. Their returns have historically been the same, why take on extra risk for no additional reward? And yes, I realize that corporate bonds have been paying a higher yield in the current low-interest environment, but how long will this continue?

Grok’s Tip #13: But Vanguard will tell you that…

grokGrok’s Tip #13: But Vanguard will tell you that…

Nothing complicated here. Just beware of your investment gurus. Even academics are often funded or directly working for various investment firms.

Be very careful about the so-called “academic” literature of investing. It’s not exactly the “ivory tower” out there these days- far from it. Many of these so called “academics”are in bed with various investment firms etc. You should always check what the authors affiliations are-how they get paid. Follow the money.

1) MIT Professor Andrew Lo, for example, is a hedge fund manager:
http://www.bostonglobe.com/business/201 … story.html
He is not the guy who is going to tell you that passive management is best and hedge funds are an expensive waste of time (they are!)

But Vanguard will tell you that:
https://institutional.vanguard.com/iam/pdf/VIPS_mixed_bag.pdf
“A mixed bag: Performance of hedge fund categories during and after the financial crisis.”

2) Wharton School Professor Jeremy Siegel is on the payroll of WisdomTree (can you say spindexes?)
http://en.wikipedia.org/wiki/Jeremy_Siegel
He is not the guy who is going to tell you that fundamentally weighted indexes (aka Spindexes) like those offered by Wisdom Tree are not useful but are merely expensive, high turnover tilts toward “small” and “value” that can be more cheaply and easily done otherwise.

But Vanguard will tell you that:
https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/AskExpertSauter
Gus Sauter wrote:When you analyze so-called fundamental indexes, you find that, by and large, they are providing exposure to segments of the market, particularly value and smaller-cap stocks. In other words you are getting factor exposure, not broad-market exposure. This tilt is based on numerous academic studies showing that value and small-cap stocks have historically outperformed the broad market. If an investor believes small-cap value stocks will continue to outperform, we think it’s best to get exposure using a market-cap-weighted index that targets that segment of the market. That approach is more cost-efficient and more tax-efficient than using indexes that are based on ad hoc rules.

3) Emeritus Princeton Professor Burton Malkiel is on the payroll of Alpha Shares and Alpha Shares is in bed with Claymore Securities doing China ETFs.
http://en.wikipedia.org/wiki/Burton_Malkiel
He apparently is very excited about the fact that China is growing quickly (who knew?). He is not the guy who is going to tell you that there is basically no relationship between how fast a country’s economy grows and how well its stock market performs. In fact some people think that the relationship is inverse.

But Vanguard will tell you that:
http://www.vanguard.com/pdf/icriem.pdf
(See figure 2 on page 4 for that inversely sloping regression line).
Vanguard wrote:The intent of this paper is to caution long-term investors against making asset allocation decisions solely on the basis of expected economic growth. Our analysis shows that the average cross-country correlation between long- run GDP growth and long-run stock returns has been effectively zero. We show that this counterintuitive result holds across the major equity markets over the past 100 years, as well as across emerging and developed markets over the past several decades.

When I read an academic paper from Vanguard, I start out having a very high degree of apriori trust. When I read a paper by many of these so called academics, I am reminded of the following William Bernstein quote (From investors manifesto http://www.amazon.com/dp/1118073762):

William Bernstein wrote:you are engaged in a life-and-death struggle with the financial services industry. … If you act on the assumption that every broker, insurance salesman … and financial advisor you encounter is a hardened criminal, you will do just fine.

and to his list I would add, “so called academics on the payroll of the financial services industry.”

I don’t have much to add. As Grok says, do your research. And one of the best places to research appears to be Vanguard.

Grok’s Tips #11 and #12

grokGrok’s Tip #11: Take Grok’s pledge!

Grok decided an investing pledge would be a good idea after looking at investor’s bad behavior during the growth years of the late 1990s. (I admit that I exhibited very bad investing behavior during that time, and paid the price in 2000-2001.)

1. I will index at least half of my equities. [I would expand this to 90-100% of my equities. --Bryce]
2. I will own some international equities
3. I will own at least 20% bonds in my portfolio:

Benjamin Graham’s rule of thumb was to always have at least 25% of your portfolio in bonds. And yet young and/or aggressive investors sometimes propose putting 100% (or more!) of their portfolio into equities. Vanguard itself puts 90% of the Target Date 2050 fund into stocks. The rationale for this seems to be the belief that, over long enough periods of time, stocks will beat bonds.

And yet:
a) Looking decade by decade, stocks have only beat bonds in 3 of the past 5 decades:
(http://www.raymondjames.com/weisswealth … Decade.pdf)
b) Over the past 30 year period, Bonds have beat stocks.
(http://www.bloomberg.com/news/2011-10-3 … ntury.html)

The reality is, as William Goldman used to say “Nobody knows nothing”. Faced with uncertainty, wise investors spread their bets. Do yourself a favor- buy some bonds!

