Gil Hanoch

Optimal Retirement Income in the face of Financial Disasters

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After living through the Great Recession of 2008, you might ask: “What is the best way to provide myself with retirement income that can sustain through future catastrophes?” This article answers this question, when considering extreme cases, including severe and prolonged declines, far worse than 2008.

Imagine that you are a retiree and are fully dependent on your investments to provide you with income for as long as you live. The amount can be your total estimated expenses minus any social security income and pension plans. You would like to receive a certain amount of income each year, with adjustments for inflation in subsequent years.

The ideal investment would survive all of the following:

  1. Withdrawals during a prolonged decline.
  2. Withdrawals growing with inflation, as well as hyperinflation.
  3. Withdrawals lasting for as long as you live.
  4. All local damages including natural disasters, theft, confiscation during a war, and legal changes.
  5. Change in supply and demand.

The risk of a short life: While longevity introduces the financial risk of running out of money, the risk of a short life is not a financial risk. By definition, if your money can support you for 30 years, it can support you for 29 years, 3 years or 3 days. Therefore, we limit the discussion of need #3: “Withdrawals lasting for as long as you live”, to the case of a long life. While this may sound trivial, some retirees confuse the health risk of a short life with a financial risk. To be clear – a short life, by definition, cannot be riskier than a long life, financially speaking.

When testing various investments, we can weed-out the ones that cannot survive any of the above:

  1. Cash, Checking, Savings, Money Market, High-Grade Bonds: These all have very low growth rates (#2, #3). Some even have negative real growth. Putting substantial portions of your money in any of these may help you temporarily during stock declines, but they all share longevity risk – running out of money. For a high enough allocation you are actually guaranteed to run out of money.
  2. Fixed annuities: A fixed annuity with inflation-adjusted income is exactly the product that should provide you with income for as long as you live. The problem is that it is backed by an insurance company. Bankruptcy of the company could hurt your annuity income. Given that your income depends on the solvency of a single company, the risk is too big to bear, no matter how stable the company seems. Additional problems are:
    1. Annuities with inflation protection tend to provide a very low payment.
    2. Nothing is left for your heirs, unless you accept an even lower payment.
    3. If you have a surprise expense at some point, there is no way to make a bigger withdrawal at one point, and make up for it later.
  3. Work: While not an investment, it is a way to provide retirement income. It is nice to work for as long as you enjoy it and are able to, but you cannot count on this for life. You may lose your job during an economic contraction (#1), or at any other time. Most people are not able to or do not want to work for as long as they live (#3).
  4. Tangible assets: Anything you can touch (tangible) is subject to local damages (#4). It can be stolen or lost, and therefore cannot be useful. The one exception is a limited amount of cash to keep you going, in case of no access to an ATM.
  5. Gold and other commodities: These do not generate any value (#3). Any change in real-price reflects changes in supply and demand (#5), making these speculative investments with zero expected real returns. In fact, after a 28% tax on long-term holding of gold (taxed as a collectible), storage costs and high transaction costs, you should expect negative real returns. None of these assets appreciate in value reliably during declines. Gold has been especially risky with a nearly 30-year decline to recovery period in recent history. Commodities tend to be highly volatile, and may decline in value irreversibly whenever replacements are found.
  6. Real Estate – Individual Properties: Any individual property is subject to local damages (#4). It can be destroyed in a natural disaster or war. Insurance may not cover all types of damages, and the insurance company may not stay solvent and able to repay all homeowners, in case of a large scale disaster. Even if all damages are covered, no rental income is available during the rebuilding of the property. Vacancies can occur also during economic downturns. Another risk is a drop in property values and rental income due to local changes, including irreparable structural problems, and change in demographics or job opportunities.
  7. Real Estate – Dispersed Individual Properties: Geographic dispersion can alleviate most of the problems described above, if the number of properties is large enough. To account for country-wide problems (including confiscation during wars), international dispersion is necessary. Structured correctly this may be a viable solution, but it is impractical for most individuals. If ownership is leveraged with mortgages, the risk of dropped income gets magnified. To own tens of properties with no leverage, you may need substantial resources, and still need an array of professionals to help with management, repairs and taxation. The result is not too appealing, because income after all expenses tends to be limited, and the growth of property values is not spectacular. In the very long run you can expect real estate to grow only in line with wage increases. In the past 100+ years, this was about 1% higher than inflation, providing minimal real growth.
  8. Real Estate – Pooled (REITs = Real Estate Investment Trusts): These investments are similar to stocks in terms of their volatility and returns. They can be held as a part of a diversified stock portfolio.
  9. Real Estate – Own Home: Owning your home has value beyond investment considerations. It can be a good idea, as long as you have large enough investments to supply you with ongoing income as well as money for maintaining your home.
  10. Stocks, concentrated portfolios: Concentrated stock portfolios may decline for many years, and may never recover.
  11. Stocks with a high withdrawal rate: Globally diversified portfolios have recovered from all declines, but with a high enough withdrawal rate, you may not live to enjoy the recovery period.

One investment that can survive all of the above: Globally diversified stocks with a low withdrawal rate, no market timing and representing entire markets . Below is a description of how it can survive the different risks:

  1. Withdrawals during a prolonged decline: Globally diversified portfolios have recovered from all declines, and it is reasonable to expect this trend to continue as long as people will want to get things in the cheapest and easiest way possible. With a low enough withdrawal rate, you can weather extreme declines.
  2. Withdrawals growing with inflation, even in the face of hyperinflation: Inflation represents the rise in cost of goods. By owning the companies that provide these goods, your investments grow with inflation over time.
  3. Withdrawals lasting for as long as you live: Given that company ownership provides the highest growth rate in the long run, diversified stocks provide the highest chance of lifelong income.
  4. All local damages including natural disasters, theft, confiscation during a war, and legal changes: Thanks to the global diversification, no local damage can decimate your entire portfolio.
  5. Change in supply and demand: A global stock portfolio holding companies in all industries, does not depend on demand for any specific product or service. If there is weaker demand for a specific product or service, this demand gets replaced by demand for an alternative that other companies in your portfolio provide. As long as people keep looking to get things done cheaply and simply, they will use the products and services of companies in your globally diversified portfolio.

