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Investing Blog Roundup: 20 Years of the “4% Rule”

The retirement planning concept of “safe withdrawal rates” (and the accompanying “4% rule” concept) can be traced back to an article by financial planner Bill Bengen — an article that was published 20 years ago this month (October, 1994). This week, the Journal of Financial Planning published a piece by financial planner Jonathan Guyton (with additional perspectives from a number of other big names in the retirement planning field) discussing the impact of Bengen’s research.

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Tax-Gain Harvesting with Bonds

Tax-loss harvesting is a very common tax strategy in which you sell a holding when its value is less than the amount you paid for it, then reinvest the proceeds from the sale in a similar (though not “substantially identical”) investment. The idea is that you then get to use the capital loss (up to $3,000 per year) to offset ordinary income on your tax return, without having to make any significant change to your portfolio.

Tax-gain harvesting is a somewhat less common strategy, as it’s generally only helpful for people in the 15% tax bracket or below. The idea is to sell a long-term holding for a gain, then reinvest the proceeds in a similar investment. The benefit comes from the fact that, if you’re in the 15% tax bracket or below, you do not have to pay any tax on the long-term capital gain, and now your cost basis in the asset has increased to the asset’s current value, thereby reducing the size of the capital gain that you might have to pay tax on in the future.

There is, however, a form of tax-gain harvesting that can be helpful even to investors who are in a tax bracket higher than 15%. It becomes relevant when you’ve held a bond for more than one year, and it is currently valued at a price higher than what you paid for it (i.e., the price has gone up because interest rates have fallen since you purchased the bond).

The idea is that, rather than holding the bond and continuing to receive payments at the bond’s higher-than-market interest rate, you sell your bond at a premium, then reinvest the proceeds in a bond that:

  • Has a similar credit quality and remaining maturity (so that you’re not changing the risk of your portfolio), yet
  • Is selling at (or very close to) its par value (e.g., because it’s a new bond).

By doing so, you essentially convert a portion of the yield that you would have received as interest into a long-term capital gain, which will be taxed at a lower rate than the interest income would have been. While it does result in having to pay the tax sooner than you otherwise would have had to (which is generally not a good thing), taking advantage of the difference in tax rates often allows you to achieve a higher after-tax return.

Investing Blog Roundup: Active Management Risk

The big news last week and early this week was the abrupt departure of legendary bond fund manager Bill Gross from PIMCO. (For those who don’t bother to learn the names of mutual fund managers: Bill Gross was one of founders of the company, and he ran the firm’s Total Return fund for many years with very impressive performance.)

This event is the perfect example of the “management risk” that investors in actively managed funds have to deal with. That is, investors in the fund now have to decide whether they should follow the fund manager to his new fund, stick with the fund without the legendary manager, or do something else entirely.

Jason Zweig and Allan Roth discuss the situation (and accompanying lessons to be learned) this week:

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Financial Advisor Fees Are Irrelevant, If You’ve Already Paid Them

A reader writes in, asking:

“After reading your books and others on the Boglehead reading list, I think I’ve determined that my new money should go to Vanguard index funds. But I’m thinking about keeping my existing savings with the advisor I’ve been using for several years. I’m less optimistic than ever about his ability to beat index funds but it seems like leaving him would mean that all the money I’ve paid in commission and fees over the years would be a waste. Does this line of thinking make sense?”

To put it bluntly, no, that line of thinking doesn’t make sense.

In economics, the commissions and fees that you’ve already paid your advisor would be referred to as “sunk costs” (i.e., costs that you’ve already paid and which cannot be recovered regardless of which action you take). For decision making purposes, sunk costs are irrelevant and should be ignored.

This concept is often best explained with an analogy. Imagine that it’s Saturday afternoon, and you just spent $9 to see this summer’s latest blockbuster movie. Twenty minutes into the movie, however, you realize that it’s simply not for you. In fact, it’s terrible. At this point, the $9 ticket price is irrelevant. Sitting through the rest of the movie doesn’t get you your $9 back. All that matters is what you want to do with the next 90 minutes of your life. If sitting through the rest of the movie isn’t the option that brings you the most happiness, you shouldn’t do it.

Commissions and fees that you’ve already paid to an advisor are like that $9 movie ticket. You’re not getting them back. So the only question that matters is which route looks best going forward.

In other words, if there is no cost to make the switch (e.g., capital gains taxes), the only thing that matters is which you expect to perform better in the future: money that you have invested with the advisor, or the Vanguard index fund portfolio that you’ve planned. If you think the index funds would perform better, there’s no sense continuing to pay more fees just because you’ve already paid some fees.

Investing Blog Roundup: Spending in Retirement

This week, two articles dealing with recent retirement-related research came across my radar — one discussing income, spending, and overall satisfaction in retirement, the other discussing mental health in retirement:

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Investing Blog Roundup: Market Valuations and Retirement Asset Allocation

Housekeeping note: We have family and friends visiting from out of town this week and early next week, so there will be no article on Monday.

This week researchers Wade Pfau and Michael Kitces released a new paper looking at an assortment of different asset allocation strategies in retirement — ranging from various static allocations, to various “glide path” allocations that either increase or decrease the stock portion over time, to various valuation-based allocations that adjust the stock/bond ratio over time based on whether stock valuations are high or low.

The paper and the authors’ respective summary articles can be found here:

If I were to offer my own very brief summary, it would be as follows:

  • Based on historical US data, adjusting asset allocation based on market valuations has modestly improved results for retirement portfolios, and
  • A fixed 60%-stock allocation is pretty darned good as well.

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