Miscellaneous

A reader writes in to ask,

“Does it make sense to apply what I call the ‘retirement model’ to a large windfall — that is, spending a percentage of the windfall each year, while allowing the rest to grow? If so, what withdrawal rate do you recommend? The 4% rule, I gather, means that the money could likely run out after 30 years or so. Since I am 33 now, that means that it could run out just as I was hitting retirement. What withdrawal rate should I use to have the money last until I am 100?

And what about your readers? I’d be curious to see how other readers have dealt with this experience.”

Mike’s note: What follows is my answer to this question. If you’re comfortable sharing your own answer, please chime in via the comments section on this post.

You’re right that if you wanted the money to last for 60+ years, it would be wise to use a withdrawal rate lower than 4%.

To back up a step though, I doubt that’s the approach I’d apply at all. Rather than thinking about at what rate you can spend from this money, I’d simply incorporate the windfall into your existing plans. That is, now that you have this additional money, at what rate (if any) do you still need to be saving for retirement and other financial goals?

Matching Resources to Goals

To go about answering this question, I’d make a list of your financial goals in order of importance. For example:

• Basic retirement living expenses,
• A replacement for your aging car,
• College for children,
• “Fun” spending in retirement,
• etc.

Then I’d make a list of resources available to meet those goals:

• Your current and future work income,
• Your existing savings (including the new windfall),
• Social Security,
• etc.

Then I’d play a matching game — allocating resources to satisfy your goals in order of importance. Once the highest priority goal is satisfied (using any combination of resources), you can start allocating resources to the next highest priority.

For example, if retirement is the #1 priority, are your existing savings (including the windfall) large enough that they would likely fund your retirement if you let them grow untouched between now and your planned retirement age? If so, then you no longer need to save for retirement every year, and you can begin allocating resources to other goals. (Of course, this decision should be revisited periodically based on how well the money is/isn’t growing over time.)

Tax-planning note: Even if you no longer have to save for retirement per se, it still likely makes sense to max out your retirement accounts every year. For example, contribute $16,500 to a 401(k) and $5,000 to a Roth IRA, while spending $21,500 out of the taxable windfall you received in order to effectively transfer as much of the windfall as possible to tax-advantaged accounts.

In short, my suggestion would be to make decisions from the broader perspective of how to meet as many of your goals as possible (in order of importance) using your total resources rather than trying to figure out what to do with just this one part of your resources.

November 30, 2011 6 comments

My post last week encouraging you not to hesitate to ask questions resulted (not at all surprisingly) in a great many questions from readers.

What did surprise me was that the most frequently asked-about topic wasn’t investing at all — at least not directly. People had lots of questions about working as a financial advisor. Specifically, they wanted to know:

• Why I left the field despite still being very interested in investing,
• How much of an advisor’s time is spent on sales work as opposed to actually working with clients, and
• What I thought about working at Edward Jones as opposed to other firms.

Why I’m No Longer an Advisor

In short, the reason I quit working as an advisor is that I was not very successful at it. It didn’t take long for me to realize that I had a lot more fun when I was researching and learning about investing and tax planning than when I was networking, knocking on doors, or making phone calls.

But, as it turns out, reading books doesn’t bring in very many clients. And not-many clients means not-much income.

Are Advisors Salespeople?

As far as Edward Jones goes, yes, it’s definitely a sales position. Back when I went to work for them (2006), their website stated this fact very clearly, and the people involved in the recruiting process made sure to point it out as well. I’m not entirely sure why they’ve changed that.

To be clear though, the same thing applies to new financial advisors at other firms. When you’re new in the business, you have no existing clients. So, naturally, most of your time is spent trying to bring in clients. And that means sales-work.

[Exception: If you're able to find a position at a firm that currently has more clients than it can handle, your time would obviously be spent differently. My understanding, however, is that these positions are not exactly abundant.]

The difference between brokerage firms (like Jones) and fee-only firms is that at a brokerage firm your job is to sell investments (specifically, ones that pay a commission), whereas at a fee-only firm your job would be to sell the service — the planning itself.

