Bye Bye High Yield Bonds

We’re making a trade in our portfolio models this week and will be selling our high yield bond fund (SPDR Short-Term High Yield ETF, ticker SJNK). The last 18 months have been excellent for high yield bonds; so excellent, in fact, that at this point the now lower yields don’t justify the risks. For those who might be interested in our process behind this decision, please read on.

High Yield, or “Junk”, Bonds are highly cyclical and go through wide swings up and down. They have much higher volatility than other types of bonds, and in spite of their higher yields, have the potential for negative returns to a greater degree than most other types of bonds. Additionally, they have a fairly strong correlation to equities, meaning that when stock markets plunge, high yield bonds – which are issued by lower quality companies – are also likely to drop in value. In times of recession, several percent of high yield issuers will default on their bonds and go bankrupt each year.

How can we determine if high yield bonds are a good value? One of then most common ways is through Credit Spreads. A Credit Spread is the additional amount of yield a high yield bond will provide over a safe bond like a US Treasury.

As recently as January 2016, high yield bonds were paying 6-7 percent over Treasuries. Today, that spread has shrunk into the 3% range, a level which is closer to the lows of the past 20 years. You can see a chart of US Credit Spreads on the website of the Federal Reserve Bank of St. Louis.

Investors today are not being sufficiently compensated for taking the extra risk of high yield bonds, and given the headwinds of higher interest rates and a late-inning stock market, we believe it is time to remove the high yield position from our portfolio. They’ve done their job. While no one can predict if or when these bonds will have their next downturn, we’d rather make the change now.

This is a small trade in most portfolios; our 60/40 model, for example, has only a 4% position in high yield. The proceeds will be reinvested into other bond funds which have lower volatility and also a short duration.

In the future, if yield spreads widen, we might buy back into high yield bonds. When pessimism is at its highest, low prices on high yield bonds can be a great value for patient investors. And that’s the time to be a buyer, not today. Credit spreads are a unique consideration for high yield bonds, but know that we look at each category within our portfolio models closely and will not hesitate to make adjustments after cautious and deliberate study.

If you have any questions about high yield bonds, fixed income, or any other aspect of portfolio construction, please give me a call!

Tracking Your Home Improvements

When you eventually sell your home, it may be helpful to have a record of your home improvement expenses. Because people often own their homes for decades, this is an area where a lot of records and receipts are lost. Here is what you need to know.

At the time of a home sale, the difference between your purchase price and your sale price is a taxable capital gain. Luckily for most people, there is a significant capital gains exclusion from the IRS: $250,000 (single) or $500,000 (married), for your primary residence. If your gain falls below this amount, you will not owe any taxes. In order to qualify, the property must have been your primary residence for at least two of the previous five years, and you must not have taken this exclusion for another property for two years.

If you make a capital improvement (described below), that expense increases your cost basis in the home. But because of the large exclusion ($250,000 or $500,000), many people don’t even bother to keep track of their home improvement expenses. That may be a mistake. Here are a number of scenarios which could be a problem:

  • If you get divorced or your spouse passes away, your exclusion will decrease from $500,000 to $250,000.
  • If you make another property your primary residence for four years, you will lose the tax exclusion on the previous property.
  • If you own your property for the next 30 years, it is possible your capital gain ends up being higher than the $250/$500k limits. These amounts are not indexed for inflation.
  • Congress could reduce this tax break, although it would be very unpopular to do so. They are not likely to change the definition of cost basis and capital gains.

What constitutes a Capital Improvement which would increase your cost basis? In general, the improvement must be permanent (lasting more than one year), attached to the property (not removable or decorative), and add to the value, use, or function of the property. Maintenance and repairs are generally not capital improvements unless they prolong your home’s useful life. The IRS provides the following specific examples of expenses that are Capital Improvements:

  • Additions, such as a new bathroom, bedroom, deck, garage, porch, or patio.
  • Permanent outdoor improvements, including paved driveways, fences, retaining walls, landscaping, or a swimming pool.
  • Exterior features, such as new windows, doors, siding, or a roof.
  • Insulation for your attic, walls, floors, or plumbing.
  • Home systems, including heat/central air, wiring, sprinkler, or alarm systems.
  • Plumbing upgrades such as septic systems, hot water heaters, filtration systems, etc.
  • Interior improvements, including built-in appliances, flooring, carpet, kitchen remodeling, or a new fireplace.

While there are many expenses which count as improvements, repairs and upkeep do not. Painting, replacing broken fixtures, patching a roof, or fixing plumbing leaks are not improvements. Also, if you install something and later remove it, that expense may not be counted. For example, if you install new carpet and then later replace the carpet with wood floors, you cannot include the carpet expense in your cost basis.