Psychological Risks: Given the volatility of stocks, investing large portions of your money in them requires iron discipline. Many individuals lost substantial parts of their life’s savings during major market crashes due to fear. The best way to minimize this risk is to get the help of a professional that demonstrated iron discipline during stock declines, and kept his clients’ money as well as his/her own fully invested during those times.

Withdrawal Rate : The acceptable withdrawal rate from the stock portfolio depends on the portfolio. Some portfolios can withstand withdrawal rates of up to 4%, and survive substantial declines. To be prepared for very extreme and rare declines, that may occur less than once in a lifetime, you may want to go down as low as about 3%. The exact percentage depends on the portfolio.

Low Withdrawal Rate: If you can limit yourself to a very low withdraw rate from your globally diversified stock portfolio (with inflation adjustments), you may have the best plan for your retirement income, even at hypothetical times when people on the streets are begging for food.

With a very low withdrawal rate, putting a portion in more stable investments like cash or bonds will not help your already high short-term security (very low withdrawal rate), but will hurt your long-term security in the face of longevity and inflation.

Making up for a Higher Withdrawal Rate : For higher withdrawal rates, a limited allocation to bonds may provide you with income during severe declines and improve your security. Once you withdraw much more than 4%, there is nothing that can save you from extreme catastrophes.

What if this Solution is not Good Enough? You may feel that no matter how low you bring the withdrawal rate, there could always be a case that will result in a depletion of your assets. This is true, and it would be nice to get a perfect guarantee. Unfortunately, all alternatives fail under certain conditions. While no solution is perfect, the diversified stock solution is likely to withstand the most extreme scenarios.

When comparing the different risks, the odds for the global stock portfolio are much higher than the alternatives, thanks to the combination of high diversification and high average growth rate. Most other solutions fail in the face of inflation combined with longevity and/or concentration risks.

Summary

During substantial stock market declines, you may be concerned with the security of a diversified stock portfolio, and look for more stable alternatives. There are investments that suffer less extreme declines, but they suffer from other risks including inflation, longevity and various localized risks. When considering the entire bag of financial risks, diversified stocks provide the highest likelihood of success in providing lifelong retirement income. This is all subject to you or your advisor having iron discipline in staying invested at all times.

Disclosures Including Backtested Performance Data

Forecasting Yesterday

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Does the stock market affect your mood? Do you feel happy when the stock market is up and upset when it goes down? This is natural, and it affects many of us. A problem occurs when people act on these feelings. This article analyzes the drivers of change in stock prices, with some practical consequences.

Stock prices change every day. Some of the changes are due to company-specific information, and some are related to the whole economy. Changes related to the economy may occur in the following sequence:

  1. Economic data is released, resulting in change of expectations for the future of the economy. The change is assessed relative to the prior expectations.
  2. This new economic data gets reflected quickly in the stock market. For example, an expectation for a slower economy than previously expected will cause the stock market to decline soon after this information becomes public.
  3. When the stock market declines, some individuals and professionals become negative about the future of the stock market, and expect it to keep going down.

This last step is where the logical sequence breaks:

  1. You can expect the future of the economy to affect today’s stock prices.
  2. The future of the economy should not affect tomorrow’s stock prices. Once the data is released, it gets reflected in stock prices quickly (typically within seconds to minutes). There is no economic reason for stock prices to repeat their adjustment to the same data the next day.
  3. You cannot expect today’s stock prices to affect tomorrow’s stock prices, since prices are related to expected economic value, not prior prices.

Furthermore, stock prices do not change according to the expectation for the economy, but according to the changed expectation for the economy. The results may be counterintuitive, for example:

  • If investors expect the economy to boom in upcoming quarters, data indicating a slower expected expansion would be a reason for stocks to decline.
  • The same works in the other direction: if investors expect the economy to slow down in upcoming quarters, new data indicating a more moderated slowdown would be a reason for gains in stocks.

Once you digest the ideas above, there is another factor to consider: Stock valuations ultimately gravitate towards neutral values:

  • The higher the valuation (e.g. Price/Book Value) of stocks, the more the price will sink given a less positive prediction for the economy.
  • Similarly, the lower the valuation of stocks, the more the price will jump given a less negative prediction for the economy.
  • For example, in March 2009 stock valuations hit extremely low values. When bad news came, but just slightly less bad than before, stock prices went up. Given the extremely low valuations, instead of a moderate increase, stocks shot up very high very fast.

One more phenomenon plays into the mix: Given that investors (including some of the biggest institutional ones) are not perfectly rational, they sometimes tend to keep buying stocks that are already expensive or sell stocks that are already cheap. This is what I referred to as “the herd effect” in prior articles, and what is called “momentum” by the investment profession. The results:

  • You can make money by buying expensive stocks (or selling short cheap stocks) for some stretches of time. Given that valuations do not change indefinitely in one direction in the long run, these upward and downward runs get broken by huge upward and downward corrections. As a result, stock valuations cannot be used to predict the near-term changes in stock prices in a systematic way.
  • In general, high valuations cannot be used to predict declines even for long time horizons, since book values of companies tend to grow over time. By the time a bubble gets popped, book values can keep up with prices, resulting in the next bottom being higher than current prices. For example, Extended-Term Component by QAM was more expensive than usual in the end of 2004. Despite that, it had gains all the way to the end of 2008 (around the recent bottom of the worst recession in nearly a century).
  • Low valuations can be used to predict gains in the long-term. Global stock markets always grow in the long run (at least as evidenced in the past few hundreds of years, and as logically expected). The chances of gains, and specifically abnormally high gains, go up the lower the current valuations are.

