Asset Allocation for 529 Plans (and other similar scenarios)

In a post a couple weeks back, I asked readers their thoughts (and provided my own) on asset allocation, specifically:

  • At what point should you begin shifting your allocation away from stocks? and
  • How gradually or suddenly should you do so?

In the comments, Neal brought up the fact that in the article I was making the (unstated) assumption that a person’s investments were intended exclusively for retirement, when clearly that’s not always the case.

So today the question is: What should a person’s asset allocation look like when the investment portfolio is intended to pay for a specific cash outlay at a known time in the future? (Example: A 529 plan intended to pay for college in X years.)

What guideline could an investor use as a starting point (which then, of course, must be adjusted for personal factors such as volatility tolerance)?

My own thoughts

My own attempt at a generalized guideline (for a cash outlay X years from now) would be something to the effect of:

Stock allocation = 4x – 10 (with all negative values considered to be zero, and possibly with a cap at, say, 90%), thereby yielding the following allocations:

  • 1 year: 0% stocks
  • 5 years: 10% stocks
  • 10 years: 30% stocks
  • 20 years: 70% stocks
  • 30 years: 90% stocks

Thoughts from the Bogleheads & David Swenson

I asked over on the Boglehead forums for their thoughts on the matter. One of the replies brought up the method suggested by David Swenson (in his book as well as in this interview), which is essentially to have two separate portfolios:

  1. A long-term portfolio, in which you maintain an (unchanging) equity-oriented asset allocation, and
  2. An extremely low-risk portfolio, such as a money market or online savings account, possibly with some TIPS thrown in.

And, as the date of the expenditure draws nearer, simply shift money from the first portfolio toward the second. This would provide an asset allocation as follows:

  • More than 8 years from expenditure: 70% stocks, 30% bonds
  • 6-8 years: 52.5% stocks, 22.5% bonds, 25% cash
  • 4-5 years: 35% stocks, 15% bonds, 50% cash
  • 2-3 years: 17.5% stocks, 7.5% bonds, 75% cash
  • Less than 2 years: 100% cash

What do you think?

What guidelines would you use as a starting point for consideration when developing an asset allocation (and glide path) for a portfolio that’s intended for a specific expenditure in the future?

June 22, 2009

Converting Mutual Funds to ETFs: Weekend Reading

I’m trying a new, condensed format for the roundup this week. Hopefully it will make it easier to read at a glance to find which articles you are or aren’t interested in.

Investing

Other Articles of Note

Happy Father’s Day to any dads/grandpas. (And Happy Weekend to everybody else.) As always, thank you for reading. :)

June 20, 2009

401k Overhaul: Yes, we really do need it!

People have been discussing the problems with 401k plans for decades. With all the media coverage of failed retirements and shattered dreams over the last year, the idea of revamping the system has now become particularly popular.

Earlier this week, however, Jeremy from GenXFinance provided a counter-argument, mentioning that–while the 401k system is not perfect–the larger problem is that most investors have:

  • Outlandish expectations, and
  • Poor investment strategies.

I absolutely agree. Those problems are bigger than the problems with 401k plans. However, I think that an overhaul of the system could go a long way toward solving both issues.

First, I agree with Kyle:

Solution Part 1: Eliminate 401k plans entirely.

Meanwhile, remove the income limits for IRA contributions, and increase the contribution limit to $20,000 per year–roughly equal to the current IRA contribution limit plus the current 401k contribution limit.

This way, investors will have the freedom to choose where to invest their money, rather than being stuck paying exorbitant fees to invest in mediocre funds.

While we’re at it, however, new regulations must be created that make it perfectly obvious what the costs of the plan are. Without good information, it’s difficult to make a good choice.

Of course, those two changes would only solve part of the problem. After all–as we can see from the existence of an entire industry of financial advisors–many people don’t want to choose on their own. Whether it’s due to lack of confidence, lack of interest, or lack of time, many people want help.

Further, it’s clear that–when left to their own–many investors don’t, well, invest.

So what could we do about both of those problems?