For full information on calculating your gain or loss on a home, see IRS Publication 523. While most homeowners are focused on mitigating taxable gains, I should add that if your capital improvements are significant enough to make your home sale into a loss, that loss would be a valuable tax benefit as it could offset other income. Here’s an example:

Purchase Price: $240,000
Capital Improvements: $37,400
Cost Basis: $277,400

Sale Price: $279,000
Minus 6% Realtor Commission: -$16,740
Closing Costs: -$1,250
Net Proceeds: $261,010

LOSS = $16,390

If you just looked at your purchase price and sales price, you might think that you would have a small gain (under the exclusion amount), and there was no need to keep track of your improvements. However, in this example, you do indeed end up with a loss, which would be valuable to your taxes. As a reminder: capital losses can offset any capital gains. Additionally, you can use $3,000 a year of losses to offset ordinary income. Unused capital losses carry forward into future years indefinitely, until they are used up.

Unlike other receipts, which you only need to keep for seven years, you do need to keep records of your capital improvements for as long as you own the home, and then seven years after you file your tax return after the sale. Even if you think you are going to be under the $500,000 tax exclusion, I’d highly recommend you keep track of these capital improvements which increase your cost basis.

Stop Trying to Pick the Best Fund

So much attention is paid to picking “the right fund” or “the best fund” by investors, but in my experience, this question has little bearing on whether or not an investor is successful in achieving their goals. In fact, I don’t even think fund selection is in the top 5 factors for financial success. There are so many more important things to consider first!

1) How much you save. If you contribute $500 a month to your company 401(k) and your colleague contributes $1,000 a month, I would bet that they will have twice as much money as you after 10 years, regardless of your fund selection process. Hot funds turn cold, so most investors just average out over time. Figuring out how to save and invest more each month will get you to the goal line faster than spending your hours trying to find a better fund.

2) Sticking with the plan. Your behavior can have a greater impact than your fund selection. Many investors sold in 2009, incurring heavy losses and then missing out on the rebound in the second half of the year. Trying to time the market is so difficult that investors are better served by staying the course rather than trying to get in and out of the market.

I know that people think they are being rational about their investments, but what usually happens is that we form an opinion emotionally and then find evidence which corroborates our point of view. This is called confirmation bias. Better to remain humble and recognize that we don’t have the ability to determine what the future holds. Buy and Hold works, but only when we don’t screw it up!

3) Starting with an Asset Allocation. People may spend a vast amount of time picking a US large cap fund, but then miss out on the benefits of diversification. Other categories may outperform US large cap stocks. I recently opened an account for a new client, whose previous advisor had him invested in 180 positions – all of which were US large cap and investment grade bonds. No small cap, no international equities, no emerging markets, no floating rate bonds, no municipal bonds, etc.

The most important determinant of your portfolio return is the overall asset allocation, not which fund you chose! Our process begins with you, your goals, timeline, and risk tolerance to first determine a financial plan, including an appropriate asset allocation. The asset allocation is really the portfolio and then the last step is to just plug in funds to each category. Funds in each category perform similarly. If it’s a horrible year, like 2008, in US large cap, that fact is more significant than which large cap fund you chose.

A famous, and controversial, 1995 Study found that 95% of the variability of returns between pension funds was explained by their asset allocation.

4) Not chasing performance. The problem with trying to pick the best fund is that you are always looking through today’s rearview mirror. There will always be one fund that has the best 5, 10, or 15 year returns. There are always funds which are doing better than your fund this year. But if you buy that new fund, you may quickly become disappointed when the subsequent returns fail to match its “perfect” track record.

So then you switch to another new fund. And like a financial Don Juan, the performance chaser is quick to fall in love, but just as quick to move on, creating a tragic, endless cycle of hope and failure. If you are investing for the next 30 years, changing funds 30 times does not improve your chances of success! By the way, if you exclude sector funds, single country funds, and other niche categories from your portfolio, you will be well on your way to avoiding this pitfall.

5) Setting Goals. If you have a goal or large project at work, you probably create a plan which breaks that goals down into a series of smaller steps and objectives. Unfortunately, very few people apply the same kind of discipline, planning, and deliberate process to their finances as they do to their career and other goals. When you begin with the goal in mind, your next steps – how much to save, how to invest, what to do – become clear.

