AssetBuilder Inc., Registered Investment Advisor

The Financial Condition of Pre-Retirees: Precarious

admin — Fri, 17 May 2013 21:00:00 Z

“We must all hang together, or assuredly we shall all hang separately.”

That famous Benjamin Franklin quote came to mind as I read a paper by three researchers who’ve made important contributions to the study of retirement finance — James M. Poterba at M.I.T., Steven F. Venti at Dartmouth, and David A. Wise at Harvard.

What could possibly connect a statement from a revolutionary at the signing of the Declaration of Independence and an academic study of pre-retirees financial resources?

Lots. The paper shows what amounts to two separate and distinct Americas. One is the large portion of our population— at least half— that enters retirement, often unwillingly, with very limited resources and struggles every day thereafter. The other is a smaller group that we see pictured in magazines offering long cruises, well landscaped retirement communities, and other signs of affluence— the top 30 percent that is doing OK to very, very well.

If the two groups can’t figure out a way to coexist, the figures make it clear that most people are facing a future of strife and shortage while those who are better off will feel they are targeted by a growing horde of tax hunters. Or maybe just hunted.

What makes this research different is that it tries to put a value on things like Social Security and pensions. This isn’t done by the well-known Survey of Consumer Finances that is the basis of most wealth studies. Nor is it done by journalistic efforts such as my regularly updated Wealth Scoreboard. And it isn’t done by the financial services industry, either. Their research tends to focus on our financial assets exclusively and regularly tells us that we need to save much, much more.

The reality is that when Social Security and pensions are considered, the gap between top and bottom is reduced substantially. Substantially, however, turns out to be not nearly enough.

One measure of the chasm is how much life-annuity income pre-retirees could buy with their savings. The researchers found that nearly half of all households could convert their entire savings into no more than $5,000 a year of lifetime income. Their savings, in other words, weren’t going to do much for their retirement security. The top 11 percent of households, on the other hand, could buy at least $50,000 a year of lifetime income.

Here are some of the important messages culled from the paper:

Social Security is really important for nearly everyone.

Whether viewed as a percent of income or as a form of ‘virtual wealth,’ Social Security varies from important to ‘life or death.’ Even small changes in benefit formulas will have enormous future consequences. While it is essentially the only resource available to those in the bottom 50 percent, it still appears to account for one-third of financial resources for those in the top 20 percent.

Home equity is a vital source of security for some retirees.

It appears, the researchers note, to be used like a deep reserve. To some extent, middle-income households seem to regard home equity as a reasonable substitute for long-term care insurance or a good sized emergency fund. While more than 90 percent of married households have some home equity, the bottom 30 percent of single households have none.

Being married is good for your finances.

Being single isn’t. While married households tend to have financial assets, housing equity, defined benefit pensions and strong Social Security income, single person households have less of each. So single person households have less flexibility as well as less money.

These differences are important because we are becoming a nation of singles. As recently as 1989 only 5.3 percent of women ages 40 to 44 had never been married. By 2009 the figure was up to 14.1 percent. It’s also a matter of actuarial reality that the percentage of population that is coupled peaks at ages 40 to 49. It declines after that because of death, not divorce. While 78 percent of households were married couples in 1950, only 48 percent were married in 2010.

This explains why our supermarkets are now filled with “single” servings of frozen vegetables. It also gives us a hint of the financial disadvantage our entire society will have as the boomer generation retires.

Marriage, friendship and sharing have never been so important— and so ignored.

Public Pensions: Nice Deals If They Can Be Delivered

admin — Wed, 15 May 2013 22:00:00 Z

Q. I am facing a difficult retirement funding decision. I am a 52-year-old municipal employee. I’m vested in a defined-benefit plan. It will provide me a lifetime annuity beginning at age 62. I have the option of purchasing an additional five years of service for about $75,000. This will bump my monthly annuity at 62 up by $1,200 a month, which seems like a really good deal. What bothers me is that I have to rob my 401(k) for the $75,000. That means I have to give up its potential market growth for 10 years. How would you suggest doing a comparison of these options? —J.A., Austin, TX

A. Giving up 10 years of potential market growth may not be so painful when you consider the apparent value of the annuity income being offered for that $75,000. If you visit the website, immediateannuities.com you will find that a 62-year-old Texas man would now have to pay $230,539 for a life annuity income of $1,200 monthly if the annuity paid no benefits to any beneficiaries. It would cost still more if there any provisions for payments to beneficiaries.

To have that $230,539 purchase price available in 10 years the $75,000 you need to commit today would have to grow at a stunning compound annual rate—11.88 percent. That makes it a very good opportunity, with one really big risk.

What could that risk be? Just this: Do you think the municipality you work for can earn returns like that? We are now at the beginning of a series of public sector bankruptcies. Most of them will involve government units that have promised future pension incomes without putting aside nearly enough money, or earned high enough returns on that money, to deliver the promised cash at the appointed time.

Most government entities base their pension promises on an actuarial assumption that the money they put aside will earn about 7.5 percent, down from somewhat higher assumed returns years ago. Needless to say, neither corporate nor public pension funds have earned 7.5 percent over the last 10 years. That's why many pension funds are seriously "under-funded."

Can they "catch up" in the future? With a 10-year Treasury yielding less than 2 percent today, it's not very likely that pensions will earn 7.5 percent over the next 10 years, let alone 11.88 percent.

What you can be certain of is that anyone who is given the opportunity to buy years will be very tempted to do it: the retirement income offered is looking better by the day. This means further stress on the pension fund and more pressure on pension managers. It also means you're supposed to believe that the folks who haven't been able to make 7.5 percent in the past can make 11.88 percent over the next 10 years. That turns what you've been offered into a pretty risky bet.

Should you make the bet? Yes, but don’t bet the ranch: Be certain that $75,000 is a relatively small portion of your existing 401(k) balance.

Q. I have about $20,000 in a DWS Core Equity Fund. I would like to transfer it to the Vanguard Balanced Index Fund for two reasons: The lower expense ratio 0.10 percent versus 0.69 percent, and to have all my investments in one company.

Is this a wise move, especially with the market being up? This will involve selling and paying taxes on capital gains and purchasing at a higher price. —J.W., by email

A. Cutting expenses is good. So is consolidating where your investments are located. Moving from DWS Core Equity Fund to Vanguard Balanced Index Fund, however, isn't an apples-to-apples move since one is an all equity fund and the other is a balanced fund. Balanced funds generally are about 60 percent equities, 40 percent fixed income. The move you propose would lower costs and reduce risk at the same time. Whether that is a good idea or not depends on how your other assets are invested.

You may not have enough capital gains to realize for taxes to be a concern. With the stock market only now reaching the highs of 2007, you may find that your tax liabilities from selling will be quite modest.

Prius at Ten

admin — Sun, 12 May 2013 00:00:00 Z

It’s hard to believe, but it has been 10 years since I bought a funny-looking car, the 2003 Prius. It was the first model, a tiny sedan. It looks nothing like the now iconic 2004 Prius, which was introduced a few months later.

Our pre-iconic, subcompact Prius has 115,000 miles on it and is still a bright, un-dinged metallic green. It has covered that distance at about 43 miles per gallon. During the 10 years, it has needed only one expensive repair. It has been trouble-free year after year and it has been happy wherever we’ve taken it, from aggressive Dallas traffic to long stretches of remote New Mexico roads. It has been a practical companion to the inevitable SUV that occupies the rest of our garage.

In a few weeks we will give it to our 16-year-old granddaughter. My wife and I hope she will be driving the car until she finishes college. Some of the 2003 Priuses advertised on autotrader.com give us hope that the car is good for the distance. As I write this, for instance, one is listed with 178,519 miles. Another has 153,072 miles and still another has 140,229. So unless she gets into Dean Moriarty-like road trips, the odds are pretty good it will do the job.

What have we learned during the last ten years? A bunch.

First, the worries many people had about the batteries that enable much of the fuel efficiency of hybrids were unjustified. Ours is still going strong. I’ve also met multiple owners who’ve never replaced the battery and have far more miles on their car than we have on ours. This is important. Early naysayers claimed that every dime saved in fuel would be spent on replacement batteries.

We’ve burned about 2,700 gallons of regular gasoline during those ten years. A comparable size non-hybrid car would have burned about a thousand gallons more. So our fuel saving was about $3,300 and about 7.8 cents a mile. I also figure the car, which was $20,000 new, has lost about $13,500 in value. That would make depreciation about 12 cents a mile, or $1,350 a year.

Perhaps you can burn less gas and suffer less depreciation, but there are no obvious examples. According to the AAA, for instance, the cost of gasoline for a typical small sedan is 14.5 cents a mile. The AAA also figures the cost of depreciation at 15.2 cents a mile. The 10-cent lower cost per mile of the Prius implies a 10-year savings of $11,500— not bad for driving a car that is quieter and smoother (because it has a continuous variable transmission) than most small cars.

I will leave to readers whether a Prius is a good car to “wear.” Driving a Prius can give you a deep sense of automotive inadequacy in the tonier areas of Dallas or Houston. My wife has worried about being crushed by a Ford F-250 while in the Tractor Supply parking lot. We’ve both happily balanced those awkward feelings with the ease of sliding into small parking spots throughout the known universe.

The good news today is that car buyers have a lot of choices if they want to drive a fuel-efficient car. Prius, improved and still iconic, faces a veritable armada of competition. A lot of it is made in the USA. The new Ford C-Max, for instance, is larger and more fun to drive than a Prius and also less expensive, even if it doesn’t get the claimed 47 mpg. If you want to go lux, the $42,000 Lexus ES300h is a really nice way to get 40 mpg. Then again, a tricked out Ford Fusion hybrid has the looks to get in the ring against the Lexus. You can explore and compare all the possibilities of hybrid by visiting fueleconomy.gov. While comparing, you’ll probably notice that it’s pretty easy to find a high mpg conventional car. The diesel offerings are growing, too.

What did we buy to replace the 2003 Prius?

A new Honda Fit, sport model. It doesn’t get the 40 plus mpg of a hybrid, but at $20,000 it cost about $10,000 less than most hybrids. It’s also fun to drive, has great visibility and very flexible seating/storage. We figure the $10,000 difference will buy a lot of gasoline.

Question Number One for Life Insurance: Is It Necessary?

admin — Wed, 08 May 2013 21:00:00 Z

Q. I am a 74-year-old man with a $40,000 life insurance policy. I have been paying on it for 21 years and it has been building surrender value as well. My current annual report reveals "guaranteed assumptions" of a death benefit of $40,000 for nine more years and a current surrender value of $13,000 - declining to zero at the end of the nine years.

In addition to the "Guaranteed assumptions" there is another column labeled "current non-guaranteed assumptions" (these may be changed by the insurance company). It shows the death benefit of $40,000 running through age 84 and a current surrender value of $14,100 that will increase to $22,000 at the age of 84, and $44,000 at age 94.

I can't get a "good" feeling from the insurance company regarding the guaranteed assumptions versus the non-guaranteed assumptions. I am wondering if I should seriously consider redeeming the policy for its surrender value in the near future. —L.H., Austin, TX

A. The real question here isn't what your cash value is earning. It is whether you still need to protect someone else by providing $40,000 in the event of your death. If not, continuing the policy is reduced to a speculation about dying young vs. dying old.

Unless you can name someone who will truly need that $40,000 death benefit upon your demise, the cash value of the policy is really a savings account set up to assure the insurance company that it will receive its annual premium plus the equivalent of a daily lottery ticket purchased for your beneficiary. You might have a better use for the money. In addition, your beneficiary might have a better use for $13,000 today than for $40,000 at an uncertain date in the future.

The size of the policy also suggests that you don't need a death benefit to deal with estate taxes. Like the vast majority of Americans, you probably don't need to concern yourself with estate tax issues.

Q. We need some advice on possibly rolling over 403(b) retirement fund mandatory distributions into our Roth IRAs. My wife and I live comfortably on a military retirement, Social Security, and income from stocks, CDs, and two rental houses. We can add significantly to our savings each year. We have no debts, live on a cash basis, and pay off two credit cards monthly. Next year we must plan to start withdrawing from IRAs, a SEP, and the 403(b). Since we don’t expect to need the withdrawn mandatory funds for our day-to-day living expenses, can we roll those funds into our Roth IRAs? —J.J. by email

A. Quite a few people would like to do that but the regulations don't allow it. To move money from an IRA or other qualified plan to a Roth after age 70 1/2 you must first take your RMD and pay taxes on it. Additional money can be withdrawn, creating still more taxable income, and that money can be put into a Roth account. Unfortunately, the combination of an RMD and an additional withdrawal often pushes people into relatively high tax brackets. This pretty much defeats the purpose of Roth conversion.

The best alternative is to reinvest your after-tax RMD cash in a tax-efficient or tax-deferred investment. Broad equity funds such as the Vanguard Total Market Index ETF (ticker: VTI), Schwab Multi-Cap Core ETF (ticker: SCHB), Fidelity Spartan Total Market Index Fund (ticker: FSTMX) or iShares Core S&P Total U.S. Market ETF (ticker: ITOT) are good low-cost candidates. You'll have a modest taxable dividend income, but otherwise little or no taxes to pay until you sell part or all of the investment.

If you'd rather avoid risk, you should explore the large variety of CD-like tax-deferred annuities. One place to explore is mrannuity.com. This website, used for data purposes only, has a weekly list of top yielding CD-like annuities. Recently, yields were far better than comparable maturity Treasury obligations and CDs. Here’s an example. While the 5-year Treasury is yielding 0.68 percent and the average yield on a 5-year CD is 0.49 percent, the top yield 5-year CD on bankrate.com was 1.54 percent. But on the mrannuity top10 list you can find a 5-year annuity at 3.05 percent. Big difference.

‘Having Money’ Isn’t So Easy

admin — Fri, 03 May 2013 21:00:00 Z

Hold those guillotines! I’d like to say a few words to provoke your sympathy for the well-off, particularly those who “have money” and don’t work for a living.

Legend has it that such people have it made. They don’t suffer the indignity of work. They clearly chose their parents or grandparents well. They’ve never had to worry about money. They tend to be taller and have straighter teeth. Their investments seem to work a lot better for them than working for a paycheck works for the rest of us.

Or so it seems.

Well, it turns out keeping up isn’t that easy. In fact, most of the people who “have money” are likely to need to get a job if they aren’t very careful. For all the problems Johnny Paycheck has been having in recent years, keeping up with him is harder than keeping up with the Jones, and you know how difficult that is.

How can this be? Easy. If you depend on income from investments it is very likely that, over time, your income will fall behind what people who work for a living are paid. You also have to be a really long-term investor. While retirees may need to consider periods of 25 or 30 years, the young rich have to think about entire lifetimes. Being independently wealthy, it turns out, can be, well, difficult.

Surprised? So was I. But here is what I learned in a not entirely scientific exercise.

Let’s start by going back 50 years and trying to figure out how much money we would have needed to be pretty well-off. Back then the Social Security employment tax stopped coming out of paychecks at $4,800 a year. It seems puny now, but it didn’t seem so small in 1963. And then, as now, more than 90 percent of all workers earned less than the wage-base-maximum.

Having a private income of $4,800 a year in 1963 seems like a good starting place. Being well-off begins with having more money than most people.

You could get nearly that much income by investing $100,000 in Fidelity Puritan fund, one of the oldest surviving balanced funds. In that first year it would have provided $4,650 according to Morningstar data. Of course, having $100,000 to invest in 1963 wasn’t easy. Back then the IRS identified you as a “top wealth holder” if you had a net worth of $60,000.

But let’s assume you had that $100,000 and you invested it. Where would you be now?

Well, your investment would have grown to $1,480,758. Your income for 2012 would have been $26,535. That’s down from a peak of $40,561 in 2007. It’s more than 5 times your income in 1963. Unfortunately, inflation for the period in question was higher. You’ll have lost ground if your income isn’t about $36,000.

What’s to blame? We can point one finger, but just one, at Federal Reserve boss Ben Bernanke. If he weren’t so intent on keeping interest rates near zero, bond yields would be higher. Ditto stock yields.

And this is just the beginning of the problem. To keep your position as a pretty-well-off person, your income would need to rise faster than inflation. To match the growth of the wage-base-maximum, which hit $113,700 this year, it would have to grow at a 6.57 percent annual rate. For our young investor to keep up, there would need to be some judicious withdrawals of principal.

As a person of independent wealth, you need to have a total return on your investments that is equal to the increase in the wage index plus your annual withdrawal rate. This suggests an annualized total return of 10 or 11 percent, if you can live with a withdrawal rate around 3 or 4 percent.

Can it be done in real life? Yes, but it’s no slam-dunk. Here is a list of five well-known mutual funds that Morningstar Principia data shows provided at least 10 percent annualized over that 50-year period:

Templeton Growth A shares, 13.06 percent
T. Rowe Price New Horizons, 11.71
Vanguard Windsor, 11.49
American Funds American Mutual A shares, 10.82
Fidelity Puritan, 10.74

It turns out that having money is a bit like having cake: It’s difficult to have it and eat it too.

How To Start As a Small Investor

admin — Wed, 01 May 2013 22:00:00 Z

Q. In a recent column you suggested to a reader that they should take their $400,000 and put it in a low-cost index fund such as Vanguard Balanced Index shares. I have no idea what that means, but I hope you might be able to give me some advice as well. I have no 401(k), no retirement pension, and no clue.

I am 42 years old. I have worked as a bartender and waitress since I was in my twenties. I make $2.13 an hour and always have (our minimum wage has been the same for over 20 years). Over this time I have managed to save $17,000, which I put into a CD. Recently, I transferred the CD to my checking account because CD's are only paying 0.25 percent. Now, a month later, I really want to invest the small amount I have saved into something that would earn more money.

Should I put the money back into an 18-month CD at 0.25 percent or in a savings account at 0.65 percent? I have asked a couple of close friends what to do, and they cannot give me any kind of answer or advice that makes sense. —K.M, Dallas, TX

A. It's difficult to save money when your income varies significantly from week to week and your employer doesn't offer any kind of plan. Basically, the whole burden of creating your future is in your lap, as it is with millions of other people who are employees in small businesses.

Worse, no one is going to get very far by preparing for retirement at current interest rates on certificates of deposit. So let me make a series of suggestions:

First, start a checking account at a discount broker, such as Charles Schwab. Visit an office and someone will help you. (You can close your existing checking account, too.)
While you are at it, open a brokerage account and an IRA account. Make sure you get online access.
Deposit 2 or 3 months of your expenses into the checking account,
Put most of the remainder of your $17,000 in the brokerage account, but reserve about $1,000 to start the IRA account.
Put half of your brokerage account money in the Schwab U.S. Dividend Equity exchange traded fund, often called an ETF (ticker: SCHD).
Put the other half in the Schwab U.S. Aggregate Bond ETF (ticker: SCHZ)
In the IRA start by investing in the Schwab U.S. REIT ETF, ticker SCHH)

All of this can be done with no commission cost and the highest annual expense ratio for any of the ETFs is 0.07 percent a year. This means you will get 99.93 percent of the return on your money, an amount as pure as Ivory Snow. Your brokerage account will be invested in a very similar way to my original Couch Potato portfolio, except that it will lean a bit more toward yield. The current yield on the Dividend Equity fund is 2.95 percent and the current yield on the Aggregate Bond fund is 1.37 percent. The current yield on the REIT ETF for your IRA is 3.21 percent.

Put your paychecks and tips in your checking account and make a regular monthly
transfer to your IRA.

These investments are not risk-free. Sometime over the next 25 years you are likely to suffer a significant loss. So let me tell you one of the advantages you have as a bartender/waitress. Unless you accumulate a very large amount of money over the next 25 years, the odds are that the majority of your retirement income will come from Social Security. Since such a small portion of your future depends on investing you can afford to take more risk than people who make substantially more, such as doctors and lawyers.

The most unusual thing suggested here is to start your IRA investing with a commitment to a real estate investment trust index ETF. This suggestion is based on the assumption that you rent, so you don't have anything invested in real estate. Homeowners, as a group, should only commit to real estate investments after they have committed to other asset classes because most Americans have most of their net worth in their home equity. You don't.

Once you’ve taken these steps you don't have to do anything until the value of the REIT investment equals the value of the other two investments, then you'll need to start investing in the Schwab International Equity ETF, ticker SCHF. That's about all you'll need to do for about two years. During that time, you can learn about Couch Potato investing in this column and on my website.

Today, The Big Risk Is in Bonds

admin — Fri, 26 Apr 2013 21:00:00 Z

Few investment research reports become turning point documents. But I have kept one for nearly 30 years because it was so important and so powerful. It still says a lot to us today, but in reverse.

The report, “The Investment Magic of ‘Zero’ Bonds,” came from the Leuthold Group in late 1983. The Leuthold Group is in Minneapolis. Its prime mover is Steven Leuthold, a researcher who has often identified himself as “an equities guy.” The existence of bonds was acknowledged, but only as distant competitors for stocks.

That’s what made this report so compelling. In it’s 61 pages of comment, tables and data it shows how it would be virtually impossible for common stocks to beat the guaranteed 12 percent return zero-coupon Treasury obligations offered at that time.

(A zero-coupon bond is a bond that is issued at a discounted price. Its value grows to its maturity value. Since it has no coupons, you can be certain of the compound annual return if you hold to maturity.)

Back in 1983, even with interest rates below the record rates of 1981, you could buy a zero-coupon Treasury maturing in 20 years— 2003— for $1,051 with the promise it would mature at $9,500. That’s a compound annual return of 11.65 percent. The argument in the report was that interest rates were so high that investors were virtually invulnerable. Only hyperinflation could defeat bonds with such high yields. Whether interest rates went up or down, stocks would have a very hard time producing as high a return.

Today we know: The report was right on the money.

It showed, for instance, that a decline in interest rates would cause the value of the bonds to soar. If the interest rate on a 20-year Zero declined from 12 percent to 10 percent in 5 years the annualized return on the bond would be 18 percent. In fact, interest rates fell more, so the return if you sold before maturity was still higher. Basically, buying bonds was a no-brainer, a very low risk deal.

But that was then.

Now the situation is nearly the opposite. While people are still worried about government deficits, rising federal debt, and the possibility of hyperinflation, yields on Treasury obligations are approaching record low levels. Worse, in all short-term maturities the yield is lower than the rate of inflation. Today, for instance, the yield on a 10-year Treasury is 1.70 percent— about the same as the trailing rate of inflation.

The risk that interest rates will rise is now greater than the opportunity of a continued decline. More important, the losses could be significant.

How significant? Well, let’s see what investors would pay for that 10-year Treasury if interest rates rose by different amounts. If the market demanded a 2.7 percent yield— an increase of only 1 percentage point— the value of that $1,000 Treasury would fall to $912.87. That’s a loss of $87.13. So you could lose 8.7 percent of your money. Viewed another way, you’d lose an amount equal to about 5 years of interest income.

If interest rates rose to 5 percent, a yield closer to historical norms, the value of the same bond would decline to $742.78. That’s a loss of 25.7 percent, an amount that would feel like a stock market crash.

Shorter-term securities would lose less and longer-term securities would lose more, but the basic principle remains the same: In today’s fixed income market we are risking a large amount of principal to capture a smidgeon of yield.

Will interest rates rise in the future? Many analysts, but not all, think so. Everyone with savings wishes that interest rates would rise and just about everyone would agree that interest rates are more likely to rise than to fall. Just because everyone thinks something should happen doesn’t mean that it will. (For a contrary view, one that indicates we may be stuck with low interest rates for many years, read this interview with economist Lacy Hunt.)

Bottom line: If you’ve been obsessing over yield and reaching for it in fixed income securities, this may be a good time to take a close look at where the exits are.

