Sound Investing 6: Expenses

June 20, 2013

Previous | Next

Avoid unnecessary fees and expenses

You can’t invest without incurring some fees and expenses. When you buy and sell individual securities through a broker, you pay a transaction fee. When you invest in a mutual fund, you pay the fund’s annual management expenses. If you have a retirement plan like a 401(k), you pay a fee to the plan manager. If you buy financial advice, you pay your advisor in one way or another, whether it’s an hourly fee, a flat fee for a financial plan, a commission on financial products you buy, or an annual management fee to manage your investments for you.

The challenge here is to determine what you are actually getting for what you are paying. When something in my house needs fixing, I’m often willing to pay someone to fix it because I can tell the difference between an expert repair and one that I try to do myself. But how many investors can tell the difference between a cost-effective investment and an overpriced mediocrity, or between sound financial guidance and a bum steer? Investors may not even be aware of some of the expenses they are incurring because they’re quietly deducted without showing up explicitly on a statement. And the impact of costs on investment results is hard to assess because so many other factors affect financial performance, not the least of which are general market conditions and luck. Your financial service provider isn’t to blame if the market falls, but may be to blame for promoting products whose excessive costs aren’t justified by superior performance. Unfortunately, the complexity of financial products provides many opportunities to take advantage of unwary consumers.

Although the question won’t have an easy answer, the right question to ask is whether you are achieving any added value for your portfolio by incurring a particular expense.

No-load, low-expense funds

The post on diversification discussed mutual funds as a convenient way of investing in a wide variety of securities. Now consider how to get the benefits of mutual funds without unnecessary fees and expenses.

First, give preference to no-load funds. Loads are sales commissions on mutual funds purchased through a broker, ranging anywhere from 3% to 8% of the money invested. Frequently you have a choice of different fee structures, such as a choice between a one-time up-front commission or higher expenses in every year you own the fund. If you intend to own the fund for a long time, the up-front commission (the “A” shares) can be the better choice. But often an even better option is to contact a mutual fund company that sells its funds directly to the public, such as Vanguard or T. Rowe Price. There you can probably find an acceptable fund with neither a sales load nor high expenses. You don’t have to sacrifice performance when you go this route. The American Association of Individual Investors says, “Funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. For every high-performing load fund, there exists a similar no-load or low-load fund that can be purchased more cheaply.”

Every mutual fund prospectus is required to list the fund’s fees and expenses. Ideally you will see “none” in the fees part, or only some very small fees for good reasons, such as a fee for redeeming shares within one year, in order to protect the fund and its shareholders against the costs of short-term trading. What you do have to pay in any fund is annual management expenses, but you can pay very different expenses for quite similar products. This is especially true for the kinds of funds whose returns are otherwise fairly predictable, such as money market funds and bond funds holding similar types of bonds. Expense ratios may seem to vary in a narrow range (1.5% per year for one fund vs. 0.5% for another, for example), but over time, such small differences compound into large variations in investment returns. If you invest $10,000 and let it compound for 20 years, you will have $56,044 if you get a 9% return, but only $46,610 if you get an 8% return because of an extra 1% in expenses. The longer you invest in a fund, the more of your investment return you will forfeit if the fund underperforms the market because of its fees. A study by Stewart Neufeld found that underperforming the market by just 1% will cost you about 30% of your total gain over 30 years and about 40% over 50 years (Journal of Financial Planning 12/11).

When trying to hold your fund expenses down, consider exchange-traded funds (ETFs) as well as traditional mutual funds. You will pay at least a small transaction fee to purchase an ETF through a broker, but annual expenses should be as low or lower than the least expensive mutual funds. Many new kinds of ETFs are appearing, however, and not all of them are designed to provide a market return at low cost.

Index funds vs. actively managed funds

The lowest expenses are generally found in index funds because they save money by doing less research and making fewer trades. An S&P 500 index fund will hold the same 500 stocks until Standard and Poor’s changes the stocks included in the index itself. This is also known as passive investing. Its goal is to get as close to a market return as possible, unencumbered by high fees, and it can achieve that goal pretty reliably. In contrast, actively managed funds buy and sell more frequently in order to try to beat the market, so they incur additional expenses for trading and researching companies. The additional costs to shareholders can easily knock two or three percentage points off your investment return. One of the most hotly debated questions in the industry is how often active management adds enough value in skillful security selection to offset and justify the higher costs. Is active management worth paying for, or is it more cost-effective to invest primarily in low-cost index funds?

Both sides in this debate agree that an index fund can only provide a market return (minus a very small amount for expenses), while an actively managed fund has at least some potential to beat the market. The question is how often actively managed funds actually live up to that potential. Researching that question isn’t a simple matter, since there are so many kinds of funds, so many management styles, so many fluctuations in performance, so many old funds closing and new ones opening, and so forth. One of the key issues is what “benchmark” to use when comparing a particular fund to the market. The S & P 500 stock index is a good benchmark for comparing US large-cap stock funds, but appropriate benchmarks are less obvious for funds with less common specializations. The best research does appear to support these broad generalizations:

  • Index funds provide a return that is close to the market average, but an actively managed fund can do either better or worse than the average
  • Fewer actively managed funds beat their market benchmark than fall short of it
  • The longer the time period considered, the more likely it is that an actively managed fund will underperform the market

The last point is a particularly interesting one, since it calls into question not only the ability of most active managers to beat the market, but the ability of investors to identify the ones who can be relied on to beat the market in the long run. Studies of mutual fund performance do find some tendency for performance to persist from year to year, but the finding must be carefully qualified. One of the reasons for continuity is that many of the same overpriced, low-performance funds do badly year after year. Those can be avoided. But choosing among the remaining funds is hard, since continuities in market-beating performance tend to be short-lived. Most of today’s winners probably won’t be the highest performers a few years from now. That leaves the active investor with two alternatives: either chase performance by frequently moving assets to “hot” funds (running a significant risk of losing money by buying high and selling low), or stay in one fund hoping that it’s one of the very few that can beat the market in the long run despite the burden of its management and trading costs.

