Archives for June 2012

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How Does Human Capital Affect Asset Allocation?

One of the major trends in finance in recent years is the increasing popularity of the “human capital” concept. In case you’re not familiar with the idea, your human capital is defined as the value (as measured today) of all of your future earnings from work.

In short, the ramifications are that:

  1. Over time, you must accumulate financial capital in order to make up for the fact that your human capital is being depleted as you move toward retirement (at which point it will be mostly, or entirely, depleted), and
  2. When considering how much risk to take on in your portfolio, you should consider how much risk you’re already taking on via your human capital.

How About a Few Examples?

Janelle is 24 years old, and she is employed by the federal government in a position with a great deal of job stability. In other words, she has a great deal of human capital (because she’s young, with many years of work ahead of her), and it is very low-risk. As a result, Janelle can afford to take on a good deal of risk with her portfolio.

Geoffrey is 28, and he’s self-employed in a business with an unpredictable income. Because Geoffrey’s overall economic picture is dominated by a large amount of high-risk human capital, he should probably take on very little risk with his portfolio.

Beth is 68 years old and retired, with no intention of going back to work. At this point, her human capital is depleted. Beth can afford to take on a moderate amount of risk with her portfolio.

(Important caveat: All of the above examples are extreme simplifications, ignoring numerous other factors that would typically affect a person’s risk tolerance.)

Human Capital and Investing Guidelines

Most often, when I see human capital brought up in a book or article, it’s as a rationale for why most investors should shift toward more conservative allocations as they age. The idea is that most people’s human capital is bond-like (because most people’s income is relatively stable), so as their bond-like human capital decreases, they should increase the allocation to bonds within their portfolio.

That’s fine, as broadly-applicable guidelines go. But I think the more useful application of the human capital concept is to use it as a tool for contrasting different people’s economic situations and considering how they should tailor their portfolios accordingly. If your human capital is high-risk, it’s not particularly relevant that most people’s human capital provides a nice, safe, bond-like income.

The common sense takeaway: The riskier your job, the less risk you should take on in your portfolio.

Taxes on Bonds and Bond Funds

A reader writes in with a question about taxes on bond funds:

“When I own a Treasury bond fund, I’m guessing I would be paying taxes on the interest through the term of the bond. When I sell, would there be additional tax consequences?

I get that other types of investments — stocks for example — have price changes that affect the tax consequences when I sell. But a Treasury bond would only have interest, right? No gains/losses, because it pays at a fixed rate?”

Before discussing how a bond mutual fund is taxed, it’s probably easier to back up a step and discuss the tax treatment of an individual bond.

If you buy a bond for when it’s originally issued, and you hold the bond until it matures, yes, you would only have to pay taxes on the interest along the way.

However, if you buy a bond and sell it prior to its maturity date, you would probably have either a capital gain or a capital loss, because the sale price would almost certainly be either higher or lower than what you paid for it. (Because, as we’ve discussed here before, bond prices move up and down in the opposite direction of market interest rates.)

If the bond is sold for a capital gain, it would work the same as selling a stock for a capital gain. That is, if you had held the bond for one year or less, it would be a short-term capital gain, taxed at your ordinary income tax rate. If you had held the bond for greater than one year, it would be a long-term capital gain, taxed at a maximum rate of 15%.

Taxes on Bond Funds

Owning a bond mutual fund works a bit differently. Each year, shareholders of mutual funds are responsible for paying taxes on:

  1. Their share of the interest and dividends earned by the fund’s holdings, and
  2. Their share of any net capital gains realized within the fund’s portfolio (that is, gains that occur when the fund sells investments within its portfolio for an amount greater than what it paid for them).

In other words, with mutual funds (including bond funds), you often have to pay capital gains taxes even while you still hold the fund.

Finally, when you do sell the fund, there will typically be a capital gain or loss on that transaction, calculated just like you’d expect: proceeds from the sale, minus your cost basis in the mutual fund shares that you sold.