Sidebar: How To Estimate The Risk In Your Bond Fund Investment.

Want to get some idea of how much money you could lose if interest rates rise? You can do it without being a bond expert. First, go to the Morningstar website and look up your fund. Find its average maturity and current yield. Then go to an online bond value calculator and enter the values for your fund and test against higher interest rates.

Here’s an example. On the Morningstar website the Vanguard Total Bond Market ETF (ticker BND) is listed as having a current yield of 2.64 percent and an average maturity of 7.1 years. The calculator tells us that an increase in interest rates up to 3.64 percent would cause a loss of about $66 or 6.6 percent. That’s about 2.5 years of current interest income.

If Investments Provide Little of Your Total Income, You Can Take More Risk

admin — Wed, 24 Apr 2013 21:00:00 Z

Q. My husband and I have pensions totaling $64,000 annually. We also have his Social Security of $18,000 a year. Next summer I’ll start receiving my Social Security of $24,000 a year. With my Social Security starting at age 66 we won’t really need to use our IRA money – at least for awhile. (We have been supplementing our income from the IRA.)

My question is this: How, at ages 67 and 65, should we allocate our IRA money? It’s all at Vanguard. Currently there is:

$215,000 in the Total Bond Market Index, Admiral shares (VBTLX)
$115,000 Diversified Equity (VDEQX)
$85,000 in the Total Stock Market Index, Admiral shares (VTSAX)
$40,000 in the Total International Stock Index, Admiral shares (VTIAX)
And in the Roth IRA, we have $32,000 in the Total Stock Market Index, Admiral shares (VTSAX)

When I look at the pie chart on the Vanguard site, it shows that I am allocated 55 percent in stocks and 45 percent in bonds. Do you think this is an appropriate allocation for our age and income? —C.M., Wenatchee, WA

A. You can increase your allocation to equities more than most people due to your other sources of income. Let me explain. Between your combined Social Security income of $42,000 and combined pensions of $64,000, you will have a relatively secure income of $106,000 a year before you start to consider your investments. Since your investments total just under $500,000 they are not likely to safely add more than $20,000 (at 4 percent) to $25,000 (at 5 percent) to your income.

Although you have a large sum saved, its potential contribution to your other income is relatively small. This means you can take a bit more risk. You can accumulate and reinvest until you need to do Required Minimum Distributions. Even then, the starting RMD is only 3.65 percent.

As a practical matter, your pension income is fixed and will suffer from declining purchasing power, so a good use for your IRA money is to have it more aggressively invested. Then you can use the required minimum distributions as a tool for offsetting the damage inflation does to your pension income. It would not be unreasonable to have a traditional 60/40 allocation, or even greater, since less than 20 percent of your income is affected by the ups and downs of the equity markets.

Q. We have 2 pieces of real estate that we plan to leave to our children. One will be left to our son (who wants to keep it). The other will be left to our daughter. We would like to have it sold and the money put into an annuity for her. Our son is prudent with his money. She is not, and he doesn't want to be responsible for her after we are gone. If we just leave her the proceeds from the sale, it will probably be gone within a couple of years.

We are not sure that our plan for an annuity is a good idea for her. The property we are leaving her is worth about $500,000. Do you have any other suggestions that would give her a monthly income for years other than an annuity? We had been told this was the best way to do it, but you don’t seem to favor annuities. We don't want to invest it in the stock market. —M.A., by email

A. There are many kinds of annuity contracts. The ones I don't have much use for are variable annuities that allow you to invest money inside a contract that provides tax deferred accumulation of investment returns until a later date. As I have demonstrated many times, the expenses of these annuities tend to defeat their purpose. This is particularly true for individuals in a relatively low tax bracket, as your daughter is likely to be.

But there is another kind of annuity contract that may suit your purposes better. It is called a life annuity. To get such a contract you give up your principal in exchange for an income that is based on the life expectancy of the beneficiary. You can explore how much income this might yield by visiting immediate annuities.com. Recently, for instance, a $500,000 payment would provide a lifetime income of $2,293 a month for a 60-year old woman and a lifetime income of $2,889 for a 70-year old woman.

In the current interest rate environment these contracts aren't wonderful deals because it takes many years before you start getting back anything but your original principal. With that caveat, however, this is a way to provide a lifetime income for a child who isn't very responsible.

All That Glitters … May Be Silver

admin — Fri, 19 Apr 2013 23:00:00 Z

Gold and silver aren’t lining a cloud these days. They’re under it, big time. Both precious metals dropped sharply last week, extending a nasty slump. Silver, for instance, has lost nearly 50 percent of its value over the last two years.

Is this the end of the long precious metals bull market? Probably not. The cause of the decline may be as simple as the slowdown of economic growth in China and India. People in both countries have long believed more in gold and silver than in paper money. But when they have less paper money, they buy less gold and silver.

Indeed, if you read Shayne McGuire’s’ new book, “The Silver Bull Market: Investing in the Other Gold” (Wiley), you’re likely to come away convinced that owning some silver coins is a good idea. They may be a happy alternative to the nearly-no-yield-CDs that are starving solvent seniors. The same low-yield environment is doing damage to the pension funds, life insurance policies and long-term care policies on which millions of real people have based their financial planning. At some point, all of those investors may look for a better, more trust-worthy, alternative.

Columns on how Federal Reserve policy is affecting real people:

“The Great American Bank Robbery,” (3/19/10)

“Solvent Seniors and the Matrix of Misery,” (7/16/10)

“How to Be a Millionaire and Live in Poverty,” (7/22/11)

“Playing Roulette with Long-Term Care,” (11/30/12)

“Low Interest Rates Endanger Life Insurance Policies,” (2/13/13)

“Coping with the Zero-Interest-Rate Policy,” (1/4/13)

One thing you should understand right now is that Mr. McGuire isn’t one of those TV shills urging you to put every dime of your IRA into gold or silver. Nor does he suggest, anywhere in the book, that we are heading for some kind of Armageddon. In fact, he doesn’t sell precious metals. He buys them. He manages the precious metals portfolio for the Teachers Retirement System of Texas. Just as he made a prudent and reasonable case for gold in an earlier book, he has now made a strong case for owning some silver.

The operative word here is “some.” Indeed, while he thinks that silver will be a more volatile investment than gold and urges caution, he also makes a strong case that silver may appreciate more than gold as people around the world trust paper money— and the governments that print it— less.

Here are the basic elements of his case for rising silver prices:

Gold and silver have been used as money for centuries. They were a solution to awkward bartering and encouraged trade. Many nations issued coins in both gold and silver. The exchange rate between them was about 15 ounces of silver for 1 ounce of gold.
While gold has been marginalized as a monetary metal and silver has been completely commoditized, both are real assets that aren’t someone else’s liability. They have real value on their own. They are real money. Meanwhile, the supply of paper money, which has no intrinsic value, continues to grow.
A minor resumption in the use of gold and silver as a financial asset would have a dramatic impact on both because they are such a small part of the global asset base. The Teachers Retirement System of Texas is the largest (and one of the few) institutional investors in silver, yet less than one-tenth of one percent of its assets are in silver.
The exchange rate between silver and gold is now 58, nearly 4 times it’s historical rate and gold isn’t 58 times as rare as silver. Gold is so valuable that little of it has been lost while the supply of above ground silver is shrinking.
Both silver and gold are easily storable and can be removed from the financial system. You can’t do that with cash, stocks, bonds or other financial instruments. Gold and silver can be stored at virtually no cost, something you can’t say about most other commodities, such as corn, oil or oranges.

Mr. McGuire’s most powerful argument, I believe, is that silver is everyman’s gold. With the price of gold at $1,400 an ounce, buying a single ounce is a non-starter for most of the world’s population. At that price, buying an ounce of gold is a bit like laying out $160,000 for a single A share of Berkshire Hathaway. Institutions can do it, ordinary people can’t.

But silver at $24 an ounce and a bit more for a silver dollar that weighs an ounce, well, it can be purchased by nearly anyone, anywhere. Better still, it can be purchased quietly and invisibly. It is traded in coin shops and coin shows, not just in the United States but all around the world.

Broad Exchange Traded Equity Funds Make Good Tax-Efficient Investments

admin — Wed, 17 Apr 2013 21:00:00 Z

Q. Last night I came to the realization that I'm not allowed to contribute to my Roth IRA if I have no earned income, which I don't. All I have is my teacher retirement income. Bummer. This is a kink in my plan. I wanted to put away about $5,000 a year in the Roth IRA and let it grow tax-free. Where should I put my money to make the most of it? What are my options? Cut expenses? Tax-exempt fund? Annuity? Get a job? I really don't want to work, or cut expenses, I've done that. My tax rate is around 15 percent. —R.S., by email

A. The tax efficiency of the broad exchange-traded index funds (ETFs) that invest in equities is quite powerful, particularly since dividend yields are so low. This is also a place where the tax accounting for regular investments comes in handy.

If you were to invest in a tax-deferred annuity, the return on your investment would be the first dollars to come out, so every dime of withdrawal is immediately taxable. Investing in a taxable stock, on the other hand, allows you to realize only the proportion of appreciation that you experienced on your actual shares sold. So if you make a $10,000 investment and it doubles in 10 years, you can sell half of it and recoup $10,000. Your taxable gain on that $10,000 sold, however, will only be $5,000.

Q. My husband's job was eliminated last April. He has a 401(k) worth around $200,000. We know we need to reinvest it somewhere, but have no idea what to do with it. He is 60 and I am 56. Neither of us plans to retire in the near future. Should we roll it over into an IRA? Or divide it up between various other investments?

We've gone to a broker and the information he gave us makes us feel most of our income generated from the investment would be spent on fees. We aren't very savvy when it comes to investing and feel a little lost. What do you suggest? —P.E., Austin, TX

A. The best course of action would be to do an IRA rollover from the 401(k) account to a new account at a place like Schwab. They have quite a few offices, so they can walk you through the process in person if need be. To keep the expenses low you can invest the proceeds very simply in a variation of one of my Couch Potato portfolios.

You could, for instance, keep it really simple and divide your investments equally between:

Schwab U.S. Broad Market ETF (ticker: SCHB) which has an expense ratio of 0.04 percent and
Schwab U.S. TIPS ETF (ticker: SCHP), which has an expense ratio of 0.07 percent.

At an average cost of 0.055 percent your investment expenses would be nominal. You can learn more about these ETFs at schwabetfs.com/overview.asp

Investment advisors tend to pooh-pooh client concerns about the costs of investing, acting as though high expenses were the only way to achieve superior performance. Unfortunately, the reality is that expenses have a big impact on performance and what seems like a minor cost— say 1 percent to 1.5 percent— will work to reduce both your income and our long-term performance.

Let me give you an example: At the end of 2012 the Morningstar Principia database showed that the average net expense ratio for all "moderate allocation" funds (think balanced funds) was 1.33 percent. This is quite a bit more than the 0.055 percent expense for investing in low-cost, no-commission ETFs. But over the last 3 years a fund at the 25th percentile (meaning that it has done better than 75 percent of its competition) provided an annualized return of 8.69 percent while a fund at the 50th percentile provided a return of 7.67 percent. In other words, a cost difference of "only" 1.02 percent took performance down a full 25 percentile, from superior to median.

Doing the same measurement over the last 10 years shows that a fund in the 25th percentile provided a return of 7.19 percent while a fund in the 50th percentile returned only 6.40 percent, a difference of 0.79 percent. While these spreads change from month to month (and asset class to asset class) the reality is that the cost of investing has a major impact on the return you receive.

How We Lose in the Mutual Fund Casino

admin — Fri, 12 Apr 2013 21:00:00 Z

Las Vegas is profitable because most gamblers know little or nothing about the game they are playing and the odds against winning. Basically, players go to be entertained by the unexamined possibility of winning.

Millions of people do much the same in the casino of investing. We do it with our 401(k) plan choices. We do it with our “play money” choices. We even do it when we hire a financial advisor to make our choices for us.

The only difference between the two casinos is that in Las Vegas you lose your money and in the investing casino you get a lower return.

You can understand this by examining the odds and expenses we face when selecting a mutual fund. According to the Morningstar fund database there were 684 managed “large blend” funds at the end of 2012 with track records of at least ten years. (Large blend funds are the funds that invest in the largest domestic companies by market value.) As a group these funds had an average annualized return over the last ten years of 6.63 percent. They also had an average net annual expense ratio of 1.28 percent.

Picking a winner in this group would have had a big payoff— funds in the top 10 percent returned at least 8.31 percent, a big premium over the average.

Index funds that were built to duplicate the performance of the S&P 500 index, however, beat 66 to 69 percent of all the managed funds. The Vanguard 500 Index fund Admiral Shares, for instance, returned 7.09 percent while the Investor Shares that require a smaller minimum investment returned 6.99 percent. Other well-known funds that track the same index were inside that return range— Schwab S&P 500 Index Fund, the Fidelity Spartan 500 Index Fund, and the SPDR S&P 500 exchange traded fund.

What explains the small differences in returns for funds that track that same index? Differences in expenses and “tracking error”— duplicating an index isn’t easy.

The most important fact, however, is that any of these basic index funds beat the average managed fund, as noted above. If you had simply invested in the oldest of these funds, the Vanguard 500 Index Investor Shares, your 6.99 percent return would have beat the average managed fund by an annualized 0.36 percent.

But suppose we play to win. What are the odds? What would you have gained if you had selected one of the managed funds that did better? Those funds provided an average return of 8.04 percent. So if you had been able to pick a winner you would have gained an average of 1.05 percent a year.

The unexamined promise and prospect of picking a “winning” fund and gaining that 1.05 percent a year is what fills pockets of the mutual fund casino owners— and their croupiers.

Now let’s look a little closer. To bet on a managed fund we have to pay more. These funds have an average expense ratio of 1.28 percent a year. That’s 1.11 percent higher than the 0.17 percent expense of the Vanguard 500 Index Fund. So get this: To take a chance on improving your return by an average of 1.05 percent a year you had to pay an extra 1.11 percent a year.

Would you buy a managed fund if the odds of gain were presented in this way? Probably not. But wait, that’s not all.

When you make a bet that you can select a winning managed fund, you don’t just bet on the pool of winners. Instead, you must select from the entire pool of funds. In this case, you’ve only got a 34 percent chance of picking a winner. So you’re really paying $1.11 to win a prize of $0.36 (.34*1.05).

When you figure the odds, picking winners is a losing proposition.

What I’ve just told you isn’t a special case. The same exercise can be done with any and all asset classes with similar (but not identical) results. This example actually understates the odds because the Morningstar database is limited to funds that survived the measuring period. Many did not.

The same math and odds apply, with added costs, if you pay a fund advisor to select winning funds for you. That’s why you read about index fund investing in this column. It’s how you win the mutual fund game.

To Earn Any Interest At All, You Have To Take Risk

admin — Wed, 10 Apr 2013 21:00:00 Z

Q. I know CDs are not paying anything, so I decided to look at the lowest risk
Vanguard fixed income funds. When my CDs matured I switched to Vanguard Intermediate Term Treasury fund and Vanguard Short-Term Investment Grade Fund. I have other investments, but want to keep a portion safe. Does this make sense? —J.P., by email

A. Your decision makes sense, but it is not without risk. With a CD you have neither interest rate risk nor credit risk. By moving some money to Vanguard Intermediate Government Securities (ticker: VFITX) you've taken on some interest rate risk to get a 0.77 percent yield. With an average maturity of 5.6 years, this fund would be damaged by an increase in short-term interest rates. Even a small increase in rates could offset a year or more of interest income with losses in net asset value.

Vanguard Short-Term Investment Grade fund (ticker VFSTX) has a higher yield (1.7 percent) and a lower average maturity (2.9 years) but it has more credit risk than the Intermediate Government fund. Neither risk can be ignored, but you are taking the risks necessary to have some income from your investments.

Q. My wife and I are both 72 years old. We are considering buying a home in a Georgetown Texas area that is like Sun City. We are both retired. My wife and I have a total income of $45,323 annually, most of which is hers. My income is about $10,000 a year, but I have several hundred thousand in savings. Most of our income is from Social Security and pensions. We are currently renting an apartment that costs about $1,200 monthly. If we buy a house, we plan to pay equally on it, like half the mortgage and expenses. Do you think this would be a good idea and, if so, how much home can we comfortably afford? What mortgage rate would you recommend, like 15 year or 30 year? Thank you. —J.P., Austin, TX

A. According to the Del Webb website, Sun City Georgetown now offers homes priced from about $150,000 to $373,000. Using one of the online home affordability calculators I found that you could, in theory, afford a home that cost about $240,000 if you have no auto loans, no consumer loans or credit card debt, a good credit rating. You would also need to make a down payment of about $40,000. As a practical matter, this price level is very likely on the high side, largely because lenders are concerned with your capacity to make payments. They don't care much about how often you have to have soup and crackers for dinner.

If you try to keep your mortgage, taxes and insurance payment close to your $1,200 monthly rent payment, the house you buy should be priced closer to $200,000 with a $40,000 down payment. Having those ownership expenses—mortgage, taxes and insurance— match your monthly rent, however, does not mean your shelter costs will be the same after you move.

The house will likely be larger than your apartment, so the utilities will be higher. You will likely have a homeowner’s association fee to pay and you'll also have responsibility for ongoing repairs and replacements. Even figuring with an optimistic and well-sharpened pencil, my bet is that a $200,000 house will have total out-of-pocket costs of at least $18,000 a year. So your half would be $9,000. That doesn't leave much room for any other personal expenses.

This suggests that you and your wife should have a long discussion about how you pool and share your income.

Finally, don't count on tax deductions from home ownership to cut your income tax bill. On a $200,000 house with a $160,000 mortgage at 3.5 percent (and assuming a tax bill equal to 2 percent of the home's value) your itemized tax deductions for interest and taxes would be about $9,600. The standard deduction for a joint income tax return is $12,200 for 2013. That means no tax reduction unless you have a lot of deductions from other sources. Most people don't unless they live in a high income tax state like New York or California. In Texas your state income tax is nada, but you pay more in real estate taxes than do people in most other states. Deductions are a big deal for the affluent, but they do nothing for most homebuyers.

The Best Funded Part of Our Government

admin — Fri, 05 Apr 2013 21:00:00 Z

Today’s quiz: Which part of our government has banked enough money to pay its bills for more than three years?

Yes, believe it or not, part of our government that has actually done that— put aside enough money to cover its expected spending that far in advance. It’s called Social Security.

The information comes from a table in last years’ Trustees report. The table shows the history of the combined Social Security and disability income trust funds since 1937. At the end of 2011 the combined trust fund had enough assets to cover payments for 3.54 years.

It wasn’t always this way.

The same table tells us that in 1983, the year before the Greenspan Commission Social Security reforms took effect, the fund had assets to cover only 0.14 years. That’s less than two months of benefit payments— less than the amount regular people are supposed to have as an emergency fund.

Since then every working stiff who has had a paycheck has been paying extra money to build the trust fund. While we only paid in an extra two cents for every dollar that was spent in 1984, the extra pennies quickly climbed. They reached an extra 18 cents for every dollar spent in 1990, then receded a bit. The extra payments peaked at an extra 21 cents for every dollar spent on benefits 2000.

While the employment tax was constant during this period, the surplus over benefits paid out varied from year to year. Only in 2010 and 2011 did costs exceed our employment tax payments, due to the combined effects of recession and the 2-percentage point cut in the employment tax. On average, we paid an extra 11 cents for every dollar spent on benefits over the entire period.

When you add all those extra dollars we put in, and all the interest they earned, you get a combined Social Security and disability trust fund with nearly $2.7 trillion in assets— enough to cover last years’ payments for 3.54 years.

During the same period the rest of our government wasn’t doing so well. While Social Security had a surplus in all but 2 years, the “on budget”— which includes most government operations except Social Security— had a deficit in all but 2 years. While Social Security was collecting $1.11 on average for every dollar paid out, the rest of our government was collecting only 77 cents, on average, for every dollar paid out. In 2011 it collected only 56 cents for every dollar paid out.

That’s why the publicly held Treasury debt grew from only $1.3 trillion in 1984 to $10.1 trillion in 2011 and a stunning $12.6 trillion today. (The graphic below shows how Social Security and the On Budget compare over the entire period.)

That $12.6 trillion in public debt (which includes the money we owe China and other nations) would be still higher if all that extra money we paid in hadn’t been used to pay for other government spending. But it was, and we have the trust fund IOUs to show for it.

And that’s also where this becomes a big-time problem, a problem that is a lot more serious for young workers than older workers or retirees.

The same Trustee’s report contains estimates for future revenues and costs. For this year, 2013, the trustees estimate that benefit payments will exceed actual cash revenue— the money received in employment taxes and from taxes on benefits. More important, they estimate that benefit payments will exceed actual cash revenue in every year in the future.

So here’s the problem. The Trust fund has $2.7 trillion in U.S. Treasury obligations— lots of assets. But those assets aren’t cash. Benefits have to be paid with cash.

A Primer on Social Security from Recent Columns

Means Testing Social Security (1/11/13)

Social Security Is a Social Program, Not a Pension Plan (1/30/13)

How We Missed the Truly Golden Years for the Social Security Trust Fund (8/11/12)

For the Real Condition of Social Security and Medicare, Turn to Appendix F (5/4/12)

Social Security Reforms— Like Putting Lipstick on a Duck (12/2/11)

The Big Double Whammy (7/29/11)

What does all this mean? Simple. The same program that has been a cash cow for government overspending since 1984 is now turning into a cash hog. It will be competing with other programs for a limited supply of revenue. Whether the weasels in Washington increase the employment tax, increase the amount of income that can be taxed, or change the method for calculating future benefits, it’s true purpose will be to increase cash in and decrease cash out.

It’s all about cash flow. It’s not about the IOUs our officials call assets.

Cutting Taxes After Age 70 Gets Tricky

admin — Wed, 03 Apr 2013 21:00:00 Z

Q. I have been taking the mandatory distributions from my IRAs for several years (I am 75). I am a part-time worker, making $10,000 or so a year. I have not contributed to an IRA for the last five years that I've been working. I think I am eligible to still contribute to an IRA up to $35,000. Is there any advantage to contributing to an IRA while still taking mandatory distributions? I’m thinking the money could be invested in a new low cost account. —J.W., by email

A. You can't contribute to a traditional IRA after age 70 1/2 but you can contribute to a Roth IRA after that age if you are still working for income. You’re still working, so you can still make contributions. The contribution limit for 2013 is $5,500 plus an additional $1,000 for those over age 50.

If it were possible to contribute to a traditional IRA your tax deductible contribution would work to offset a portion of the taxable income from your required minimum distribution. But they figured that out in Washington, so you can’t. Contributing to a Roth IRA won’t reduce your income tax bill, but it would start to build an account you can withdraw from in the future without creating what the IRS calls a "taxable event." That would give you more flexibility vis-à-vis your taxable income in future years since withdrawals are tax-free.

Q. If you had several CD's maturing and no need of the money in the foreseeable
future, which would you choose? A 5-year CD at 2.15 percent or a 7-year CD at 2.70 percent? I am tempted to go out 7 years, as interest rates don't seem likely to be going up any time
soon, but I would like your thoughts on which you would choose. —J.F., San Antonio, TX

A. Go for the 7-year CD. One way to look at this is to ask how much you are being paid in each of the two additional years— years six and seven. If you total the expected interest for the 2.70 percent 7-year CD and subtract the 2.15 percent interest on the 5-year CD, it turns out that you are, in effect, earning at about a 4.075 percent interest rate in each of the last two years. Not bad.

This is based on measuring what economists would call your “incremental return” when you add two years to the maturity of the CD. While the additional yield is spread out over 7 years, you would not get it without committing the additional two years. So your effective yield on those added years is materially higher.