Beating the market is both very appealing and theoretically possible, but it’s harder than most people realize, contrary to the message of some financial media and some financial services sales forces. Since there are thousands of funds, some of them are on winning streaks at any given time, either because they’re lucky or because market conditions happen to favor their particular investing style. Apparent winners get a lot of play in the media, both in advertising and press coverage, creating the impression that their managers have extraordinary abilities. But the more spectacular the performance over a few years, the greater the chance of deteriorating performance over the next few years (a familiar statistical phenomenon known as “regression toward the mean”).

Why is beating the market so hard? One reason is the inherent difficulty of stock picking, since stock movements depend so heavily on earnings surprises (discussed in the risk section). The second is the fact that so much of the market consists of mutual funds, so that professional fund managers are competing against one another: If some are performing above the market average, others must be performing below it. The third problem is the higher costs associated with active management, which tend to drag even more of the funds below the market average. When Andrew Feinberg reported that only one out of every eight mutual funds beat the S&P 500 index over a twenty-year period, he titled his article “Lake Wobegon in Reverse” because so many of the funds were below average (Kiplinger’s 11/03).

A few managers probably are truly superior, but only a long and consistent track record can distinguish skill from luck. By the time the true superiority of a fund becomes apparent, it may be closed to new investors, or the manager may switch jobs or retire. Fidelity Magellan did very well while Peter Lynch was managing it, but not so well after he retired. If the fund does remain open with the same manager, it may get so large that it has to buy too many stocks in order to avoid bidding up the price of the fewer companies it would most like to buy; so it becomes less selective and more mediocre. Many big fund managers are really “closet indexers,” too unselective to have any hope of beating the market, but charging fees as if they could! If all you need is an index fund, then that’s all you should pay for.

Consider one additional point, requiring a bit of reflection. Suppose that actively managed funds had a wide range of performance (that much is true), but on the average performed as well as the general market (that part is not quite true because expenses are a drag on performance). Would you be willing to risk underperforming the market for an equal chance at outperforming the market? Suppose your employer let you choose between receiving your regular salary or randomly selecting from different envelopes with varying amounts of money, some more than your salary but some less. Would you gamble with your livelihood, knowing that in the long run you have no rational expectation of coming out ahead? Where is the added value, especially if your employer starts charging you a fee to select an envelope!? I repeat that the issue is hotly debated, but many financial planners are skeptical about the added value of actively managed funds for the ordinary investor. Dan Wheeler says, “The most rigorous studies–those with adequate sample sizes and periods, benchmarks that control for risk and survivorship bias–reveal a trend: the pros don’t add value on a consistent enough basis to warrant their fees” (Financial Planning 11/06).

That’s why many financial planners, as well as many of the most sophisticated investors like Warren Buffet, recommend that most ordinary investors make index funds the core of their investment holdings. Investors who would also like to have some potential for outperforming the market should seek actively managed funds with moderate expenses, relatively high returns for several years, and managers who have been with the fund a long time. But recognize that you will need some luck to avoid underperformance, so there is an element of gambling in this approach.

Insurance costs

Insurance companies have developed a number of products that combine insurance with investment. Part of what you pay to the insurance company is invested on your behalf, and may have a potential for a high return. Another part insures that you will receive at least some benefit, such as a death benefit or a guaranteed minimum annual payment. In general, these products are both more expensive and more complicated than direct investment in mutual funds, so consumers should tread carefully in this area. The insurance features of the product should add enough value to justify the added cost, but that is often difficult to determine.

First, consider a case in which insurance does appear to add value. You are retired with a nest egg large enough to live on for many years, but you have a reasonable probability of living long enough to run out of money someday. One solution is to take a portion of your nest egg and purchase an immediate life annuity, guaranteeing that you will have at least some income for life. Another alternative is to buy longevity insurance, which starts paying an annuity only if you live beyond a certain age. There is added value here in the form of a potential to receive something you wouldn’t otherwise have gotten, an income if you live a very long time. (If you live too short a time, you won’t recover your premium cost.) Immediate annuities and longevity insurance will be discussed further in a later post.

What you want to avoid is buying insurance you don’t really need, or that doesn’t do enough for you to justify its cost. One insurance product that companies are often accused of overselling is the variable deferred annuity. Many financial professionals earn commissions from selling them, but others neither sell them nor encourage their clients to buy them. A variable annuity is an investment through an insurance company in assets that can fluctuate in value, especially stocks. You fund the account with a lump sum or with periodic payments over time. Eventually the account will be annuitized–converted to a series of regular payments, often for life. “Deferred” means that this will happen sometime in the future rather than immediately. Investment returns are sheltered from taxation until withdrawals begin, but are taxed as ordinary income when withdrawn. (This additional tax shelter appeals to investors who are already maxing out their contributions to their retirement plans, as well as to aggressive traders who want to be able to buy and sell in the account without worrying about capital gains taxes.) Variable annuities have a death benefit that is paid if the owner dies before withdrawals begin. Many also have “living benefits” that guarantee some minimum value when the account is annuitized. In effect, you are paying the insurance company to insure you against some of the risks of investing in fluctuating markets.