One way to benefit from this last point is to buy stocks with low valuations (Price/Book Value), and hold them for the long run.

Summary

Not much can help us predict the future of the stock market. The best you can do is hold stocks with low valuations for the long run, to enjoy high average returns.

New economic data affects stock prices today, but neither this data or current stock prices can do a lot to help you predict future stock prices. Understanding this can help individuals as well as professionals avoid ‘forecasting yesterday’.

“Valuation” is a term for how expensive a stock is. Two common measures are Price/Earnings and Price/Book Value.

Disclosures Including Backtested Performance Data

Why do Investors Love Large U.S. Stocks?

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Investors in the U.S. typically have a strong bias towards buying Large U.S. Stocks. This article discusses some reasons for this bias, with their benefits and costs.

Here are some reasons for buying Large U.S. Growth (high price to book value) stocks:

  • Low Risk . This group of companies is the most stable in the world. They are located in the most developed country in the world, and have very large markets to their products and services. If you were to pick a single stock to invest in, a Large U.S. stock would be a conservative choice, relative to other stocks.
  • Home Bias . Investors feel comfortable investing in companies geographically closer to them.
  • Familiarity Bias . Investors feel comfortable investing in names they hear often. Historically this made more sense, when information traveled slowly, and for people who analyzed individual stocks.
  • Costs . It is cheapest to buy these stocks, in terms of bid-ask spread. This trading cost can reach several percent of the stock price, and historically was even higher, making it a big factor to consider when trading frequently.
  • Tradition Bias . Investors are afraid of change. Some of the reasons listed above were good reasons for people to buy these stocks in the past. People feel comfortable sticking to approaches that worked in the past, even if they are no longer the correct ones.

As explained above, Large U.S. stocks made sense at times when trades were very expensive, and there were no options to cheaply invest in highly diversified portfolios, with very low turnover . Today, assuming you are not a speculator that happened to believe in a certain Large U.S. stock, there is only one reason to invest in such stocks: diversification.

The group of Large U.S. stocks is the least volatile, and has less than perfect correlation with other groups of stocks. These characteristics make it a good addition to a portfolio to reduce its volatility. Given that the returns of this group are the worst of all groups of stocks, in some cases by a wide margin, it makes sense to limit the allocation to this group. Greater allocations should be made to small stocks, international stocks and emerging markets stocks. It may feel riskier to limit the allocation to the safest stock class, but it is not. A highly diversified portfolio of large and small stocks around the world is a lot less volatile than a portfolio concentrated in Large U.S. stocks. See “Can the S&P 500 be dangerous?” (Hanoch, Apr. 2005) for a demonstration of this concept.

Summary

There are many reasons for investors to love Large U.S. stocks, and almost none of them makes financial sense for a conservative investor. The one good reason to hold such stocks is to diversify a global stock portfolio.

Turnover = the percent of the portfolio that is being sold each year. Low turnover means low trading costs. Mutual funds that represent a wide asset class with no market timing or individual stock selection tend to have very low turnover.

Disclosures Including Backtested Performance Data

Has Stock Diversification Failed?

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During 2008 and 2009, some claimed that diversification of stock investments is no longer beneficial, and, consequently, that we should look elsewhere to reduce our investment risks. This article assesses these claims, and demonstrates, through analysis, the benefits of diversification, even in the face of the 2008 decline. More specifically, it will discuss the potential benefit of adding small, international and emerging markets stocks, to help diversify the typical US centric portfolio.

What seemed wrong with Stock Diversification in 2008? During the market decline of 2008 all stock classes declined substantially. Adding small, international and emerging markets stocks, not only did not help a U.S. centric portfolio, but even aggravated the decline, leading to a lower bottom. This can be seen in the graph below, comparing the globally diversified portfolio Long-Term Component with the S&P 500 in 2008-2009.

2010-04 Has Diversification Failed_image001

This result may lead you to believe that stock diversification failed.

If you redeemed your entire investment after these two years, stock diversification would not have helped you. However, a two-year investment should not be put into any stock portfolio.

Appropriate usages of stock investments include:

  1. Long-Term Growth
  2. Immediate retirement income, as long as withdrawals are limited to a small percentage every year1.

Contrary to Some Claims, Global Diversification of Stocks was Successful . If we expand the period of comparison by two additional years, starting in 2006, we get improved results, thanks to higher returns surrounding the decline. Diversification provided substantially improved security, flipping the total returns to positive, with a total difference of 24%.

2010-04 Has Diversification Failed_image002

If we further expand the comparison to the 10 years 2001-2010, we get a striking difference greater than 200%.

2010-04 Has Diversification Failed_image003

While the correlation between the portfolios seems relatively high, the diversified portfolio provided substantially better results. Two factors helped, as can be seen in the graph above:

  1. In early 2002 there were several months in which the diversified portfolio gained, while S&P 500 declined. These few months were enough to have the diversified portfolio recover from the early 2000’s recession very quickly and have a lasting impact until today.
  2. In 2003-2007 the diversified portfolio had faster overall growth, providing a result 3 times larger (200% higher) than the S&P 500. So, while the S&P 500 stayed at levels below the level of 10 years ago for a long period, the diversified portfolio maintained nice gains throughout the entire 2008 decline.

To judge whether diversification is beneficial, we should do two things:

  1. Compare the length of declines, in addition to the depth. In the middle graph (4 years), you can see that, thanks to the higher 2009 returns, the recovery above the 2006 level occurred many months earlier.
  2. Expect diversification to provide some moderation or shortening of declines, but not eliminate severe declines altogether. Given that diversifying a U.S. Large centric stock portfolio does not hurt the long-term returns (it actually increases them), it would make sense to diversify even without any risk-reduction benefit. Not only is there a risk reduction benefit, it occurs in most declines and tends to be substantial.