Q. After reading a recent column about home mortgages, my wife and I have a question. We have a two family house that we don’t live in. It is currently valued at about $400,000 and we owe less than $150,000 on it at 6 percent, with 23 years remaining. We also own our one family home valued at $425,000 with a mortgage balance of $195,000. We refinanced this house two years ago at 4.25 percent. I am looking to refinance the two family investment home at about 3.75 percent but my wife suggests we just pay it off and have no mortgage.

We are both in our sixties and can afford to take the money out of savings without touching any IRA account money. Based on current market conditions would it be prudent for us to leave the money in investments or take it out and pay the house off? —R.K., by email

A. Since you have tax-deferred accounts and can pay the $150,000 mortgage with cash from other investment accounts, paying off the mortgage is a good choice. It will save you $9,000 a year in interest costs (it will also increase your taxable income by that much) and you'd need a lot more than $150,000 to earn $9,000 a year in any other investment.

Doing this is particularly good for someone your age. If you are considering retiring, you have to be thinking about what you can do to increase the income from your savings. Significantly, many people are looking for real estate properties that they can buy for cash, simply because they will generate a net yield they would not be able to earn elsewhere.

You might also investigate yet another refinancing of your own home mortgage since you might knock another 0.75 percent off the rate.

The Four Question Wealth Test

admin — Fri, 29 Mar 2013 21:00:00 Z

Are you wealthy yet?

Don’t laugh. It’s a serious question. You’ll know if you are wealthy depending on your answers to a simple four-question test later in this column.

Who knows, you might be wealthy and not know it! You could also be poor and not know it, which is more likely.

The problem here is that we don’t have a shared definition of wealth. In spite of the unrelenting attention to spending, consumption and statements of net worth that fill virtually all of our glossy magazines, the reality is that we only see wishful images of what some people imagine wealth to be and what advertisers want us to think it is. In general, being wealthy appears to be all about stuff.

In fact, if you focus on the stuff part, you’re missing the boat.

A definition of wealth that I favor comes from the late economist and journalist Ferdinand Lundberg. In his 1968 epic “The Rich and the Super-Rich” he defined being poor this way:

“For my part, I would say that anyone who does not own a fairly substantial amount of income-producing property or does not receive an earned income sufficiently large to make substantial regular savings or does not hold a well-paid securely tenured job is poor. He may be healthy, handsome and a delight to his friends— but he is poor.”

Got that? Wealth is about income producing assets. It’s not about consumption stuff. Lundberg’s definition quickly eliminates the faux wealth exhibited by the folks we might call Monthly Payment Millionaires— people who flash all the stuff that makes them appear wealthy but which can disappear in a single missed sales quota, a short-term job loss or some other life hiccup. The existence of Monthly Payment Millionaires explains those strange places where it seems everyone is rich because all the cars are new, shiny and expensive.

Lundberg’s definition shifts our attention from having the stuff of imagined wealth to having secure sources of income to support however we happen to live. Lundberg’s definition is a first step in breaking the link between the work we do and the life we live. As long as there is a link, we’re working stiffs. We may proudly drive our Ferrari to a reserved parking spot near the elevator, but we’re still working stiffs if keeping the Ferrari requires showing up for work. (Readers curious to know how they score for net worth should see my regularly updated wealth scoreboard.)

So here is my four-question wealth test:

Do you make payments on your house or car? If you answered yes, it’s unlikely you are wealthy, although exceptions can be made for car loans where the interest rate is lower than the rate of inflation. According to the most recent data on consumer debt, older people are carrying more debt into retirement, not less; so fewer retirees can be considered wealthy.
Does your interest income exceed what you pay in interest? With the Federal Reserve holding interest rates down it isn’t easy to find interest income these days, but dividends are an acceptable substitute. If you answered yes because you have income from dividends, rental properties, pensions, or even patents, copyrights and royalties on your country and western song portfolio, that’s a pretty good sign that you are a budding rentier— a person who lives on non-work income. The more income you have from sources that don’t involve working, the closer you are to being wealthy. For retirees, Social Security can be a big part of this income.
Can you keep what you have without actually working? If losing your job means the repo guy will be visiting in a matter of days, you’re definitely not wealthy. But if you can answer yes to this question, you’re definitely not poor. At very worst, you have a foothold among the wealthy.
You are at a cocktail party and a stranger asks: “What do you do?” If you answer this with any known occupation, you are not wealthy and you’re probably a workaholic. You’re still a working stiff, even if your job is, as Lundberg suggested, “a well paid securely tenured” one. The only acceptable answer here is to remember your Jane Austen. Give the stranger your best disdainful Darcy look and say, “In the event of what?”

For Some Retired Singles, “The Golden Girls” May Be a Model Future

admin — Wed, 27 Mar 2013 21:00:00 Z

Q. May I suggest an article for an upcoming column: "Singles Retirement."
There are large numbers of us singles out here nearing retirement. We have only one Social Security check and most have no pension.

What steps can we take? Should we relocate to a cheaper area - or stay near family? Many of us live in apartments, so downsizing is really out of the question. Any suggestions or comments would be appreciated. —P.O., by email

A. Like the rest of life, much of retirement as a single depends on how adaptive you are. While downsizing may be "done deal" for many single retirees, my reader mail indicates that the biggest decision— and biggest opportunity— most seniors have is about shelter. Many have much needed equity trapped in a home or condo that is larger than what they want or need.

When it comes to where you live, family usually trumps shelter economics— unless family can be part of the economic solution. There is nothing wrong with extended families living in the same house and many families would benefit by sharing shelter.

This applies to friendships, too. While living with a stranger to save money would probably be a hardship for most people, it's hard to complain about sharing with good friends. Two can't live for the price of one, but they can certainly live for less than the price of two living separately. The savings can go well beyond shelter. Think about transportation, telephone, cable, Internet service, and food as well. One of the best places I’ve found to observe different shared living arrangements is RV parks. There, sharing often evolves as an enjoyable communal activity, whether it is sharing a car for shopping, putting together a potluck supper, or helping someone who is ill. A small amount of money can go a long way.

Would such arrangements be as good— and funny— as “The Golden Girls” TV series? No, probably not. But it has a lot more going for it than living alone.

When I wrote "How to survive on $15,000 a year" in 2008 many readers responded with anger. They said the idea of sharing with another person was repulsive. I think that's wrong-headed. Very few people aspire to living in isolation. Most hope for communication and companionship.

Q. I’ve heard a lot about No-Load mutual funds. It seems to make sense that it would be best to make money with a financial planner who charges a percentage of total assets, recommending no-load mutual funds, as opposed to a broker that charges a percentage on each trade and recommending funds that have front- and back-end loads making regular changes. Is it reasonable to guess that in the case of the broker, it would take super performance of the funds in order to break even after you factor in the fund costs and loads? —E.R., by email

A. The answer here is maybe, or maybe not. But you are more likely to get advice that is not biased by a need for commission generating transactions if you pay a percentage of assets each year. That said, a commission-based relationship could, over time, work to your advantage. Let me give you an example. The American Funds group offers funds with very low annual expense ratios through a traditional brokerage commission arrangement. The selling broker gets an up-front commission and an annual trailing fee (the 12b-1 fee) that is about 1/5 of the 1 percent fee charged for typical asset-based fee arrangements.

Sadly, the American Funds group has been in net redemption— people redeeming more shares than they are buying. One reason may be the growth of aggressively sold brokerage-based “wrap” accounts that are likely to cost two to three times as much as an American Funds portfolio.

So while the broker may be paid a 5 percent commission up front, it can be recovered fairly quickly when measured against a wrap account with total annual expenses approaching 2 percent. How this actually works out also depends very much on the expenses of the underlying funds. If your commission-based funds have annual expense ratios that are lower than the funds chosen by the asset-based fee broker, you long-term cost advantage can be substantial.

The bottom line here is "it all depends."

And Now, a Few Words about Reality and Context

admin — Fri, 22 Mar 2013 21:00:00 Z

Don’t you wish they would just shut up? I’m serious. Wouldn’t it be great if we could just have a day without their whining?

Yes, I’m talking about the Washington drama queens. Democrats cringe. They tell us horrible things are about to happen. Republicans tell us we are only weeks away from having the defense of our country depend on slingshots and frozen paintballs.

The media have eagerly trumpeted all this whining with a remarkable lack of context. Here’s an example. The White House released a report on the expected damage from sequestration in late February. The report was carefully broken down by state. The report for Texas, a state that happens to contain my five grandchildren, warned that 280 fewer schools would receive funding and 172,000 fewer students would be served. Not mentioned: Texas has 8,317 public schools and 4,329,841 students.

Don’t get me wrong: Reductions always hurt someone. The change, however, is a small part of total spending. It is not a seismic event. That reality was entirely lost as the long lists of possible cuts filled media time and space.

What we are looking at here is similar to what the majority of American households had to cope with starting January 1. Sequestration not withstanding, the Congressional Budget Office expects federal spending to increase in every year out to 2024. It may be a small increase. It may be less than inflation. But it is well short of a freeze.

Actual working people, on the other hand, have experienced actual loses. With the restoration of the full employment tax, the 94 percent of all workers who earn less than the $113,700 Social Security wage base maximum have seen their paychecks cut by 2 percent. Only a raise in pay will restore their spending power.

We can get a still broader context by going back to a happier time, like 2007. Back then our government collected $1,933 billion in revenue and spent $2,275 billion for a deficit of $342 billion. These figures are for the “On Budget,” the one that contains most of the funding for government, but excludes Social Security. The on budget is where the cuts will take place.

If we use the handy CPI inflation calculator provided by the Bureau of Labor Statistics to adjust this spending figure, we learn that on-budget spending would now be $2,527 billion if government spending had just kept pace with inflation since 2007. But it didn’t.

Instead, spending is projected to be $3,122 billion for 2013. That’s a whopping $595 billion greater, for a single year, than what would have been spent if government spending had only risen with inflation. Some of that over-inflation spending, of course, was necessitated by the economic collapse of 2008-09: Bank bailouts, extended unemployment benefits, a surge in food stamp spending, etc. We can argue about the bank bailouts, but millions of people were saved from a lot of grief by some of that spending.

But that spending was temporary. We would not be unreasonable to expect that non-military government spending has a plenty of room to recede, just as military spending has a lot of room for moderating as we withdraw from two major conflicts.

It also helps to measure spending cuts against revenue shortfalls. This year our government expects total On Budget receipts of $2,090 billion and total On Budget spending of $3,122 billion, for a deficit of $1,032 billion. It is, in other words, spending about 50 percent more than it takes in. That would be like you or me having income of $100,000 but spending $150,000 and increasing our borrowing by $50,000 a year. If we did that, cutting back our spending by a few percent would look entirely reasonable. It would not be a matter of public horror. Not a soul would feel sorry for us. We’d just be taking entirely inadequate steps toward avoiding bankruptcy.

Finally, there is the matter of reality. When real people talk about cutting their spending, they are talking about actual cuts in dollars spent. Washington doesn’t work that way. While spending is supposed to be cut by $1,200 billion over 10 years in the sequester, $216 billion of it is in supposed interest savings from the cuts. That leaves actual program cuts of less than $1 trillion over the entire ten-year period. In other words, we’re hearing all this noise about cutting less than $1 trillion over ten years while Washington is overspending that amount every year.

It’s time for both parties to get real.

Required Minimum Distributions Can Cause Your Tax Bracket to Rise

admin — Wed, 13 Mar 2013 21:00:00 Z

Q. We haven't seen much information on folks in our position. Here is our situation: My wife is 65. I am 67. We have been retired for five years. Our yearly income is around $120,000. Together, we have close to $1,000,000 in two 457 accounts (Govt. version of 401(k), one IRA and my self-directed portion of a state pension. Currently, we are not taking any money out of those accounts. I know that at the age 70 1/2 we will be required to start taking distributions from the accounts.

Will it be better to wait until we have to start distributions, or start now? Is there a magic income number that we should avoid due to income tax, or are the taxes just a gradual progression? —LJF, Seattle, WA

A. You'll need to visit with your tax accountant to get a fix on this because it should be tailored to your situation. But let me point out the major milestones in your tax future. First, the 15 percent tax bracket now ends at $72,500 for those filing a joint return. Every dollar of taxable income over $72,500 is taxed at 25 percent until you reach $146,400. That's when the marginal tax rate rises to 28 percent. Make allowance for your deductions and exemptions and you've got some run room before hitting the 28 percent racket.

Meanwhile, you are solidly in the 25 percent tax bracket today. Required minimum distributions in the future will move you toward the 28 percent tax bracket. You can create some future financial flexibility by making withdrawals from your qualified accounts up to the edge of the 28 percent tax bracket. You can do a Roth conversion with the withdrawals until you reach RMD age. This will help you create a pool of money that will grow tax deferred. Later, making a withdrawal won't cause a "taxable event” because withdrawals from Roth IRAs are tax-free.

The other milestone you want to watch for is the threshold rate for having to pay a surcharge on your Medicare insurance. This year the basic monthly premium for Medicare Part B for most people is $104.90. The Part B premium will rise to $146.90 for joint filers with taxable incomes of $170,000 ($85,000 for single taxpayers) and there will be a Medicare Part D surcharge of an additional $11.60 a month. Required minimum distributions may drive your taxable income into this range, so some amount of Roth conversion will serve to reduce the odds that this will happen.

This is what some would call a "Cadillac problem," a dilemma few people will get to experience. It is, however, further evidence of the rising de facto means testing of Social Security and Medicare that I discussed in a recent column.

Q. I am 66 years old and retired. I have owned one rental property for the past 25 years.
I am earning about 5 per cent on this property (after taxes, insurance, upkeep, etc.). Because I don’t really want to own any more rentals, can you tell me what options I have to capture a 5 percent yield? Are there any REIT's or ETF's that can give me anything close to this kind of return? —D.G., San Antonio, TX.

A. There are REITs that can provide a yield of 5 percent or more but you will find that most are doing this by paying out more than they are generating from FFO (funds from operations). So their 5 percent yield may not be the same (or as secure) as your 5 percent yield. More important, it may not be as sustainable. Most yields are lower. The yield on the iShares FTSE NAREIT Residential index REIT (ticker: REZ), for instance, is just over 3 percent. The yield on the Vanguard REIT Index, ticker VNQ, is about 3.4 percent. So looking for 5 percent is reaching and may be quite risky.

My suggestion: Either lower your yield requirement or consider another high yield venue such as a pipeline master limited partnership, known as an MLP. Kinder Morgan Energy Partners (ticker: KMP), a leader in the field, currently yields a bit under 6 percent. There are many others, as well. (Caveat: these are complicated investments and will deliver tax benefits at the expense of making your tax return much longer.)

Variable Annuity Watch, 2012

admin — Fri, 08 Mar 2013 21:00:00 Z

The big claim for variable annuities has always been that they allow investors to invest and watch their money grow, tax deferred, until they need it. The basic idea is that you can avoid paying at a high tax rate now and pay at a lower tax rate later, probably when you are retired.

Sounds good, right?

Unfortunately, what seems to be a good idea doesn’t work in practice, largely due to fees. Nothing shows this more clearly than results over the last decade. In a sense, investors got hit with a double whammy: low returns and high fees.

How could low returns matter, you might ask? After all, low returns were universal. Whether you chose mutual funds, exchange traded funds, or variable annuities, if you invested in domestic common stocks you got low returns by historical standards.

The problem is that the fees work like the tax you’re trying to defer. According to the Morningstar variable annuity database, a typical VA contract carries insurance costs of 1.00 to 1.25 percent. So in a period when domestic stocks provide a historically normal return of 10 to 11 percent a year, the cost of the insurance “wrapper” that provides tax-deferral would take about 10 percent of the return. Have a really good period— such as the 1990s— and the insurance cost burden is less.

But the fee burden becomes punitive in low-return period. Over the last 5 years, for instance, the return of the Vanguard Total Market Index (a proxy for all U.S. stocks) was 2.18 percent a year. So if you were investing via a variable annuity with an insurance expense of 1.1 percent a year, the cost of the insurance wrapper was a whopping 50 percent of your return. That’s higher than the highest of our new tax rates.

So you’ve paid 50 percent of your return just to get tax deferral on what’s left. And it would have been a bit worse if you had invested in the Vanguard 500 Index (a proxy for domestic large cap stocks) because it returned less. Over the last 5 years its return was 1.57 percent, indicating that a 1.00 percent insurance wrapper cost would have taken 64 percent of the return.

To make matters worse, the return of the average domestic stock fund or the average balanced fund was lower than any of the index returns over the last one, three, five and ten year periods.

Low-Cost Index Investing Beats High-Cost Variable Annuity Investing, Yet Again

This table compares the annualized returns of two major categories of investment funds over four different time periods ranging from the last year to the last 10 years. In all periods, a simple, low-cost index fund provided a higher return than its higher cost variable annuity competition.

	1 year	3 years	5 years	10 years
Domestic Equities
Vanguard Total Market	16.25	11.18	2.18	7.83
Vanguard 500 Index	15.83	10.72	1.57	6.99
Avg. Large Blend VA	13.98	7.98	(0.21)	5.86
Balanced Funds
Vanguard Balanced Index	11.33	9.46	4.14	7.07
Avg. Mod. Allocation VA	11.02	6.77	1.45	5.50
Source: Morningstar Principia data for period ending 12/31/2012

At this point the “yes, but” sales crew would like to object. “Yes, but— you’re talking about an index versus the merely average VA domestic stock fund. You could have done a lot better with an above-average managed fund.”

Yes, you could have— but the odds are greatly against it. Over all four time periods, the worst performance by either the S&P 500 fund or the Total Market fund was when the Vanguard 500 Index ranked 606th against 3,051 variable annuity funds over the last year. In other words, the worst either index fund did was to beat 80 percent of its variable annuity competition.

Much the same happens when you examine the performance of variable annuity balanced funds against the Vanguard Balanced Index fund, a proxy for traditional 60/40 balanced portfolios. The index fund beat 90 percent of its VA competition over the last 3, 5, and 10 year periods. In 2012, it was disappointing. It beat only 50 percent of its variable annuity competition.

As a practical matter, while these figures are yet another example of why variable annuities are a product sold by the commission motivated, they actually understate the superiority of avoiding fees and gimmicks through index investing.

What could make these performance figures worse? Taxes.

The return from a variable annuity is taxed, upon withdrawal, at ordinary income rates. Those were just increased. Much of the return from a broad index fund, however, will be taxed at the capital gains rate. That’s now 20 percent, up from 15 percent last year. So index funds beat the tax deferred variable annuity funds before taxes… and may beat them by still more after taxes.

Is there a silver lining in this dark cloud of variable annuity failure?

Yes, but only if you have a dark sense of humor.

If President Obama continues to succeed with raising the tax rate on capital gains so that it approaches the tax rate on ordinary income, tax deferral could become something to value.

Life Expectancy: Guessing How Long Your Money Will Last

admin — Wed, 06 Mar 2013 21:00:00 Z

Q. ?My wife and I are in our early eighties. We are considering going into a continuing care retirement community with independent living. We live in our own home now, worth about $280,000 to $300,000. We are debt free. We have a Fidelity account worth a little over $600,000 invested about 60 percent bond funds, 30 percent stocks and 10 percent cash. About $160,000 of this money is in regular IRA's. The rest is in a joint account. We also have about $60,000 in a CD at 4.5 percent interest, maturing in November.

I won't renew because I'll never get that kind of yield again. We have about $30,000 (todays value) in EE bonds also at 4.5 percent. They were purchased in 1992, so they will only draw interest another 9 years. Our only income is from Social Security and a very small pension, a total of about $33,000 a year. We take required distributions from our IRA and draw from our other account if needed.

The unit we would like costs about $4,600 a month, including our main meal, all utilities, etc. The only added cost is for telephone. We don't live frugally, but we are certainly not spendthrifts. Our children are doing very well and don't need our help at all, but I still would like to leave them a little something. What are you thoughts? —R.W., by email

A. The rough numbers here are that you have about $900,000 in assets and Social Security or pension income of $33,000 available to support you and your wife as you move into the independent living section of a continuing care retirement community that has an annual cost of $55,200. This means you'll need to take at least $22,000 a year (plus taxes and other living expenses) from your savings. The biggest worry most people have is whether or not they will run out of money and the answer, for you, is "probably not."

The reason has nothing to do with investment returns and everything to do with our mortality. At age 80 there is only a 1 percent chance that a man will still be alive at age 100 and a 4 percent chance that a woman will be alive. The probability that both will be alive is 0 percent— it won't happen. The probability that one of you will be alive is 5 percent and the probability that neither of you will be alive is 95 percent.

You've probably never heard the odds so precisely before, but my bet is that none of this is a surprise to you. In its odd way, death solves a lot of personal finance issues.

Now lets look at your assets in that framework. If your savings earned absolutely nothing over the next 20 years you could spend an additional $45,000 a year and not run out of money until age 100. While withdrawals from your IRA would be taxable, none of the money you’re your other accounts would be taxable. In addition, since it is likely that one of you will die in 7 or 8 years, that $55,000 annual bill would be reduced somewhat for most of the 20 years.

The amount of money you leave will depend on when you die and what return you earn on your savings.

The hard part here is accepting the idea that you are entering the period that you saved for— the time to spend your savings. Once you do that I think you'll find your choice of going into a continuing care retirement community will make your life a lot easier and less anxious.

Q. I am 83 years old with diversified banking and investments. Do you recommend investing in I Saving Bonds? —R.K., Nashville, TN

A. Currently the only "yield" that I Savings Bonds provide is an adjustment for the inflation rate. Eventually, you will get your original purchasing power back, but every dollar of inflation adjustment will be subject to income taxes. Another limitation is that you can only purchase $10,000 a year per Social Security number. Between the amount limit and the promise of taxing the inflation they compensate you for, these securities are just another slap in the face to savers who have already suffered years of abuse from government policy. I suggest looking for a more flexible alternative, such as a TIPS mutual fund or exchange traded fund. You'll still be slapped in the face by government policy, but at least your investment amount will be flexible.

Required Minimum Distributions: Not Such a Bad Thing After All

admin — Fri, 01 Mar 2013 21:00:00 Z

It isn’t wise to complain about some things too loudly. Yes, I’m talking about the people who mutter about the cost of repairing their BMWs or the scare they had landing their jet at Aspen’s airport.

The cruel injustice of required minimum distributions is a bit further down my list of inappropriate complaints, but it’s there. If you don’t know what RMDs are, you’re probably well under age 70. So listen up: the exam is coming.

Required minimum distributions are what we all experience at the end of all those qualified plans that allow us to put aside income, tax-deferred, while we are working. We love those plans because they help reduce our tax bill. But all good things come to an end.

Required minimum distributions are the way our government collects, with interest, the taxes we deferred. They start the year you turn 70 ½. They dictate the percentage of your account value you have to take out each year. The initial rate starts at 3.65 percent at 70. It rises to 5.37 percent at 80 and 8.77 percent at 90. Each year, regardless of need, you must withdraw the prescribed percentage and pay taxes on it.

And that’s the rub. Some people don’t want to touch their retirement plan money. Complaints about required minimum distributions are inappropriate for two major reasons. One is that most people never face this “problem”— they need to start withdrawals much earlier. If you get to age 70 without making a withdrawal, you are one lucky dog. You’ve benefited from more years of tax deferral than the vast majority of retirees.

The other reason is that required minimum distributions also happen to be a remarkably simple, effective, and convenient way to manage your income in retirement. They escalate your withdrawal rate, year by year, and may actually be more efficient tools for using that money than the safe withdrawal rate plans that have been discussed in this column for years.