Solution Part 2: Expand the Thrift Savings Plan

What is the Thrift Savings Plan, you ask? The TSP is the retirement savings plan for Federal government employees. Its investment options are extremely low cost and very easy to understand:

  • A government bond fund. Expense Ratio: 0.018%
  • A fixed income index fund. Expense Ratio: 0.018%
  • An S&P 500 index fund. Expense Ratio: 0.019%
  • An index fund that tracks the Wilshire 4500. Expense Ratio: 0.019%
  • An international stock index fund. Expense Ratio: 0.019%
  • 5 “Lifecycle” funds that are just target date funds made up of the other 5 funds. Expense Ratio: 0.019%

My proposal is to expand access to the TSP to all investors in the U.S. Let us invest our new, $20k-contribution-limit IRAs the same way government employees can.

In fact, don’t just give everybody access, automatically sign people up for it (with contributions going to the appropriate lifecycle fund) when they get a new job. Of course, give people the chance to opt out at any time (including at the date of hire). This way:

  • Anybody who wants to try his hand at picking stocks, picking funds, or timing the market is free to do so, and
  • Everybody who doesn’t want to mess with any of that will have access to low-cost, low-maintenance, easily-understood investment options.

Haven’t we tried this already?

Yes. I’m aware that I have more or less recreated Social Security here. I’d say that there are two primary differences:

  1. An opt-out option for people who want to do it on their own.
  2. Everybody will have their own account rather than being reliant upon the government not spending the money on something else (including the retirement of workers from prior generations).

Sounds pretty good to me.

June 19, 2009

Safe Withdrawal Rates and Short-Term Trading: Weekend Reading

Another week’s worth of excellent reading from other personal finance blogs. I hope you enjoy them. :)

Investing

Bargaineering has some investing advice for recent college graduates.

The Dividend Guy shares his Investor’s Manifesto.

ABCs of Investing discusses safe withdrawal rates for investment accounts.

Investing-School reminds us that short-term trading isn’t as easy as it looks.

Monevator reminds us that constant pessimism isn’t usually profitable when it comes to investing.

Favorite of the week: The Coffeehouse Investor bemoans the fact that even when schools do offer personal finance courses, they often focus the investment section on picking stocks.

Other Personal Finance

The Digerati Life explains the importance of personal property insurance.

Wealth Pilgrim shares the idea of Daddy Dates–a fun (relatively inexpensive) way to share time with your kids.

Frank from Bad Money Advice has a guest post at Consumerism Commentary explaining why we’re hardwired to make poor spending decisions.

Moolanomy shares some tips for how to find the best mortgage rate.

Economics

I Hope to Retire Someday provides some thoughts on ways we can fix social security.

Weakonomics argues that government spending isn’t a problem–the problem is lack of oversight.

Thanks again to everybody for reading, and I hope you enjoy your respective weekends. :)

June 13, 2009

Do you have a portfolio or an investment collection?

coincollection

Coin Collection

One thing that I’ve seen time and again when looking at people’s investments is that they could more accurately be described as “collections” than as “portfolios.”

Often, people seem to accumulate investments rather haphazardly over the years. By the time an investor is in his 40s or 50s, he (and his spouse’s) investments might look something like this:

Taxable Accounts:

  • 100 shares of this stock
  • 100 shares of that stock
  • a $5,000 muni bond from a local government agency
  • a handful of assorted mutual funds

Retirement Accounts:

  • 3-6 different funds in his 401k
  • 3-6 more funds in his spouse’s 401k
  • 3-6 more funds in his IRA
  • 3-6 more funds in his spouse’s IRA

It’s essential to know what you own.

In my experience, when an investor has an investment collection like the one above, he can’t even tell you what his stock/bond allocation is. Naturally, it’s only made worse when the funds involved are actively-managed funds such that it’s impossible to know precisely what’s in them at any given point.

In case it’s not obvious: This is a serious problem because it can mean that the investor is exposed to more risk than he’s aware of.

Further, when you own actively-managed funds, your diversification may not be as thorough as you’d expect, as the funds’ holdings may overlap significantly.

Complexity doesn’t increase return.

Of course, if you own 20 different mutual funds, it can be hard to keep tabs on what each of them own. The solution: Simplify.