To further demonstrate the benefits of stock diversification, a table is provided, comparing the diversified stock portfolio to the S&P 500 over different horizons, all relevant for a retiree looking for current income:

Annual Returns: S&P 500 vs. Diversified Stock Portfolio (Long-Term Component)
Calendar Years S&P 500 Long-Term Component Annual Benefit
2007-2009 3 -5.6% -2.2% +3.4%
2005-2009 5 0.4% 7.7% +7.3%
2001-2010 10 1.4% 14.3% +12.4%

Summary

Despite claims to the contrary, stock diversification still holds, and is beneficial through declines, including the great 2008 decline. Diversification may help shorten tough declines and/or make them shallower. In some cases, the benefit appears before and/or after the decline, still providing a great benefit to the long-term investor as well as the retiree that depends on current income.

1 3%-4% is a common range, depending on the portfolio

Disclosures Including Backtested Performance Data

What is a Retiree’s Time Horizon?

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Have you ever heard about the principle of shifting the portfolio allocation from stocks to bonds as you approach retirement? This article presents an alternative to the principle above that may be more in line with a retiree’s needs.

Before continuing, you are encouraged to read the article “What is your Time Horizon?” (Hanoch, Apr. 2006). It demonstrates several cases in which the principle above does not work.

When was the principle above appropriate? The idea of having most of your portfolio in bonds as you near retirement worked in the days when people retired at age 65 and typically lived for another 5 to 10 years. Under those conditions, and assuming limited resources, it was very important to protect the income for the upcoming few years, even at the expense of long-term depletion of assets.

Can you do better? The article mentioned above presents a more accurate approach to evaluating the time horizon of any person regardless of their age:

Your time horizon is the time until you will need to use your money. Each person may have several time horizons for different parts of their savings.

If you are about to retire, and have a very short life expectancy and limited resources (the case described above), your time horizon is short, and most of your money should be invested in bonds, as suggested before.

In any other case the principle above fails, and the more accurate definition of time horizon, provides a better guideline for investment. Let’s review several cases:

Case 1: Your income needs are very small compared to your portfolio size . If you withdraw a small enough percentage of your portfolio every year, even a high (as high as 100%) allocation to diversified stocks can be the most conservative plan. Depending on the portfolio, once the withdrawal rate becomes as low as 2%-4%, the stock portfolio can handle severe declines without depleting over time. In such a case, given your high short-term security in retirement, it is better to keep a very high allocation to stocks, to retain and increase your financial security over time, for as long as you live.

Case 2: Your income needs are fairly high compared to the portfolio size. If you expect to need, say 10% of your portfolio each year, you cannot afford having all of your money in stocks, because a big decline early in your retirement can deplete your whole portfolio in the first decade of your retirement. In such a case, the rule above should be applied as follows: leave enough money in bonds and cash to cover a number of years of living expenses, depending on how diversified your stock portfolio is. To maximize your financial security, the bond allocation should be used whenever the portfolio experiences a severe decline, and at no other time. As your portfolio grows, resulting in a lower annual withdrawal rate, you can reduce your allocation to bonds and shift into stocks, despite (actually, regardless of) your growing age. This is because your short-term security increases with your portfolio size, and you better address the now bigger risk – outliving your money.

Case 3: Guaranteed income that covers all expenses. If you are expecting guaranteed retirement income to provide for all your needs, your portfolio time horizon is infinite. You will not depend on any of the money while you are alive, and your heirs cannot depend on your money at any specific point, since they don’t know how long you will live. In this case a high allocation to stocks (up to 100%) may be the most appropriate, providing the highest potential future extra cash for any desire or unexpected need.

Lifelong Security in Retirement

When people talk about retirement, the immediate thought is that the time horizon is short and emphasis should be given to providing money for short-term needs. Given the growing longevity of humans, this proposition has become incorrect and even dangerous. The average life expectancy of an individual retiring at age 65 is currently around 20 years, and this number keeps growing over time.

Say you spend 8% of your money per year, and you put most of it in bonds at age 65, with a growing allocation to bonds over time, you have a risk of going broke. Based on my analysis above, an allocation of more than 50% to stocks is likely to be appropriate, and should provide short-term security throughout extreme declines, as well as much higher security for as long as you may live.

Just as you don’t count on your portfolio to grow every year by its average growth rate, you shouldn’t plan on dying according to your life expectancy. The portfolio Long-Term Component has average returns greater than 10%, yet any conservative plan should not count on withdrawals much greater than 4%. Similarly, I would not recommend on planning to die (or alternatively go broke) anytime before age 100. As explained in the article “Preparing for a Long Life” (Hanoch, Dec. 2006), the difference between the withdrawal rate that will deplete your money in 30-40 years and the withdrawal rate that will never deplete your money, is relatively small. This leads me to construct retiree investment portfolios to last forever, in nearly all cases.

If this seems extreme to you, think about the hundreds of thousands of 100+ year-old people alive today, and imagine the millions that could reach this age group in upcoming decades, if you project the historic longevity growth. Preparing for life at this age, is no less important than preparing for a big crash in your stock portfolio starting precisely as you retire.

Assumptions

The ideas in this article depend on several important assumptions:

  1. Your stock portfolio is globally diversified, and you do not individually select stocks or try to time the market.
  2. You are highly disciplined, with nerves of steel, or your Investment Advisor has such nerves and you listen to him/her at all times. Specifically, you use stocks for living expenses when the stock portfolio is growing, and bonds when the stock portfolio is at a decline. Only if you depleted all your bonds at an extended decline, and there is no other source of money, you go back to selling stocks, and replenish your bond reserves when, and only when, the portfolio is recovered.