You can explore this by using a free online calculator on the Fidelity website. It calculates the RMDs for any starting sum at an assumed rate of return out to a wildly optimistic age 115. The calculator doesn’t figure the ups and downs of the markets, but it does give you a pretty good idea of what can happen under different return assumptions. Here are two sample results.

Assuming a modest 5 percent return on $100,000, your initial withdrawal will be $3,774, rising to a peak of $8,126 at age 93. The account value will peak at $105,644 at age 78. The value of the account would be reduced to $40,225 by age 100, but your income would still be $7,164. It helps to consider, here, that only 18.5 percent of those surviving to age 70 will still be alive at age 93.
Assuming a historical balanced fund return of about 8 percent on the same starting value, your initial withdrawal will be that same $3,774, but it will peak at $17,553 at age 98. The value of the account will peak at $157,030 at age 88. At age 100 the value of the account will be $100,361. Only 5.7 percent of those surviving to age 70 will still be alive at age 98.

Actual required distributions will vary, of course, because the value of your tax-deferred account can vary greatly from year to year.

What this tells us is that RMDs can deliver a nicely rising income for 20 years or more. At the same time, our mortality virtually guarantees that most people will leave some money on the table when they die.

Finally, a recent study at the Center for Retirement Research at Boston College found that Required Minimum Distributions were a very efficient way to distribute retirement income compared to a number of other well-known methods. Researchers Wei Sun and Anthony Webb created an efficiency index and found that RMDs scored better than the popular four percent rule. A modification of the RMD rule— taking the RMD plus dividend and interest income— was even better. (You can find the study on the Center for Retirement Research website.)

The message here? Taking your yearly RMD is a good way to prevent a lot of hand wringing. It’s simple and it works.

‘Surprise Singles’ Face Tough Decisions

admin — Wed, 27 Feb 2013 21:00:00 Z

Q. I could be the person you described in your recent column about Social Security as an insurance program, not a pension program. I was married over 30 years, left a career, raised children and was left behind when my former spouse went to look for himself. He is currently one year from full retirement age.

I've been 'surprise single' for over four years. I will reach full retirement age in four and a half years. I have been unsuccessful in gaining employment— in part because of my lack of recent employment and my age.

Should I begin to collect half of his Social Security now or should I wait until he reaches full retirement next year? Would the amount I qualify for be more if I wait a year since he will have one year more of earning? Will the amount be different if I wait until I reach full retirement age (if I am able to wait)?

I have enough funds to buy a small home (about $95,000, with no mortgage) and am currently renting. Should I purchase a home in order to have more control over my future living expenses and actually have an investment? —A.C., by email

A. I'm sorry you find yourself in this position. The benefit you can collect will increase in both circumstances you mention. It will increase if you wait a year simply because the benefit your former husband is eligible for will increase for a year of delay. (It may also increase if his earnings during the year are large enough to displace credits from an earlier year because the benefit is determined by the 35 highest years of earnings.) It will also increase for each year you delay applying for benefits because you will be a year older as well.

While buying a home may give you some control over some future shelter expenses, it will also expose you to major repair bills. So sinking all of your money into a home is not a good idea. You will be better able to manage the uncertainties of expenses and events if you keep as large a reserve of investment funds as possible. So I would not suggest buying a traditional home.

If you feel you must own, you might explore age 55+ manufactured home communities. In many of these communities it is possible to buy an older unit for very little money. You'll still have to pay land rent, but it is possible to reduce your total shelter bill. I have seen units available for less than $30,000. You can explore this by using the National Association of Realtors website, www.realtor.com. It allows you to select shelter types.

Q. I read many of your articles advising us to delay taking Social Security. I am 62, retired and have a small pension income. I am taking money out of my regular IRA account to support my living standard. Each year I receive a 1099-R form. My understanding is that regular IRA distribution is treated as ordinary income.

My question regards the hidden tax on Social Security. Your article indicates that the income threshold for "married filing joint" is $34,000 - i.e. if the combined earned income (if I decided to work), passive income (interest and dividend), pension income, and Social Security payments is over $34,000, a certain percentage of the Social Security payment will be subject to tax.

My two questions are: First, is my statement above correct? I.e., earned income, passive income, and pension income are all included in the threshold amount calculation?

Second, does my IRA distribution (1099-R) count as earned income, passive
income, or ordinary income? Is it included in the threshold amount calculation? —W.S., by mail

A. Your statement is correct except the threshold amount for a couple is $32,000, not $34,000, and the threshold amount for a single person is $25,000. Because there are two levels of taxation for Social Security benefits it is best to do the calculation using tax software or by consulting with a tax accountant. But if you'd like a quick estimate of how much of your Social Security benefits may become taxable, you can use an online calculator at www.calcxml.com/do/inc08. Yes, your IRA distribution is treated as ordinary income.

The Sacred Cows of Taxation

admin — Fri, 22 Feb 2013 21:00:00 Z

They are the most treasured of all the sacred cows in taxation. Threaten them and you will be reviled. Mention that they are becoming irrelevant and your sanity will be questioned.

Yes, I’m talking about home mortgage interest and real estate taxes as beloved itemized deductions. I’m also saying that it is time for them to go.

I’m serious. Please bear with me for a few minutes before throwing the rotten tomatoes.

The notion of eliminating the deductions for home mortgage interest and real estate taxes, two of the largest tax breaks we consumers have, came to mind after I examined the stunning data for housing affordability in a recent column. I realized that losing the deductions would affect only a few areas of the country and a small segment of the population.

Here’s the basic case:

The Federal Reserve has given homeowners a bigger break than the IRS ever will.

How can this be? Simple. Back at the peak of the housing bubble, home mortgage rates averaged 6.82 percent. Today rates are running about 3.57 percent, a decline of 48 percent. Since most of us get a tax benefit of 15, 25 or 28 percent on our interest deductions, riding the home mortgage refi gravy train over the last six years has been a lot more valuable than any tax break.

If you’ve ridden that big payment reduction train I have a suggestion. Rather than sending a thank you note to Federal Reserve Chairman Ben Bernanke, take a senior citizen to lunch and express your gratitude. Your lower interest payment has come out of the yield on her savings. In this kind of thing there is no free lunch. And you’re the one who now has the money to pay for lunch.

Another implication is that if we really want to simplify our tax code— reducing deductions as a way to get the lower tax rates the Simpson-Bowles commission suggested— this is the time to do it.

The standard deduction is so high most homeowners don’t benefit from itemizing.

One of the things the fans of itemizing mortgage interest and real estate taxes seldom recognize is that you only benefit when your deductions exceed the $12,200 standard deduction on a joint return and $6,100 on a single return. So while everyone has kind thoughts about the beauty of home-related tax deductions, the reality is that lots of people don’t have much in other deductions, either. Medical deductions are limited. Charitable contributions are smaller than we’d like to think. Basically, shelter deductions are the ball game unless you live in a state with a punishing income tax.

So let’s do the math. At current mortgage rates and with a real estate tax equal to one percent of market value, you’d need to own a house worth more than $316,000 before you would begin to enjoy a reduction in your income tax. (This assumes a 20 percent down payment.) Raise the real estate tax rate to two percent of market value and you get there at a lower home value, $251,000. Since most homes are taxed at one to two percent of market value, there is no tax benefit for homes of lower value.

Now examine median existing home sale prices across the country, as compiled by the National Association of Realtors. Of the 154 reporting metropolitan areas in a recent report, 14 had median home sale values over $316,000. Only 19 had home median sale values over $251,000. Add sly little facts like the reality that many people didn’t buy their homes yesterday and have more than 20 percent equity. Or that an impressive 30 percent have no mortgage, and the benefit of itemized home deductions really isn’t all it’s cracked up to be.

The deductions are only important in what might be called “the usual suspect cities”— places like San Jose/Sunnyvale/Santa Clara; Honolulu; San Francisco/Oakland/Fremont; Anaheim/Santa Ana/Irvine; and New York/Wayne/White Plains. These places had median sale prices from $467,800 to $673,000. In those areas the tax breaks to offset the cost of shelter compensate a bit for the most punishing state income taxes in the country.

The mortgage and real estate tax deductions have become perverse incentives.

While tax breaks in high cost areas allow some upper middle income households to own houses, the tax breaks have nothing to do with what Congress originally intended, which was to increase the rate of home ownership for the middle class.

Investors Can’t Hide from the Fiscal Cliff

admin — Wed, 20 Feb 2013 21:00:00 Z

Q. I'm one of many who have gotten so disenchanted with the stock market that I withdrew most of my money and sat on the sidelines. Is that a good idea in the fiscal cliff climate, or not? —M.G., Austin, TX

A. The problem the fiscal cliff presents is that no investments look good. The dollar could decline against other currencies. Interest rates could rise, reducing the value of bonds. Reduced federal spending could put all expansion plans on hold, bringing down stock values. There is nowhere to hide. Since the issue covers everything, the only reasonable (if entirely imperfect) response is to be widely diversified. It also helps to have little or no debt as well as having income from multiple sources. That, of course, is easy to say, but lots harder to do.

Q. I am a public school teacher. I will be retiring at age 66 in three years with 30 years of service. I earn $61,000 a year. In retirement I will have both Social Security and Teacher Retirement.

My husband has a civil service pension of $1,700 a month and will also get $400 a month when he retires from his current job in three years. I am in good health and expect to live a long time.

I recently inherited $400,000 from my mother. I have no children, so I can use up the $400,000 before I die, or leave what's left to my husband if he outlives me. I am in a quandary deciding what to do with the money. We have had a broker in the past and have discussed the $400,000 with him. He offered two choices: ??

Put it with a major investment management firm. My broker says they are very adept at managing customer accounts and charge 1.25 percent a year. My broker will charge an additional 0.75 percent fee per year, making a total two percent a year.
Invest in mutual funds with my broker instead. He charges 0.75 percent a year, BUT says my front-end load charge will be $7,500.

Which choice would you recommend? Another question is the amount of risk we should take. I have been conservative in the past but that doesn’t make much extra money. We are hoping we can take a low percentage from the $400,000 each year and still have our investment grow.

What risk level should I take in this investment—conservative or moderate risk? ?

A. Your broker has provided you with what he must—- two ways of investing through his fat clogged distribution system. With total costs of 2 percent a year it will cost as much, or more, to manage your money than it will earn in dividends and interest. In other words, every dime of actual earnings will go to the broker and his firm. What you will get is the risk. Somehow that doesn't seem fair since it is your money.

So allow me to suggest a third alternative that will give you some income to compensate you for the risk you'll be taking. Put that $400,000 in a low-cost index fund solution such as Vanguard Balanced Index Admiral shares, ticker VBIAX. This fund is rated five stars by Morningstar, has no commission cost to purchase and has an annual expense ratio of 0.10 percent. This traditional balanced fund beat at least 75 percent of its more expensive managed competition over the last three, five, 10 and 15-year periods. It also has a current yield of about 2.15 percent, so you'll actually have some income from your investment instead of paying it all to the managers.

This is simple, one-stop shopping. The number to call at Vanguard is: 800-937-5544. You can learn more about the benefits of low-cost index fund investing by reading about Couch Potato investing on my website.

The Balanced Index fund is typical of moderate risk funds. It invests 60 percent in domestic equities and 40 percent in domestic fixed income. Is that too much risk for you? No. Here’s why. Between Social Security benefits and pension benefits that you and your husband have, a substantial part of your living expenses is covered. If you have an issue, it is longevity and that argues for owning more in stocks and less in bonds.

For Couch Potato Investors, 2012 Was a Good Year for Margaritas

admin — Fri, 15 Feb 2013 21:00:00 Z

A little elbow bending with your investments paid off in 2012. The return on my Margarita portfolio, a mixture of one part domestic stocks, one part international stocks and one part inflation-protected bonds, provided a return of 13.31 percent. That’s better than 78 percent of the managed funds categorized at “moderate allocation” funds by Morningstar.

But what is striking is that using a three-part Margarita mixture did so much better than the yet more slothful two-part Couch Potato portfolio. That portfolio, an incorrigibly lazy equal mix of domestic equities and inflation-protected bonds, returned a mere 10.91 percent. It not only trailed the Margarita portfolio, it also trailed the 11.72 percent return of the average managed fund. Indeed, it ranked in the 73rd percentile. (See table below)

Is it possible that truly canonical sloth is slipping? This is not the kind of performance we’ve come to expect from sublime inattention and willful ignorance.

Yes, excuses can be made. One is that the 50/50 Couch Potato is going to underperform typical moderate allocation funds that are 60 percent equities and 40 percent bonds whenever equities have a good year— that would be 2012.

The same reality, played in reverse, is why the basic Couch Potato beat 92 percent and 95 percent of all moderate allocation funds over the last three and five years, respectively. Equities suffered some trauma over that time period and the Couch Potato portfolio had fewer equities. (As some will recall, the Federal Reserve worked heroically to lower interest rates over the last five years, causing bonds to appreciate handsomely.)

Another excuse is that 2012 was the first year in the last five that international equities did better than domestic equities. It also explains why the Margarita was only a so-so portfolio over the last three and five years. It has a big slug of international equities.

Now let’s look out to 10 years— the kind of time scale true Couch Potato investors like to consider. When we do that, the happy reality of low-cost index investing reveals itself. The Couch Potato did better than 70 percent of its competition. The Margarita portfolio did better than 82 percent of its competition. The Vanguard Balanced Index fund, a 60/40 mix of domestic equities and domestic fixed income, duplicates the asset allocation of the average moderate allocation fund. It did better than 71 percent of its expensively managed competition.

A Good Year to Be Driven to Drink

This table compares the performance of three index fund portfolios with the performance of similar managed portfolios over the last year, three-year, five-year and 10-year periods. Numbers in parenthesis are percentile ranks in each time period.

Fund	1 year	3 years	5 years	10 years
Couch Potato	10.91 (73)	9.79 (8)	4.47 (5)	7.02 (30)
Balanced Index	11.33 (65)	9.46 (11)	4.14 (9)	7.07 (29)
Margarita	13.31(22)	7.81 (46)	1.53 (76)	7.38 (18)
Avg. Balanced Fund	11.72	7.69	2.41	6.43
Source: Morningstar, data for period ending 12/31/2012

The message here is simple: the longer you invest, the greater the odds that the slothful investing I have advocated for many years will provide returns that beat a majority of the expensive alternatives. Indeed, the proof burden is now on the wing-tip shoe covered foot popular among fund managers.

Managed investing has demonstrated only one thing: It’s a great way to make a living from other peoples’ money. While the three index portfolios cost about 0.10 percent a year to manage, the average net expense ratio of the 284 managed funds of this sort is 1.22 percent, a full 12 times as much. The difference will make a lot of Mercedes payments— for someone who isn’t you.

Skeptical? Then let me offer you some history. When I started writing this column in 1977, the Investment Company Institutes’ Fact Book listed only 404 mutual funds (not counting the 40 newfangled money market funds). At the close of 2012 the Morningstar database listed a grand total of 8,666 distinct funds, including 1,438 exchange-traded funds. You don’t get growth like that unless someone is making lots of money.

All 8,666 of these funds argue and advertise that they strive for superior management and performance in their chosen category. The reality, again and again, is that Joe Index beats Joseph Wall Street at least 70 percent of the time.

Low Interest Rates Endanger Life Insurance Policies

admin — Wed, 13 Feb 2013 21:00:00 Z

Q. In 1995, when my husband was 60, we took out a $100,000 insurance policy on him prior to his early retirement. We did this so he could take the higher single life pension rather than the lower joint life pension. There is a 12-year age difference between us. We've made monthly payments since then of $225. The policy accrued value was frozen at $117,158. Then I read this on our last statement:

"With future premiums, and assuming the current (policy) interest rates and risk charges will continue, your policy will remain in-force through 06/07/2023. With future premiums, and assuming guaranteed interest rates and risk charges, your policy would remain in-force through 07/07/2018."

I recently called my agent and was instructed to call the company directly. I was then told that the only way to keep the policy in effect beyond 2018 or 2023 is to increase our payment considerably. When I asked if the policy could be converted, I was told to contact my agent, who again said I would have to talk with the company! ?Could you tell me what we should do to protect the nearly $34,000 investment we've already made and to keep the policy from lapsing? —S.F., by email from Texas

A. What you have is called a "pension maximization plan." They are frequently offered by life insurance sales people as a clever way to take the highest possible monthly pension benefit (the benefit for a single life) so you can have more income while protecting the surviving spouse with a life policy. It's an intriguing idea except that I've never seen a set of numbers that actually works, particularly when taxes are considered. Worse, if the yield on your policy declines after it is written, the policy may end up cash short.

That's what has happened to you and your husband. The only way this policy will do what it was originally intended to do is if your husband dies before 7/2018, later if interest rates don't continue to decline. And while that may have him pushing 83 years of age, it may not be what either of you had in mind when you bought the policy.

While much of your investment is simply gone, you might consider asking the insurance company how much fully paid up insurance you could buy with the current cash value of the policy. It will be less than $100,000, but it will at least give you a known death benefit. With a paid up policy and a fixed death benefit, you'll then be able to buy a larger life annuity replacement income with each passing year.

Q. We are 83 and 88. We have about $830,000 in CD's and money market funds that pay us next to nothing. We have a $700,000 home with no mortgage and no other major debts. I have a small private pension. My wife and I have Social Security benefits. Between my pension and SS we are able to live O.K. We have four children and several grandchildren. Is it worth it to put most of our savings in a balanced index fund such as Vanguard VBIAX? We are healthy enough to stay in our home right now, however, ailments are starting to limit what we can do around the house. —C.M. by email from California

A. At your ages it is a good idea to have some zero-risk liquidity ready at hand in addition to your investments. You could, for instance, keep a cash reserve (earning next to nothing) equal to the estimated cost of one or two years in assisted-living or a nursing home as a safety measure.

In California the costs for both are higher than the national averages, about $42,000 for an assisted-living facility and $91,000 for a private room in nursing care. The purpose of keeping this reserve is to provide cash when you need it and not add the anxiety of having to sell investments willy-nilly.

A year of reserve will allow whoever is managing the money to make changes at a rational pace. The same reserve can also be used to pay for home health aides for some period of time, if your ailments make living at home hard but not so difficult that you need to move to an assisted-living facility. Having a reserve large enough to cover most contingencies, with the remainder invested in the fund you suggest, will help you strike a good balance between your personal needs and your bequest hopes.

What Readers Want: More Taxpayers, Completely Different Taxes

admin — Fri, 08 Feb 2013 21:00:00 Z

If our elected representatives listened to the people who vote for them, we’d have a radically different tax system. That’s the message from nearly 600 reader responses to a recent column.

Missed that column? Let me give you the CliffsNotes. I asked a question: How could it be that only 53 percent of households paid federal income taxes, but a much larger percentage of households had microwave ovens, personal computers, cell phones, flat panel TV sets and other goodies? I suggested that if we examined taxes in a framework of civic duty rather than envy, more people would be taxpayers.

Then I asked for suggestions that would improve our system and allow us to have more taxpayers.

The email flood started immediately. What was amazing was the consistency of the responses. Unlike most political topics, ideas weren’t all over the map. Virtually all pointed in the same direction. They made a lot more sense than the indefensible tax system that we all labor under today. If there is primary message it is this: our tax system is truly despised.

Here are the basic themes:

Everyone should have some “skin in the game.”

Indeed, that phrase was used dozens of times. One reader suggested a flat $100 minimum tax that everyone should pay, no exceptions. Another suggested $10 a month as a minimum tax. Others thought civic responsibility should begin when household income exceeded the poverty level. While there is a big difference between a minimum tax of $10 a month and one that begins at poverty level, both would expand the percentage of households paying income taxes well beyond the current 53 percent.

Not a single reader thought expanding the number of taxpayers would bring a revenue bonanza. Many noted that more people should pay income taxes, but that the top 1 percent could pay more and had paid more during much of the post war period.

The important thing, a guiding principle, was that everyone should contribute something, if only a token amount, to the cost of running the country we love and share. They wanted to avoid a voting block of no-pays. They wanted to make sure everyone understood that our government was spending money that it received from taxpayers.

The existing tax system is complex and unfair.

Many cited Warren Buffett’s example of how he pays at a lower rate on his investment income than his secretary pays on her paycheck. Others noted that while we have very high marginal tax rates there are so many deductions and wrinkles in our tax law that anyone with substantial income could pay at a much lower rate. Why, one reader asked, should anyone be able to take tax deductions on a boat simply because it had a toilet and qualified as a second home?

Reader comments about unfairness and complexity went well beyond the personal income tax. Several mentioned that while we in theory had one of the highest corporate income tax rates in the world, few corporations paid at that rate and a number of highly visible corporations paid no taxes at all. It’s all about having a level playing field.

And the solution is? A flat tax or, better still, a consumption tax.

Frustrated by our current system, some readers wanted to eliminate all the deductions, preferences and exemptions that distort the proportionality of the tax system. Then they would tax every dime of income, but tax it at a single lower rate. Even more readers suggested that we morph from the complexity of taxing income, which is difficult to define, to taxing consumption.

Quite a few advocated dumping our entire tax system. They would replace it with something like the progressive national sales tax advocated by the Fair Tax organization in Houston.

The argument there is simple. Washington would no longer try to influence our decisions, at any level, with tax breaks. We’d make our choices, spend our money as we wanted and pay a sales tax to do it. That sales tax could be high enough to bring in more revenue than the current loophole-ridden hodge-podge of income, employment, corporate and estate taxes.

Collectively, we make a lot of sense. Sadly, what makes sense for you and me would eliminate the deduction, preference, exemption tools every member of Congress depends on to raise the fortunes spent to stay in office. It’s a truly hateful impasse.

Home Is Where The Hard Assets Ought To Be

admin — Wed, 06 Feb 2013 21:00:00 Z

Q. I was Googling tangible asset brokers in the Dallas area when I came across your column from April 2010 about the consequences of a change in asset-holding preferences. I have been very uncomfortable putting money into my 401(k) since the crash. I think tangible assets may be the way to go. Can you recommend a broker that can diversify in all tangible assets not just coins and gold? —L.Z., Dallas

A. Sorry, no recommendation. First, putting all your money into a variety of tangible assets isn’t diversification. But, more important, if you bought a gun for self-protection, would you keep it at a neighbor's house or in a safe-deposit box? No. Doing that would defeat the purpose of owning the gun.

The major reason for wanting to own hard assets is the anticipation of a truly catastrophic breakdown in markets and in our economy. If that happens, having gold, silver or other commodities in your 401(k) or IRA is not a very good idea. Neither is having them in a taxable brokerage account. Much the same applies to holding real estate in an IRA due to valuation and distribution issues. The greater your concern with a possible future catastrophe, the more important direct ownership is.

Q. My wife and I are some of the "leading edge" baby boomers getting ready to settle into retirement. I am 67 and she is 60. My wife recently retired. I will retire in early 2014. We are basically debt-free except for the mortgage on our house, about $325,000. We currently have about $945,000 in savings inside various IRA's and 401(k) s.

Both of us are eligible for small pensions, less than $1,000 per month. I am not drawing Social Security at this time. Both of us will be eligible to draw the maximum amount of Social Security.

Our question is that we would like to pay off our home mortgage, but since all of our savings are in IRA's and 401(k) s, won't we be subject to a large tax bite of 33 to 35 percent if we withdraw the necessary funds to pay off the mortgage? I figure at a tax bite of 35 percent, we would need to take out $500,000 to net $325,000. That would only leave us $400,000 in savings. We have 14 years left on our mortgage. We are torn between selling the house and downsizing or staying here. We love this house. It is more house than we need, but the thought of moving is not something we would look forward to.