Which Firm to Work For

Personally, I think the fee-only model does a better job of preventing conflicts of interest between the advisor and the client. Unfortunately, the biggest recruiters in the industry (i.e., large brokerage firms, banks, and insurance companies) use the commission-paid model for most of their business.

That leaves you with three options, each of which presents its own challenges:

1. Look for a position at a fee-only firm. (The challenge here being that such positions are more difficult to find.)
2. Start your own independent practice. (The challenge being that you have to pay the start-up expenses and you’ll be earning very little while you find clients.)
3. Go to work at a bank, brokerage firm, or insurance company, building your business in the most ethical way possible within that firm’s constraints, possibly with the intention of going independent later once you’ve built your client base.

Of course, all of the above comes with the caveat that this is the viewpoint of somebody who was only in the industry for approximately one year, worked for only one firm, and wasn’t particularly successful there. So if being a financial advisor is a career path you’re seriously considering, I’d definitely suggest getting other opinions as well.

November 16, 2011 8 comments

Carolyn writes in to ask,

“I recently started a new job and am looking for some help with the 401k. The plan doesn’t offer any bond funds with expense ratios below 1%. The plan does offer a stable value fund, but I’m not really clear on what that is, and there’s no ticker symbol for me to look up the fund online. Is a stable value fund a good replacement for a bond fund when you have no other low-cost choice?”

In short, a stable value fund is a bond fund that has an additional level of protection via insurance contracts that guarantee the value of the fund against fluctuations — whereas normal bond funds fluctuate in value every day due to changes in the value of the underlying bonds.

Risk and Expected Return

Because stable value funds have a double layer of protection (high-quality bonds, plus insurance protection) they’re definitely at the low-risk end of the investment spectrum.

Their risk level is somewhat higher than that of a savings or money market account (because insurance companies don’t quite offer the same degree of protection that you get with FDIC insurance) and somewhat lower than that of a typical intermediate-term bond fund (one without an insurance “wrapper”).

And as you might expect, stable value funds typically offer higher returns than FDIC-insured accounts (because they’re investing in investments that carry some degree of risk) and lower returns than a typical intermediate-term bond fund (because of the costs of the insurance protection).

Speaking of Costs…

Naturally, the fee that the insurance company charges reduces the fund’s return. With regard to asset allocation decisions, this fee is relevant for two reasons.

First, if the fee is particularly high, it may mean that the stable value fund isn’t actually any lower-cost than the other bond funds available in the plan — in which case you may want to use one of the other bond funds instead. (Or, even better, do your best to satisfy your bond allocation using low-cost bond funds in an IRA where you have your choice of investment options.)

Second, if you do decide to use the stable value fund for your bond allocation, it’s worth recognizing that it has lower risk and lower expected return than most bond funds. As a result, you may want to adjust your overall stock allocation upward slightly relative to what it would be if you were using a typical bond fund for your bond allocation.

October 19, 2011 3 comments

I don’t particularly enjoy the administrative aspect of managing my portfolio. And my correspondence with readers suggests I’m not alone. Many people find rebalancing to be confusing and/or a hassle.

Some financial advisors provide a rebalancing service. But I don’t think that’s an ideal solution in this case. The value of a financial advisor is in the advice that he or she provides. If you don’t need any advice, it’s probably not worth hiring an advisor just to handle menial stuff like rebalancing.

Similarly, target retirement funds are a step in the right direction, but they still leave some things to be desired:

• At companies other than Vanguard, they cost too much;
• Even at Vanguard, it’s possible that none of the funds have an allocation that’s a good fit for a particular investor (for example, somebody who is in a high tax bracket and investing in a taxable account would probably want to use tax-free muni bonds for his/her bond allocation); and
• There’s always the possibility that the fund company will shift the fund’s allocation (away from the allocation you were counting on) without you noticing.

My Request: A Rebalancing Service

I’d like my brokerage firm to be able to handle rebalancing for me.

In its simplest form, this would just be an alternative method of placing buy/sell orders. Currently, when I rebalance, I calculate the dollar amount of each fund that I need to buy/sell, then I place a transaction for each fund.