The special features of variable annuities come at high cost, since you are paying for a layer of insurance protection in addition to the costs of managing the investments themselves. Total fees can be many times what you would pay for a mutual fund, substantially reducing your returns. For that you are getting the promise of an annual payment for life someday. (But then, you could get that by annuitizing whatever nest egg you accumulate yourself.) You are also being protected against catastrophic losses, but a properly diversified portfolio of mutual funds or ETFs can provide much of that protection at lower cost.

Variable annuities have other disadvantages: The data needed to evaluate them as investments, such as risk-adjusted performance measures, are not as readily available as they are for mutual funds. Variable annuities are not very liquid, since they often carry surrender charges or other penalties for terminating the contract before a certain number of years. And although investment returns are tax-sheltered until you begin withdrawals, this provides no benefit if the annuity is held within an account that is already tax sheltered, such as an IRA or 403(b). Annuities can even have adverse tax consequences, since dividends and capital gains will ultimately be taxed at ordinary income rates instead of at the lower rates that otherwise would apply.

The main argument for variable annuities is that they can provide a moderate income for life even if markets perform badly. Investors who have that guarantee may feel more comfortable allocating a larger portion of their portfolios to stock. The high return from stock could offset the costs of the annuity and produce a superior return for the entire portfolio. But few purchasers of variable annuities may understand that point or feel comfortable acting on it. Investors who don’t like to invest aggressively may not get much added value from a variable annuity. They might do just as well–and keep their portfolios simpler, clearer and more liquid–with a balanced portfolio of stocks and bonds. Then their portfolio may not be risky enough to require insurance.

An even more controversial version of the variable annuity is the equity indexed annuity. On the one hand it offers the security of a minimum fixed return on one’s investment. On the other hand it offers a potentially higher return based on some portion of the stock market’s gains. (For example, if the market is up 15%, your gain might be capped at 7%. Since stock investors make most of their money in the really good years, this is a significant limitation.) You get some protection from downside risk, but at the cost of high fees and a cap on upside potential. This is another complex arrangement that is hard for a buyer to evaluate. Most independent evaluations I’ve seen have concluded that it doesn’t offer enough advantage over a balanced portfolio of stocks and bonds to justify its higher cost, so that most investors will come out behind by buying it.

Paying for financial advice

The same principles apply to buying financial advice: Don’t pay for more than you need, and expect added value for any costs you incur. You may be able to manage your own investments just fine with a little occasional help. If so, you don’t have to pay someone an annual fee of 1% to 2% of your assets to manage them for you. That can easily add up to thousands of dollars a year and put a heavy drag on performance. You may find it more economical to pay a one-time fee for help in formulating a plan, and then deal directly with mutual funds in order to avoid sales commissions.

Some people pay an annual fee for a financial manager, who may also be a salesperson with products to promote; then they pay commissions to buy mutual funds or annuities; then they pay high fees and expenses for active fund management or insurance features they may not need. So they pay and pay and pay without getting much added value, and they end up with much less than they could have had with a simpler and less expensive approach. A later section will deal with options for getting financial advice.

Sound Investing 11: Advice

June 27, 2013

Previous | Next

Get good financial advice

Do you need a financial advisor?

In their book Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich talk about the “ego trap,” their term for the overconfidence people often display in financial matters. Research shows that people are very likely both to overestimate their financial knowledge and to think that they are in better financial shape than they really are. Smart people shouldn’t be embarrassed to admit that they need financial advice. Part of the price we pay for our advanced economy is that our finances have become very complicated. Financial firms offer us a bewildering variety of investment products. The federal tax code imposes a complicated set of rules for taxing different kinds of investment returns. Employers present their workers with a confusing set of savings options instead of protecting them with traditional pensions. Very few people have the time and knowledge to evaluate all the alternatives by themselves.

Unfortunately, financial mistakes can be costly, especially if the results are compounded over many years. Here are some of the most common ones:

  • underestimating future financial needs, such as by underestimating how long one may live in retirement
  • saving too low a percentage of income
  • carrying debt at exorbitant rates of interest (especially credit card debt)
  • putting too much money into one kind of investment
  • risking too much money on trying to beat the market, instead of planning for an average market return
  • investing money needed in the near future too aggressively, or investing money not needed for a long time too conservatively
  • accepting high investment fees and expenses that are not justified by superior returns
  • paying too much to buy “hot” stocks or mutual funds, while overlooking more reasonably priced alternatives
  • failing to take full advantage of tax-sheltered savings plans, especially by passing up employer matching contributions

Investors who should know better often make these mistakes unwittingly, just by not giving enough attention to each financial decision. A good financial advisor should spot such problems very quickly and recommend solutions. In addition, professional advisors have technical tools for analyzing a client’s financial data and projecting long-term consequences of present choices. For example, a “Monte Carlo” simulation can forecast future returns, taking into account not only historically average rates of return for different investments, but also reasonably likely deviations from the historical averages. This approach can estimate the probability of achieving a financial goal by means of a particular investment strategy. Advisors cannot guarantee positive financial results, but they can help improve the odds.

What kind of advisor do you need?

The financial services industry has gotten very large, and investment advice is now available from many sources, such as brokers, mutual fund companies, insurance companies, accounting firms, and banks. Any of these could be a source of good advice. In order to avoid paying too much for too little, you should consider what kind of advice you need and how you will be charged for it. Beware of “free” advice that isn’t really free, because it steers you into unnecessarily costly investment options.