Bonus, 6) Doing what works. Why reinvent the wheel or take on unnecessary risk? We know that 80% or more of actively managed funds lag their benchmarks over five years and longer. With 4 to 1 odds against you choosing a fund that outperforms, why take that risk at all? Even if you get it right once, do you realize how small the possibility is that your choice will outperform for another five years? Better to stick with Index Funds and ETFs. Besides the better chance of performing well, you will also start with very low expenses and excellent tax efficiency. When you use Index funds, it frees up your mind, time, and energy to focus instead on numbers 1-5.

Choose your funds carefully and deliberately because you should plan to live with those funds for many, many years. There are genuinely good reasons for changing investments sometimes and we won’t hesitate to make those trades when necessary. But on the whole, investors trade way too much for their own good. The grass is not always greener in another fund!

Reducing Sequence of Returns Risk

The possibility of outliving your money can depend not only on the average return of the stock market, but on the order of those returns. It doesn’t matter if the long-term return is 8%, if your first three years of retirement have a 50% drop like we had going into March of 2009, your original income strategy probably isn’t going to work. Taking an annual withdrawal of $40,000 is feasible on a $1 million portfolio, but not if your principal quickly plummets to $500,000.

We evaluate these scenarios in our financial planning software and can estimate how long your money may last, using Monte Carlo analysis that calculates the probability of success. For most people retiring in their 60’s, we plan for a 30 year horizon, or maybe a little longer. And while this analysis can give us a rough idea of how sound a retirement plan is, no one knows how the market will actually perform in the next 30 years.

What we do know from this process is that the vast majority of the “failures” occur when there are large drops in the market in the early years of retirement. When these losses occur later on, the portfolio has typically grown significantly and the losses are more manageable. This problem of early losses is called Sequence of Returns Risk, and often identifies a critical decade around the retirement date, where losses may have the biggest impact on your ability to fund your retirement.

There are ways to mitigate or even eliminate Sequence of Returns Risk, although, ultimately I think most people will want to embrace some of this risk when they consider the following alternatives. Sequence of Returns risk is unique to investing in Stocks; if you are funding your retirement through a Pension, Social Security, Annuity, or even Bonds, you have none of this risk.

1) Annuitize your principal. By purchasing an Immediate Annuity, you are receiving an income stream that is guaranteed for life. However, you are generally giving up access to your principal, forgoing any remainder for your heirs, and most annuities do not increase payouts for inflation. While there is some possibility that the 4% rule could fail, it is important to remember that the rule applies inflation adjustments to withdrawals, which double your annual withdrawals over the 30 year period. And even with these annual increases, in 90% of past 30-year periods, a retiree would have finished with more money than they started. The potential for further growth and even increased income is what you give up with an annuity.

2) Flexible withdrawals. The practical way to address Sequence of Returns Risk is to recognize upfront that you may need to adjust your withdrawals if the market drops in the first decade. You aren’t going to just increase your spending every year until the portfolio goes to zero, but that’s the assumption of Monte Carlo Analysis. We can do this many ways:

  • Not automatically increase spending for inflation each year.
  • Use a fixed percentage withdrawal (say 4%) so that spending adjusts on market returns (instead of a fixed dollar withdrawal).
  • Reduce withdrawals when the withdrawal rate exceeds a pre-determined ceiling.

It is easier to have flexibility if withdrawals are used for discretionary expenses like travel or entertainment and your primary living expenses are covered by guaranteed sources of income like Social Security.

3) Asset Allocation. If we enter retirement with a conservative allocation, with a higher percentage in bonds, we could spend down bonds first until we reach our target long-term allocation. Although this might hamper growth in the early years, it could significantly reduce the possibility of failure if the first years have poor performance. This is called a Rising Equity Glidepath.

Other allocation methods include not withdrawing from stocks following a down year or keeping 1-3 years of cash available and then replenishing cash during “up” years.

4) Don’t touch your principal. This is old way of conservative investing. You invest in a Balanced Portfolio, maybe 50% stocks and 50% bonds, and only withdraw your interest and dividends, never selling shares of stocks or bonds. In the old days, we could get 5% tax-free munis, and 3% in stock dividends and end up with 4% income, plus rising equity prices. Since you never sell your stocks, there is no sequence of returns risk. This strategy is a little tougher to implement today with such low bond yields.

Investing for income can create added risks, especially if you are reaching for yield into lower quality stocks and bonds. That’s why most professionals and academics favor a total return process over a high income approach.

5) Laddered TIPS. Buy TIPS that mature each year for the next 30 years. Each year, you will get interest from the bonds (fairly small) and your principal from the bonds that mature that year. Since TIPS adjust for inflation, your income and principal will rise with CPI. It is an elegant and secure solution, with a 3 1/3% withdrawal rate that adjusts for inflation.