Rather than using dollar amounts, and rather than having to execute multiple transactions, I’d like to be able to just enter a percentage for each fund, click one button, and have the account rebalance to that overall allocation.

Even better would be a “build-your-own-target-date-fund” concept. I’d love to be able to:

• Pick a group of funds,
• Pick a current allocation between them and an asset allocation glide path (i.e., what the allocation will be in the future), and
• Have my brokerage firm automatically rebalance back to that allocation for me on pre-determined dates.

Potential Hang-Up: Multiple Accounts

Admittedly, I’m not entirely sure how the service would most-ideally work in the case of a portfolio made up of multiple accounts. It’d be easy to set things up to rebalance each account to the desired allocation, but that’s not always ideal, as it can result in higher costs as a result of:

• Holding tax-inefficient funds in taxable accounts, or
• Not qualifying for the lower-cost admiral shares as quickly as could be done otherwise.

In addition, things get tricky when the investor has a retirement plan at work that has to be considered as well when calculating the investor’s overall asset allocation.

But I don’t think that’s necessarily a problem. It seems to me that as long as the current method of rebalancing is still offered, investors could simply use that approach when it’s a better fit.

What Do You Think?

For investors: What do you think of this idea? Would you use it? Do you have any suggestions for ways to improve on it?

For fund companies/brokerage firms: Is there anything stopping you from offering this service? I know of one brokerage firm (Folio Investing) that offers something like this, but why not the larger brokerage firms too (ideally those that offer commission-free trades)?

September 28, 2011 22 comments

A reader writes in to ask:

“I’ve read several articles arguing that you should save for your own retirement before saving for your kids’ college. What is your opinion on this matter? Should IRA/401k contributions be a higher or lower priority than 529 contributions? And what factors play a role in the decision?”

I don’t always agree with conventional wisdom, but in this case I think it’s on-target. Retirement saving should usually be a higher priority than saving for one’s children’s college.

It’s About Flexibility

The primary reason that retirement saving should be a higher priority is that there’s a lot more flexibility when it comes to paying for college than paying for retirement. Specifically:

• You can often take out very low-cost loans to pay for college. There are no such loans available to pay for retirement.
• You get to choose when you go to college. You don’t always get to choose when you retire.
• There’s a possibility of college scholarships. There are no retirement scholarships.

In addition, IRAs offer a bit more flexibility than 529 plans in that amounts in IRAs (Roth, traditional, SEP, etc.) can be withdrawn without having to pay the 10% penalty if you use the money to pay for qualified higher education expenses. In contrast, if you were to withdraw earnings from a 529 plan in order to pay for retirement expenses, you’d (usually) have to pay a 10% penalty.

That said, if you’re already ahead of schedule with regard to retirement savings, it can be a great idea to start funding a 529–especially if your state offers tax breaks in addition to the Federal ones.

How to Know if You’re Ahead of Schedule

As we’ve discussed before, I have a strong distrust for most online retirement planning calculators. They tend to be based on such poor assumptions that the calculator’s final output ends up being meaningless.

Vanguard’s Retirement Income Calculator, however, is better than most. It can give you a rough idea of whether or not your retirement savings are on track. Still, it does make two questionable assumptions:

• It assumes a constant rate of return during the accumulation years, and
• It assumes you’ll need 85% of your pre-retirement income during retirement. (Note: If you have a better idea of how much monthly income you’ll need in retirement, you can simply adjust the “current annual income” input so that the “what you’ll need” output is more on-target.*)

Even if your retirement savings are on track though, I’d suggest erring heavily on the side of retirement savings rather than college savings. It’s easy for an investor who was on track saving for retirement to end up off track after an unexpected period of unemployment or after being forced into retirement several years earlier than expected.

*If you use the “Get your SSA.gov Social Security benefit estimate” button, having changed your income input will throw that estimate off. That said, Social Security benefits are calculated based on your 35 highest-earning years, not just your current income, so any estimate based only on your current income (even if it’s your correct current income) is unlikely to be of much value.

June 8, 2011 2 comments