If these two are not true for you, please disregard this article.

Disclosures Including Backtested Performance Data

Planning for Unlimited Roth IRA Conversions

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If you have high income, you may know that a Roth IRA is off limits for you. You cannot contribute to it or convert a Traditional IRA to it. Starting in 2010, Roth IRAs will be accessible to everyone. This article can help you decide whether and when to convert your Traditional IRA to a Roth IRA.

Before continuing, note that this article is not intended to provide a full review of IRA tax laws. You are encouraged to consult your CPA before making tax related decisions.

How can you contribute to a Roth IRA? The new law does not remove the income cap on contributing to a Roth IRA, but it does remove the income cap on converting a Traditional IRA to a Roth IRA. This means that every year you can contribute to a Traditional IRA and the next day convert the contribution to a Roth IRA, essentially resulting in a contribution to your Roth IRA.

Here are a few characteristics of IRAs (referenced later as #1 to #5):

Characteristic Traditional IRA Roth IRA Taxable
1 Are investment taxes1 imposed? No, investments are tax free while the money is in the account Yes
2 When is income tax paid? When money is taken out When income is earned
3 Can income tax be paid from outside the account? No Yes N/A
4 How long can money stay in the account? Up to age 70½, then withdraw throughout life For life, then withdraw throughout life of heirs Forever
5 How soon can money be withdrawn from the account? Age 59½; disability; death; up to $10,000 for first home for you, your parents, children or grandchildren; unreimbursed medical expenses above 7.5% of AGI; higher education; medical insurance after getting 12 weeks of unemployment payments due to losing your job; as a result of an IRS levy; or equal payments at least till age 59½ and at least for 5 years, but:
Roth Contributions: Can be withdrawn any time.
Roth Earnings & Rollovers: Cannot be withdrawn for 5 years after the first ever contribution to a Roth IRA.		 Anytime

Maximize IRA Balances: Both IRA types are free of investment taxes for as long as the money is in the account (#1). Therefore, you should maximize contributions of money designated for retirement into IRAs, and minimize withdrawals. Given #5 above, you can maximize Roth IRA contributions regardless of when you may need the money (with limitations on withdrawal of earnings).

Maximize Roth IRA Balances, with several exceptions. The Roth IRA provides the following benefits:

  1. Reduced Taxable Portfolio: When paying income taxes from outside the account, you have more money grow free of investment taxes (#3). If you are at the 33% tax bracket and you convert today using taxable money, you save investment taxes on 33% of the IRA balance. If you are taxed on 4% of your portfolio per year on average, at about 30% combined federal & state tax rate, it equals 1.2% in taxes on 33% of the IRA balance = 0.4% saved per year.
    Put differently, if you take money out of the IRA with your income tax rate at 33%, you are left with $67 on every $100 withdrawn. By paying the tax from outside the IRA earlier on, you increase your balance by 49% (100/67-1), and substantially increase the amount that is free of investment taxes.
  2. Money Growing Longer with the Tax Benefits: You can keep your money in your Roth IRA for your life expectancy beyond age 70½ + the age difference between you and your heirs (#4), typically providing 20-50 extra years free from investment taxes.
  3. Reduce Taxes During Stock Declines: When your IRA balance shrinks during stock market declines, any dollar amount you choose to convert will represent a larger percentage of your IRA balance, allowing you to convert a greater portion of your money at the same tax rate. If your IRA has a diversified long-term stock investment, this is an opportunity to save on taxes.
  4. Convert Less Money at High Tax Rates: As your IRA balance grows, more of the amount that you later withdraw or convert to a Roth IRA gets pushed into higher income tax brackets. If your IRA grows faster than the expansion of tax brackets, converting earlier on can keep more of the converted amount at lower tax brackets.
  5. Shield from Uncertain Future Tax Rates: Given that current tax rates are known while the future is unknown, it is more conservative to pay the taxes in today’s known rates, as opposed to risking being subject to higher future rates. Any risk you can remove may help you better plan for your retirement.
  6. An extra incentive in 2010: Only in 2010, the payment of taxes on converted amounts can be deferred by an average of an additional 1.5 years (½ the tax is paid in tax year 2011, and ½ in 2012). If your portfolio grows on average by 15% per year, the money used to pay the income tax on the conversion can grow by an average of 23.3% over 1.5 years, reducing your effective tax rate by 18.9% (=(1-1/(1+23.3/100))*100). For example, converting in 2010 at the 28% tax bracket, would be equivalent to converting any other year at 22.7% (28*(1-18.9/100)).
Rule of Thumb : You should not convert your Traditional IRAs to Roth IRAs (or contribute to a Roth IRA), if you expect your tax rate to be:

  1. Much lower (typically 10% less or more),
  2. In very few years (typically 5 or less).

Otherwise, you probably should convert, since the growth of the IRA balance can push you into higher tax brackets2, negating the benefit of waiting. In addition, if you have money outside your IRA for paying the income tax, by paying it now, you shield the tax amount from future investment taxes, making the case for conversion soon even stronger.

When in the Year should you Convert to a Roth IRA? It is most beneficial to convert your Traditional IRA to a Roth IRA right in the beginning of the tax year (January 2 nd ), for two reasons:

  1. Your converted money can grow an additional 1.3 years until you pay the taxes on the conversion (4/15 of the following year).
  2. You can undo the conversion (officially named: “recharacterizing”) until your tax filing deadline 4/15 (or 10/15 with an extension). During these 1.3 years, you can choose to undo the conversion if the account declined, and redo it next year at a lower cost.

Convert More than Planned. If you have any doubts regarding the amount to convert, a beneficial strategy could be to convert the full IRA (or at least the most you could possibly expect wanting to convert). Up to 4/15 of the following year, you can undo any part of it, providing you maximum freedom to leave converted as much or as little as makes sense, with the benefit of hindsight. This is especially useful in 2010, given the benefit of extra tax deferral, and while the stock market is so low.