The only problem is that if you live past 30 years, you will no money left for year 31 and beyond! So I would never recommend that someone put all their money into this strategy. But if you could live by putting 80% of your money into TIPS and put the other 20% into stocks that you wouldn’t touch for 30 years, that may be feasible.

Except you’d still likely have more income and more terminal wealth by investing in a Balanced Allocation and applying the 4% rule. However, that is a perhaps 90% likelihood of success, whereas TIPS being guaranteed by the US Government, TIPS have a 100% chance of success. (Note that 30 year TIPS have not been issued in all years, so there are gaps in years that available TIPS mature.)

If the market fell 30% next year, would your retirement be okay? How would you respond? What can you do today about that possibility? If you worry about these types of questions, we can help address your concerns about risk, market volatility, and Sequence of Returns.

What we want to do for each investor is to thoroughly consider your situation and look at your risk tolerance, risk capacity, other sources of retirement income, and find the right balance of growth and safety. Although the ideal risk would be zero, you may need substantially more assets to fund a safety-first approach compared to having some assets invested. And that means that for how much money you do have, the highest standard of living may come from accepting some of the Sequence of Returns Risk that accompanies stock investing.

When a 2% COLA Equals $0

Social Security provides Cost of Living Adjustments (COLAs) annually to recipients, based on changes to the Consumer Price Index. According to an article in Reuters this week, the Social Security COLA for 2018 should be around 2%. Social Security participants may be feeling like breaking out the Champagne and party hats, following a 0.3% raise for 2017 and a 0% COLA for 2016.

Unfortunately, and I hate to rain on your parade, the average Social Security participant will not see any of the 2% COLA in 2018. Why not? Because of increases in premiums for Medicare Part B. Most Social Security recipients begin Part B at age 65, and those premiums are automatically withheld from your Social Security payments.

Social Security has a nice benefit, called the “Hold Harmless” rule, which says that your Social Security payment can not drop because of an increase in Medicare costs. In 2016 and 2017 when Medicare costs went up, but Social Security payments did not, recipients did not see a decrease in their benefit amounts. Now, that’s going to catch up with them in 2018.

In 2015, Medicare Part B was $105/month and today premiums are $134. For a typical Social Security benefit of $1,300 a month, a 2% COLA (an increase of $26 a month) will be less than the increase for Part B, so recipients at this level and below will likely see no increase their net payments in 2018. While many didn’t have to pay the increases in Part B over the past two years, their 2018 COLA will be applied first to the changes in Medicare premiums.

I should add that the “Hold Harmless” rule does not apply if you are subject to Medicare’s Income Related Monthly Adjustment Amount. If your income was above $85,000 single, or $170,000 married (two years ago), you would already pay higher premiums for Medicare and would be ineligible for the “Hold Harmless” provision. And if you had worked outside of Social Security, as a Teacher in Texas, for example, you were also ineligible for “Hold Harmless”.

The cost, length, and complexity of retirement has gone up considerably in the past generation. Not sure where to begin? Give me a call, we can help. Preparation begins with planning.

How to Be a World Traveler

When asked to describe The Good Life, many of us include a desire to travel and see the world, often in our top three or four goals. Yet, often we find reasons why it seems impractical or impossible to do so today. My college roommate, Marty Regan, travels more than anyone I know, and I have always found it fascinating to talk with Marty about how he does it. Here’s my interview with Marty.

SS: We met up in Taos in May and now you are in Tokyo for the summer. Give us a rundown of where you’ve been in the last 12 months.

MR: Last year I was conducting research in Cambridge, UK, and during the summer I traveled to Ireland, Italy, and Iceland. I returned to the USA in late August and have since taken domestic trips to Maine, New York, California, and New Mexico. Over Christmas and New Year’s I traveled in New Zealand for five weeks.

To be a world traveler, a lot of people think you have to be very wealthy. Did you win the lottery or inherit a family fortune? This is all from your college professor salary?

Yes, it is. However, I am single with no children, have no debt and lead a simple lifestyle in an area with a relatively low cost of living, so I have dispensable income to spend as I wish.

What do you enjoy most about travel? What have you learned from other cultures? 

As a composer, I have always been fascinated with the relationship between life experiences (including travel!) and artistic expression. If a writer, artist, or composer experiences a cathartic moment when doing something significant like cycling through the Netherlands when the tulips are in full bloom or witnessing an architectural masterpiece like the Pantheon in Rome, how are those experiences manifested when they begin their next work? For writers and visual artists, it seems to me that the relationship is often quite direct. For example, a writer could attempt in prose to capture the details of a particular scene or space, while an artist could be inspired to render the scene realistically or perhaps more abstractly in a painting. In either case, one could argue that the resultant work was directly inspired by the experience. For a composer however, this relationship is a bit more slippery. For me, musical “inspiration” often involves finding myself in a new and unfamiliar environments and allowing myself to be stimulated by the experiences that await me.

