Trump Order is Bad News for Retirement Savers

February 9, 2017

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On February 3, President Trump issued a memorandum to the Secretary of Labor regarding the “Fiduciary Duty Rule” that was scheduled to go into effect this April. Suggesting that the rule “may not be consistent with the policies of my Administration,” he directed the Department of Labor to reexamine the proposed rule and consider rescinding or revising it.

The Department of Labor has been working on this rule since 2009 with the aim of improving the quality of investment advice received by investors in retirement plans. With traditional pensions on the decline and participant-directed retirement plans like 401(k)s and IRAs replacing them, more people need investing advice than ever. This has highlighted a problem described in a Department factsheet:

Many investment professionals, consultants, brokers, insurance agents and other advisers operate within compensation structures that are misaligned with their customers’ interests and often create strong incentives to steer customers into particular investment products. These conflicts of interest do not always have to be disclosed and advisers have limited liability under federal pension law for any harms resulting from the advice they provide to plan sponsors and retirement investors. These harms include the loss of billions of dollars a year for retirement investors in the form of eroded plan and IRA investment results….

To put it bluntly, too many so-called advisors recommend the products that earn them big commissions, not the ones that offer the best value for the investor. When we buy a car, we understand that the dealer is just a salesperson who would love to sell us the most expensive car, whether we need it or not. When we go to a doctor, we expect the recommended treatment to be in our best interest, not what is most profitable for the doctor. The question is what is the appropriate standard of care when we depend on an advisor’s expertise for our financial health.

The proposed Fiduciary Duty Rule would require all those who provide retirement plan advice for compensation to adhere to a fiduciary standard, which requires “putting their clients’ best interest before their own profits.” This requirement would apply whenever advisors recommend an investment, if they are compensated in any way for doing so. It doesn’t matter whether the client is paying for the advice itself or whether a sales rep is earning a commission for selling a product.

Closing a loophole in the fiduciary standard

Debate over the fiduciary standard goes back a long way. I have discussed it before, especially in Section 11 of my “Sound Investment” series and in my review of Helaine Olen’s Pound Foolish, a critique of the personal finance industry.

Many people may not realize that the fiduciary standard is already well established in law. The Investment Advisers Act of 1940 required anyone giving investment advice for compensation to register as such and adhere to such a standard. So what’s the problem? The Securities and Exchange Commission made an exception for those whose primary business is trading securities, even if they 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.

After the Great Recession, the Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) gave the SEC the authority to reexamine the issue and write a new regulation. After studying the matter, the SEC concluded that the loophole it previously created should now be closed: “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.” The actual regulations that will implement this principle continue to be hotly contested. Meanwhile, the Department of Labor has finalized a fiduciary rule based on a different statutory authority, its authority to regulate retirement plans under the Employee Retirement Income Security Act of 1974 (ERISA). The DOL’s rule would apply only to financial advice relating to retirement plans, not to investments more generally. This is the rule whose implementation the President is now blocking.

Last month, the Consumer Federation of America issued a report, “Financial Advisor or Investment Salesperson?: Brokers and Insurers Want to Have it Both Ways.” The report documented the two-faced way that “transaction-based financial professionals” describe themselves:

When they are marketing their services to the investing public and enticing clients into handing over their hard-earned savings, these sales-based financial professionals present themselves as “trusted advisors” whose only concern is their clients’ best interest. But try to hold them legally accountable for meeting that standard, and those same “advisors” quickly change their tune. Because they are salespeople who are “merely selling” investment products, they claim, no fiduciary standard ought to apply.

In their marketing materials, brokers and insurance companies use terms like “financial advisor,” “financial consultant,” or “retirement counselor” to describe themselves. They characterize their services as “a comprehensive approach to total wealth management delivered by your most trusted advisor,” and claim to be “safeguarding the money of others as if it were our own,” to quote some of their websites. Surveys show that this kind of marketing is successful in getting the general public to confuse sales reps with the registered investment advisors who actually are held to a fiduciary standard. But when they are fighting that standard in legislative hearings or in court, they are quick to claim that they are just salespersons. They deny having the special relationship of trust that would justify classifying them as fiduciaries under existing or proposed law.