Is there a way to minimize our tax bite and pay off our mortgage or are we better to take out what we need each of the next 14 years to make the scheduled payments? —T.D., by email

A. Taking pre-tax dollars out of your retirement plans is not the way to skin this cat. Your first choice should be a "right-sizing" move that would secure shelter appropriate to your retirement. But if you can’t bring yourselves to do that, the second best way is to refinance the mortgage to the lowest rate possible for 30 years.

This will turn your mortgage into a homegrown inflation hedge. It will leave you with a monthly payment just more than $1,400 a month, if the interest rate is about 3.5 percent. It's a good bet that you will be returning less purchasing power than you have already borrowed.

(I do think this is a slam-dunk for younger people, but it is less certain for retirees who must pay mortgages off with investment funds rather than wage earnings.)

With the low-rate mortgage in place you can then work on paying it down, hopefully while remaining in the 15 percent tax bracket. For 2013 you can have $72,500 of taxable income on a joint return and still pay taxes at no more than 15 percent. Add deductions, exemptions and some untaxed Social Security benefits and you should be able to make a good payment toward the mortgage without exceeding the 15 percent tax bracket.

Meanwhile, the purchasing power of the money you owe will be declining. The only task left to make this a good deal is making certain that your retirement funds enjoy good returns. (No small task.)

The Restoration of Middle Class Wealth

admin — Fri, 01 Feb 2013 21:00:00 Z

Things change.

One of the big changes is in housing affordability, a figure that is currently so positive it‘s likely to drive home prices upward for the rest of 2013. That price change would do a lot to restore our confidence.

Imagine: No more middle class depression, less worry about the future.

Late last year, the National Association of Realtors announced that its housing affordability index was about to have its best year ever. That means home ownership is more affordable, for more Americans, than it has been since they started the index more than two decades ago.

In November, the last month for which a figure is available, the affordability index hit 198.2, down slightly from its record reading of 200.7 in October. The index is constructed by comparing the median family income to the income necessary to qualify for the median priced existing single family home. In October, the record month, the median price was $177,000. The home mortgage rate was 3.57 percent. This calculates out to a very low 12.6 percent of the median family income, some $61,752 at that time.

Work the numbers a bit more and you learn that an income of only $30,768 would qualify you to buy the median priced existing home. Mortgage interest rates have declined slightly since then, so it’s pretty easy to say that a whole lot of people, more than ever before, can qualify to buy a house.

This is a gigantic change. To explore just how big it is I asked the researchers at the NAR for their affordability figures as far back as 1989. Those figures show that we simply have never had a time like this. If you want to buy a home and have any faith in your future, this is the time to do it. If you want to buy a second home, this is the time to do it.

You can understand why by looking back to the housing bubble peak in 2006. Back then, the affordability index bottomed at 101.1 in July. That’s when the median home price was $230,900 and mortgage interest rates were 6.82 percent. The result was a mortgage payment that would take 24.7 percent of the median family income ($58,590 at that time) and a qualifying income that was nearly as high, $57,936. Today, home prices are about 20 percent lower, mortgage rates have been cut in half and the median income (believe it or not) is slightly higher.

This isn’t a regional thing, either. While the western and northeastern states continue to be less affordable than the Midwest or the South, more people who actually work for a living can still afford houses all around the country. In the expensive west, for instance, the median home price is substantially higher ($251,200) than the national median— but it only requires an income of $43,584 to qualify for that home and the actual median income is $63,527, slightly higher than the national median. (Needless to say, these figures don’t apply to really expensive locations such as San Francisco and San Diego.)

Another way to examine this is to ask how much house could the median family income afford to buy today? Using the home purchase calculator on bankrate.com, I found that today’s median income family could afford to buy a home priced around $250,000. Note that this is a soft figure— the actual amount will depend on real estate tax and insurance costs in each area as well as family obligations like car loans, credit cards and other debt. But a family with good credit, limited consumer debt and a good down payment can afford a $250,000 house. That figure, by the way, is very close to the current median price of a new home, according to the Commerce Department.

Is this important?

Yes. Here’s why. Being able to afford a $250,000 house shows that we have the mortgage interest rates and the income to drive home prices to their old peak— and beyond. If that happened, we would no longer have millions of homeowners living upside down, owing more on their houses than their market value. Homeowners could sell and move without bringing a check to the closing. The biggest single source of wealth for the vast majority of all Americans would be restored.

Is this a lead pipe cinch? Absolutely not. Lots of things can go wrong, most of them in Washington.

But it isn’t a pipe dream, either.

Social Security Is a Social Program, Not a Pension Plan

admin — Wed, 30 Jan 2013 21:00:00 Z

Q. I read an article about divorced wives being able to collect on their ex-husbands’ Social Security and the ex-husband doesn't even have to know. I have a hard time figuring out how anyone can get half of her husband’s or ex-husband’s Social Security when the calculations don't add up. Where does this money come from? For example, if a man qualified for $1,000 benefit and his wife gets $500 that would mean that he is getting $1,500. If the ex-wife is also entitled, then he is now getting $2,000.

They don’t cut his in half to give her half. So where is the additional money coming from? I believe the additional money is coming from future recipients. Is this why Social Security won’t have enough funds to allow my son (who works) to collect when he retires? How does our government allow this to happen?

Also, what about all the people collecting Social Security disability never getting rechecked to see if they still qualify? I am 70 years old. I still work so I can keep up with the $10,000 property tax. I will never be able to retire; yet women who have never worked, or worked off the books, are collecting Social Security. That’s money from my paycheck. Why is our government so dumb? —M.S., Clifton, NJ

A. How you see things is correct— or would be— if Social Security were an actual pension plan. If that were the case, all benefit payments would be proportional to the employment taxes paid in. But Social Security is NOT a pension plan. It is a social program designed to provide at least some amount of income for everyone. This includes the disabled, former spouses who were married for at least 10 years and under-age children of deceased Social Security recipients. It doesn't compute as transactions for individuals. But many argue that it does compute for the greater good.

Let me give you an example. Suppose a woman marries, has children and elects (at her husband’s request) to be a full-time mom. Suppose that thirty years later, her husband dumps her for a younger woman. This leaves the full-time mom out in the cold, with no work history and no retirement income. She could be destitute. I have met women in their late 50s in this position. For them, having rights to draw benefits based on the work record of a former spouse may be all they have. In this instance, Social Security functions as an instrument of compassion and care.

Similar circumstances apply for people who are born with severe disabilities or with a mental illness that renders them unemployable. The disabled can either draw benefits based on their work record, or when that record isn’t sufficient to qualify for benefits they qualify for a program known as SSI— Supplementary Security Income. While some of the disabled are those wishing to avoid work because of, say, a "bad back," the reality is that there are hundreds of thousands of people who are blind, mentally impaired, mentally ill, or otherwise incapable of supporting themselves.

Are they taking money from your son, or you or me? No. A portion of the employment tax is earmarked for people who are disabled. "There but for the grace of God" is where we would obtain our income if we were disabled.

In fact, these issues are a sideshow. Their costs are minor compared to the cost of living longer. Greater longevity means we will receive Social Security benefits longer. In 1935, life expectancy at birth was 61.7 years— less than the age for collecting Social Security benefits. By 2010, life expectancy at birth had risen to 78.7 years. What we, and the politicians we elect, want to do is live the added years of life and duck the bill. That won’t happen.

We have a big choice to make in the next few years. We can point fingers at cases of imagined injustice or unfairness and get nowhere. Or we can take a happier road. We can appreciate the gift of life. We can man-up (and woman-up) enough to pay for the extra years of life.

The alternative is to duplicate the living and health conditions of the many nations where life is short and few live long enough to retire.

How Many Should Pay Income Taxes?

admin — Fri, 25 Jan 2013 21:00:00 Z

Should more people pay income taxes? It is widely agreed that the top 1 percent of Americans can, and should, pay more. This is not surprising. It’s a pretty good bet that you’ll get a majority vote from the 99 percent to increase taxes on the 1 percent.

So the top 1 percent will be paying more taxes this year. So will millions of others, including every working stiff. But let’s take the question a bit further. Let’s view it in the context of civic duty rather than envy.

At what level of income should we feel a need to contribute, however modestly, to the support of our government? It’s easy to look at the top dogs and say, “Gee, those folks have it made. Let’s have them pay more taxes.” It’s not so easy to look down the income scale and ask where paying taxes should start.

It’s also political suicide to speak dismissively of those who don’t pay income taxes. Presidential candidate Mitt Romney learned that painful lesson when he noted, in a private talk, that 47 percent of the voting public received tax dollars rather than paid them. That’s a lot of people. His comments, however, were greeted with howls of indignation. The media awarded him lifetime membership in the National Association of Grinches.

But maybe we should think on this a bit. Let’s juxtapose that 47 percent figure to the ownership of various consumer goodies.

More than 90 percent of all households have a microwave oven.
88 percent of households have a television set in their living or family room
87 percent of households subscribe to cable or satellite TV
77 percent of households own a personal computer
72 percent of households have a flat panel TV set.
68 percent of households have broadband Internet service.
68 percent of households have a television set in their bedroom.

Does this mean it is nearly twice as important to own a microwave oven as it is to make a contribution to support, say, the Department of Justice? I’m serious about this. Pick a department of government. Surely they can’t all be entirely worthless. Isn’t it possible that our interstate highway system adds at least the same amount of convenience and timesaving to our lives as possession of a microwave oven?

Is cable or satellite TV more worthy of support than government? After all, 87 percent of households support cable or satellite TV, but only 53 percent of households pay federal income taxes. Surely our government doesn’t suffer from as much waste, fraud and abuse as what’s offered on television.

It has been argued that not paying federal income tax should not be confused with not paying taxes. Everyone who works pays the employment tax. The difference is that we pay the employment tax in the expectation of a direct future benefit— Social Security retirement benefits and Medicare insurance. We get pretty upset when our friends in Washington talk about reducing the benefits. So the employment tax, like it or not, is a separate deal. It has a quo for the quid.

The federal income tax supports the daily operation of the rest of government, yet 47 percent of all households won’t contribute a dime to the $3.1 trillion to be spent this year. That leaves the other 53 percent to carry the whole thing.

Other data suggests that those who are officially defined as poor (having an income below the official poverty line) have been making some material progress even if they aren’t living as well as the rest of us. In a Census Bureau report, “Living Conditions in the United States, 2005”, it was reported that only 36.7 percent of poor households owned a dishwasher in 2005 compared to 64 percent of all households. But ownership among the poor was still double the 18.8 percent dishwasher ownership of all households in 1971.

In other areas the poor were on par with the entire population. While 98.9 percent of all households owned a color TV in 2005, 97.4 percent of the poor owned one.

Don’t get me wrong. Being poor is no bowl of cherries. Those who have compared will tell you, “rich is better.”

So here’s what I’d like to hear from you about. First, should more people pay federal income taxes? If so, how would you change the tax code to make that happen? Write me at scott@scottburns.com. Put “More Taxpayers” in the subject line.

In Financial Advice, the Value Added Is in Planning

admin — Wed, 23 Jan 2013 21:00:00 Z

Q. I have followed your column for many years and use your investment ideas to manage my 401(k) account. My financial situation recently changed. Is there a wealth threshold at which you recommend hiring a financial adviser rather than going it alone with investing my own money? I found a few financial advisers through the National Association of Personal Financial Advisors (NAPFA) to meet with. How do I evaluate the value added by these guys? Is a financial adviser likely to better my investment returns with his fee included? —C.A., by email

A. There are two kinds of services that most people need. One is investment management. The other is financial planning. All too often, both are mixed together. This tends to inflate the cost of managing your money. If you can, you should work with your fee-only NAPFA advisor on a fee basis for financial planning, telling him that you want to focus on low-cost index funds for your retirement portfolio.

Here's why. Let's say your advisor offers financial planning and portfolio management for 1.5 percent a year of a $500,000 retirement portfolio. That means his annual bill will be $7,500. Invested in a low-cost index fund portfolio, the actual management of your portfolio will cost about 0.10 percent a year, or $500. Equally important, this portfolio is likely to provide a better after-expense performance than 70 percent of the actively managed portfolios.

The cost difference here is $7,000 a year. You should be able to get a whole lot of financial planning done for $7,000. If you figure a (hefty) billing rate of $250 an hour, you should get 28 hours of your planners’ undivided attention. That’s a lot of time, more than most people need.

This is why I have long believed that financial planning and investment management should be "unbundled"— they should be delivered ala Carte.

If you are a small business owner or the fortunate recipient of generous stock options, having a financial planner on retainer is a good idea. You will probably need help every year working through some complicated tax and allocation decisions. But if you are a working stiff— even a well-paid working stiff— you're not going to need to pay more than 1 percent of your assets every year, for life, to make personal finance decisions.

Q. How should an 18-year-old invest a lump sum of $10,000? Teenagers starting out need special help. What do you suggest? —R.B., by email

A. Many years ago a friend of mine was eager to go to his 25th prep school reunion. He was most curious about one classmate whose stated ambition was very specific. He wanted to become a senior partner in a medium-sized accounting firm in Newark, New Jersey. My friend wondered if anyone could actually follow an ambition that specific.

Well, guess what?

His classmate had become a senior partner in a medium sized accounting firm in Newark, New Jersey!

If your 18 year old is of similar nature, then he can follow the conventional wisdom and put every dime of that $10,000 in the stock market. The idea is that each dollar invested today is likely to be worth about $128 about 50 years from now.

Real life, however, varies. So do real 18 year olds. If your 18 year old is pretty serious and has a good idea of what he or she wants to do, then investing in a broad stock fund, such as the Vanguard Total Market Index ETF, would be entirely reasonable.

But if there is a small chance that your 18 year old will have some uncertainties of profession, fail to marry well, face a decaying economy or simply opt for a year or two of travel and identity crisis, they would be better advised to invest in a simple, low cost balanced fund. The one I mention most is Vanguard Balanced Index. Balanced funds are mixtures of equities and fixed income. They fluctuate less than all equity funds, so if there is a need to sell in a down market, the damage may not be so great.

Where Should You Keep Your Retirement Money?

admin — Fri, 18 Jan 2013 21:00:00 Z

How would you like to get the cost of managing your money— particularly your retirement assets— down to less than one-tenth of one percent?

It can be done. But it won’t happen unless you are careful about where you keep your money. Keep it in your old 401(k) account and it will continue costing what it cost when you were working. That could be well over 1 percent a year, unless you work at an organization that has gone into indexing— like IBM, ExxonMobil, Texas Instruments or the federal government’s Thrift Savings Plan. If you move your accounts to your local bank or credit union it is likely some expensive products will be suggested by their advisors (actually sales agents). Attend a “free” dinner and you’ll get clobbered with offers of products that can set you back 3 percent a year.

It doesn’t have to be that way.

If you transfer your accounts to one of the major financial platforms, you can get the cost of investing under 0.20 percent. With a bit of attention you can get it to less than 0.10 percent. I learned this while surveying the costs of basic index fund investing at these firms: E*TRADE, Fidelity, Merrill Lynch/Bank of America, Scottrade, Schwab, TD Ameritrade and Vanguard. In addition to commission costs, I also examined account fees and the number and type of no-commission Exchange Traded Funds available. Finally, I considered the number of offices the firm had.

So follow me down the decision trail.

Brokerage Costs.

If you made your decision based on low brokerage costs, you’d open a Merrill Edge account (their account for independent/online investors). Their commission cost, at $6.95 a trade, is the lowest in the group. By comparison, Fidelity is $7.95 and Schwab is $8.95. TD Ameritrade and E*TRADE are $9.99. Commission costs are muddied by sign-up and account size offers of free or reduced commissions.

Personally, I’d eliminate the Merrill/Bank of America choice because the combination of a part-of-the-problem broker with a too-big-to-fail bank is repulsive. And even if your self-preservation/ethical sense isn’t engaged, the reality is that commissions are no longer very important for a low-cost index investor.

Surprised by the irrelevance of commissions? I was too. But if you do 10 transactions a year in a $9.99 a trade account rather than a $6.95 a trade account, the difference is $30.40 a year. On a $100,000 account that’s all of 0.03 percent a year.

The ETF Factor.

The big divider is the number of no-commission Exchange Traded Funds— and their annual cost. Merrill and Scottrade don’t offer ETFs without commission. TD Ameritrade offers 100, E*Trade offers 90, Vanguard offers 49, Fidelity offers 30 and Schwab offers 14. The ETFs offered by E*Trade, however, are relatively expensive. Their least expensive no-commission ETF has an annual expense ratio of 0.28 percent. Seventy of their no-commission ETFs have expenses from 0.50 percent to as high as 0.88 percent. Many are also obscure.

We can create a basic Couch Potato portfolio— a 50/50 mixture of the U.S. stock market and Inflation-Protected Treasury Securities for 0.055 percent a year at Schwab, 0.075 percent at Vanguard, 0.085 percent at Fidelity and 0.13 percent at TD Ameritrade. The cost difference between the most and least expensive is 0.075 percent. This simple two-fund portfolio returned about 11.6 percent last year. Not bad for simple and cheap.

What about other asset classes? The cost of adding international equities ETF is lowest at Schwab. So is the cost of adding a REIT index. Get more complicated and you’ll pay a commission to access the broader universe of exchange-traded funds. This would level the playing field some.

And what about other factors?

There are many— but Fidelity, Schwab and TDAmeritrade are head to head in banking, online bill-pay and no-fee ATM access. If you want to consolidate all your financial stuff in one place, you can do it at these firms.

The size of a firms’ office network may not matter to some readers, if only because there are areas where none of the firms has an office presence. But Schwab has an edge when it comes to the raw count. Schwab has 300 offices and is rapidly growing more. Fidelity has 170 offices. TD Ameritrade has 126. Vanguard has only 3 offices.

Simple Ways To Own Equities in the Federal Thrift Savings Plan

admin — Wed, 16 Jan 2013 21:00:00 Z

Q. I'm risk averse, so I'm fully invested in the "F" Fund in the Federal Thrift Savings Plan. It is supposed to mirror the index for U.S. Bonds and has done okay. Recently, I saw John Bogle on CNBC. He said you should always have at least 30 percent in stocks. He also said there was an 85 percent chance of stocks outperforming bonds over the next 10 years.

So, could I do slightly better with a 30/70 split in my thrift plan? If I were following Bogle's theory would I put the full 30 percent in the S&P 500 index fund only? Or would I split it 15 percent in the S&P and 15 percent in the "S" fund, which reflects the Wilshire 4500? —W.N., Dallas, TX

A. Owning some amount of equities, even for the most conservative investor, is a good idea. While equity returns have been disappointing over the last 5 and 10 years relative to fixed-income, the past is seldom a good predictor of the future.

In the mid-1970s and late 1990s, for instance, many people were convinced stocks could only go up, but then faced miserable bear markets. Much the same may happen with bonds. While bonds have shown attractive returns over the last 5 and 10 years, their current yields are so low that they would be very vulnerable to any increase in interest rates.

Ibbotson research shows that the longer the holding period, the greater the probability stocks will return more than any type of fixed-income investment. The same research shows that small-company stocks will provide higher returns, more of the time, than large-company stocks.

Rather than deciding between a mix of large-company and small-company stocks, you could consider one of the Lifecycle fund options offered by the Thrift Savings Plan. The L Income Fund, for instance, is 80 percent fixed-income and 20 percent equities— but it mixes 12 percent large stocks, 3 percent small stocks and 5 percent international stocks. Similarly, the L 2020 Fund is about 45 percent fixed-income and 55 percent equities, with 29.45 percent in large stocks, 9.4 percent in small stocks and 16.4 percent in international stocks. If you chose to mix them equally, the resulting portfolio would be about 60 percent fixed-income and 40 percent equities.

Q. My wife’s investments are in Ameriprise and Franklin Funds. Mine are in four Vanguard funds plus money market and an IRA also with Vanguard and I have a company 401(k) plan. I am 75. She is 69. We are both in excellent health. We have a successful business and no immediate plans to retire. We recently sat down with a Certified Financial Planner at our bank (no fee) to look at our investments to see what makes sense going forward.

Our holdings total $750,000, including IRA’s. In addition, we own the building that houses our business. It has an appraised value of $1.2 million. The advisor is recommending a joint account of about $400,000.00 to be placed in the Allianz MasterDex X annuity and our IRA’s in the Pacific Index Choice a deferred, fixed indexed annuity both for 10-year periods. I have always been skeptical of annuities but the advisor has made a good case for these investments. I am intrigued, but not completely sold. Can you help us understand these options and give us your assessment of how they fit as an investment vehicle for our situation? —D.N., San Antonio, Texas

A. When someone has spent the time to earn a CFP designation you have to wonder about his integrity if the only product he suggests is an expensive, insurance-based one. It's a pretty good bet that your bank is an outlet for insurance products. They are not doing this as an exercise of fiduciary concern; They are doing it because it generates income for the bank.

Since you work, are employed in your own business, and already face compulsory rising income due to required minimum distributions, there is zero evidence that you should be seeking security and certainty of income. In addition, when you stop working you will sell your $1.2 million building as a separate transaction from selling your business. When that happens you will either have a major "liquidity event"— or you will be holding a mortgage that will bring a substantial monthly income. This suggests that you should be maintaining your current liquid financial investments rather than tying them up in insurance contracts.

Means-Testing Social Security

admin — Fri, 11 Jan 2013 21:00:00 Z

“Yeah, I’ll bet they start means-testing Social Security soon. If you make a bunch of money, you won’t be able to collect any benefits.”

Lots of people make such comments. Lots of other people listen seriously. “Means-testing” seems to be a quick solution for the inadequate funding of future Social Security benefits. What few understand is that Social Security is already means-tested. In fact, it is means tested twice.

Confused? Then come with me into the weedy details of Social Security. It’s good to remember, right here, that Social Security is the single largest part of our social safety net. It provides about 39 percent of all income received by the elderly and more than 50 percent of all income for many. Without Social Security, we’d be in something worse than chaos.

First, let’s look at how benefits are calculated. What most people don’t know is that our employment tax dollars don’t all buy the same amount of future benefit. Some of our employment tax dollars buy six times as much in benefits as others. According to the most recent Trustees Report, for instance, the first $767 of “average indexed monthly earnings” (a complex formula that adjusts earnings over time) is credited at a 90 percent rate, assuring the lowest wage workers of a retirement benefit nearly equal to their earned wage.

Wages of more than $767 a month but less than $4,624 a month are credited at a 32 percent rate. This means retirement benefits increase at a much lower rate. The benefit pinching, however, does not end there.

For wages of more than $4,624 a month up to the wage base maximum ($113,700 for 2013), the crediting rate is only 15 percent. In effect, all the wages earned (and employment taxes paid) over that $55,488-a-year “bend point” gain benefits at only one-sixth the rate of the lowest wage earners. In effect, the Social Security benefits formula functions as a sharply graduated benefits “tax,” reducing the benefits that accrue to higher wages by 85 percent. The higher your means, the lower your benefit.

The result can be seen in the percentage of earnings workers can expect their Social Security retirement benefit to replace. According to the most recent Trustees Report, while workers at low-wage levels can expect Social Security to replace 57.8 percent of earnings at normal retirement age, workers at a “medium” earnings level can expect 42.9 percent and workers at the maximum level can expect only 28.7 percent. So high-wage workers get half as much for their employment tax payments as low-wage workers— basically, a form of means-testing.

But means-testing doesn’t stop there. While the original political promise of Social Security was that the benefits would never be subject to taxation, the tax reform of 1983 (during the Reagan administration) initiated taxation of benefits. A second change during the Clinton administration created another level of tax on benefits. This increased the percentage of benefits subject to taxation from a maximum of 50 percent to 85 percent.