I strongly suggest reading Pico Iyer’s article Why We Travel.

I think many people – myselfincluded – could work from anywhere in the world, as long as we have internet. How has travel impacted your work?

As long as I have my computer or iPad with me, I can conduct most of my work remotely. Travel has not negatively impacted my work in anyway.

You’ve obviously figured out how to travel on a budget, because you spend weeks or months in some of the most expensive cities in the world. I imagine that hotels in these cities can cost $500 a night and up. How do you make this work?

Well, I am very lucky in that I have a network friends and colleagues all over the world. I sometimes plan trips where friends of mine reside, not for the promise of free accommodation, but because of the companionship and benefit of having a local teach you about their city. If I travel to a place where I do no know anyone, then I find other ways to keep costs low by living like a local. I rarely stay in hotels.

Let’s talk more about lodging. Where do you stay? How do you find places? 

When I stay in a place for a long period of time, Airbnb is my preferred accommodation option. VRBO is also dependable. Some cities I have used Airbnb for extended visits include London, Rome, Paris, Prague, Helsinki, Shanghai, and Seoul, among others.

Outside of lodging, any advice for saving money on transportation, food, and entertainment while you are travelling?

I don’t purchase plane tickets until I have spent time exploring the market for a while and I am confident that I am getting a fair price. I try to stick to the Star Alliance network and pay with my United Chase Plus credit card because purchases add up really quickly that can redeemed for free flights. I always try to stay somewhere with access to a basic kitchen so that I can buy food at local groceries to save on meal expenses. As far as entertainment is concerned, I rarely book in advance but rather show up the day of the performance (symphony orchestra concerts, ballet, theater, etc.) and inquire about last minute rush tickets. Often I am given tickets for free by patrons who can’t use them and have left them at the box office. This happened recently for a performance of Götterdämmerung at the Houston Grand Opera. I was prepared to pay $150+ for a good seat!

You rent your house in College Station through Airbnb. How has that helped you with your travel?

I started renting my house on Airbnb in 2011. Basically, I use the rental income that I receive from Airbnb to pay for expenses that I incur when I travel. At the moment, I am currently residing in Tokyo for 2+ months, but rental income from my home covers my rental expenses here. Here is a link to my home.

Who is a good candidate for Airbnb? If someone is thinking of making their house available, what should they know? 

A good candidate for Airbnb would include a person who can appreciate the unique quirks that you might encounter when living in someone’s home. If you are hoping for a cookie-cutter Hyatt or Hilton experience, then Airbnb is not for you. If you are thinking of making your house available, be aware that fielding questions from guests can sometimes take a lot of time! Create a profile in which answers to the most commonly-asked questions are available. Have a system in which guests can check in and check out without you being there, such as having a lock box on the door or installing a keyless entry system. Consider providing amenities that will make their stay memorable. In my case, I usually leave a snack and fruit basket along with fresh-squeezed orange juice. I also leave a hand-written welcome letter as well as a guest book where I request that guests leave their comments.

Do you set a daily or weekly budget for when you travel?

I have never planned daily or weekly budgets!

Favorite travel memory?

Taking a snowmobile tour in Iceland to the top of a glacier in August for my birthday to view a filming location for the Secret Life of Walter Mitty.

Best place to visit that has a surprising value?

Czech Republic.

Many thanks, Marty, and safe travels! See you in Texas in the Fall.

Originally from Long Island, New York, Marty Regan is an Associate Professor at Texas A&M University and lives in Bryan-College Station. He is a composer who specializes in composing music for traditional Japanese instruments. Marty graduated from Oberlin College, lived in Tokyo for 6+ years, and received a Ph.D. from the University of Hawaii, Manoa.

Mid-Year Report: The Return of Irrational Exuberance?

We’ve passed the mid-year point and the market has had a strong performance in the first half of 2017. Investors should be very pleased with the results of the past six months, although I believe there are reasons to be guarded going forward. Our portfolio models all notched positive returns, but our value oriented approach held back returns relative to our benchmarks.

Looking first at stocks, our global equity benchmark, the MSCI All Country World Index (iShares ticker ACWI) produced a total return of 11.92%. That would be a great return for the whole year, and it’s only July 1 as I write this. US Stocks, such as the Russell 1000 Index (iShares ticker IWB) were up 9.15% in the first half.