Advanced Planning (not typical). There is one reason to not convert the full account. If you are almost certain you want to convert a lot less than the full account, even if its value jumps substantially, you could convert, say, half of it. In case the account drops in value during the year, you can undo the full conversion, and reconvert the second half right away. Without this tactic, you would have to wait until next year, and at least 30 days from the previous conversion (the latter not being a problem if you convert early in the year), because only one convert-undo cycle is allowed per year.

Disclaimers about the Advice Above.

  1. It is usually smart to use retirement money last, and keep in it investments that grow fast (stocks). If you hold in your IRA slow growing assets, such as bonds or cash, some of the considerations in favor of a conversion are moderated. This case is not addressed in this article, since it is typically not recommended.
  2. If the government decides to abolish the income taxes, replace them with a consumption tax, and leave the Traditional IRAs free and clear of taxes, a Roth IRA would be a much worse choice. It is doubtful that the government will give such a big gift to Traditional IRA owners, but it is a possibility.

Summary

Starting in 2010, all Americans have an opportunity to convert their entire IRA balances to Roth IRA. This article analyzed some of the considerations. While it may be difficult to make the best decision, in most cases it is well worth the effort. If you do not have a professional that can help you with this decision, in most cases a Roth IRA will be your better deal.

1 Investment taxes = Interest, dividends and capital gains

2 When estimating your future tax rate, take into account the investment taxes on your taxable portfolio + IRA amounts you convert or withdraw in that year. For example, a if your portfolio generates 4% taxable income each year, and you expect to have over $20M in such portfolio in a taxable account you are may end up staying at the highest tax bracket for life.

Disclosures Including Backtested Performance Data

What is the True Tax Benefit of the IRA?

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The first thing you are likely to hear about Individual Retirement Arrangements (IRAs) is that they are: “tax deferred” accounts. Some may add that they provide: “compounded growth before being taxed”. This article refutes these claims and analyzes the actual tax benefits of IRAs:

  1. The ability to pay income taxes at a lower rate, if your income tax rate is lower at retirement.
  2. Money is investment-tax free (interest, dividends and capital gains), while in the IRA.

Identifying the actual tax benefits of IRAs is essential to decide between IRAs (called Traditional IRAs) and Roth IRAs. The decision between the two types of IRAs will be the topic of the next article.

What is an IRA?

Let’s start by defining an IRA: Individual Retirement Arrangement is a retirement plan account that provides some tax advantages for retirement savings in the United States. You can open such an account as a brokerage account, letting you invest in a similar way to other brokerage accounts. It has limitations on withdrawals, while providing tax benefits.

A Roth IRA, is an IRA that does not provide a deferral of income-taxes:

  • Any money put into the account is taxed like the rest of your income.
  • Any money taken out of the account is not taxed, like any other regular account.

Other differences between Traditional IRAs and Roth IRAs, as well as benefits specific to Roth IRAs, are left for discussion in the next article.

Potential Benefit: Tax Deferral

When putting money into an IRA, you can typically avoid paying income tax, letting the money grow for many years, until you withdraw the money. Let’s review the benefit of the tax deferral with an example. Note that this example is constructed to isolate the tax-deferral effect, leaving the other IRA benefits for a later discussion.

In this example a 50½ year-old person makes one $5,000 IRA contribution, and starting at age 70½ he starts making Required Minimum Distributions, until he dies at age 90½, and his heirs take out the full balance.

The first two years of withdrawals are detailed with 3 steps: (1) the account value before the withdrawal (reflects the investment growth), (2) the account value split to the amount to withdraw and the amount left, and (3) payment of income taxes on the amount withdrawn.

Later, two more summary lines are provided for 10 and 20 years into the withdrawal phase, followed by a full withdrawal by the heirs.

The Value of Tax Deferred Money
(Ignoring Tax-Free Gains, Income Tax Rate: 30%, Investment Growth: 17%)
Point in Time Traditional IRA Taxable Account
Income earned $5,000 $5,000
After putting into the account $5,000 $3,500 after income tax paid
Annual withdrawals at age 70½ Withdraw Left Withdraw Left
After 20 years of growth – $115,528 – $80,870
Before withdraw 1/27.4 of account $4,278 $111,249 $2,995 $77,874
After withdraw 1/27.4 of account $2,995 after tax $111,249 $2,995 $77,874
After 1 year of growth (age 71½) – $130,161 – $91,113
Before withdraw 1/26.5 of account $4,915 $125,320 $3,440 $87,724
After withdraw 1/26.5 of account $3,440 after tax $125,320 $3,440 $87,724
.        
+9 years (80½), withdraw 1/18.7 $13,356 after tax $337,714 $13,356 $236,400
+10 years (90½), withdraw 1/11.4 $52,673 after tax $782,563 $52,673 $547,794
Heirs withdraw balance $547,794 $0 $547,794 $0

In the example above, we can see that tax deferral is not a benefit of IRA accounts at all. This is apparent by seeing that all numbers under the “Withdraw” columns are equal at all times. No matter how long the money is in the account, what the income tax rate is (as long as it is the same when contributing to the account as when withdrawing from it), what the investment growth rate is, and how you withdraw the money (how often and which amounts), you end up with the exact same amount of money for use during retirement.

How is this possible? It stems from the simple mathematical law: the order of multiplication does not affect the result. Here are both calculations of the value of the accounts if withdrawn after 20 years:

Traditional IRA: $5,000 x 1.1720 x 0.7 = $80,870

Taxable: $5,000 x 0.7 x 1.1720 = $80,870

Note that after putting the money into the account, and up until right before withdrawing the money, the IRA balance is indeed greater. This may be the source of the error of seeing tax deferral as a benefit. This is an error because you cannot use the IRA money without paying income tax on it. So, you are only fooled to believe you have more money, until after paying the income taxes.