Important note: Your cost basis includes not only the amount you paid for the initial fund shares you purchased, but also any dividend/gain distributions that you chose to reinvest in order to purchase additional shares.

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Picking Bonds Based on Performance and Yield

Two readers recently wrote in with similar questions about selecting the type(s) of bonds to use for the bond portion of your portfolio.

Long-Term vs. Short-Term Bonds

Reader #1 asks:

“As of today, Vanguard’s Treasury bond funds have the following performance figures:

  • Vanguard Long Term Treasury: 1-year return = 31.6%, 10-year average annual return = 9.08%
  • Vanguard Intermediate Term Treasury:  1-year return = 8.7%, 10-year average annual return = 6.2%
  • Vanguard Short Term Treasury: 1-year return = 1.45%, 10-year average annual return = 3.54%.

Based on that information, why isn’t everyone buying long term Treasury funds?”

Bond prices and market interest rates are inversely related. When one goes up, the other goes down. And that makes perfect sense if you consider an example.

Arthur buys a 10-year Treasury bond paying 2% interest. Five years later (when his Treasury bond is now effectively a 5-year bond), market interest rates have risen, and new 5-year Treasury bonds are yielding 3%. The result: Because of the rise in rates, nobody would be willing to buy Arthur’s 2% bond unless he offers to sell it at a discount. (That is, interest rates have gone up, so the price of his bond has gone down.)

And the longer a bond’s duration, the more severely its price will change as a result of market interest rate changes. Specifically, the size of the price change will be approximately equal to the change in interest rates, multiplied by the bond’s duration. So, for example, a bond with a 5-year duration would lose approximately 5% of its price if the applicable market interest rate increased by 1%.

In other words, the reason that long-term bond funds currently have higher past performance records than shorter-term bond funds is simply that:

  1. They have a longer duration, and
  2. Interest rates have been falling fairly steadily over the last few years (thereby pushing bond prices up, with the prices of longer-term bonds going up the most).

As far as the question of “why doesn’t everybody buy the long-term fund,” the answer is simply that the opposite phenomenon can happen as well. That is, in a rising-rate environment, bond prices fall, and it would be the longer-term bonds whose prices would fall most severely.

Nominal Treasuries or TIPS?

Reader #2 writes in asking:

“Currently all TIPS with a maturity of less than 20 years have a negative yield. And even with 20-year TIPS the yield is just 0.09%. In contrast, 20-year normal Treasuries currently yield 2.28%. Even a 3 month normal Treasury (yield = 0.10%) beats a 20-year TIPS. I don’t understand why experts still talk about TIPS as a useful tool when normal Treasury bonds look so much better.”

What makes TIPS unique is that their principal adjusts upward with inflation, and their interest payments are based on the inflation-adjusted principal. In contrast, both the principal and interest payments on nominal Treasury bonds are fixed. As a result, comparing the yield on TIPS to the yield on nominal bonds does not tell you which one will actually earn a greater return.

For example, when we see that a 20-year TIPS has a yield of 0.09%, we know that (as measured in nominal dollars), its return will be 0.09%, plus any inflation that occurs over the 20 years. So by comparing that to a nominal 20-year Treasury with a 2.28% yield, we can see that if inflation is more than 2.19% per year (that is, 2.28%, minus 0.09%), the TIPS will provide a greater return. (And conversely, if inflation is less than 2.19%, the nominal Treasury bond will provide a greater return.)

So the answer to the question of why anybody would use TIPS is simply that many people are worried about the possibility of inflation that’s greater than the difference between nominal Treasury yields and TIPS yields.

Why Annuitizing Reduces Risk

In Friday’s roundup I briefly mentioned that annuitizing part of a retirement portfolio not only reduces the probability of running out of money, but also makes the oops-I-ran-out-of-money scenario not nearly as bad. Several readers asked how both of those things work.

Reducing Portfolio-Depletion Probability

The reason that inflation-adjusted lifetime annuities reduce the risk of portfolio depletion is that they provide a higher payout rate than you can safely take from a stock/bond portfolio. For example, even with today’s super-low interest rates, a 65-year-old female can purchase an inflation-adjusted lifetime annuity with a 4.4% payout.