Across the board, international stocks were well ahead of US Stocks, with both Developed and Emerging Markets producing 15% returns for the first half. Our International and Emerging small caps did even better, over 17%. Our positions in foreign equities were strong contributors to our portfolio returns. If you are just investing in domestic stocks, you really missed out so far in 2017. And International stocks remain less expensive than US stocks by most measures.

Our holdings in US Value stocks lagged, gaining only 2-4% versus the 9% of the overall market. Last year, Value outperformed both Growth and Core by a wide margin. For 2017, a handful of technology companies are dominating returns, specifically the so-called FAANG stocks: Facebook, Apple, Amazon, Netflix, and Google (now called Alphabet).

While these companies continue to post exciting growth, the price of these stocks is now incomprehensible to me. It feels like 1999 all over again, when there was no price too high for growing tech leaders. While I think that today’s top stocks are bonafide companies with genuine earnings, I still can’t justify the price of the shares.

It smells like a bubble to me, although limited to this small number of stocks. Now that doesn’t mean that we are necessarily on the verge of a collapse. Indices could continue to go higher from here, and even if a few high flyers do get clipped, that doesn’t mean that the rest of the economy will be in trouble.

Our investment process favors patience. We focus our portfolios towards the cheaper segments of the market which have lagged. We look for reversion to the mean, investing as contrarians, rather than chasing momentum. Our value funds and REIT ETF had positive returns, but were detractors from performance, as was our allocation to Alternatives. However, I remain committed to these positions because they are relatively cheap. While they did not beat the market over the past 6 months, our rationale for holding them has only grown more compelling.

In fixed income, the US Aggregate Bond Index (iShares ticker AGG) was up 2.40% year to date. Our fixed income allocations were ahead of AGG by 30 to 80 bps, with higher yields and lower duration. Our position in Emerging Market bonds was a standout performer for the half. I continue to keep a close watch on high yield bonds, but overall think we are well positioned for today’s economy and potential future rate hikes.

I write about the markets twice a year, and not more frequently, to not distract us from sticking to a long-term allocation. We focus on what we know works over time: diversification, keeping costs low, using index funds for core positions, and tilting towards value. Our discipline means that we don’t let short-term events pull us away from our strategy.

Looking at the first half, our fixed income and international equity holdings did quite well. Our value and alternatives holdings have not yet had their day in the sun. However, if the market does eventually realize that the US tech stocks have gotten “irrationally exuberant”, I think we will be glad we have our more defensive positions.

Can You Reduce Required Minimum Distributions?

After age 70 1/2, owners of a retirement account like an IRA or 401(k) are required to withdraw a minimum percentage of their account every year. These Required Minimum Distributions (RMDs) are taxable as ordinary income, and we meet many investors who do not need to take these withdrawals and would prefer to leave their money in their account.

The questions many investors ask is Can I avoid having to take RMDs? And while the short answer is “no, they are required”, we do have several ways for reducing or delaying taxes from your retirement accounts.

1. Longevity Annuity. In 2014, the IRS created a new rule allowing investors to invest a portion of their IRA into a Qualified Longevity Annuity Contract (QLAC) and not have to pay any RMDs on that money. What the heck is a QLAC, you ask? A QLAC is a deferred annuity where you invest money today and later, you switch it over to a monthly income stream that is guaranteed for life. Previously, these types of deferred annuities didn’t work with IRAs, because you had to take RMDs. Luckily, the IRS saw that many retirees would benefit from this strategy and provided relief from RMDs.

Investors are now permitted to place up to 25% of their retirement portfolio, or $125,000 (whichever is less), into a QLAC and not have to pay any RMDs during the deferral period. Once you do start the income stream, the distributions will be taxable, of course.

For example, a 70 year old male could invest $125,000 into a QLAC and then at age 84, begin receiving $31,033 a year for life. If the owner passes away, any remaining principal will go to their heirs. (Source of quote: Barrons, June 26, 2017)

In retirement planning, we refer to possibility of outliving your money as “longevity risk”, and a QLAC is designed to address that risk by providing an additional income stream once you reach a target age. Payouts must begin by age 85. A QLAC is a great bet if you have high longevity factors: excellent health, family history of long lifespans, etc. If you are wondering if your money will still be around at age 92, then you’re a good candidate for a QLAC.

2. Put Bonds in your IRA. By placing your bond allocation into your IRA, you will save taxes several ways:

  • You won’t have to pay taxes annually on interest received from bonds.
  • Stocks, which can receive long-term capital gains rate of 15% in a taxable account, would be treated as ordinary income if in an IRA. Bonds pay the same tax rate in or out of an IRA, but stocks lose their lower tax rate inside an IRA. You have lower overall total taxes by allocating bonds to IRAs and long-term stocks to taxable accounts.
  • Your IRA will likely grow more slowly with bonds than stocks, meaning your principal and RMDs will be lower than if your IRA is invested for growth.