How is this information useful? Since income tax deferral provides no benefit in IRA accounts, the deferral of income tax of Traditional IRA vs. no income tax deferral for Roth IRAs is not a reason to prefer Traditional IRAs over Roth IRAs. Only Benefit #1 below provides a reason to prefer Traditional IRAs in some cases (when the benefit exists and outweighs the extra benefits of Roth IRAs, as will be discussed in a future article).

Benefit #1: The Ability to Pay Income Taxes at a Lower Rate

If your income tax rate declines in retirement, the deferral of income taxes does provide a benefit. For example, if your tax rate goes down from 30% to 20%, you get:

Traditional IRA: $5,000 x 1.1720 x 0.8 = $92,422

If we divide this calculation by the original one (30% tax rate), we get:

Benefit = ($5,000 x 1.1720 x 0.8) / ($5,000 x 1.1720 x 0.7) = 0.8 / 0.7 – 1 = 14.3%

The benefit depends only on two numbers: the tax rate when the money is put into the IRA vs. the tax rate when the money is taken out. It doesn’t matter how fast the account grows, and it doesn’t matter if the money is in the IRA for 1 year, 40 years, or any other number of years.

On the other hand, if your income tax rate is higher in retirement, the use of an IRA creates a penalty. For example, if your tax rate goes up from 30% to 40%, you returns decline by: 1 – 0.6 / 0.7 = 14.3%

Note that the exact benefit depends on the tax paid on the full amount, which may include paying parts of the tax at higher brackets. This information is very important when comparing to a Roth IRA.

If you expect your tax rate to be higher in retirement, you can convert your IRA to a Roth IRA, to make sure you pay taxes at today’s lower rate, while keeping the other IRA benefits and more benefits specific to the Roth IRA that will be covered in a future article.

Benefit #2: Investment-Tax Free

Any money put into an IRA, is free of investment taxes (interest, dividends and capital gains), for as long as the money is in the IRA. This provides a clear benefit that increases with the time the money is in the account. For example, say you are invested in a portfolio like Long-Term Component, and assume that the long-term growth is 17%, with 7% taxed each year, at a combined federal rate of 20% (mostly long-term gains and qualified dividends at 15%, and minimally short-term gains and non-qualified dividends), and state rate of about 10%. Your tax cost is 2.1% per year. The example above becomes:

Taxable: $5,000 x 1.1720 x 0.97920 x 0.7 = $52,898

If we divide the original calculation by this calculation one, we get:

Benefit = ($5,000 x 1.1720 x 0.7) / ($5,000 x 1.1720 x 0.98620 x 0.7) = 1 / 0.98620 => 53%

Summary

IRA accounts offer tax deferral of income taxes, which, contrary to common belief, is not a benefit. They do provide two other great benefits:

  1. The Ability to Pay Income Taxes at a Lower Rate: In case your income tax rate goes down by the time you withdraw your money, you get a benefit that depends on (and only on) the tax rate when withdrawing when compared to the tax rate when depositing the money in the first place.
  2. Money is Investment-Tax Free, while in the IRA: This is a substantial benefit that grows with the time the money is in the account, and grows with the investment taxes saved.
Disclosures Including Backtested Performance Data

A Strategy for Avoiding Stock Declines during Recessions

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Can you think of the easiest way to avoid continued stock-market declines, during a recession? This article presents the most common strategy, based on ideas from various investors. It guarantees that you stop your stock losses, and you are likely to feel a big sigh of relief. There is one catch – read on for details.

The strategy has different variants, but the basics are common and are very intuitive:

  1. Follow the economic news. Whenever you hear concerns about the economy start selling your stock portfolio. If it seems like we are getting into a deep recession, sell your whole portfolio, until things look better.
  2. Keep following the economic news. Once the economists become more positive, start buying stocks. When the economic outlook looks really good, make sure you are invested heavily in stocks.

The benefits of this strategy are easy to identify:

  1. Whenever the economy is doing poorly and you hear gloomy news on a daily basis, you get to be outside the stock market. You can smile seeing your accounts retaining their value, while people around you are nervous about their investments.
  2. When everyone is optimistic, you get to have your money in the stock market, enjoying being invested when there is such excitement around.
  3. At all times, you can feel good about your actions. Not only are they intuitive – many people around you are acting the same way, providing a great support network.

There is one big catch: The stock market does not go up and down together with the economy and the sentiment on the news. It tends to precede the economy by 6-12 months. Whatever news you hear is already reflected in stock prices, and only the unknown affects the stock market moving forward. As a result:

  1. When you hear about the economy doing poorly, the stock market is already down substantially. When you learn that we are in a recession, the stock market tends to be past most of its decline. For example the 2008 recession was announced by the National Bureau of Economic Research on December 1, 2008 – close to the stock market bottom.
  2. When there is optimism, the stock market has already experienced a substantial portion of the recovery.
  3. Given the predictive nature of the stock market, bottoms tend to be reached at the moment of greatest pessimism. By selling on pessimism, you are likely to sell low. Optimism and comfort are reached when the stock market is much higher.

The strategy presented virtually guarantees that you sell low and buy high! While it provides great psychological comfort, it comes at a price of giving up some of the greatest run-ups in stock prices in history, and getting substantially reduced long-term returns.

For example:

  1. On December 9, 1974, the cover story of “Time” magazine, “Recession’s Greetings” was very gloomy. A year later, the Dow Jones Industrial Average was up 47.7%, with a new “Time” cover story: “U.S. Shopping Surge”.
  2. On March 10, 2009, there was great pessimism about the world economies as the stock market hit bottom. A couple of months later, the globally diversified portfolio, Long-Term Component, was substantially higher, as there were some initial signs of optimism.