Ideally, your financial advisor should be someone with your best interests at heart. The term for such a person is “fiduciary.” According to the Certified Financial Planners Board of Standards, that’s “one who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client.” The danger is that people who call themselves financial advisors will put their own financial interests ahead of yours. That’s one reason Congress passed the Investment Advisers Act of 1940, which required those giving financial advice for compensation to register as investment advisors and adhere to a fiduciary standard. The Securities and Exchange Commission, however, made an exception for those whose primary business is trading securities, but who also give some advice to their customers. In recent years, brokers and other sellers of financial products have expanded their financial advising functions and often receive compensation for them. Nevertheless, the SEC continued to maintain that they did not have to register as investment advisors nor adhere to a fiduciary standard because their advice was “incidental” to their job as brokers. So two types of advisors, those obligated to put their clients’ interests first and those without such obligation, have co-existed in the financial services industry, with the general public often unable to tell the difference. Brokers and insurance agents have been able to call themselves financial advisors, without being obligated to recommend the products that are best for their customers.

On March 30, 2007, the U.S. Court of Appeals for the D.C. Circuit struck down the SEC rule that exempted brokers providing financial advice for compensation from the 1940 law. In the aftermath of the 2008 financial crisis, the Obama administration also proposed bringing brokers under a fiduciary standard. The Wall Street Reform and Consumer Protection Act of 2010 stopped short of imposing such a standard, but it did give the SEC the explicit authority to do so. In January 2011 the SEC released the findings from its study of the issue. It concluded: “The standard of conduct for all brokers, dealers and investment advisors, when providing personalized investment advice about securities to retail customers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment advisor providing the advice.” Whether the specific rules issued by the SEC will be strong enough to enforce that standard remains to be seen. Resistance to the fiduciary standard remains strong, especially from the insurance industry and Republican lawmakers.

[Note: A more recent post on the battle over the fiduciary rule is here.]

If you are looking for someone with a strong commitment to a fiduciary standard, you may want to limit your choice to Registered Investment Advisors. RIAs must be able to provide a copy of the disclosure Form ADV they file when registering, and you can also check their registration online at You may also want to look for a Certified Financial Planner, because CFPs must meet rigorous standards of education and experience.

How will you pay?

A related decision concerns how you want to pay for advice. The options include sales commissions, asset management fees, hourly fees, flat fees for preparing financial plans, or some combination of these.

Sales representatives of financial services companies can advise you on how to invest your money without charging you a specific fee. They make their money from salaries or commissions on the products they market. The disadvantage for the consumer is that these representatives may steer customers toward the products they sell rather than informing them of the full range of investment choices. Brokers often recommend mutual funds with high commissions and fees, and insurance agents recommend costly insurance products such as annuities. Investment author Burton Malkiel says that investors often make unwise choices because “most individuals get ‘sold’ financial products. Brokers and advisors don’t make any money if they put you in a Vanguard index fund, but they do get paid for selling you a hot, actively managed fund” (Journal of Financial Planning, 4/05). These products often generate inferior returns once costs are factored in, while more cost-effective products are overlooked.

“Fee-only” advisors accept no commissions for what they sell, which leaves them free to recommend whatever products they view as best for the client. Some of them give advice for an hourly fee, or charge a flat rate to prepare a financial plan. Others are asset managers who manage your portfolio on a continuing basis. (Not all asset managers are fee-only however; some sell securities on commission too.) Asset managers charge an annual management fee, usually a percentage of your total invested assets. This appeals to people who don’t want to have to deal with a lot of everyday financial tasks and decisions. It can be very costly however, since you are paying all the time. A 1% fee on a $500,000 account is $5,000 a year, and many managers won’t accept smaller accounts.

What kind of advising you get depends a lot on what you are able to pay. Low-income households may have to settle for “free” advice, even though it may sometimes steer them toward products with poor trade-offs of costs and returns. High-income households may prefer to hire asset managers, despite their high fees. What about all the people in between? How to deliver financial planning services to middle-income households is a much-discussed issue, since they can afford to pay something, but often not enough to be desirable clients for asset managers. Occasional financial consultations for a flat rate or hourly fee may work best for such clients. Websites like and offer inexpensive financial consultations online. No-load mutual fund companies like Vanguard offer various levels of assistance to their customers, some of which is free.

The good news from considering the principles of sound investing is that you can be a successful investor without making a large number of difficult decisions requiring frequent and costly advice. The main things you need to do–save regularly, maintain a diversified portfolio, take advantage of tax shelters, avoid unnecessary expenses, and so forth–are not fancy financial moves but just good habits. Once adopted, they can be practiced with a small amount of effort, like tending a well-planned garden. Small investors who take the right approach ought to be able to manage their investments themselves with only occasional input from a professional advisor.

Sound Investing 10: Social Responsibility

June 26, 2013

Previous | Next

Consider socially responsible investing

A broader concept of sound investing

This principle is different from the others because it broadens the idea of “sound investment” to include more than the pursuit of good financial returns. Many investors wish to select investments that will not only meet their personal financial objectives, but also contribute to a better society. They would like the companies in which they are shareholders to be working toward desirable social goals, or at least trying to avoid doing harm.

Not all economists and financial planners like to distinguish between what is profitable and what is good for society, but the economic concept of “externalities” provides a rationale for making the distinction. Economic transactions can have costs and benefits for people who aren’t party to the transaction. Corporations and those who buy their specific products don’t bear the full costs of damaging the environment, or reap the full profits from developing new ideas that spread widely in society. Markets sometimes reward individuals for doing things that have negative externalities (social costs), and sometimes fail to reward individuals for doing things that have positive externalities (social benefits). In theory, socially responsible investors can help correct this by favoring “good” companies over “bad” ones.

