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Investing Blog Roundup: Bonds, Bond Funds, and Annuities

For the last few years, the most common questions I’ve received about portfolio construction have been about bonds — what to do about potentially-rising interest rates, whether to buy international bonds or not, whether to use individual bonds or bond funds, etc. This week, I encountered three different articles putting forth interesting/uncommon ideas about fixed-income investing.

Other Money-Related Articles

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Where Can You Get Unbiased Financial Information?

A reader writes in, asking:

“I’m a bit of a late starter, financially speaking. I am in my late 30′s but only now beginning to learn in earnest about personal finance. One challenge I have run into is that I cannot tell who is giving good information and who is just selling me something. Where would you recommend looking for unbiased financial and investing information?”

The short answer is that nobody in the financial services industry (or financial publishing industry) is an unbiased source of information.

With regard to advisors, the most obvious conflicts of interest are created by a commission pay structure. Commission-paid advisors have a strong incentive to steer you toward insurance products and mutual funds that pay a commission, rather than low-cost index funds that do not pay a commission.

But other advisors have conflicts of interest too.

  • Advisors paid as a percentage of assets under management have an incentive to maximize your portfolio size, even when doing something else (e.g., spending the portfolio down to pay off your mortgage, delay Social Security, or buy a lifetime annuity) may be in your best interest;
  • Advisors who charge a fixed periodic retainer (e.g., a flat $X quarterly fee) have an incentive to gather a lot of assets while doing the least work possible on each portfolio, even when it may be beneficial to the client to pay somewhat more attention to it; and
  • Advisors who charge an hourly fee have an incentive to make things more complicated than they really need to be. (And all advisors have an incentive to make investing appear more complicated than it really is.)

Financial publications (and their writers) have conflicts of interest as well.

  • Most financial publications make the majority of their revenue from advertising. As a result, they’re often reluctant to publish articles explaining exactly how bad certain financial products are.
  • And every financial publication (including this one!) has an incentive to convince you of the importance of each topic being discussed. We need you to keep visiting our sites, buying our books, paying subscription fees, etc.

Even academic research can’t be assumed to be conflict-free. In many cases, the research is funded by a company with a product to sell. (For instance, many pieces of research regarding annuities have been funded by insurance companies.)

Of course, this doesn’t mean that none of these sources are helpful. Advisors, financial publications, and academic studies can all be very helpful. But it’s critical to be aware of the conflicts involved so that you know how the information you are encountering might be slanted.

So Where Can You Get Unbiased Information?

About the only way to get truly unbiased information is to get it from somebody who makes their living in a completely different field. For example, your neighbor who works as a software developer has little reason to convince you to make one investment decision as opposed to another. Of course, the problem is that, in most cases, such sources not only lack conflicts of interest, they also lack expertise.

As far as unbiased sources that are still knowledgable, something like the Bogleheads forum is about the closest you can get. Most people there do not work in the financial industry at all and therefore have nothing to gain from convincing you of one course of action over another. That said, even there it is important to be careful. Most people are anonymous, so it can be hard to know how much faith to put in any one person’s information or opinions. Also, some people there do actually have conflicts of interest (specifically, those of us who work in any of the types of positions mentioned above).

Investing Blog Roundup: What’s the Biggest 529 Plan?

This week, Harry Sit of The Finance Buff asks which state has the biggest 529 plan. The answer — and the reason for it — is a pretty telling fact about how the investment industry works.

Investing Articles

Other Money-Related Articles

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The Age 55 Rule for 401(k) Accounts

A reader writes in, asking:

“I recently heard that if I am laid off at age 55, I can get money out of my 401K before turning 59.5 without having to pay the 10% penalty. Is that true, and if so could you elaborate on how that works?”

This rule comes from Internal Revenue Code 72(t)(2)(A)(v), which states that the 10% additional tax for early distributions does not apply to any distributions that are “made to an employee after separation from service after attainment of age 55.”

In reality, however, the rule is slightly more lenient than that. IRS Notice 87-13* states that “a distribution to an employee from a qualified plan will be treated as within section 72(t)(2)(A)(v) if (i) it is made after the employee has separated from service for the employer maintaining the plan and (ii) such separation from service occurred during or after the calendar year in which the employee attained age 55.”

In other words, you can take money out of a qualified plan account (such as a 401(k)) without having to pay the 10% penalty, if:

  1. You have left the employer in question, and
  2. You left that employer in or after the calendar year in which you reached age 55.

A Few Points of Clarification

There are several points about this rule that often trip people up, so let’s go through them one by one.

First, it doesn’t matter how/why the separation from service occurred. Quitting counts. Getting laid off counts. Getting fired counts.