Here’s a guideline I like to use: Outside of your 401k, if you own more than 6 mutual funds, you’re making things unnecessarily complicated. 6 funds should be plenty to provide you with sufficient diversification both among and within the major asset classes.

Moving from “collection” to “portfolio.”

If the bulk of your investable assets are in tax-sheltered retirement accounts, creating a cohesive portfolio is easy:

If a significant portion of your holdings are in taxable accounts, however, things can be a bit trickier, as the “sell everything” step could result in sizable capital gains, thereby taking a significant bite out of your portfolio.

Often, a reasonable approach is to keep your taxable investments more or less in place, while adjusting the allocation in your retirement accounts around them. (Example: If your taxable account is primarily invested in domestic stock funds, consider keeping it there and using your retirement accounts to fill out the bond and international stock components of your portfolio.)

I would, however, caution strongly against putting tax considerations ahead of asset allocation considerations. (Example: If an emerging markets stock fund makes up an extremely oversized portion of your portfolio, it’s probably a good idea to sell some of it even if that means incurring capital gains.)

June 12, 2009

How to Fill Out Form 8829 (Claiming the Home Office Deduction)

Form 8829 is the form used by sole proprietors to calculate and report Expenses for Business Use of Home (aka “The Home Office Deduction“).

Step 1: Download the Form and the Instructions.

Step 2: Fill-in your name and SSN.

Step 3: Fill-in “Part I – Part of Your Home Used for Business”

(Click to enlarge.)

  • On Line 1, enter the total square footage that you use regularly and exclusively for your business. [Note: When they say "exslusively" here, they really mean exclusively. If you use the space for anything else, you can't count it for your Home Office Deduction.]
  • On Line 2, enter the total square footage of your home.
  • Divide the square feet used for business by the total square feet of your home, and enter the resulting percentage on Line 3. Also, as long as your business is not a Daycare facility, skip to Line 7, and enter the same percentage that you entered on Line 3. This percentage is the “Business Percentage” of your home. It will be used later in the calculations for determining how much of certain expenses you’ll be able to deduct.

Step 4: Fill-in “Part II – Figure Your Allowable Deduction”

  • On Line 8, enter the total profit from your business. (This can be taken from Line 29 of Schedule C.)
  • For lines 8-35, simply follow the instructions printed on the form. It may not intuitively make sense while you’re filling it out, but here’s what’s happening:
    • In column A, you’re entering and totaling all the expenses that relate only to the business-use portion of your home. (For instance, if you repainted your home office, the costs for the paint job would go here.)
    • In column B, you’re entering costs that relate to your entire home (rent, home mortgage interest, homeowners’ insurance, ultilities, etc.). Then you end up multiplying all of these “indirect expenses” by the Business Percentage of your home (from Line 7), thus giving you the portion of these expenses that relates to your home office.

Step 5: Fill-in “Part III – Depreciation of Your Home”

If you own your home, you can include an expense known as depreciation in your Home Office Deduction. Here’s how it’s calculated:

  • On Line 36, enter the smaller of the home’s fair market value or it’s adjusted cost basis (the amount you paid for it, minus any amount that you’ve already deducted as depreciation in prior years).
  • On Line 37, enter the value of the land that your home is located on.
  • Subtract Line 37 from Line 36. The difference (entered on Line 38) is known as the basis for the building.
  • Multiply Line 38 by Line 7 (Business Percentage of Home). Enter the product on Line 39. This is known as the Business Basis of Building. This is the amount that you will be allowed to deduct, spread out over a period of several years.
  • For Line 40, you’ll enter the percentage of the Business Basis of the Building that you’re allowed to deduct this year. (See the chart on Page 3 of the instructions.)
  • Multiply Line 40 by Line 39. This is the amount of depreciation for your home that you can include in your Home Office Deduction this year. (Also enter this amount on Line 29.)

Step 6: Fill-in “Part IV – Carryover of Unallowed Expenses”

Every year, your Home Office Deduction is limited to your profit from your business. If your expenses for the business use of your home exceed the profit from your business, you’ll have to fill out Part IV of Form 8829. (What ends up happening is that the remaining expenses end up being carried forward, and you can add them to your Home Office Deduction in the following year.)

Step 7: Go Outside and Play.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less
Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
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June 7, 2009
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