To see the impact annuitizing would have, let’s look at an example.

Susie is 65 years old and recently retired with a $400,000 portfolio. She expects to need $30,000 of income per year in retirement, and her annual Social Security benefit will be $14,000. In other words, she hopes to spend $16,000 per year from her $400,000 portfolio.

If Susie does not annuitize any of her portfolio, she’d have to use a 4% withdrawal rate ($16,000 ÷ $400,000) to provide the desired level of income.

If Susie uses half of her portfolio ($200,000) to purchase a single premium immediate inflation-adjusted lifetime annuity, the annuity (given a 4.4% payout) would provide  $8,800 of income per year. As a result, she would only need another $7,200 of income from the non-annuitized part of her portfolio. That works out to a 3.6% withdrawal rate.

Naturally, Susie is less likely to deplete her portfolio with a 3.6% withdrawal rate than with a 4% withdrawal rate.

Improving the Worst-Case Scenario

And possibly even more importantly, if Susie does end up depleting her portfolio, she’ll be left with an income of $22,800 per year ($14,000 Social Security + $8,800 from the annuity) rather than the $14,000 per year she’d be left with if she didn’t annuitize any of her portfolio.

Don’t Forget About Delaying Social Security

As we’ve discussed before, delaying Social Security benefits is economically equivalent to purchasing an inflation-adjusted lifetime annuity — one with lower credit risk and a higher payout than you can get from an insurance company.

For example, for somebody with a “full retirement age” of 66, if your Social Security benefit would be $18,000 per year at age 62, it would be approximately $31,680 per year if you waited until age 70. By giving up eight years of $18,000 in benefits, you’ve effectively spent $144,000 ($18,000 x 8) to purchase $13,680 ($31,680 — $18,000) of annual inflation-adjusted income. That’s much higher than the 4-5% payout you can get from an inflation-adjusted annuity.

In other words, delaying Social Security has the same two risk-reducing effects as annuitizing part of your portfolio (i.e., reducing the probability of depleting your portfolio and protecting you somewhat in the event that you do deplete your portfolio), and on a per-dollar-spent basis, it provides more of those risk reductions than an annuity from an insurance company would.

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Inherited IRA Rules

Properly dealing with an inherited IRA can be tricky business. If you take the right steps, you can continue to delay taxation on the account for many years. But if you make a mistake, the entire account balance could be taxable immediately — thereby wasting a potentially huge sum of money on taxes.

When you inherit an IRA, the rules that apply to you depend on whether or not the deceased account owner was your spouse. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.

Inherited IRA: Spouse Beneficiary

As a spouse beneficiary, you have two primary options:

  1. Do a spousal rollover — rolling the account into your own IRA, or
  2. Continue to own the account as a beneficiary.

Note: There’s no deadline on a spousal rollover. Should you want to, you can own the account as a beneficiary for several years, then elect to do a spousal rollover.

If you do a spousal rollover, from that point forward, it will be as if the IRA was yours to begin with. All the normal IRA rules will apply — whether Roth or traditional.

If you continue to own the account as a beneficiary, the rules will be mostly the same, with a few important exceptions.

No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)

Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).

Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he died, but he had not yet taken it, you’re required to take it for him, calculated in the same way it would be if he were still alive.)

Your RMD from the account will be calculated each year based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590.**

Inherited IRA: Non-Spouse Beneficiary

When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.

No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)

Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)

Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a Required Minimum Distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)

The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**

For example, imagine that your father passed away in 2010 at age 65, leaving you his entire IRA. For 2010 (the year of death), you have no RMD. On your birthday in 2011, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2011 will be equal to the account balance as of 12/31/2010, divided by 53.3.

For 2012, your RMD will be equal to the account balance at the end of 2011, divided by 52.3. In 2013, it’ll be the end of 2012 balance, divided by 51.3.

Important exception: If you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.

Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.