Summary

It is easy to invest in a way that feels good. This article provides the guidelines for that. Unfortunately, doing what feels good bears a large price tag on your investment performance. You have to make a choice between what feels good for you and what is good for you.

Disclosures Including Backtested Performance Data

Asset Allocation during Declines

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When you face a substantial decline in your portfolio, it becomes tempting to keep the money in cash until the recovery begins. The greater the decline, the greater the temptation. Watching the news and reading economic analyses makes it even tougher to stick to your long-term plan. As demonstrated in the previous article, “Can You Avoid Market Declines?” (Hanoch February 2009), finding the bottom of a decline is virtually impossible. The problem is compounded by the difficulty in buying back when the portfolio is lower and the economic atmosphere is worse. Fortunately, if you established a well thought-out plan in advance, you may not need to face this temptation.

During declines, people try to reduce “Market Risk” – the risk of a decline in stock prices. There are two additional risks that should always be considered as well: “Inflation Risk” – the risk of losing purchasing power over time, and “Longevity Risk” – the risk of outliving your money. As you will see below there is a clear tradeoff – reducing market risk increases inflation risk and longevity risk.

The reason for the smaller focus on the other two risks is the eagerness to deal with the current pressing problem, and the need to feel in control. Since the latter two risks are not imminent, people tend to neglect them in favor of market risk.

The best way to deal with market risk is to sell some stocks. If the plan was not designed in advance to prepare for substantial declines, this is an unfortunate necessity during a decline. When done it should be a cold and rational decision that is followed in the long run, especially as stock prices go up. The desire to get back in the market as economic conditions improve is likely to lose you money and increase your inflation and longevity risks. Let’s review these now.

Inflation Risk: During severe declines, governments (both democrat run and republican run, each with their own emphasis) tend to stimulate the economy, and create the risk of inflation in upcoming years. If you hold cash or bonds during this period, you risk losing your purchasing power, since an investment that is free of market risk is almost guaranteed to lose money after taxes and inflation. This means that while maintaining the stock allocation can result in a number of years until recovery, cash or bonds are not likely to ever recover your losses.

Since inflation is the increased prices that companies charge for their products and services, company ownership (stocks) is the best way to protect yourself from inflation risk.

Longevity Risk: By selling stocks during severe declines, you realize the substantial losses, but risk missing out on the gains during the recovery. As a result, you risk outliving your money. If you maintain the lower allocation to stocks in the long run, the loss in purchasing power of your cash and bonds increases the risk of outliving your money.

By keeping your money in stocks, you miss the speculative opportunity to outperform your stock portfolio, but you also ensure that you gain the impressive long-term after-costs returns of stocks.

Conclusion

If your annual withdrawals from your portfolio are conservative (e.g. 2%-5%, depending on the portfolio), and your portfolio is globally diversified, with no individual stock selection or market timing, you may be facing greater inflation and longevity risks than market risk, especially during declines in your portfolio. In such case, you may want to think twice before selling stocks and changing your plan.

Disclosures Including Backtested Performance Data

Can you find Skilled Active Mutual Funds?

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How would you like to choose mutual funds that will outperform benchmarks of the stock market? This is an ongoing pursuit of millions of people. Up until recent decades, people intuitively believed that if you pay professionals to spend hours every day researching stocks, they would outperform a brainless benchmark. It was only a matter of how big the outperformance would be – at least that was what people believed. Since then, multiple studies compared the performance of actively-managed mutual funds with benchmarks, and found out that it is not as trivial as intuitively seemed.

The task: This article reviews an academic study that tried to find out what portion of actively-managed mutual funds outperformed benchmarks due to skill, as opposed to random luck. This can help you decide whether you want to pay someone to try to outperform the benchmarks by picking the right stocks or by timing the market.

The study is by Russ Wermers, a professor of finance at the University of Maryland, Laurent Barras of the Swiss Finance Institute, and Oliver Scaillet of the University of Geneva. It observes returns of actively-managed mutual funds over the 32-year period of 1975 to 2006. It avoids short-term biases by including only funds with at least 60 months of returns, and is free of survivorship bias, by including funds that existed at any time in the period observed.

How do you decide? Given the alternative of passively managed funds that track diversified benchmarks, combined with the fact that globally diversified stock investments recovered from all declines in hundreds of years to achieve handsome long-term averages, you have to make a good case for trying to beat benchmarks, while risking doing worse.

You may choose to use an actively managed mutual fund if the odds of outperforming the benchmark are substantially higher than the odds of underperforming it. A smart speculator would do so given any chance of success over 50%, while a more risk-averse individual may want much higher odds.

The results: Can you guess what the chance for success was based on this study?

During the 32 year period studied, from 1975 to 2006, only 0.6% of funds delivered higher returns than their benchmark through skill (not even counting sales loads).

Feel free to reread the number above – the number is indeed less than 1%.

The decision: Based on these results, choosing actively managed funds seems unlikely to make you excess money while adding the risk of one person making wrong predictions. Neither the conservative investor nor the smart speculator should see any benefit in taking this chance.

Accepting the results of passively managed funds may sound boring, without the excitement of trying to “beat the market”, and plain “average”, but when compared to the dismal results of actively managed funds, it seems like the more sensible approach. It may be average compared to the benchmarks, but outstanding compared to most investors that still use actively managed funds.

What can you control? By narrowing it down to passively managed funds, you can avoid the risks of stock picking and market timing. Instead you can focus on things you can control such as minimizing costs, minimizing taxes and maximizing diversification. By using such criteria for selecting mutual funds you can peel off the speculative layer, turning yourself from a speculator to an investor, with a more direct link to the productive capacity of the world.

Disclosures Including Backtested Performance Data