The devil, of course, is in the details. How does one go about rating companies by social criteria? In his book With Charity for All: Why Charities Are Failing and a Better Way to Give, Ken Stern shows how hard it is to find out if a charitable organization is actually doing good work. If organizations whose mission is the betterment of society rarely publish adequate data about their effectiveness, one can hardly expect profit-making corporations to provide a fair assessment of their social costs and benefits. One approach to selecting companies is to avoid industries whose products you disapprove of, such as armaments, or fossil fuels, or beef. If your concern goes deeper, including not just the product but the specific environmental or labor practices by which it is produced, you will probably need the guidance of social investment specialists.

Social investment funds

A number of mutual funds now specialize in socially responsible investing, and their assets have been growing rapidly. Today about one out of eight investment dollars flows into this type of investment. A lot of that money comes from large institutional investors like pension funds, whose investment decisions can have a large impact on society.

Socially responsible investing takes several different forms. The most common form is screening securities so as to include in a portfolio only those that meet certain social criteria. Many social investment funds avoid investing in companies associated with tobacco, alcohol, gambling, weapons, or animal testing; and many look for good records on environmental protection, human rights, and employment policies. Secondly, funds often engage in shareholder advocacy by voting their proxies in support of responsible corporate policies, or proposing their own resolutions at shareholder meetings. Finally, a few funds invest in community development in low-income areas where capital is hard to obtain. These funds may operate community development banks, credit unions and loan funds to help finance small businesses, affordable housing and community services. Socially responsible investing may be referred to as SRI, or more recently as ESG, for environmental, social and governance.

A good source of information is the Forum for Sustainable and Responsible Investing at It reports the investment policies, performance and fees of many different funds.

A financial sacrifice?

Critics of social investing suggest that investors may be sacrificing superior returns by basing their investing decisions on anything but strictly financial considerations. Some investors might be willing to make such a sacrifice, but they may reasonably ask how large a sacrifice, if any, is involved.

Some of the criticism is based on the assumption that investors can get market-beating returns by investing in the highest-performing mutual funds. Investors who limit themselves to the relatively small number of SRI funds may be overlooking most of the best performers. However, this argument may exaggerate the connection between past and future performance, and as a result underestimate how difficult it is to achieve consistently above average results even with conventional funds. In theory, an investor who could always be in the most successful funds would make more money than the social investor, but in practice, most investors who chase performance fail to outperform the market in the long run, and more often underperform it once trading costs and expenses are factored in (see my discussions of expenses and opportunity). It may be more relevant to compare the social funds to the market averages than to the highest performing funds in any given year.

Advocates of index funds argue that most investors do better in the long run by accepting the average return of the market than by paying active managers high fees to try and select superior stocks. From that perspective, SRI funds are financially sound investments only if they can offer broad diversification at low cost. Many social funds are quite selective and have relatively high fees because of the research that has to go into company screening. Although it is easy to screen companies for obvious things like selling cigarettes, it is much harder to evaluate a company’s environmental and human rights record, especially if the company has many different enterprises in many different countries. On the other hand, some funds have tried to emulate index funds by developing as diversified a list of companies as they can, consistent with social screening. Funds that want to hold down their own research costs can obtain such lists from others. Overall, social investing is probably more cost-effective than it used to be, but still a bit costlier than straightforward indexing. While the least expensive index funds have expense ratios under 0.1%, expenses for social funds are usually at least 0.5%, with many over 1.0% or even 2.0%. Performance data tracked by the Forum for Sustainable and Responsible Investing shows most social funds underperforming the S & P 500 over the past ten years, many by several percentage points a year. This is due partly, although probably not entirely, to their expenses.

One of the largest and most cost-effective index funds is Vanguard’s 500 Index Fund Admiral Shares, with an expense ratio of 0.05% and average annual return of 8.52% from 2003 to 2013. Vanguard also offers the FTSE Social Index Fund. It tracks the FTSE4Good index, which screens companies according to such criteria as environmental sustainability, human rights, labor standards, and avoidance of tobacco products and nuclear weapons. With an expense ratio of 0.29% and average annual ten-year return of 6.88%, FTSE Social Index is one of the most cost-effective social funds. Still, $10,000 invested in 2003 would have grown only to $17,860 by 2013, while it would have grown to $20,732 in the 500 Index Fund.

Your bottom line

In the end, the best investment plan is the one that is most appropriate for your particular goals and circumstances. Your financial goals don’t exist in a vacuum, but they connect to your life goals and to all that you care about in your family and your community. Investment income can contribute to the quality of life, but it can also detract from that quality if it comes at the expense of a clean environment or of human rights. Your real “bottom line” is not financial profit, but value however you define it.

Sound Investing 9: Making It Last

June 25, 2013

Previous | Next

Plan to make your assets last


“Live long and prosper”

When we save and invest, we are always trying to gain a degree of control over a future that is inherently uncertain. One of the biggest uncertainties is how long we will live. Average life expectancy is some help, but it is only an average. For example, if a man and a woman are both 65, on the average the woman can expect to live to age 84 and the man to age 81, based on current US mortality rates. (The gender gap is smaller at age 65 than at birth because the men have already survived some of their most dangerous years, when they have higher mortality from such causes as accidents and acts of violence.) But people should plan for the possibility of living long beyond the average, at least 90 or 95. Fortunately, retirement portfolios can continue to grow after retirement begins. In fact, they typically grow much more during retirement than in the accumulation phase leading up to retirement.

In order to finance a long retirement, our 65-year-old couple should still have a diversified portfolio. If they invest too much in stock, they could lose too much of their nest egg in a severe bear market, just when they need it to live on. But if they don’t invest in stock at all, their savings may not grow enough to finance a long retirement. Many planners recommend an allocation of as much as 50% stock for those who are in the early stages of retirement. As always, time horizon is an important consideration. Elderly retirees who expect to spend down their assets in the near future should not risk them in the stock market. On the other hand, financially secure seniors who expect to leave most of their assets to their heirs have a longer horizon and can better afford to ride out the volatility of the markets.