3. Roth Conversion. Converting your IRA to a Roth means paying the taxes in full today, which is the opposite of trying to defer taking RMDs. However, it may still make sense to do so in certain situations. Once in a Roth, your money will grow tax-free. There are no RMDs on a Roth account; the money grows tax-free for you or your heirs.

  • If you are already in the top tax bracket and will always be in the top tax bracket, doing a Roth Conversion allows you to “pre-pay” taxes today and then not pay any additional taxes on the future growth of those assets.
  • If not in the top bracket (39.6%), do a partial conversion that will keep you in your current tax bracket.
  • If there is another bear market like 2008-2009, and your IRA drops 30%, that would be a good time to convert your IRA and pay taxes on the smaller principal amount. Then any snap back in the market, or future growth, will be yours tax-free. And no more RMDs.
  • Trump had proposed simplifying the individual tax code to four tax brackets with a much lower top rate of 25%, plus eliminating the Medicare surtaxes. We are holding off on any Roth conversions to see what happens; if these low rates become a reality, that would be an opportune time to look at a Roth Conversion, especially if you believe that tax rates will go back up in the future.

4. Qualified Charitable Distribution. You may be able to use your RMD to fund a charitable donation, which generally eliminates the tax on the distribution. I wrote about this strategy in detail here.

5. Still Working. If you are over age 70 1/2 and still working, you may still be able to participate in your 401(k) at work and not have to take RMDs. The “still working exception” applies if you work the entire year, do not own 5% or more of the company, and the company plan allows you to delay RMDs. If you meet those criteria, you might want to roll old 401(k)s into your current, active 401(k) and not into an IRA. That’s because the “still working exception” only applies to your current employer and 401(k) plan; you still have to pay RMDs on any IRAs or old 401(k) accounts, even if you are still working.

We can help you manage your RMDs and optimize your tax situation. Remember that even if you do have to take an RMD, that doesn’t mean you are required to spend the money. You can always reinvest the proceeds back into an individual or joint account. If you’d like more information on the QLAC or other strategies mentioned here, please send me an email or give us a call.

What Are Today’s Projected Returns?

One of the reasons I selected the financial planning software we use, MoneyGuidePro, is because it offers the ability to make projections based on historical OR projected returns. Most programs only use historical returns in their calculations, which I think is a grave error today. Historical returns were outstanding, but I fear that portfolio returns going forward will be lower for several reasons, including:

  • Above-average equity valuations today. Lower dividend yields than in the past.
  • Slower growth of GDP, labor supply, inflation, and other measures of economic development.
  • Higher levels of government debt in developed economies will crowd out spending.
  • Very low interest rates on bonds and cash mean lower returns from those segments.

By using projected returns, we are considering these factors in our financial plans. While no one has a crystal ball to predict the future, we can at least use all available information to try to make a smarter estimate. The projected returns used by MoneyGuidePro were calculated by Harold Evensky, a highly respected financial planner and faculty member at Texas Tech University.

We are going to compare historical and projected returns by asset class and then look at what those differences mean for portfolio returns. Keep in mind that projected returns are still long-term estimates, and not a belief of what will happen in 2017 or any given year. Rather, projected returns are a calculation of average returns that we think might occur over a period of very many years.

Asset Class Historical Returns Projected Returns
Cash 4.84% 2.50%
Intermediate Bonds 7.25% 3.50%
Large Cap Value 10.12% 7.20%
Small Cap 12.58% 7.70%
International 9.27% 8.00%
Emerging Markets 8.85% 9.30%

You will notice that most of the expected returns are much lower than historical, with the sole exception of Emerging Markets. For cash and bonds, the projected returns are about half of what was achieved since 1970, and even that reduced cash return of 2.50% is not possible as of 2017.

In order to estimate portfolio returns, we want two other pieces of data: the standard deviation of each asset class (its volatility) and the correlation between each asset class. In those areas, we are seeing that the trend of recent decades has been worse for portfolio construction: volatility is projected to be higher and assets are more correlated. It used to be that International Stocks behaved differently that US Stocks, but in today’s global economy, that difference is shrinking.