From the start it was a sly tax. In its first year it was expected to affect only 3 percent of all retirees. The formula for the taxation of Social Security benefits, however, is one of the few items in our miserable tax code that is not indexed to inflation. As a consequence, an estimated 30 percent of all retirees now pay some amount of tax on their benefits. Ultimately, that tax will take back much of the benefits that accrue above the second bend point for higher income workers. In other words, most of the employment tax paid on wages over about $55,488 a year will bring little benefit to workers because much of it will be taxed away.

All of this is history. It all happened before our slippery friends in Washington started dealing with “entitlement reform.” Soon they will start talking about changing the formula for future benefits and other sneeky ways to reduce— or further “means-test”— benefits.

When you translate “change the formula for future benefits” from political-speak to what will really happen, what you get is yet another way to have workers pay in the same amount of taxes for less in future benefits.

The Fiscal Cliff Is No Problem for the Couch Potato Investor

admin — Wed, 09 Jan 2013 21:00:00 Z

Q. I have followed your idea of Couch Potato investing through the years. My question is: Does all the fiscal uncertainty in Washington mean your "recipes" for Couch Potato investing should be changed?

I'm 54 years old and looking at retirement when I reach 65 - I'm at that age where I'm looking at my investing a little bit differently. —S.F., Houston, TX

A/ The Couch Potato portfolios are designed with an eye to future inflation, beginning with the simplest, which holds Treasury Inflation Protected Bonds as one of its two investments. Whether we go over the fiscal cliff or not, we don’t know what the future holds.

The basic idea of Couch Potato investing is to diversify and get out of the future guessing business because we can't predict the future. What we can do is focus on our own lives and the smart decisions we can make to adapt to changes in the world around us. That may be working longer, changing our shelter arrangements, or other adaptations that are likely to be far more powerful than our investment decisions.

Q. I continue to read where more money is going into ETF’s while less and less is going into traditional mutual funds. I have a large percentage of my portfolio invested in mutual funds. Should I be worried that ETF’s will continue to grow while mutual funds decline? Should I consider moving some of my money from standard mutual funds into ETF’s? —W.C., by email

A. Exchange Traded Funds should not be a cause for concern. As with mutual funds, there are many exchange traded funds that have no reason to exist because they are too speculative, too expensive or both. If you are thinking about changing your investments to lower expenses, then you should start considering moving some of your mutual fund investments into the largest, most liquid and lowest cost exchange traded funds. You can find a list of the largest ETFs by assets at this link: http://etfdb.com/compare/market-cap/

Q. I would like to know how best to invest in silver: Would it be by depository, ETFs or silver mining stocks? —C.R., by email

A. The answer depends on your reason for investing. If you believe that silver, as a commodity, will rise in value relative to other tradable investments, then you should invest in a silver ETF, a company that produces silver, or some combination of both. This will be a low cost and liquid form of investing.

If you believe that owning silver will be good because paper money will be a future source of toilet paper, then you should invest in physical silver, preferably in small amounts that can be used as a substitute for paper money. In other words, think silver coins.

Q. I know what you think about Variable Annuities in general. ?But what about the case where the retiree and spouse have a pension, social security, and a sizable required minimum distribution (RMD) at age 72, ?with significant holdings of municipal bonds, and a marginal tax rate of 25 percent? ?He and his wife are near the threshold for a modified adjusted gross income (MAGI) of $170,000. ?Furthermore, the retirees have no need for the RMD money, either now, or in the foreseeable future. ?So do the retirees put the RMD money into the Variable Annuity for tax deferral, or put it into a taxable account? ?If taxable, would something like the Vanguard Mid Cap index be a good taxable investment to be in? —T.D., by email

A. If the primary issue is controlling your taxable income—if only to avoid the uptick in your Medicare premiums that occurs at a MAGI of $170,000—then you might consider a variable annuity that has very low costs. The cost of the Vanguard VA is about 60 basis points, all-in. This gets you tax deferral and the related control of distributions. Fidelity also offers a VA but its costs are somewhat higher. Both are materially lower cost than the vast majority of offerings.

The alternative is an index fund, as you suggest, but it will produce some income and uncertain capital gains realizations. More important, the quest to reduce taxable income will force you to invest more aggressively than you might want. With the VA you can choose a balanced portfolio and have less risk. The total cost of mortality and administrative expenses in the Vanguard product is 0.29 percent, with an additional 0.30 percent for the cost of the balanced fund. So the total cost is 0.59 percent.

Coping with the Zero-Interest-Rate-Policy

admin — Fri, 04 Jan 2013 21:00:00 Z

“You don’t need to tell me that interest rates are low and that retirees are getting a bum deal. What I need you to tell me is what to do about it. I need a decent income from my savings.”

That’s the thumbnail summary of what readers have said about my columns on the difficulty the Federal Reserve Zero Interest Rate Policy is causing. In fact, the menu of safe (or relatively safe) responses to pathetic rates on CDs and other safe investments is painfully short, but here’s my list of good tools:

Debt Is the New Thrift.

If you owe money you’ll find more opportunity in refinancing or paying down debt than in finding yield on your savings. This would be irrelevant for retirees and near-retirees if no one had any debt. But the reality is that debt has been increasing among older people. So this may be a big-time opportunity.

Let’s start with the obvious: credit cards. If you run a $2,000 balance on your credit cards and pay 18 percent a year the annual cost is $360. With the highest yielding one year CDs on Bankrate.com yielding about 1 percent, you’d need $36,000 in CDs to produce that $360 in interest income.

After that, refinance your car. As I pointed out during the summer, many credit unions now do 5-year loans on used cars at about 2 percent interest. So if you’ve got a loan at 4, 5, or 6 percent, you may save as much in interest as you could earn on the same amount in savings.

And if you have a home mortgage, start looking at opportunities to refinance at rates lower than 4 percent. Also, don’t forget that refinancing can reduce your income need as well as the current interest you pay. Here’s an example. Suppose you have 10 years left to pay on a mortgage with a $100,000 balance at 5 percent. That mortgage would be costing you $1,061 a month. If you refinance it to a new 30-year mortgage at 3.5 percent, your payment will drop to $449 a month. Only about $125 of the $612 a month payment reduction will be reduced interest cost. The remainder will come from extending the period of the loan.

Does it matter? Yes, because your debt will last longer. But you’ll also have a much easier time getting through the month. Your cash flow will have changed dramatically. Put it this way, you’d have to have over $700,000 in one-year CDs at 1 percent to produce that kind of change in your income.

You can extend the same principle: Use no-yield savings to pay off an old mortgage. The old $100,000 mortgage above, for instance, has an out-of-pocket cost of $12,732 a year, a mixture of interest (about $5,000) and principal (about $7,700). Using $100,000 of no-yield savings will make a dramatic change in your monthly budget. It will feel like getting a 12.7 percent return.

Spending Smart Is Better Than Saving Dumb.

Low yields also make good buying decisions immensely more valuable. If you take a close look at every dime you spend, you’re likely to find expenses that can be cut. Do you really need or want all the cable TV channels you get? Have you minimized your bank account expenses? Have you thought about using the public library rather than buying books? Could you buy more, at lower prices through Amazon? If you save only $100 a month from more attention to spending, a person in the 15 percent tax bracket is eliminating the need to earn $117.65 from their savings, or $1,411.76 a year. You’d need $141,176 in a one year CD at 1 percent to produce the same interest income. Even in the long lost wonder days of 5 percent CD yields you would need to have over $28,000 in a CD to have an effect equal to $100 of smarter spending.

Dare To Invest In Equities.

When you have exhausted refinancing and smart spending you will have exhausted the no risk options. Then, the best step is to begin investing in a broad index fund. SPY, the SPDR S&P 500 index exchange traded fund, provided a yield of 2 percent during 2012. That’s more than the yield on a 10-year Treasury.

And by the way, the index also appreciated about 12 percent during the year.

Retirement Isn’t Just About Income. It’s Also About Flexibility

admin — Wed, 02 Jan 2013 21:00:00 Z

Q. I am retired, drawing Social Security and a pension, with a few other investments and tax deferred accounts. I will soon need to start taking required minimum distributions. I have a 401(k) worth just over $225,000. I am earning about 2 percent annually on this money now. Does it make sense to look at a fixed index annuity that would increase in value based on the investments I choose? I would be guaranteed that the contract would never be worth less than my original investment.

I would also have a variety of choices such as investment options, living benefit options, death benefit options, as well as potential for annual step-ups and income increases. It appears that fees would be about 3.6 percent a year. I have read many things on line, but still cannot decide if this is a good and safe step to take, being retired. — R.R., by email

A. There is a strategic reason not to do this. There is also a practical reason. The strategic reason is that you already have much of what the insurance product offers— a reliable income. You have Social Security and a pension. The likely withdrawal rate you can have by putting your $225,000 tax deferred retirement account into an annuity product is about 5 percent or $11,250 a year. Now compare that to the total of your Social Security and pension benefits. Since you already have a good deal of guaranteed income, what you need in addition is flexibility and a fund to deal with emergencies. That's what you have in your current tax-deferred account. There is no reason to give it up.

The practical reason for avoiding this investment is that it is a complicated product built with smoke and mirrors. The only thing you know for certain is that the annual fees appear to be 3.6 percent. That's nearly twice the current yield on a balanced portfolio. That means the insurance company is taking every bit of the income on your money and a nice slug of principal, every year, in exchange for offering you the sizzle of possible, but unlikely, income gains.

You also need to understand that what you call "income" is likely to be the principal of your investment. So once you start taking withdrawals, the contract will no longer be worth your original investment. In addition, you need to consider the actual purchasing power of your original investment, which will be declining due to inflation. Bottom line: this is not a good choice.

Q. I am a 68-year-old widow, still working part-time at my old job. Recently, my Edward Jones agent quit, so I decided to move my IRA to Fidelity, where my 401(k) is. Everything transferred as is, except for an annuity, which is now in cash. My 401(k) is in Fidelity Freedom 2010. Edward Jones favors American and Lord Abbott funds. Fidelity wants me to decide if I want to change anything. Do you have any suggestions? I would appreciate any ideas. — I.P., by email

A. Edward Jones favors American and Lord Abbott funds because they are traditional retail brokerage firm, selling front-end load funds that provide a commission to the broker. As a practical matter, once the commissions are paid, the annual costs of most American funds are in the same ballpark, or less expensive, than comparable Fidelity funds. And each firm can make proud claims of superior performance for some of its funds, some of the time.

Fidelity Freedom 2010 fund is a conservative allocation fund with less than 50 percent of its assets in equities. It rates only 3 stars (average) from Morningstar and has an expense ratio of 0.59 percent. American Funds Income Fund of America A shares has the same rating from Morningstar and the same expense ratio, 0.59 percent. The largest and most immediate difference if you make the change is that Fidelity will be collecting the management fees, not American Funds.

A more compelling issue for you is whether you can find a fund that will be superior to either the American Funds fund you hold or the Fidelity fund that is being suggested. Fidelity Puritan (ticker FPURX) has a 4 star rating from Morningstar. It also has an expense ratio of 0.59 percent. So there are better suggestions inside the Fidelity camp than what they have suggxsted.

You could also consider moving to Admiral shares of Vanguard Balanced Index, Vanguard Wellesley, or Vanguard Wellington. This would reduce expenses further while retaining the higher performance rating. There are small differences in asset allocation between these funds so they are similar in risk, but not identical in risk.

Fearless Forecasts for 2013

admin — Fri, 28 Dec 2012 21:00:00 Z

Spending money gets easier by the minute. Today, thanks to automatic bill pay and other innovations, our entire income (or more) can be spent before we know it. And we don’t have to lift a finger. Who would have thought that technology could take us this far?

But more is yet to come. Here are my Fearless Forecasts for 2013.

2013 Will Be an Unsane Year

No, I’m not talking about the rock group. I’m talking about the word that increasingly describes our mental condition. Not sane. Not insane. But thoroughly un-sane.

A Great Reward Will Disappear

Having won it for ten consecutive years, the Incorrigible Bloviator Cup will be retired by Donald Trump. The Donald will continue to be an inspiration to bloviators everywhere.

The Biggest Tax Cut of All

“Let’s stop arguing about tax cuts,” a new and brilliant Congressman will suggest. “Let’s abolish all taxes and do it now.” Since we currently only collect 60 cents for every dollar spent, we’re already almost half way to tax-free living. Abolishing all taxes, the Congressman will note, will work better than printing money and storing it in banks that can’t, or won’t, lend. It will mean bigger paychecks for everyone who currently pays taxes and a large increase in worker purchasing power.

The same act will end all the pesky discussion of who pays taxes and how much they should pay. Instead, we will all live in harmony in the world’s first tax-free nation.

We Reach a Critical Realization about Unemployment.

Of the three newly elected Senators who have a demonstrated knowledge of basic arithmetic, one will ask a question no legislator has asked to date: “If 92 percent of all the people are employed and paying taxes, do new jobs really matter when we talk about federal deficits?” He will point out that if it takes 92 percent of all people in the labor force to cover only 60 percent of all federal spending, employing the remaining 8 percent isn’t going to improve things much.

The First No-Payment Mortgage Will Be Introduced

Federal Reserve Chairman Ben Bernanke will suggest a new mortgage innovation. Having reached the limits of payment reduction through lowering interest rates, Bond Buyer Ben will suggest the creation of no payment mortgages. With them, you can buy any house you choose, pledging to pay the mortgage off upon your death. The Federal Reserve, already the biggest buyer of home mortgages, will hold them all since it can print its own money to pay for the houses purchased with the mortgages.

The mortgage will stipulate that if the sale proceeds are insufficient to pay off the mortgage upon your death, up to two generations of your family members may be taken into custody and forced to work off the remaining balance. Most will be employed making coffee for Federal employees under the Federal Employees Minion Act of 2030.

Earlier Fearless Forecasts

A Single Law Will Reduce Unemployment: the Felony Redemption Act

The greatest impediment to getting a job is having a felony record. It is an automatic rejection for employment at most large corporations. In 2012 more than 12 million Americans were unemployed, seeking jobs. Recent estimates of the correctional population on parole or probation but not in jail or prison totals about 5.2 million. A related estimate of the total ex-prisoner/felon population--- those with felony records but no longer on probation or parole--- puts the total at about 20 million. That means 20 million people with a serious impediment to employment.

A single U.S. Senator, one of the newly elected, will propose that any country that can give amnesty to illegal aliens can also give amnesty to non-violent citizen felons.

A National Doctor’s Strike

Congress, having eliminated all taxes, will feel free to do what they have threatened to do to doctors for so many years--- cut their Medicare reimbursement rates. The action will result in the AMA calling the first national doctor’s strike. Docs will call in sick and fail to show up at offices and hospitals all around the country. The strike will go on for months.

The strike will end when it is noticed that the number of people dying has fallen. The embarrassing revelation will produce a major reduction in medical activity in America. Dr. John E. Wennberg, founding editor of the Dartmouth Atlas of Health Care, will say, “I told you so” about the massive savings.

The First Million Saver March On Washington

Frustrated seniors will march on Washington to demand higher yields on their savings. Leaving a path of destruction that can only be compared to Sherman’s march from Atlanta, they will leave a trail of broken ATM machines. “Hey, we did worse in the 60s,” one senior will say, “I just wish Jerry and Abby could be here.”

You Can Cut Investment Expenses Only So Much

admin — Wed, 26 Dec 2012 21:00:00 Z

Q. My husband retired last year at age 63 after hip replacement surgery barred him from continuing to drive a log truck. His employer offered a Vanguard funds 401(k) plan only for the past 15 years so he has less than $285,000. Vanguard called him to determine what to do with his account in retirement. After a brief conversation, the advisor moved the money to the Vanguard Target Retirement Fund (VTENX).

Your last column mentioned funds with expense ratios well below the 0.17 percent this fund carries and I question whether the VTENX is too expensive. I know retirement investing is different from saving for retirement, but I am at a loss to know if his money is in the best fund.

I am 58 and several years from retirement. I work full-time for the State of Oregon, Tier II, so I will not have the candy-coated retirement Tier I folks have. So far, we are not drawing from his 401(k). Instead, we are relying on his Social Security and my earnings for the time being. We owe $135,000 on our home. It is financed with a 15-year mortgage at 4.5 percent. We also owe $30,000 on an RV, which is financed for 15 years at 6 percent. Is there a better, cheaper Vanguard fund or option to us? —V.A., Salem, OR

A. There is a point where trying to cut investment management expenses doesn't do much for you and you’re there. You gain a great deal, for instance, by moving away from investments that cost 2 percent a year to a low cost index fund source like Vanguard because the cost difference may be every dime of dividend and interest income the fund produces and it can go to you rather than a fund company and its sales force.

Look at it this way: If most people have plans that cost 1.5 percent, you’ve eliminated 89 percent of all cost burden already with your 0.17 percent cost fund.

So when you get down below expenses of about 0.25 percent the more important question is how one fund may benefit you more than another. It is possible, for instance, to both reduce expenses and find a fund that will better suit your needs. One of the reasons Vanguard Retirement Income 2010 (VTENX) costs 0.17 percent is that it is not offered in Admiral shares. Admiral shares give you a cost break for making a larger investment and your husband's $285,000 account balance certainly qualifies.

You might consider the Vanguard Balanced Index fund Admiral shares, ticker VBIAX. This fund has an expense ratio of 0.10 percent, a recent yield of 1.83 percent, and a traditional 60/40 mix of equities and fixed income. VTENX has less in equities (about 50 percent) but has some international equities and has a higher yield. Since you are both relatively young and not expecting to make major withdrawals in the near future, a somewhat higher holding of equities would likely better suit your needs.

You'll get a lot more benefit for your cost saving effort if you look for refinancing opportunities on your house or RV.

Q. Are you allowed to show stock losses in your IRA on your 1040 IRS Income tax form? I know you can defer gains, but what about losses? —J. C., by email

A. Money that goes into an IRA account is income that has not been taxed. It is only taxed when it is taken out of the account. As a result, losses or gains while the money is in the account are irrelevant.

This is one of the reasons you should be a bit more conservative with your tax-deferred accounts than with your taxable accounts. If you make an investment in a taxable investment account, you can balance realized losses against realized gains. That's why year-end selling is often called "loss harvesting" as people sell losing stocks to offset realized gains on their winning stocks. If your losses exceed your gains, you can take a maximum loss of $3,000 against other income on a joint return, $1,500 on a single return. If your loss exceeds that annual net limit you can carry the excess forward.

Bytes, BTUs and Bullion

admin — Fri, 21 Dec 2012 21:00:00 Z

I have a confession to make. Although I’m a devoted index fund investor who has kept the bulk of his retirement and taxable accounts allocated in a way that follows the Couch Potato investing suggestions I make in this column, I’ve also got a hidden, dumb side.

It’s not a healthy part of me, so I try to keep it well controlled. Over the last 15 years about 90 percent of Burns family financial assets have been invested in a well-diversified portfolio of the low-cost index funds I write about almost exclusively. The results have been very nice.

The other 10 percent has been in an account where I pick individual stocks. It’s not a “trading account.” It’s a “keep-the-dumb-side-under-control” account. At worst it keeps me from doing dumb things with the rest of our money; at best it might fatten overall performance a bit.

There have been embarrassing moments with this account. One was during the Internet craze in the late ‘90s. I prudently sold JDS-Uniphase, a hot stock that multiplexed light waves to increase the data capacity of fiber-optic cable. What did I buy to reduce risk? Stodgy old WorldCom… Thank you, Bernie Ebbers. Stock picking is a great way to renew humility.

Fortunately, mistakes have been balanced by good moves. Last December the account had only two holdings: Apple and some cash. Over the preceding 3 years Apple had crowded out the other holdings. It kept looking better and cheaper. Everything else was looking expensive. By last January, I was a very nervous guy with 15 percent of financial assets in one stock. And even though I cut back during 2012, I’m still nervous.

Apple stock is swimming against it’s own stunning success. Does anyone not own an Apple product? It may also be the most widely owned stock in history. Those who own it have lots of unrealized capital gains. And lots of people still have unrealized losses in other stocks. So Apple has more likely sellers than buyers, even as the company continues to thrill people with its products.

So I have started to diversify. The question: Diversify to what?

My answer: By slowly shifting from Apple to a Bytes, BTUs and Bullion portfolio. This is a portfolio devoted to technology, energy, and gold. This is my way of voting for the things that work in a dysfunctional and untrustworthy world.

Bytes. I started buying Apple shares when I saw that they were capturing young minds with the iPod and iTouch. At the Northpark Mall in Dallas crowds gathered at the Apple store while a Dell store (since closed) only 200 feet away was empty. Later, Apple introduced the iPad and created a new form for computing. I think Apple will hold mind and market share for years to come. In due course I will buy other tech companies, but for the moment, Apple is still the one.

BTUs. The British thermal unit is the unspoken currency of the industrial world. Whatever happens in technology still depends on energy. Everything else depends on energy even more. If you examine the composition of the major commodity indexes, they are mostly different forms of energy. That means different ways of delivering BTUs. As any environmentalist will tell you, all of our metals, grains and meats depend on energy supplies for their production. Earlier this year I bought shares of Chevron, Conoco and Devon. So far, Chevron and Conoco are showing a profit, but I’ve realized losses on Devon twice.

Bullion. With interest rates on safe investments expected to be near zero for years, investing in most fixed income securities is silly. No one should volunteer for a certain loss of purchasing power. Owning gold may not be better, but it is a good response to a world of compulsory low yields and competitive devaluation of currencies.

When the world starts to see sane governments run by prudent politicians I’ll sell the gold. Until then I’ll keep buying, because I trust gold more than I trust government paper or government policy. The easiest way to hold gold (note I said “hold”, not “invest in”) is to buy shares of a major gold exchange traded fund such as SPDR Gold Shares, ticker: GLD.

Will this portfolio thrive? Maybe, maybe not. Whatever it does, it will keep me from messing with the rest of the Burns family money, and that’s why it exists.

Unless You Are Unhealthy, Deferring Social Security Is a Good “Investment”

admin — Wed, 12 Dec 2012 21:00:00 Z

Q. I just turned 68. I’m a single woman making about $66,000 a year. I was planning on drawing my Social Security in two years when I turn 70. I have about $260,000 in savings and stocks. A financial adviser said I should start drawing Social Security now because it would take until I'm 85 to get my money back from not drawing now. My car and house are paid for and I'm not planning on extensive travel during retirement.

Should I draw my Social Security now...which would mean early in 2013? You always recommend waiting, if you can. I know I can wait because I will work until I'm 70 at least. Please let me know if I'm looking at things correctly by waiting until 70. —K.E., by email

A. If leaving money to heirs or a charity is a major motivation for you, then you might consider taking your benefits now rather than waiting. This would reduce the demand on your financial assets for income in coming years. This would allow them to grow, which would be really nice for your financial adviser.

But if your main goal is to maximize your consumption and security through the remainder of your life, then you should defer taking benefits until age 70 and use your investment assets to cover the cost of the waiting period.

The "payback" period— the amount of time it will take for you to recoup the benefits you forgo during the two years— will be 12.5 years, this includes adjustment for inflation so it’s in real dollars. The life expectancy of all American women at your age is now 17.4 years. It will be 15.9 years when you turn 70. Your expectancy will be higher because people in the top half of all wage earners live about 4.5 years longer than people in the bottom half.

So while no one can say that deferring is a cinch, it’s a very good bet that you will benefit with a higher and more secure income all of your probably longer life.

The clincher on this is the alternative. If you defer $1,000 of benefits for the next two years, the $2,000 you give up will get you a lifetime benefit increase of $160 a year. So your $2,000 "investment" will earn you a lifetime 8 percent payout, adjusted for inflation. Basically, you are making a life annuity investment and getting a return you could not possibly get in the private market.