Retirees may also wish to adjust their asset allocation to take into account income from other sources besides investments, such as a pension or immediate annuity. A lifetime income stream has a substantial present value that may be added to one’s investments when calculating total financial assets. A pensioner who wishes to have 40% of total financial assets in stock might put more than 40% of invested assets into stock, to offset the pension as an uninvested fixed-income asset.

Safe withdrawal rates

Once you reach the point of living off an accumulated nest egg, how much can you safely withdraw from it each year? That’s another area where sophisticated mathematical tools are useful. If we know the allocation of your portfolio and the number of years you want to plan for, we can calculate a withdrawal rate that has a high probability of making your savings last. For example, if you have 50% in stock, 40% in bonds and 10% in cash, and you want your savings to last for 30 years, many mathematical models suggest an initial withdrawal rate of 4%. That means that in the first year you can withdraw an amount equal to 4% of your retirement savings, then increase the dollar amount by the rate of inflation each year.

A withdrawal rate of 4% may sound very low. That would mean that you need $250,000 in investments just to take out $10,000 the first year. But a nest egg that large is not an unreasonable goal for an ordinary household, when you consider the power of compounding (see the discussion of getting time on your side).

Recently, a number of analysts have questioned the simple 4% rule, arguing that it relies too heavily on average historical returns and neglects current economic conditions. If you retire at the end of a bear market, when stock prices are low relative to corporate earnings, then you can probably sustain a higher rate of withdrawal, since chances are good that stock prices will rise over the course of your retirement. But if you retire at the end of a bull market, your portfolio may not get too much larger than it is already, so a very conservative withdrawal rate may be called for. One rule of thumb is to withdraw more than 4% a year if the Price/Earnings ratio of the S&P 500 when you retire is below its historical average (about 16), but withdraw less than 4% a year if P/E is above its historical average. The bull market that preceded the crash of 2008 had an especially high spike in P/E (over 40), leading some analysts to warn those who retired at the peak that they could run out of money if they took annual withdrawals of more than 2%!

Some mutual fund companies now offer special funds to manage your withdrawals for you. Some of them adjust the mix of investments to sustain a given withdrawal rate, while others adjust the withdrawal rate to make the funds last for a given number of years. These funds cannot guarantee that you won’t run out of money, but they reduce that risk.

Savings rates reconsidered

Recognizing that unfavorable economic conditions can easily reduce the amounts available for retirement income, you shouldn’t assume that your retirement will be secure if you are on track to accumulate a nest egg of a certain size or intend to withdraw a set percentage each year. That doesn’t mean you can’t plan with some confidence of success, however. Wade Pfau argues that your savings rate before retirement is a more reliable predictor of your retirement income than the size of your nest egg at retirement or your withdrawal rate after retirement (Journal of Financial Planning, 5/2011). To see why, consider two workers. John wants to accumulate a nest egg of $500,000 and then withdraw $20,000 a year (4%) for life. The trouble is that he doesn’t know what savings rate is necessary to get there, since it depends on whether he is investing in good times or bad; nor can he know that a 4% withdrawal rate will be sustainable under the economic conditions in retirement. Jane on the other hand doesn’t worry about hitting particular numbers, but just saves at a rate of 13% per year. If economic conditions are better before retirement than after, her savings do surprisingly well, so she can get by with a relatively low withdrawal rate in retirement. If conditions are better after retirement than before, her nest egg will be smaller, but growth during retirement will allow her to compensate by sustaining a higher withdrawal rate. Her chances of success are excellent under a variety of conditions.

Looking back over the last century, the savings rate necessary to support a comfortable retirement has varied somewhat, but it hasn’t varied as much as the savings rate necessary to accumulate a nest egg of a given size, or as much as the withdrawal rate necessary to live on a nest egg of a given size. The prudent savings rate has been within a range of 11% to 15%, with the higher part of the range providing the greatest probability of success.

Immediate annuities

There is a way of insuring a lifetime income while spending a little more than the conventional percentage of savings, such as 4% per year. You can take a lump sum and convert it to an immediate fixed annuity (not to be confused with the deferred variable annuity discussed in the posts on expenses and taxes). The issuer of the annuity, usually an insurance company, assumes the risk that you will live beyond your average life expectancy, because it has to keep paying you no matter how long you live. The company makes that up from somebody else who dies sooner than expected. The advantage for you is that the annuity can give you a higher payment than you can safely give yourself. The downside is that the money you use to buy the annuity isn’t available to your heirs (unless you accept a reduced payment in return for a guaranteed number of payments). If you die in the first year, the insurance company has your money. If you want to preserve your estate for your children, then you shouldn’t spend your whole nest egg on an annuity. You might want to compromise, by annuitizing part of your savings and holding onto the rest. The higher the proportion of your savings you annuitize, the higher the guaranteed income you can expect to receive, but the smaller the estate you can expect to leave.

When you buy a large annuity at one time, you could be locking in a low income because of low interest rates at the time of purchase. Your income could also be eroded by inflation. You can deal with the second problem by buying an inflation-protected annuity. Your initial payment will be smaller, but it will rise with inflation. You can deal with the timing problem by laddering your annuities, buying a series of smaller annuities over a period of years. As interest rates fluctuate, lower-rate annuities have a good chance of being balanced by higher-rate annuities.