This means that our projected portfolios not only have lower returns, but also higher volatility, and that diversification is less beneficial as a defense than it used to be. Let’s consider the historical returns and risks of two portfolios, a Balanced Allocation (54% equities, 46% fixed income), and a Total Return Allocation (72% equities, 28% fixed income)

Portfolio Historical Return Standard Deviation Projected Return Standard Deviation
Balanced 8.53% 9.34% 5.46% 10.59%
Total Return 9.18% 12.20% 6.27% 14.23%

That’s pretty sobering. If you are planning for a 30-year retirement under the assumption that you will achieve historical returns, but only obtain these projected returns, it is certainly going to have a big impact on your ability to meet your retirement withdrawal needs. This calculation is something we don’t want to get wrong and figure out 10 years into retirement that we have been spending too much and are now projected to run out of money.

As an investor, what can you do in light of lower projected returns? Here are five thoughts:

  1. Use projected returns rather than historical if you want to be conservative in your retirement planning.
  2. Emerging Markets are cheap today and are projected to have the highest total returns going forward. We feel strongly that they belong in a diversified portfolio.
  3. We can invest in bonds for stability, but bonds will not provide the level of return going forward that they achieved in recent decades. It is very unrealistic to assume historical returns for bond holdings today!
  4. Investors focused on long-term growth may want more equities than they needed in the past.
  5. Although projected returns are lower than historical, there may be one bright spot. Inflation is also quite low today. So, achieving a 6% return while inflation is 2% is roughly comparable in preserving your purchasing power as getting an 8% return under 4% inflation. Inflation adjusted returns are called Real Returns, and may not be as dire as the projected returns suggest.

Applying The Rule of 72

The Rule of 72 is a very simple financial short-cut: divide your rate of return into 72 and you have (approximately) the number of years it takes for your money to double.

Double Your Money
2% = 36 years
4% = 18 years
6% = 12 years
8% = 9 years

This gives you an idea of the importance of compounding. But aside from being a way to impress children and small animals with your math prowess, is there a practical application of the rule of 72? Yes, there are a number of ways that thinking about The Rule of 72 can improve our behavior and give us better financial outcomes with our investing. For example:

1) Think Long-Term. Think in terms of “doubling periods”. If you are targeting a 7% rate of return, your doubling period would be 10 years. If you have 20 years until retirement, you would expect your money to double twice. If you have $200,000 today, you should have $800,000 in 20 years, in this hypothetical scenario. And that is without any additional saving!

2) Start Early. You want to double your money as many times as you can, but let’s face it, a life expectancy of 85 years can only contains so many periods of 9 or 12 years. To maximize your wealth, you have to start as early as possible.

Let’s consider two investors: Smart Sally and Late Larry. Sally starts investing $500 a month at age 22, while Larry waits until he is 32. He’s still young, right? He also invests $500 a month and they both earn an 8% return until retirement at age 62. At age 62, here’s where they stand:

Smart Sally has $1,745,503. Late Larry has $745,179. Sally has a million dollars more because she started 10 years earlier! Not saving in your 20’s could mean you have a million dollars less for retirement. Don’t miss out on getting that extra doubling period.

3) Invest for Doubling. I see people with money markets in their retirement accounts even though they aren’t going to retire for decades. Nobody knows what the market is going to do tomorrow or this year, but if you are investing for 20 years, recognize that a 2% return will take 36 years to double and a 1% return will take 72 years. What does your money market pay in 2017? Less than 1%? At that rate, even your great-grandchildren won’t live long enough to see that double.

Stop thinking that a lack of volatility equals safety. Investing at a low rate of return basically guarantees that your money isn’t going to grow significantly. In that regards, cash is a riskier investment to your goals than stocks.

Use the rule of 72 to choose diversified investments that are in line with your goal of doubling your money. If you have the time and risk tolerance, you need to be invested in a way that will generate long-term returns of 6%, 8%, or more. The S&P 500 Index returned 12% annually from 1926 to 2010. Although our expected returns are lower today for stocks, they are also lower for cash, bonds, and inflation.

Let’s say that you are 41 and plan to retire at age 65, in 24 years. You have $250,000 today. if you are investing in a high quality bond fund that returns 3%, you will double your money once in 24 years, to $500,000. Invest in a balanced allocation at 6% expected return, and you will double every 12 years, bringing you to $1,000,000. But if you can invest aggressively, and achieve a 9% return, you could doubles your money three times, once every 8 years. That would bring you to $2 million at age 65.

If you understand the Rule of 72, you can focus on long-term results, starting early, and investing for growth. There will be volatility along the way; there will be down years and bear markets. But if you are in the accumulation phase of your life, your focus should be to strive for long-term returns that will double your money. And with retirement often lasting 20 to 30 years, age 65 is not the end, or a finish line, but just the start of a new phase of investing. You still need growth even in retirement!