Second, it is the separation from service (not just the distribution) that must occur at the age in question. For example, if you left your employer at age 53, even if you are now age 55, distributions from your 401(k) with that employer would still be subject to the 10% penalty, unless you meet one of the other exceptions.

Third, you don’t have to be retired to qualify for this exception to the 10% penalty. For example, if at age 56 you leave Employer A and take a job with Employer B, your 401(k) account from Employer A is now accessible penalty-free — even though you’re not retired.

Fourth, it doesn’t have to be your most recent employer. For example, if, at age 56, you leave Employer A and take a job with Employer B, then you retire from Employer B at age 58, your 401(k) accounts from both Employer A and Employer B are now accessible penalty-free (because in each case, you separated from service in or after the calendar year in which you reached age 55).

Fifth, this exception does not apply to IRAs, and that’s true even if the money in the IRA came from a 401(k) that would have met the requirements. For example, if you leave your employer at age 57 and roll your 401(k) into an IRA account, distributions from that IRA would still be subject to the 10% penalty, unless you meet one of the other exceptions. (And yes, in some cases, this is an excellent reason to wait to roll over a 401(k) until you have reached age 59.5.)

*Unfortunately, the only place I can find this notice online (it is from 1987, after all) is in the Internal Revenue Cumulative Bulletin 1987 [Part 1], available here. (Be prepared to wait a while for the download. The relevant wording is on page 441.)

Investing Blog Roundup: Finding the Optimal Portfolio

A pattern I’ve seen over and over is that, when an investor starts to learn about passive investing, they get stuck trying to figure out how to allocate their portfolio. They can’t figure out exactly how much they want in Fund A as opposed to Fund B, and they can’t quite decide whether or not they should include Fund C.

As Rick Ferri explains this week, trying to find the precisely optimal portfolio is an exercise in futility — even for the experts with access to the best data and software — because the critical inputs (including average returns for asset classes and correlation between them) change meaningfully over time.

Investing Articles

Other Money-Related Articles

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How Social Security Disability Benefits Are Calculated

A reader writes in, asking:

“I have a medical condition that would automatically qualify me for Social Security disability benefits. What I am trying to figure out is whether I should file for those benefits now or wait a few years until I’m 62 and file for retirement benefits. Could you explain for readers how disability benefits are calculated?”

The easiest way to get an estimate of your potential disability benefit is to create an account on the SSA.gov website. If you sign in and click over to the “estimated benefits” tab, you can see what your disability benefit would be if you were deemed disabled right now. (You can also see what your retirement benefit would be, given certain assumptions.)

If you’re interested in understanding the actual math though, the short answer is that disability benefits are calculated very similarly to retirement benefits, but with fewer years of earnings history in the calculations.

More specifically:

  • Your disability benefit is calculated as if it were a retirement benefit, and as if you were age 62 at the beginning of your 5-month disability waiting period.*
  • The “primary insurance amount” upon which the disability benefit is based is calculated in exactly the same way that it would be for a retirement benefit. That is, it still replaces a percentage of your “average indexed monthly earnings” [AIME], with a lower percentage being replaced the higher your AIME is.

The primary difference between retirement benefit calculations and disability benefit calculations is that your AIME is calculated differently.

How AIME is Calculated for Disability Benefits

In non-disability cases, your AIME is calculated based on your 35 highest years of (wage-inflation-adjusted) earnings.

With disability benefits, however, the law recognizes that you may not have been able to acquire 35 years of earnings. So an additional calculation must be done to determine how many years will be included in the calculation.

Specifically, the SSA counts the number of years beginning with the year in which you reach age 22 and ending with the year before the year you become disabled. Then they subtract the lesser of:

  • One fifth of that total number of years (rounded down), or
  • 5 years.

Note that this “beginning with age 22″ business is only with regard to determining how many years they will count, not which years they will count. In other words, if some of your highest-earning years are actually before age 22, those years can be included in the calculation.

Example 1: If you become disabled in the year in which you turn 36, there would be 14 total years between age 22 and the year before the year you become disabled. From that, they subtract the lesser of:

  • One fifth of 14 years, rounded down (i.e., 2 years), or
  • 5 years.

So the calculation of your disability benefit would be based on your 12 highest years of (wage-inflation-adjusted) earnings.

Example 2: If you become disabled in the year in which you turn 59, there would be 37 total years between age 22 and the year before the year you become disabled. From that, they subtract the lesser of:

  • One fifth of 37 years, rounded down (i.e., 7 years), or
  • 5 years.

So the calculation of your disability benefit would be based on your 32 highest years of (wage-inflation-adjusted) earnings.

*In order to apply for disability benefits, you must have been disabled for 5 full consecutive months. This “waiting period” begins with the first month in which you were disabled, but no earlier than the 17th month before the month you apply, no matter how long you were disabled before then.

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Topics Covered in the Book:
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