Some planners argue that once you have secured a lifetime income with fixed annuities, then you can afford to be more aggressive with the rest of your investment portfolio, favoring stocks over bonds. On the average, retirees who adopt that strategy will probably end up with a larger estate. But outcomes will differ greatly depending on stock market performance. If you may need to use your nest egg for yourself, such as to buy into an expensive retirement community or assisted living facility, then you may want both a guaranteed annual income and some conservative, wealth-protecting investments.

Longevity insurance

Still another approach to making your money last is a relatively new insurance product called longevity insurance. This is an income annuity with a long deferral period, typically 20 or 30 years. You might buy it at age 65 but schedule payments to start at 85. You would do this if you expect your nest egg to cover you pretty well unless you live beyond 85. It costs a lot less than an immediate annuity because it will pay out for a shorter time, and maybe not at all. If you live an unusually long life, you’re covered. If you die young, the loss to your estate is smaller than if you bought an immediate annuity.

Multiple sources of income

Hopefully you will have other sources of retirement income besides investments. Financial planners sometimes talk about the “three-legged stool” supporting retirement: Social Security, pension and personal savings. Increasingly they are talking about some form of continuing employment as a fourth leg. So your own investments don’t have to carry the full load. But investment earnings are becoming increasingly vital, now that fewer employers are offering traditional pensions and the Social Security system is facing a possible cash-flow problem as the baby-boomers retire. Although more workers expect to remain in the labor force longer, the economy may be hard-pressed to create employment for both older and younger workers. That is all the more reason to incorporate the principles discussed here into your life plans, so that the investment leg of the stool will be on a solid foundation.

Sound Investing 8: Taxes

June 24, 2013

Previous | Next

Avoid unnecessary taxes

Federal tax law provides many tax breaks for investors. Among the most important are tax-sheltered retirement plans giving favorable tax treatment to money that is set aside for later years. Participants may fund the plans through payroll deductions, as in 401(k) and 403(b) plans, or through personal contributions, as in IRAs. In most plans, the contributions and the investment returns they earn are exempt from taxation until they are withdrawn in retirement. There are also tax shelters for college saving: 529 College Savings Plans and Educational Savings Accounts.

The tax shelters discussed here are perfectly legal strategies allowed by tax law in order to encourage saving. They shouldn’t be confused with tax shelters of questionable legality, such as transactions designed to create an appearance of capital losses where no real losses have occurred.

Advantages of tax-sheltered investing

To appreciate the value of tax-sheltered investment, think of it as an interest-free loan from the IRS. You get to hold onto some capital that you would have paid in taxes, make money by investing it, and keep most of the investment earnings. Better still, many employers will match a portion of the employee’s contribution to a tax-sheltered plan, which results in an instant high return on the investment.

Tax-sheltered retirement plans usually offer a number of investment options, although some plans are far more flexible than others. Changing asset allocations is usually easy because one investment can be exchanged for another with no tax consequences. A final advantage is that lower-income taxpayers can get a credit on their taxes for a portion of their annual contribution. That means that they not only exclude their contribution from their taxable income, but they reduce the amount of tax paid on the rest of their income. Most investors should consider it a high priority to contribute to tax-sheltered plans.

The Roth IRA is also a tax shelter, but it works differently from a traditional IRA or any retirement plan that is funded with pre-tax dollars. In the traditional IRA, you don’t have to pay taxes on the money you put into the account, but you do have to pay taxes on everything you take out. The Roth IRA works in reverse: You do have to pay taxes on the earnings you put in, but you don’t have to pay taxes on what you take out. When the applicable tax rate is held constant, the results are mathematically equivalent. With $4,000 to contribute and a tax rate of 25%, investing 3,000 post-tax dollars to a Roth would generate the same income as investing 4,000 pre-tax dollars to a traditional IRA and later paying taxes on the entire compounded account. In reality, the applicable tax rate may not be constant, and then the cost of present taxes must be weighed against the potential cost of future taxes. The Roth IRA can be a good deal for young workers in very low tax brackets, who by paying a little in taxes now can create a growing account that will escape taxation when they have moved to a higher bracket. For workers already in higher brackets, on the other hand, the deductibility of a traditional IRA contribution is a significant advantage. Since the deduction comes “off the top” of their income, they save taxes now at the highest rate they pay. On the other hand, if someday their IRA withdrawals constitute a large part of their income, only the portion of their withdrawals exceeding a certain bracket threshold may be taxed at the highest rate they pay. That subtle distinction may tilt the decision in favor of the traditional IRA for middle- to higher-income workers, assuming that the IRA is fully deductible (see below).

A 529 College Savings Plan works like a Roth IRA. The contributions to the plan are not tax-deductible, but the withdrawals are tax-free if used to fund higher education.

The advantages of any tax-sheltered plan are partly offset by the fees you pay for participating in it. Some of these may be unavoidable, such as the management fee charged to all participants in a 401(k) plan. Others may be minimized by careful selection of mutual funds within the plan. You can set up an IRA very inexpensively by going directly to a mutual fund company that offers no-load mutual funds or ETFs with low expenses.

Less advantageous shelters

Not all tax shelters are appropriate for all investors. Some tax shelters do shelter earnings on investment returns until withdrawal, but offer neither tax-deductible contributions (the advantage of most retirement plans), nor tax-free withdrawals (the advantage of a Roth IRA). An example is the deferred variable annuity offered by insurance companies. If you invest in it outside of an employer-sponsored retirement plan, you have to fund it with after-tax dollars. You don’t get to exclude your contributions from your taxable income, as you would in a 401(k) or traditional IRA; you only get to shelter the earnings on those contributions. And as with other shelters, when you take money out, you will have to pay taxes on the earnings at ordinary income tax rates, not the lower dividends or capital gains rates. In addition, many annuities have very high costs (see expenses).