The people that benefit most from deferral are married couples because if the primary earner defers benefits, the increased benefit will be received during the joint life expectancy of the couple, which is about 25 years. So for couples it pretty much is a cinch. For singles, it’s a good bet, but not a cinch.

Q. I have a question on financial advisers. I read a recent Wall Street Journal article about when exchange traded funds cost too much. The article mentioned that the cost of a managed ETF portfolio should be 1 to 1.25 percent of the amount invested per year. In one of your recent columns, however, you mentioned a method where a person basically bought their own ETFs at a much lower cost. Is there a list of financial advisers that work within the 1 to 1.25 percent cost profile? —C.T., by email

A. The fees you will pay an investment adviser depend very much on the affiliation of the adviser and the amount of money you will be investing. So the important reality here is that moving to low-cost exchange traded index funds won't do anything for you if everything you save on ETF expenses is simply transferred to your adviser. The idea is to find a way so that you get more of the return on your money.

If you start your search among Registered Investment Advisers— advisers who have a sworn fiduciary duty to you— I think you will have a good chance of finding an adviser who will manage your account at 0.5 to 1.0 percent. Whether an adviser can make good enough decisions to recoup his cost is another discussion.

Beyond Envy: Wealth Addiction Revisited

admin — Fri, 07 Dec 2012 21:00:00 Z

“Money is America’s most powerful drug. Here’s how it weakens us and how we can free ourselves.”

So reads the dust jacket of my signed copy of “Wealth Addiction.” The 1983 book issociologist Philip Slater’s take on our growing, crippling obsession with wealth and money. In late 2002 I found multiple copies of the audio version of the book on sale at a Half-Price Books store and flew to California to interview him.

Back then I was thinking that millions of people had just lost a lot of wealth. They could use some therapy about it. And if wealth addiction was a problem in 1983, it was much more of a problem in 2002.

It is even more of a problem today. Our money addiction problem has only gotten worse as the concentration of wealth has increased and we focus more and more attention on extreme wealth. Is the concentration of wealth a problem? Yes. But we won’t solve it by obsessing over how much Gates, Buffett and the other top names on the Forbes list have.

Sadly, both the book and its audiotape version were out of print back in 2002. Worse, there was some uncertainty about who owned the copyright, so my efforts to produce a re-release of the audiotape version were fruitless.

But that was then. If you visit Slater’s website today you can download a free PDF copy of the book. On the website, he cautions readers that the amounts and prices used in the original 1983 text now look silly. “In those days,” he notes, “the word ‘millionaire’ used to mean an extremely rich person. Today we have to use ‘billionaire’ to convey the same meaning.”

I heartily recommend reading this book. Like addictions to drugs or alcohol, it’s easy to dismiss wealth addiction as a problem. “Hey, everyone needs money. We’ve got to have it. It gets us through the day.”

Reasonable use is not addiction, just as a glass of wine with dinner is not alcoholism. We are addicts when we feel lost and incomplete without something, whether it is heroin, alcohol, sex or money.

Wealth addiction, Slater points out, takes quite a few forms. You can test yourself with these simple questions.

Are you a money addict? Do you accumulate it without immediate plans to use it?
Are you a possession addict? Are you obsessed with displaying your wealth through possessions?
Are you a power addict? Do you use your money to gain power or advantage?
Are you a fame addict? Do you crave recognition and use your money to get it?
Are you a spending addict? Can you not stop spending, even when it isn’t necessary to spend?

Addiction doesn’t have to be extreme to affect how you think and live. It can be as simple as an excessive interest in a particular material possession. Some men, for instance, obsess over a particular car, whether it is a Shelby Mustang, a Porsche Carrera or an Aston Martin. For me it has always been houses, particularly having a second home. (Thankfully, I have overcome that!)

One of the hallmarks of wealth addiction is very simple: more possessions, but less use. We become so interested in possession of the thing that we lose the experience it provides. This can be as vast as owning homes all around the world, as some of the very rich do, as simple as Bernie Madoff's shoe collection, or as obsessive as a collection of rare watches. Whatever it is, the wealth addict confuses possession with experience.

Is there a First Step in overcoming wealth addiction?

Yes. Ignore the never-ending attention to wealth in our culture. This means not pondering the wealth of the top 1 percent. It means avoiding the seductive material excess of TV programs like Royal Pains or Revenge, not to mention avoiding the banality of the Kardashians and related pop phenomena.

Instead, we can focus on the abundance most of us already have. For as many as 80 percent of all Americans what we already have is a life of material comfort and ease that is beyond anything dreamed of a century ago; an abundance of possessions even at modest income levels; and an ease of communication and entertainment. All of this gives most of us a capacity to say “enough,” a capacity that surpasses anything in previous world history.

Retirement, Like Beauty, Is In the Eye of the Beholder

admin — Wed, 05 Dec 2012 21:00:00 Z

Q. I turn 56 this month and would like to retire soon. I have questions about whether I can afford to, about health care, and if changing my living arrangements will it make a difference. Here’s the deal.

My wife and I own a four-bedroom house worth around $275,000, which we have paid off. We have no debt, and our 3 children are living independently after graduating from college. I have about $1 million in my 401(k) and other investments, including a $150,000 annuity. Our property taxes are around $8,000 a year. We are both healthy and have excellent health insurance through my employer.

Can I retire before I turn 62? Do I have enough money? And what about healthcare? I have even considered renting vs. owning because I think we could get a nice rental for $1,000 or so per month. That would net to about $4,000 against what I pay in property taxes alone. In addition, I would not have the expenses for upkeep of a 50-year old house.

If I did retire, what would I be looking at in health costs? —D.C., Irving, TX

A. The greatest impediment to early retirement is the cost of healthcare. I have met many people who had buyout offers from their employers— but decided not to take them when they learned how much health insurance would cost before they reached Medicare age. The cost can be punitively high, and that assumes you can get the insurance.

The sad reality is that while modern healthcare can do much that wasn't even imagined 50 years ago, you and I have to treat the healthcare system as if it were a blood-sucking monster. While the doctors and nurses who care for us may be altruists with utterly benign intentions, the institutional delivery of healthcare is bankrupting the country.

You can start exploring costs by getting quotes online. Blue Cross Blue Shield, for instance, quotes plans from about $750 a month to $1,250 a month for a $1,000 deductible plan for a non-smoking couple in their mid-fifties. Plans with larger deductibles cost less.

With $1 million in financial assets you have far more resources than most Americans. Many retired readers would assure you that they do nicely on much less. This is particularly true if you are willing to be flexible about your largest single expense— shelter. As you suggest, you can rent an apartment for less than the operating expenses of your house. This would free every dime of equity for the creation of additional income.

An even better option is the purchase of a low-cost condo or a manufactured home in a 55-plus community. Owning the unit will reduce costs significantly. It could provide you with more space while reducing your out-of-pocket shelter expenses to less than the cost of a rental unit. Let me give you some extreme examples. If you visit realtor.com and check the multiple listings for manufactured homes you will find many in high quality 55-plus communities available for well under $60,000. Something like this would leave you with an additional $200,000 or so to invest. A very quick way to start exploring this notion is to pick up a copy of Where To Retire magazine, available in most Barnes & Noble bookstores.

You'd still have to deal with the blood-sucking monster of healthcare. Fortunately, both health insurance and medical care are much less expensive if you live outside of our country. It's sad that this is the case— particularly since American business has been an engine of low-cost products and distribution— but the reality is that your resources and personal health security will be better if you leave the country. So I suggest you research living in Europe or an Asian country like Thailand— at least until you are eligible for Medicare.

The important reality here is that retirement isn't just about "the number"— the financial assets you need to kiss your job goodbye. You can change the number at will by thinking of retirement as an opportunity to do a major "reset" for your life and embracing the most powerful capacity human beings have— our ability to be flexible and adapt. This, by the way, is beautifully captured in a lovely recent film, "The Best Exotic Marigold Hotel."

Playing Roulette with Long-Term Care

admin — Fri, 30 Nov 2012 21:00:00 Z

Is this the winter of long-term care insurance?

It sure is quiet. In most years my mailbag will have a healthy dose of questions about buying long-term care insurance. This is entirely reasonable. On the one hand, our ever-lengthening life expectancies result in an increasing probability of needing long-term care. On the other, some of the insurance industry’s most active marketing efforts went into the sale of long-term care policies.

But this year is different.

The only reader questions have come from people who already owned long-term care policies. Those readers were trying to figure out whether to continue, or drop, their policies after receiving notice of major premium increases. Not a single reader wrote to ask about whether a salespersons’ proposal was reasonable, probably because so many insurance companies have been de-emphasizing or withdrawing altogether from the long-term care insurance market.

No hyperbole here. Genworth, the largest vendor of LTCI announced major premium increases and a variety of other changes to tighten access to policies. Some companies have stopped selling group policies. Others have stopped selling individual policies. So it is possible that even if you wanted a policy, you might not be able to get it.

This is not a tragedy.

The idea of long-term care insurance is a good one, but it’s really a shame it has been in the hands of, well, the insurance industry. In good times, insurance companies have piled into the market, overestimating the number of policies that would be dropped before claims were made. At the same time they, like everyone else, overestimated the return they would earn on those premiums. The result was artificially low premiums.

Now, in bad times, the industry is facing low returns on premiums and, even worse, a high rate of policy retention. The result is a big squeeze— more claims against less income. Bottom line: As an actual product, long-term care insurance is a great idea, poorly executed.

So let’s ask a rude question: Is the fast fade of LTCI something we should worry about? Here are my tough-hearted reasons that it isn’t.

Most people have minimal assets to protect. As a result, Medicaid is their future if they ever need long-term care. Sorry, there is no way to sugar coat this. It’s the way it is. Since Social Security benefits account for at least 50 percent of income for 65 percent of all retired couples and individuals, paying for long-term care through assets or insurance isn’t possible for most retirees.
You don’t have to be in the 1 percent to self-insure. If your retirement income is large enough support your household in long-term care, you will likely be OK if you need it. In 2011, according to the American Association for Long-Term Care Insurance, the average annual cost of assisted living communities was $40,000 a year. The average annual cost of nursing homes was $76,285 a year. Retirees with incomes that high aren’t common, but when you add in drawing down assets for a period of time, this could be as much as 25 percent of all households.
Death may eliminate the need. Just as financial planners often want us to be 95 percent certain of having money for a 30 year retirement when we have only a 16 percent chance of still being alive after 30 years, the reality is that (a) most people will die before needing care or (b) they will need care for only a short time. Among women, who are more likely than men to need care because they live longer, only 12.4 percent of those age 75 will need care for more than 2 years. Only 3.9 percent will need it for more than 5 years. For men the comparable figures are significantly lower. This suggests that playing Russian roulette with long-term care is a lot safer than playing Russian roulette with a revolver.
The Continuing Care Retirement Community Alternative. You can receive guarantees of lifetime care by becoming a member of a Continuing Care Retirement Community. These residential communities bundle senior residences, assisted living and nursing care in a single property to provide a continuum of care. You become a member with a substantial initial payment and a monthly payment for a broad package of services. Some of the initial payment may be returned to your estate upon death.

Given the uncertainties that we all face, perhaps we should change how we confront major life issues. Rather than think about insuring against change, perhaps we should think about learning how to adapt to change.

Personal Decisions: Often More Powerful Than Investment Decisions

admin — Thu, 29 Nov 2012 03:00:00 Z

Q. A little over a year ago I took over managing of my accounts from our financial planner. I switched the accounts to Vanguard and read a couple of the books that you have recommended. I have read and re-read William Bernstein's "The Investor's Manifesto" and Andrew Hallam's "Millionaire Teacher.” Both are excellent books, especially for beginners like myself.

My question for you regards the rebalancing of the accounts. When the annual rebalancing is done, as has been recommended, do I concern myself with whether the market is high or low? I have been agonizing over this question for a couple of months now and would really appreciate some advice. Also, do you have any more book recommendations for beginners? —S.F., Houston, TX

A. Rebalancing should not be a source of hand wringing. Remember, we don't know the future— so speculating about the best moment to rebalance is not a fruitful use of your time. A less wearing path is to set some time of year, such as anytime in the first quarter, as when you rebalance. Set a date that suits you. And then, if the allocations have moved enough to get your attention, rebalance. If the change is small, don't bother.

Why is the first quarter a good time? Two reasons. First, you are starting a new year and may want to make some cash distributions, even if you have not reach the age of Required Minimum Distributions. If you have reached that age, the need for a distribution is a good time to rebalance.

Both of those books, and their authors, are wonderful. You also can't go wrong with any of the books Daniel R. Solin has written and would likely benefit from "The Smartest Retirement Book You'll Ever Read" (Perigee, 2009).

In addition to the investing side of the retirement question, I think everyone would benefit from books that show the power of personal decision-making. They are important and empowering. Fred Brock's "Retire on Less Than You Think’" (Times Books, 2004) is direct and helpful. So is "Rags to Retirement: Stories From People Who Retired Well On Much Less Than You’d Think” by Gail Liberman and Alan Lavine (Authors Choice Press, 2007).

Q. I am 65 and my wife is 67. We are retired. I currently have a 401(k) with my past employer worth about $618,000. I want to be able to access some money each year for personal reasons, not to exceed 3 percent of the total investment. I understand that at age 70, if I am in an IRA, that one must make required minimum distributions. The 401(k) is currently invested in two bond funds. We also have a reserve account with about $30,000 in it.
Our combined Social Security benefits will be about $40,000 next year. I also have a defined benefit pension of $43,500 a year with a 100 percent survivor benefit to my wife, if something happens to me first. So our total income is about $83,000— without touching the $618,000 in the 401(k). If something happens to either of us it would result in only $14,000 less a year— my wife’s Social Security. I want to be able to take some money out each year this account, if needed, not to exceed 3 percent of total invested.

Our goal is to leave some money to our son. Question is: Should I roll over my 401(k) to a Roth or a Traditional IRA? I would have to pay the taxes with money from the roll over if it is to a Roth IRA. —B.K., Austin, TX

A. Converting to a Roth is a non-starter for you unless you do it in small segments over a number of years, pushing the edge of the 15 percent tax bracket. Since a couple filing jointly can have a taxable income up to $70,700 in 2012 and remain within the 15 percent tax bracket and you also have at least $19,500 in exemptions and the standard deduction— not to mention some of your Social Security benefits not being subject to taxation— you should make sufficient withdrawals from your tax deferred accounts so that you can put as much as possible into Roth accounts without triggering a 25 percent tax rate.

The tax brackets, exemptions and deductions are adjusted for inflation each year so you should have some flexibility going forward. Also, the Required Minimum Distribution schedule isn't harsh: in your first year it is only 3.65 percent. It is, however, more than the 3 percent you wish to distribute, so you may want to re-invest some of your distributions.

This isn't a casual back-of-the-envelope exercise: I suggest visiting with your accountant so you'll have the guidance of a professional. The main thought is that converting to a Roth isn’t worthwhile if you have to pay at a higher tax rate to do it.

Dis-Intermediating Higher Education

admin — Sat, 24 Nov 2012 03:00:00 Z

Few expenses are scarier than college tuition. At both private and public colleges, tuition has been rising faster than inflation for decades. One example is my alma mater, MIT. As I entered, the tuition crossed $1,000 a year.

Yes, it was a long, long time ago. Tuition rose to about $1,200 a year by the time I graduated in 1962. I didn’t think much about the cost at the time because my stepfather paid the bill. He didn’t have to, but he did. Although he never finished college himself, he paid all the bills and I graduated without a dime in debt. I could never thank him enough.

The total cost of tuition over 4 years was less than $5,000. Measured another way, the payback period was about 9 months gross salary at my first job. Viewed as an investment in equipment, getting an MIT education was, as they say, a real no-brainer. If tuition costs had risen in line with inflation, that original $1,000 for a year’s tuition would now be $7,972 according to the CPI calculator on the Bureau of Labor Statistics website.

Today the actual tuition is $40,732 (not including room and board), so it’s pretty safe to say that everyday inflation hasn’t been the driving force behind the increase in college tuition. More important, the payback period, based on a likely starting salary for new graduates of about $65,000, is now about 2.5 years. That’s a big increase, but it’s still a payback period lots of people would like on their investments, so we can’t say that going to MIT isn’t “worth” it from a purely economic perspective.

And as experiences go, I’m sure classes at MIT are as fabulous today as they were back then. If you will excuse my total geekiness, I absolutely loved Uno Ingard’s freshman physics lectures. I was thrilled in the late Patrick Wall’s biophysics course and by the drop-in visits from the late cognitive scientist Jerome Lettvin, not to mention the intensity of Hubert Dreyfus in his existentialism course. These experiences were, well, priceless.

But things have a way of getting back to the economics. Today, if you take a normal coarse load, a college student will have about 360 hours of teacher exposure in a school year. So blowing off the early Monday morning lecture is like throwing away $113. That’s what each contact hour costs. You can get the cost down by taking more courses, but few do it successfully. At least not for long.

You can, of course, cut your cost by going to a public college. But that only cuts the price you pay. It doesn’t cut the actual cost. Taxpayers cover that.

The real problem in higher education is how it is delivered. And that is dictated by the way colleges are structured, which has changed very little in centuries.

Does this mean higher education will be prohibitively expensive forever?

Nope. Enter computers and the Internet as a dis-intermediating force— in other words, moving education out of the lecture hall to a new venue, the internet. Just as the World Wide Web has brought revolution to the newspaper industry, the music industry and the book publishing industry, it may soon be dropping that $113 delivered cost for an hour of talented lecture.

Last spring, MIT offered an online course in circuit design, Circuits and Electronics. It was free. Anyone could take it. According to a recent discussion of the course in Technology Review, 154,000 people enrolled. Of those, 7,157 passed the course. If you’re a glass half-empty person kind of person that could be an intimidating fail rate.

But viewed another way, it is stunning. It took traditional classroom MIT forty years to teach that many students Circuits and Electronics the old fashioned way. If one semester of online class can have the output of 40 years of traditional class, you can bet big changes are coming.

Anyone who doubts this wave of change should check out the expanding offerings at iTunes U or the amazing math lessons at the Khan Academy. Then, just for broad interest, check out the lectures available on the TED Talks. My recent favorite there is the amazing visual display of the global advance for human life expectancy shown by Swedish demographer Hans Rosling.

The price of creating knowledge capital is coming down.

In Retirement, think “Right-Sizing”, not Down-Sizing

admin — Wed, 21 Nov 2012 21:00:00 Z

Q. My wife and I are 62 and 64 respectively. We are fully retired. We own our home free and clear. And we are considering a move in order to downsize and reduce the financial and physical maintenance costs of our current house. We like the idea of renting, though we have always been homeowners in the past, because we don't want to be burdened with the illiquidity of another home.

If we cash out of our current house, we will have at least $200,000 of tax-free funds. We're thinking that this money should be set aside in risk-free or low-risk investments and earmarked for rent payments. In this way, we are paying our rent from the equity in our home. So we won't need to tap into our traditional IRA to boost our income for the rent, thereby avoiding higher income taxes. It will also allow our current budget to be unaffected, even though we will be making rent payments in the future. Is this a sound strategy? If it is, what type of investments would you think to be suitable for the $200,000?

We are also concerned that the folks in Washington, DC may change the tax code to eliminate the $500,000 a couple can keep tax-free of gains from home appreciation. We think that selling our home and cashing out sooner, rather than later, would eliminate this concern. It would also be nice to “beat the rush” if others also decide to cash out of their homes to avoid losing this tax-free benefit. Do you envision a rewrite of the tax code to include the elimination of this source of tax-free cash? —A. M., Dover, DE

A. You may be overthinking this. While reductions in all "tax expenditures" (the label Congress uses to describe any tax breaks people or businesses receive through special tax provisions) are likely to be under consideration for years to come, this is a change that would likely be fought house by house and street by street, as well as by the usual lobbying groups. So a tax change should not be a major consideration in your shelter decision. Also, the tax-free benefit is for appreciation on the house, which is different from home equity.

It's also not clear that avoiding "ownership risk" is a good play since you have to give up the powerful inflation hedge of housing to do it. Finally, it is entirely possible to own a home where virtually all exterior maintenance is taken care of by your homeowner association, e.g. town homes and patio homes.

The real issue here is “right-sizing” not down-sizing: Picking the shelter arrangement that serves you best. So while avoiding or reducing risk is a good idea for your $200,000 of home equity, giving up all return in order to avoid an increase in taxes is pretty close to cutting off your nose to spite your face.

What you could do is (a) establish a cash fund to pay rents for a particular period and (b) invest in a balanced mutual fund that invests in stocks and bonds. Many of these now yield about 3 percent so you would have about $6,000 a year of new income to contribute to your new rental expense. Savings from the lower operating expense of an apartment or condo compared to a house might come close to covering the remaining rental costs.

Q. Social Security benefits change depending on the age when they are begun. Ages 62, 66 and 70 are typically cited. Is there a sliding scale between these benchmark ages? For example, if one retires at 64 are the monthly benefits the same as that realized if one retired at 62? Or are the benefits somewhere between those received at 62 and 66? —J.H., by email

A. Your benefit will be increased for each month of delay from age 62, the earliest age at which you can get benefits. The monthly increases continue to age 70, and then cease. Between your full retirement age (which depends on the year in which you were born) and age 70 your benefit will increase by 2/3rds of 1 percent a month. Between age 62 and full retirement age the increase in benefits depends on your year of birth.

The reduction in benefits for taking them at 62 rather than full retirement age is about 25 percent, a bit more than 6 percent a year. So your benefits will increase somewhat less for the period between age 62 and full retirement age than they will increase for the period between full retirement age and age 70.

Target Mutual Funds: Oops They Glide the Wrong Way

admin — Sat, 17 Nov 2012 09:00:00 Z

Some ideas give us great comfort and security. They’re also easy to market since we all like comfort and security. That’s one reason “Target-date” mutual funds have been the big idea in 401(k) plans since they were introduced about 20 years ago.

Today many 401(k) plans have Target-date funds as the default selection if a worker fails to pick a particular fund— and plan sponsors feel safe making that decision. In 2009, according to a report from the Employee Benefit Research Institute, 43.2 percent of all 401(k) participants used a target date fund if their plan offered one.

Too bad Target-date funds don’t work.

While questions were raised after the 2008 market crash when target-date funds failed to protect the assets of many near-retirees, the marketing blitz for the funds has continued unabated. They are easy to explain, they are a good story, and workers can make a single decision that will last through their working careers. So what’s not to like?

Well, how about lack of efficacy? They don’t do what they are supposed to do. Indeed, I believe the idea just received a fatal shot from Rob Arnott, the creator of fundamental indexes. He’s also a man who loves to ask awkward financial questions, the kinds that often prove the conventional may not be wisdom.

Writing in a recent note from his firm, Research Affilliates, Arnott examined the futures of three workers with different investment paths.

“Prudent Polly” invested in a target date fund that slowly reduced from 80 percent equities to 20 percent equities over her 41years of working. “Balanced Burt” had an identical career and savings but invested in a fixed 50/50 mixture of stocks and bonds. And “Contrary Connie” did just the reverse of Prudent Polly. She started with 20 percent equities and increased her commitment to 80 percent equities over the same 41 years. (Arnott used 141 years of investment data to examine the distribution of results.)

Now guess. Who did best?

It wasn’t Prudent Polly. Not only did Balanced Burt and Contrary Connie do better than Prudent Polly on average, they also did better over the worst time periods all the way up through the best time periods. So the idea of a career glide-path, of prudently decreasing exposure to equities as you approach retirement, sounds good and feels good… but it simply doesn’t work.