4. I will avoid funky bonds like junk bonds, convertibles, structured CDs, etc. Take your risk on the equity side!
5. I will own some ibonds or TIPs.
6. I will not try to time the market. (See William Goldman quote above!)
7. Instead I will evaluate my portfolio for rebalancing at least once a year. Even if I am too chicken to rebalance (think March 2009) I promise not to sell out of my stocks when the market is down.
8. I will not put more than 10% of my portfolio in the stock of my employer (because maybe I work for the next Enron and don’t know it. Again see William Goldman quote above).
9. I will not put more than 10% of my portfolio in individual stocks.
10. I will not sell covered calls.

I have taken Grok’s pledge to heart, and hope you do too.

Grok’s Tip #12: “Press on, regardless” [of the past 5 years]

This was written in October 2012.

 “Press on, regardless,” John Bogle
“Keep moving forward,” Walt Disney.

A week ago I went to a corn maze. As some may know, one way to get through a maze is to consistently take only right turns. Or consistently take only left turns. I had tried this approach last year and it worked just fine then. I’m sure it wasn’t the fastest way through the maze but I didn’t get lost. Moreover because I was confident of not getting lost I was able to move at a steady pace-no hemming and hawing over which way to turn, etc. I found moving steadily forward through the twists and turns of the maze to the final goal to be very satisfying emotionally.

Well I had so much fun a year ago that I decided to go again this year. So a week ago I went to a different maze and tried the same approach. It didn’t work out so well this year! At the start of the maze there was a fork. I took the right fork and then took all right turns and yet after about 15 minutes I found myself coming back down that same fork to the place where I started. Frustrated, I took a coffee break and thought things over. I then started again, this time taking the left fork and taking all left turns and, yes, you guessed it, the same thing happened- I ended up back where I started after about 15 minutes. Frustrated, I quit!

I’m sure many of you have this all figured out by now. When I got back to the beginning the first time through, I should have then made a right turn into the other fork (i.e. the left hand fork if you are facing into the opening of the maze) and then continued taking all RIGHT turns. When I had got back to the “beginning” I was actually in the MIDDLE of my “take all right turns to get through the maze” path. But I couldn’t see that at the time. Returning to the beginning felt like “failure” although really I was on the path to success if only I had “pressed on, regardless” and “kept moving forward.”

What does all this have to do with investing you may ask? Well the S&P 500 is at around 1450 today. And 5 years ago it is was at, you guessed it, around 1450 as well. So we’ve spent 5 years going nowhere but have experienced tremendous volatility- the S&P 500 bottomed out at 666 in March of 2009. And like my experience with the corn maze this year, many investors seem to be throwing in the towel on stocks. The 10/4/12 Wall Street Journal article “Despite Gains Many Flee the Stock Market”
http://finance.yahoo.com/news/despite-g … 00651.html
cites fund flow data from the investment company institute (ICI) that since the market’s bottom in March 2009 investors have pulled $138 Billion out of stock funds but added $1 Trillion to bond funds. And in total over the past 5 years, investors have pulled roughly $500 Billion out of stocks.
http://www.ici.org/info/flows_data_2012.xls

However even though the S&P 500 is back where it started 5 years ago, some things have changed:

  1. Over the past 5 years the Shiller PE10 (http://www.econ.yale.edu/~shiller/data/ie_data.xls) has dropped from 26 to 22. While a PE10 of 22 is still high compared to the long term average of 16, arguably stocks are cheaper now-i.e. expected future returns should be higher.
  2. Inflation is lower now.
  3. 10 year treasury yields have dropped from 4.5% in late 2007 to 1.7% today. So real bond yields have dropped from +1.3% to -0.6%- i.e. bonds are less attractive now.
  4. Putting the above together the equity risk premium (the enticement to invest in stocks rather than bonds) should be higher now. The equity risk premium = expected future nominal stock return – 10 year treasury return. From 1) and 2) expected nominal stock returns should now be about 1 percentage point higher. And 10 year treasury yields are about 3 percentage points lower. So the Equity risk premium should now be about 4 percentage points higher.
  5. Which means of course that, rationally, investors should have shifted money from bonds to stocks over the past 5 years. Instead the opposite has happened.

So even though it FEELS like we are in the same place and haven’t gotten anywhere, the numbers above suggest that, just like me in the corn maze, that feeling may be wrong. If we “press on, regardless” and “keep moving forward” the next 5 years may very well turn out quite different (better!) than the last 5 years for equity investors.

This was a very prescient post from Grok. He looked at the indicators he had and decided the market would likely head up. We all know how the stock market did in 2013. We shall see what the market has in store for us in 2014 and beyond. I plan to “press on, regardless” and “keep moving forward.”