Successor beneficiaries are subject to the same rules as the original beneficiary, with one exception: The successor beneficiary must continue to take distributions each year as if they were the original beneficiary.

By way of illustration, in the example above, if you had died in 2013, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2013 distribution, she’d have to take it. Her 2014 distribution would be exactly what yours would have been if you were still alive: the 12/31/2013 balance, divided by 50.3.

Tips for Non-Spouse Beneficiaries

  1. When you retitle the account, be sure to include both your name and the name of the original owner.
  2. Name new beneficiaries for the account ASAP.
  3. If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.

Inherited IRA: Multiple Beneficiaries

If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.

However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:

  • A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
  • Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.

To split an inherited IRA into separate inherited IRAs:

  1. Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
  2. Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
  3. Change the SSN on each account to be that of the applicable beneficiary.

A Few Last Words

When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes (attempting a rollover rather than a trustee-to-trustee transfer, for instance) can be very costly.

Also, should you elect to get help with the decision — a good idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.

**If a) the inherited IRA is a traditional IRA, b) you are older than the deceased IRA owner, and c) the deceased IRA owner had reached his “required beginning date” (i.e., April 1 of the calendar year following the calendar year in which he turns age 70.5) by the time he died, your RMD could actually be smaller than the amount calculated above, as you can calculate it based on what would be the deceased owner’s remaining life expectancy (from the “Single Life” table) using the owner’s age as of his birthday in the year of death (and reducing by one for each following year).

Should Asset Allocation Change with Age?

Conventional wisdom says that as you age, you should shift your asset allocation steadily toward bonds — perhaps via the “age in bonds” guideline or via a target date fund that steadily becomes more conservative as the named retirement date approaches.

But there’s at least some degree of evidence suggesting that this commonly-recommended shift might not be entirely necessary. For instance, Wade Pfau’s research (see charts here and here) shows that for retirement portfolios using withdrawal rates of 5% or less, there’s startlingly little difference in success rates for allocations anywhere from 30% stock to 70% stock.

In other words, from a U.S. historical data standpoint, a retirement portfolio with a typically-conservative allocation of just 30% in stocks isn’t convincingly better than a more aggressive allocation of 70% stocks (i.e., something you’d see more often in an accumulation stage portfolio).

Still, I think there’s a perfectly good, common sense reason for most people to want their asset allocation to become more conservative over time.

As we’ve discussed before, risk tolerance is a function of both:

  1. The degree of flexibility you have with regard to your financial goals, and
  2. Your personal comfort level with volatility in your portfolio.

From what I’ve seen, for many investors, that second factor really takes a nosedive as their portfolio grows and they approach and enter retirement.

Let’s Look at a Few Examples

Allison is 27 years old. Her retirement savings are currently equal to 6 months of her salary. She also has a good-sized emergency fund, so she knows she probably won’t have to touch her savings for many years.

Phil is 59 years old. His retirement savings are equal to 10 years of his income. He’s starting to think seriously about retirement sometime in the next year or so.

Dorris is 70 years old. Her portfolio is sizable (about 15 years-worth of expenses), but it’s significantly smaller than it was 8 years ago when she retired. Dorris has absolutely no desire to return to work — not to mention the fact that she’s worried she’d have a heck of a time finding a job if she did have to return to work.

It’s only natural that Allison would be the least concerned about volatility in her portfolio. For example, imagine that each of our three investors has the same asset allocation (70% stocks, 30% bonds) and that the stock market takes a 50% plunge.

  • Allison sees a small loss (when measuring the loss in dollars, as most people do), and her daily life isn’t really impacted in any way.
  • Phil sees a very large loss, and he may begin to worry about having to work for a few more years than he’d planned.
  • Dorris sees a large loss, and she may begin to worry about whether she needs to cut back on her spending.

There’s nothing terribly tricky going on here. And it’s got nothing to do with Monte Carlo simulations or academic studies. For many investors it makes sense to shift toward more conservative investments over time simply due to the fact that the bigger your portfolio and the closer you are to having to spend from that portfolio, the worse a loss of a given percentage feels.

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