The high financial stakes

The Consumer Federation described how savers are being hurt by this situation:

Investors who unknowingly rely on biased salespeople as if they were trusted advisors can suffer real financial harm as a result. It is estimated, for example, that retirement savers lose $17 billion a year or more as the result of the excess costs associated just with conflicted retirement advice. The cost on an individual basis, in the form of lost retirement savings, can amount to tens or even hundreds of thousands of dollars over a lifetime of investing, money that retirees struggling to make ends meet can ill afford to do without.

Here’s a hypothetical example. Suppose you save $500 a month for 20 years in a tax-deferred retirement plan holding mutual funds, for a total investment of $120,000. With a 7% annual return after expenses, you would accumulate $260,463 over the 20 years. However, if you lost $25 of each $500 invested because of unnecessary commissions or fees, and then received only a 6% return because of higher annual mutual fund expenses, you would accumulate only $219,469, a shortfall of about $40,000. Multiply this by millions of savers and you begin to see the size of the problem.

Of course, every company that charges high fees, commissions or expense ratios will try to justify them as fair compensation for value provided. So the question is whether investors who are being charged more are receiving any added value. Although investment returns can be all over the map, most of the evidence does not support the contention that the investment products pushed by brokers and insurance reps outperform investments that are available less expensively elsewhere. In particular, index funds that you can buy directly from companies like Vanguard and Fidelity with no sales commissions and rock-bottom expense ratios outperform the majority of high-cost actively managed mutual funds. For more explanation of why so many aggressively marketed investments have such disappointing returns, see Section 6 of my “Sound Investing” series.

When I worked as a registered investment adviser (the kind who was legally bound by the fiduciary standard), many clients came to me for a portfolio review. Using standard measures of costs and risk-adjusted performance, I routinely found overpriced, underperforming, and often unnecessarily confusing products that had been recommended to them by brokers or insurance agents. In most cases, they would have accumulated more if they had gotten simpler and better advice.

What we see here is a massive and unearned transfer of wealth from middle-class savers to financial service companies that too often serve themselves at the expense of their customers. This is one reason why the era of self-directed retirement accounts has also been an era of increasing inequality in the distribution of wealth. The new regulations are intended to give middle-class savers a fighting chance.

Alleged adverse effects of the fiduciary rule

Businesses that oppose consumer protection initiatives rarely admit what really concerns them, that a new rule may interfere with a profitable business model. They almost always claim that it will hurt consumers in some way that consumer advocates and regulators fail to see.  President Trump’s order takes a pro-consumer stance by asking the Department of Labor to examine whether the fiduciary rule would “adversely affect the ability of Americans to gain access to retirement information and financial advice.” The implication is that retirement savers may be losing something if they cannot get the “free” advice offered by brokers and insurance agents, even if that advice is flawed by conflicts of interest that work against investors’ best interests.

Investors of modest means do need financial advice that doesn’t cost them much, and accepting the recommendations of sales reps is one way to get it. Investment advisors who do not make their money from sales commissions derive their income from flat fees for advising sessions or for writing financial plans, as I did, or from asset management fees based on a percentage of assets under management. Making a living while keeping these charges affordable for small investors is not easy. It is one thing to set a fiduciary standard, but another thing to make fiduciaries available at a price most savers can afford.

However, the fiduciary rule need not leave most retirement savers with no affordable advice at all. The kind of basic advice that small investors need to handle their retirement plans is already pretty widely available, and could be even more available if employers and schools made more of an effort to provide it. Most savers will do fine putting the bulk of their retirement savings in a single “target retirement fund,” or in a small number of index funds covering domestic and foreign stocks and bonds. (Of course, they need to follow other basic advice like getting an early start and saving 10-15% of income.) Financial professionals can still make a good living selling advice to people of means who are interested in playing riskier or more sophisticated investment games. But for the average worker, the present system relies too heavily on a business model that institutionalizes conflicts of interest and needlessly skims off too large a portion of the savings that people need for their retirement.

President Trump’s order is an anti-consumer measure shrouded in pro-consumer rhetoric. It purports to protect American savers, while really protecting businesses that charge them too much and deliver too little. It ignores years of research by the federal government’s own agencies as well as by professional financial planners, academics and consumer groups. It shows that the people who have Trump’s ear are the billionaires and bankers he has brought into his administration, not advocates for the general public. It is one more piece of evidence that–populist rhetoric notwithstanding– he intends to serve the economic elites rather than the people.



Sound Investing 11: Advice

June 27, 2013

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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

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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

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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

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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.