Grok’s Tip #10: Get Real (Returns)! – the 3% Solution

grokGrok’s Tip #10: Get Real (Returns)! – the 3% solution

In this tip, Grok expands on the barbell strategy to increase expected real returns from 1.3% to 3%. (This tip was written in Oct, 2011, so Grok’s inflation numbers may differ from current numbers.)

Investing is risky. In 2008 the S&P 500 lost 37% and Emerging Markets lost more than 50%. From mid 1980 to mid 1981 the 10 year treasury rose 400 bps- a move like that today would cause losses to 10 year treasuries of around 30%. During 1980 the price of Gold was cut in half from $800 to around $400. But at least for bearing all these risks investors can look forward to the prospect of good future expected real (i.e. after inflation) returns, right? Hmmm…maybe NOT!

1) Let’s start with the Vanguard Inflation Protected Securities Fund (VIPSX). It currently has a real yield of -0.32%. Similarly the nominal yield on the Vanguard Intermediate treasury fund is just 0.96%. Year-over-year inflation (August) is currently running at 3.6% and Break-even inflation is around 2%, so the expected real return for the treasury fund looks to be -1% or worse.

2) Now let’s look at the S&P 500. Stock returns have 3 components: dividend yield, dividend growth, and multiple expansion. Let’s take the last component first- Professor Shiller’s irrational exuberance website shows the S&P 500 to have a PE10 multiple of over 20 vs. a long term average of around 16. So the S&P 500 looks fairly richly valued already and future multiple expansion seems unlikely. Turning now to dividend yield, the Vanguard S&P 500 Index (VFINX) has a yield of 2.2%. As far as dividend growth, historically real dividend growth has averaged a bit over 1% (over the last 50 years it’s 1.06%). So a reasonable guess for the future expected real return of the S&P 500 is dividend yield + dividend growth = 2.2% + 1.05% = 3.25%.

3) So if you had 50/50 stock/bond portfolio using these 3 funds you might expect a future real return of about 1.3%- not very enticing compensation for all those investing risks…Let’s see if we can perhaps do a bit better…

4) I Bonds and 30 year TIPs: Instead of VIPSX why not use a combination of IBonds and 30 year TIPs? IBonds have real yield of 0% which is at least not negative. 30 year TIPs are yielding 1.05%. So using a 50/50 mix of these would result in a real yield of 0.53%. Plus IBonds have a nice “Put option” feature. If real rates rise both VIPSX and 30 year TIPs will take a hit (30 year TIPs will get hit more as they have a higher duration). But with I-Bonds you can cash in at par and reinvest at the higher rates. Newly issued TIPs have some optionality as well- they have a “deflation put.” What this means is that TIPs will always guarantee you your full return of nominal principal even if there has been net deflation over the period from their issue date to their maturity date. It’s hard to place a value on these put options embedded in Ibonds and Tips but let’s say for the sake of argument it is worth 25 bps (0.25%). That brings the real return for the Ibonds/Tips mix to 0.78%

5) Similarly instead of the Vanguard Treasury fund yielding less than 1%, why not invest in 7 year PenFed CDs yielding 2.75%? 7 year break-even inflation is about 1.80%, so that’s a real yield of 0.95%. And similar to Ibonds you get a valuable put option. If rates rise you can cash in early (losing just 1 years interest) and reinvest at the higher rates. Again, For the sake off argument let’s assume the put option is worth 0.25% bringing the real yield to 1.2%

6) European equities: Many people are quite negative on Europe right now. Perhaps because of this European stock markets seem to offer better future expected returns than the S&P 500. According to the Economist, the PE10 for European markets is about 12, much lower than the 20 for the S&P 500. Dividend yields are higher as well. VGK, the Vanguard Europe Stock ETF currently yields 5.2%.

So to sum up you have the possibility of multiple expansion and a better dividend yield. Even if dividend growth in Europe is weak, future expected real returns for European Stocks might be 6% or so.

7) Now I wouldn’t advise putting all your equity allocation in Europe. But if one did a 50/50 mix of the US and Europe that would boost the average expected real stock return to 4.625%. And if you use Ibonds, 30 year Tips and CDs for your bond money they should have a positive real return of about 1% bringing the real return figure for the 50/50 portfolio up to 2.8% or more than double the 1.3% we started out with in 3) above.

And finally since your equity portfolio is now a bit better diversified, arguably one could shift ones asset allocation a bit more towards equities with their higher real returns. I think one should be a bit cautious with this line of reasoning- in 2008 international diversification didn’t really pay off. But perhaps one might shift 5% points from bonds to equities. With a 55/45 stock/bond mix, with equities split between US and Europe, and bonds in the Ibonds/30 year TIPs & CD mix the expected real rate of return rises to 3%.

In this world of low expected returns and turbulent markets 3% real return is good enough for me!