For workers who have retirement plans through their employer, the deductibility of traditional IRA contributions phases out at higher incomes, reducing the advantage of traditional IRAs for higher-income taxpayers. (This doesn’t apply to Roth IRAs, where the contributions aren’t deductible to begin with.) You can mix deductible and non-deductible contributions within the same IRA, but the calculation of tax liability when withdrawals begin will be more complicated.

Minimizing taxes in taxable accounts

Most of the returns from bond investments take the form of interest, while most of the returns from stock investments take the form of dividends and capital gains. Interest is taxed as “ordinary income” so the rate depends on the taxpayer’s income tax bracket. Dividends and long-term capital gains (long-term refers to investments held for at least one year) are taxed at special low rates: currently 0% for taxpayers in the 10% or 15% brackets, 15% for those in the 25% to 35% brackets, and 20% for those in the top 39.6% bracket. Note, however, that all withdrawals from traditional tax shelters are taxed as ordinary income, even if the money came from dividends and capital gains; and withdrawals from Roth IRAs aren’t taxed at all. So the favored tax treatment of dividends and capital gains only applies to investments outside of tax shelters.

That means that investors in stock have another way of minimizing taxes besides deferring them in tax-shelters; they can generate tax-favored income in taxable investment accounts. That’s why wealthy investors can pay taxes at a lower rate than workers with modest incomes. But anyone fortunate enough to have non-sheltered as well as tax-sheltered investments can benefit to some degree.

In addition to being taxed at favorable rates, dividends and capital gains are easy to avoid or postpone. If you don’t need any income from your stock right now, you can avoid dividend taxes by investing in companies that retain their earnings rather than paying them out in dividends (or in mutual funds whose stated objective is growth rather than income). Your return will then be in the form of capital gains when you sell. In addition, you can put off capital gains taxes for a long time by buying and holding stocks rather than selling them frequently. People who trade frequently have to pay taxes immediately on any capital gains they realize. Frequent trading is also a problem for many mutual funds, especially actively managed funds that are trying to beat the market. They can generate a lot of capital gains that you have to pay taxes on, even if you don’t need the income. Index funds are more tax-efficient because they have lower turnover. They don’t generate very much taxable income until you decide to sell your shares. Some other mutual funds are deliberately “tax-managed” funds that try to avoid generating any taxable income, by avoiding both turnover and dividend-paying stocks. Ideally you don’t pay any taxes at all until you sell.

As we consider the principles of sound investing, we accumulate a long list of advantages of investing in index funds: They provide automatic diversification because they buy every stock in the index, low risk because they always give you close to a market return, low fees and expenses because they don’t have to do much research or trading, and high tax efficiency because of low turnover.

Prioritizing investment options

With so many kinds of tax breaks to choose from, how should investors distribute their investment dollars, especially when saving for retirement? For most employees, the first priority should be to contribute enough to their employer-sponsored retirement plan to take advantage of any matching funds contributed by the employer. If you are currently in a low tax bracket, the next priority would be to contribute the maximum allowed to a Roth IRA. Then make additional contributions to retirements plans as permitted by contribution limits, or to an educational savings plan. If you are fortunate enough to have more money to invest than you are willing and able to shelter from taxes, put it into investments that either generate little taxable income or that take advantage of the low tax rates on dividends and capital gains.

As you prioritize for tax purposes, don’t become so impressed by the tax advantages of stock investing that you lose sight of the benefits of a balanced asset allocation.

Dividing investments between taxable and sheltered accounts

If you have both tax-sheltered investments and taxable investments, which investments to put in which category can be tricky. This is sometimes called the asset location question as opposed to the asset allocation question. One consideration is time horizon. If your taxable investments are short-term investments, then they should be conservatively invested in cash and bonds rather than stock. In that case, hold your stock in your tax-sheltered retirement account, where it has time to ride out the ups and downs of the market.

But if you also have long-term taxable investments, you have more options. Now you need to decide which of your long-term investments belong in your tax shelter, and which belong in your taxable account. The investments that benefit the most from tax sheltering are those with both a high return and a potential to generate current taxable income. Real estate investment trusts, high-dividend stocks, and actively managed mutual funds realizing a lot of capital gains would be in this category. Investments that benefit the least from tax sheltering are stocks that are held for appreciation rather than dividends, or tax-efficient index funds that rarely realize capital gains by selling shares. They generate little taxable income now, and when you realize your gains in retirement they will be taxed at low capital gains rates. But if they are held in a traditional tax shelter (not a Roth), the gains will eventually be taxed at ordinary income rates when you make withdrawals. You get a tax break when you put money in, but forfeit a tax break when you take money out.

That doesn’t mean that index funds never belong in tax shelters. It makes sense to set up a retirement plan where you can invest with pre-tax dollars, and it also makes sense to own index funds for their diversification, low risk and low expenses. If your retirement plan is all you have in long-term savings, then that’s where your index funds will be. But if you have a choice, keep your most tax-efficient investments in your taxable account and less tax-efficient investments in your tax shelter. This distinction is most important for investments with a high long-term return, such as stock, real estate and commodities. The stakes are not as high for bonds, although bonds with higher yields do benefit from tax sheltering more than bonds with lower yields. Treasury bonds benefit a little less from sheltering than corporate bonds, since treasuries are already exempt from state taxes. Municipal bonds are not appropriate for tax shelters at all, since they are exempt from federal taxes.

The Roth IRA is a special situation because you’ve already paid your taxes before you put the money in, and the earnings will never be taxed at any rate. So you may want to invest a Roth in whatever you expect to give you the highest long-run total return, consistent with your tolerance for risk. That could be something like a small-cap value stock fund.