If Prudent Polly saved $1,000 a year in inflation-adjusted dollars, she would accumulate enough for a life annuity of $4,590 a year if her results were in the bottom 10 percent of all periods and $11,180 if her results were in the top 10 percent of all periods. Bottom results for the two alternatives were virtually the same while the upside results were the same or better. Balanced Burt ended up with $11,760 in the top 10 percent periods while Contrary Connie ended with $15,070 in the top 10 percent periods. Quite a difference.

Arnott wasn’t satisfied with back-testing the past. He also asked another question— what would the results be like if risks were the same but returns were lower? Since he, PIMCO’s Bill Gross and many others are expecting a sustained period of lower returns going forward, that’s not an unreasonable question to ask. So Arnott reduced the average annual real return on bonds from 3.9 percent to 2.0 percent and the average annual real return on stocks from 8.3 percent to 5.4 percent. Then he recalculated.

The result?

All three investment methods built smaller accumulations due to lower returns, but the disadvantage of Target-date funds remained. While results in the worst performing periods were virtually the same for all three investing methods, the contrary method resulted in a significant advantage in average or better investing periods.

While Prudent Polly accumulated enough for a life annuity of $3,390 a year at the 50th percentile and $5,230 at the 90th percentile, Balanced Burt reached $4,010 and $5,300, respectively, and Contrary Connie reached $3,890 and $6,630.

This leaves us with three questions. How long do you think it will take before the mutual fund industry says anything about this? (Answer: Don’t hold your breath.)
What were mutual fund industry research departments doing over the last 20 years? (Answer: Nothing that had to do with improving results for you and me.)
Where should we be investing our money? (Answer: Probably in a traditional balanced fund with equity exposure of 50 to 75 percent. That range has appeared to be “the sweet spot” in many research reports.)

Don’t Jump For a Lump-Sum Pension Settlement Just Because It Is Offered

admin — Wed, 14 Nov 2012 21:00:00 Z

Q. Like many others, I recently received a "one-time-only offer" for a lump-sum distribution as a settlement for a vested defined-benefit pension. I am 58 years old. The lump sum offer is $250,000. The normal annuity benefit starting now is $1,489/month. At age 65 it would be $2,089.

If I take the distribution and buy an annuity with Fidelity, the monthly benefits are $1,185 and $1,700 respectively. I calculate that the "offer" is asking me to take a 20 percent haircut on my pension! Of course, I can simply take my normal monthly benefit through the pension. But if I do that I am accepting the risk of a future default by my former employer. If that happens, my future benefits would be at the mercy of the Pension Benefit Guaranty Trust Corporation.

So, here is my question: Is it worth 20 percent to eliminate the default risk of the normal pension plan? Are there other factors I am not considering? —S.O., by email

A. Before you take the reduced offer I suggest that you do two things. First, take a close look at the company you work for and the financial condition of the pension fund. If the company is profitable and the pension fund is well funded— at least 80 percent—then you should stick with the company plan and not take the haircut. Assuming the company you work for is publicly traded, you will find information on the funding status of the pension fund in the footnotes of the annual report.

Your next step is to assess your second line of defense: the Pension Benefit Guaranty Corporation. For 2012 the maximum monthly benefit under the PBGC for a 58 year old, according to their website, is $2,652. That’s well above the $1,489 you cited for your earned benefit. The PBGC guarantees fundamental benefits earned before the termination date of the plan or by the date of the company's bankruptcy proceeding. In the event of such events you are likely to lose health and welfare benefits, vacation pay, severance benefits, etc.— but your basic lifetime pension income will be safe.

Bottom line: If your company plan is close to fully funded you're better off sticking with your company pension.

Q. I am 86 years old. I rent an apartment for $3,100 a month plus utilities. The total averages $3,400 monthly. I do not own real estate or vehicles and I have no dependents. I'm considering moving into an all-inclusive retirement community. The average monthly fee is $4,000. I also have to pay an up-front fee but my estate upon my death will recover 90 percent of it.

My monthly income is $12,000 from a combination of Social Security and a company pension. I have about $1.3 million in financial assets—annuities, mutual funds and certificates of deposit. Should I plan on liquidating $400,000 cash as my deposit and not touch the mutual funds or annuities? Is there another approach to paying this entrance fee? —PJW, Austin, TX

A. You've made a good decision— the continuing care retirement community model is a good one. I wish more seniors would consider it, although many balk at the monthly expense.
As a practical matter, a CCRC provides a lot more in its monthly cost than the simple costs of shelter. Lots of bills you have as a renter will disappear. In a recent speech in Oregon, for instance, I compared the cost of a CCRC or owning a house to the difference between what a high-priced luxury cruise actually costs and a cruise line known for lower prices. In the end, the total out-of-pocket costs for both cruises may be the same.

Why? Because the high-priced cruise included lots of things that weren't included in the lower priced cruise line— e.g. excursions, unlimited wine, paid gratuities, etc. Similarly, lots of services and amenities are rolled into the monthly cost of a CCRC that aren’t part of the regular monthly cost of owning a home or renting.

As to the entry payment, take as much as possible from your low-yield cash investments to make it. Remember, many of the contingencies that you have worried about will now be covered by your new living arrangement. In addition, your other sources of income indicate that you don’t have to draw heavily on your financial assets.

Life, Death and How Long Your Money Will Last

admin — Fri, 09 Nov 2012 21:00:00 Z

When I talk to large groups I like to ask a peculiar question: If you have never been surprised, will you please raise your hand?

Whether the group is 100, 300 or 600 people the result is always the same. No one has ever raised a hand.

The question produces a lot of rueful smiles. People recall events they would, mostly, rather forget. It’s also pretty dramatic proof that somewhere between birth and age 65 most of us discover that life is full of surprises. That’s why one of the persistent themes in this column is adaptation. Just as Ronald Reagan said, “Trust, but verify”, I believe we should ‘plan, but adapt.’

Nothing brings this out more clearly than the “safe withdrawal rate” question. How much can we withdraw from our retirement savings without running out of money before we die? The question has been actively discussed and researched by financial planners and academics since the mid-1990s but there is still no hard, definite, answer. This happens because the answer depends on what you assume about the future.

If you start with a 60/40 equities/fixed income portfolio, for instance, history says it will be safe to withdraw 4 percent a year for 30 years 97.45 percent of the time, a failure rate of 2.55 percent. But if you withdraw more or if future returns are lower than historical averages, the failure rate will go up.

It is important to know that financial planners are a persnickety group. They like to offer us security. Many cater to the idea that, with their help, it will be a 95 percent lead pipe cinch that we’ll be able to sustain our current standard of living for 30 years. They pick 30 years because that’s how long we might last.

As a practical matter, I’m not convinced this is a reasonable standard for ordinary mortals. While some people would like to leave big bucks to their kids, alma mater or favorite disease, the reality is that most of us will settle for squeaking through our last day just barely solvent. We also have a gut feeling that anyone talking about being 95 percent certain of anything 30 years in the future is probably delusional.

So I propose a different measuring stick: How long are we likely to live? Like portfolio survival, how long we live is uncertain. But as a practical matter, there is a 100 percent certainty that we will all die and, so far at least, we have all preferred to die well before reaching age 100. The longevity figures change over time, but the change is gradual.

You can start to visualize this by comparing portfolio survival rates with the percentage of people who survive for the same period of time. Here are the major events, all focused on the 30-year period from age 65 to 95:

Portfolio Survival:

97.45 percent of 4 percent withdrawal portfolios will survive 30 years
86.18 percent of 5 percent withdrawal portfolios will survive 30 years
69.83 percent of 6 percent withdrawal portfolios will survive 30 years

Human Survival:

84 percent of 65 year old couples will have no one survive 30 years
16 percent of 65 year old couples will have one person survive 30 years
1 percent of 65 year old couples will both survive 30 years

These figures convey some important realities.

84 of the original one hundred 65-year-old couples needn’t worry about portfolio survival, because they won’t be around to experience it.
Although 16 of 100 couples will have one spouse survive 30 years, only 5 couples will face running out of money at a 6 percent withdrawal rate. They may be able to avoid running out of money when they support one person rather than two. In other words, they have an opportunity to adapt.
Only 1 of 100 couples will have both survive 30 years.

Is this the last word on the running-out-of-money problem?

Absolutely not. If future returns are lower than historical returns, the odds change.

Similarly, if you are among the top 50 percent of all earners during your working life, you’re likely to live longer than average, so you’ll need to allow for that.

The bottom line, however, is that death reduces the risk of running out of money more than does portfolio management.

Quantitative Easing and Your GNMA Mutual Fund

admin — Wed, 07 Nov 2012 21:00:00 Z

Q. My wife and I are both in our seventies. We have a considerable amount of money invested in the Vanguard GNMA mutual fund. How will the latest move by the Federal Reserve to purchase mortgage bonds affect this fund? I have a feeling this does not bode well for us. —J.R., by email

A. Let's start with getting an idea of just how large the Federal Reserve’s promised monthly $40 billion purchase is. The Vanguard GNMA fund (ticker:VFIIX) is the largest, by far, of all the funds that specialize in securitized, government-backed mortgages. Formed in 1980, it has grown year after year through a combination of low expenses and superior performance. According to Morningstar, the fund has ranked in the top 19, 15, 9 and 4 percent of competing funds over the trailing 3, 5, 10 and 15 year periods. Over the last year it has been in the top 36 percent.

All that said, Federal Reserve mortgage purchases to stimulate the economy by suppressing interest rates will be done at a rate sufficient to absorb the entire Vanguard GNMA fund— in the first month. It would take only a few more months to absorb the entire mutual fund sector that specializes in GNMA securities.

The entire GNMA market, however, is about $7 trillion, a much larger figure. Even so, these monthly purchases will have a profound effect. Whether it will be good, or bad, for you as a shareholder is another question. Here's why.

If you buy a conventional bond fund, the value of the bonds will decline when interest rates rise and rise when interest rates fall. This happens because the value of the fixed interest rate coupon on your bond remains the same, so new investors will pay more or less for it depending on whether rates rose or fell.

That doesn't happen with a mortgage-backed security. Why? Because the people making mortgage payments are free to refinance or keep their mortgages. So guess what they do?

When interest rates decline, they refinance to lower rates, depriving the mortgage owner of an increase in value. When interest rates rise, they hold onto their mortgages longer than they otherwise might. This locks the mortgage investor into a below-market yield and causes values to decline somewhat.

As a consequence, the cash yield on GNMA funds has run a bit higher than the yield on comparable conventional bond funds. Although the average effective maturity, according to the Morningstar website, of the fund is 5.5 years, it's recent yield was 2.94 percent. The yield on a 5-year Treasury at the same time was 0.65 percent. That suggests holders are being well rewarded for their interest rate risk.

Will you lose money or face some disaster? Probably not. What you should prepare for is a continuing decline in interest income from the fund.

Q. I am probably not going to earn enough credits to qualify for Social Security. Does this mean I won’t qualify for Medicare as well? Or is Medicare something one automatically receives? —M.S. by email

A. Those who don't qualify with enough work credits through the regular Social Security program can qualify for Supplemental Security Income benefits. This program guarantees that everyone has at least some level of disability or retirement income, even if they haven't worked long enough to qualify for Social Security.

Supplemental Security Income is funded from general revenues, not from the employment tax. Currently, some 5.5 million people receive SSI benefits according to the Social Security Administration. The majority are disabled and under age 65, but some 908,000 are 65 or older. In all states, the SSI benefit is reduced for people who live in the households of other people.

This year the basic monthly SSI payment is $698 for an individual and $1,048 for a couple. This compares to an average monthly benefit of $1,130.94 for individuals who receive Social Security retirement benefits.

The basic SSI monthly benefit is often supplemented with additional funds that vary from state to state. According to the Social Security website, for instance, the monthly minimum in California is $854.40. If you qualify for SSI benefits, you will also qualify for Medicaid. In addition, you will also be eligible for food stamps. The value of food stamps now averages $133.14 a month. Currently, 46.4 million Americans are receiving food stamps.

Lacy Hunt: The End of the Yield Famine Is Far Away

admin — Fri, 02 Nov 2012 21:00:00 Z

If Lacy Hunt was into making bumper sticker style sound bites, his would be a riff on James Carville’s “It’s the economy, stupid.”

The Hunt sound bite would simply say: “It’s the debt, stupid.”

But Dr. Hunt, the economist at Hoisington Investment Management, an Austin fixed income asset management firm, isn’t into sound bites. Instead, he’s a meticulous data collector who has been telling clients, year after year, that interest rates were headed down. Those who doubted or bet against him, thinking interest rates couldn’t possibly go lower, lost money.

Earlier interviews with Dr. Hunt

Scott Burns, “Interest Rates Can Go Lower, But You Won’t Like It,” 7/23/2010

Scott Burns, “High Debt Means Deflation, Not Inflation,” 6/5/2009

Scott Burns, “Lacy Hunt: Expect Lower Interest Rates,” 11/25/2006

Scott Burns, “Different Drummer Investing,” 5/29/2005

Scott Burns, “A Future of Low Growth and Lower Interest Rates,” 2/23/2003

The reason this is happening, he argues, is that we’re in a long-term slump due to massive over-indebtedness. We’ve simply got too much debt for the economy to return to normal growth. Worse, none of the usual policy fixes— like debt-funded government spending— will work.

So I’m visiting with him now, looking for answers to some vexing questions. Like, if debt is the problem, what is the solution?

Or: Yes, but what about the positive signs like housing and car sales?

Or: How long can this low interest rate siege last?

Borrowers will love his answer to the last question. Savers will be troubled. Flipping through one of his chart collections, Dr. Hunt comes to a chart that overlays the history of interest rate declines after major financial panics. If the future replays such past events, it takes about 14 years for interest rates to hit bottom. Since our last financial debacle was in 2008, that suggests interest rates may continue falling until 2022. Yes, savers, you read that right: 2022.

And when that happens, the same data shows that long-term government bond yields will bottom at about 2 percent, compared to their current rate of 2.9 percent. Even 20 years after financial disasters like 2008, interest rates are only about 2.5 percent.

Savers are facing a yield famine that could last beyond 2028. And borrowers who just refinanced their homes at 3.5 percent may have yet another opportunity to reduce their mortgage payment.

What about the signs of recovery in auto sales and housing?

He shakes his head. Probably not sustainable, he suggests. “Student loan debt keeps rising. Real household income continues to decline. It doesn’t work if you add jobs that pay $20,000 to $40,000, but you lose jobs that pay $70,000.

“The median household income has declined more over the 3-year expansion than it did during the recession.” he points out. “Median household income is down from 1997 and unchanged from 1995.”

Is there a government policy solution?

Not much hope there, he observes. “The Federal Reserve has really been on the wrong course for a long time. It started with the response to the S&L crisis in the early ‘90s, then the Long Term Capital crisis, the failure to regulate the growth of mortgage debt after 1995 and all three quantitative easings— all involved liquidity injections and reduced interest rates. And it is continuing now.”

“The argument is that if you have gains in the housing and equity markets (induced by low interest rates) you’ll stimulate consumption. But it really depends on who has the higher propensity to spend out of income, savers or debtors. Remember, the income of one is going up and the income of the other is going down.

“Another problem with additional debt is that it’s likely to be the wrong kind of debt— debt that won’t generate enough income to repay itself… The process of building this massive debt takes a long time and in the build-up there is a persistent erosion of economic capability.”

As a consequence, he points out, the favored response from Washington is likely to make our economic problems worse, not better, because the only “cure” is time— time for the burden of debt to decline.

But what happens, I ask, if debt just continues to climb?

“At some point, a government will exhaust every avenue for obtaining new credit,” he said.

Dr. Hunt then gives me a modern vocabulary lesson. He notes that the limits of government borrowing are such a big part of current discussion that we’ve now got four different phrases for talking about the same event:

“The fiscal limit” (the least scary, most polite description);
“The Keynesian Endgame” which references the end of an idea about the role of government that has dominated economics for more than 75 years;
“The John Cochrane Condition” which references an important but little known paper; and, finally, the dramatic;
“The Bang Point.” That’s when lenders will say to all the big borrowing governments, including ours: “In God we trust. All others pay cash.”

Buying Your Retirement Home Early Can Be a Good Idea

admin — Wed, 31 Oct 2012 22:00:00 Z

Q. My wife and I would like to retire in 3 to 5 years (I am 60 and she is 56). We are wondering if we can buy a home in Corpus Christi. We would then rent out the home, either short term or long term, with the goal of eventually moving to the area and making this our retirement home.

We stayed in this home during our summer vacation. We really enjoyed the house and location. In the process we got to know the owners (a retired couple with 3 rentals in the area) and it turns out they would like to sell the house we rented to buy an additional beach property (this house is not on the beach, but inland about 15 minutes from the beach). ??

The selling price is $130,000. It is very well maintained, fully furnished and is fairly priced based on area comps. They also have a guest list of previous renters/vacationers via VRBO that they would share (the home has been a rental for about a year). My main concern is that we live in Dallas. They live in the area and perform the major property management duties. If we did buy it, we would look for a long-term rental versus short-term vacationers. We would also look for a reliable property management company.

We have modest assets: 401(k), $260,000; IRA's, $80,000; emergency fund, $60,000. Our home is paid for and worth about $300,000. ??I make $125,000 per year and my wife about $20,000. We save about 25 percent of our income and?the only debt we have is $14,000 on a new Prius.

Do you think buying this house in Corpus to diversify and eventually relocate is a good idea? —J.R., Dallas, TX

A. Yes, I do. The basic facts here suggest that you are hoping to do what many retirees do— move from an expensive area to a less expensive area and a less expensive house. Moving from a $300,000 house to a $130,000 house will liberate $170,000 to use as income producing financial assets while reducing your shelter expenses at the same time. That's a big and positive lever on your retirement living expenses.

Buying the house now may pinch your savings rate unless the rents cover the operating expenses (unlikely), but the deal is probably a good bet, as long as you understand that it is a bet and you'll need to tend your other resources very carefully to have enough assets to retire. If the numbers don't work in 5 years—when your wife will still be under minimum age to collect Social Security— you can finesse things quite a bit by working longer. You won't be alone.

If a mortgage on the house is hard to come by, you can use part of your emergency fund for the down payment and finance the rest with a home equity credit line on your primary home, but a first mortgage on the home you are purchasing would be better.

Q. I will be receiving a pension of about $24,000 a year soon. ?How much do I need to have invested (say in a mutual fund) to counteract?the effects of inflation over time on that $24,000? I have other investments and will have Social Security, but I'd like to know how much to set aside to keep the buying power of my $24,000?the same over time. —S.S., Austin, TX

A. Inflation-adjusted life annuities are rare. When they were more available they cost roughly 50 percent more than a fixed life annuity for the same starting payment. So your inflation compensation fund would need to be about half of the value of your $24,000 annuity. That value will depend on your age, so I suggest you look at current life annuity offers and terms on www.immediateannuities.com.

Recently, a fixed single life annuity for a 65 year old man required a payment of $345,399 to provide a fixed lifetime income of $2,000 a month. That's a payout rate equal to 6.95 percent of your payment. That suggests you would need a side fund of about $172,000 (one-half of that $345,000 cost) to compensate for future inflation. The operative word here is “about.”

This "do-it-yourself" inflation adjusted annuity would not have an insurance company guarantee backing. It would, however, also create the possibility of increases in monthly income slightly in excess of inflation and the possibility of leaving an estate. The operative word here is "possibility."

(Nearly) Free, at Last: A New Opportunity at Schwab

admin — Fri, 26 Oct 2012 21:00:00 Z

Discount broker Charles Schwab has opened a new kind of office in Dripping Springs, Texas. Don’t worry if you didn’t hear about it. I only noticed because that’s where we live.

Both Schwab and Fidelity have traditional offices in the city of Austin. That’s what you would expect: it’s where the money is. Dripping Springs, on the other hand, is a very small town, most often identified by a stoplight at the intersection of two highways.

So what’s going on? The new Schwab office is part of a new opportunity that is developing for frustrated savers and investors. Most of Schwab’s 300 offices, like Fidelity’s 170 offices, can be found in major urban areas. This office is one of the first of an expected 300 new offices to be operated by individuals as franchise ventures. By expanding with smaller offices, Schwab is taking a major step toward offering an alternative to conventional brokerage and financial services to just about everyone. Schwab is bringing the cost structure of discount brokerage— the business it pioneered— to places that previously have only been served by high-cost brokerage offices and other high-cost selling methods, such as insurance.

The second part of this opportunity is Schwab’s recent announcement of going further into the world of low-cost, commission-free exchange-traded-funds. After startling the industry at the beginning of 2011by announcing that their own ETFs would be offered commission-free, Schwab is now offering a broader selection of its own ETFs at costs that are lower than the equivalent ETFs at Vanguard. (Significantly, the expenses for iShares ETFs have also just been cut, bending to the power of Vanguard pricing.)

Here are some examples:

The Vanguard Total Stock Market ETF (ticker VTI) has an annual expense ratio of 0.06 percent. Schwab has priced its equivalent fund, the Schwab Multi-Cap Core ETF (ticker SCHB) at only 0.04 percent.
Vanguard’s Short-Term Treasury Inflation-Protected Securities ETF (ticker VTIP) is priced at 0.10 percent while Schwab’s equivalent ETF, the Schwab U.S.TIPS ETF (ticker SCHP), is priced at 0.07 percent.
Vanguard’s MSCI EAFE ETF (ticker VEA) has an expense ratio of 0.12 percent. Schwab’s equivalent ETF, Schwab International Large Cap (ticker SCHF) has an expense ratio of only 0.09 percent.

Anyone with a $1,000 deposit can open a checking account and an IRA account, set up direct deposit of their paycheck to the Schwab checking account and arrange for automatic monthly purchases in their IRA account. The same worker can then create a simple Couch Potato portfolio (50 percent Total Stock Market, 50 percent TIPS) and the cost of her plan is only 0.055 percent. Get more complicated and build my Couch Potato Margarita portfolio (1/3 Total stock market, 1/3 International stocks, 1/3 TIPS) and the cost is still under 0.07 percent.

This is a big deal.

At the risk of sounding hyperbolic, it is like being released from the decades of bondage to expensive defined contribution plans. It means that virtually anyone, anywhere, can now have a retirement savings plan at a cost that rivals the biggest and most cost-efficient plans in the country— the plans at places like IBM, Exxon-Mobil and Texas Instruments.

Over a 35-year contribution period, I estimate that keeping more of the return on your money will accumulate 20 percent more retirement assets than plans that cost 100 basis points a year. It will accumulate about 45 percent more than plans that cost 200 basis points a year.

You can benefit from this if you answer yes to these three questions:

Does your employer sponsored 401(k) or 403(b) plan have a cost burden of more than 1 percentage point a year? (This will be most teachers in 403(b) plans and most workers in small plans.)
Is there no employer match for your contributions? (Employer match can compensate for high plan costs, but many plans don’t have an employer contribution.)
Do you contribute $5,000 a year or less to your current plan? (While contributions to 401(k) and 403(b) plans are limited to $17,000 a year or $22,500 a year if age 50 or older, IRA contributions are currently limited to $5,000 a year or $6,000 a year if age 50 or older.)

Since most workers contribute 6 to 8 percent of income to retirement plans, it’s a good bet that many workers who earn up to about $80,000 a year would benefit by taking advantage of new cost reductions for basic exchange traded funds.

That’s a whole lot of people.

Federal Retirees with Pensions Should Focus on Keeping Some Liquid Assets

admin — Wed, 24 Oct 2012 21:00:00 Z

Q. I retired a year ago last June from the federal government. With my Civil Service Retirement System retirement and my husbands’ Social Security we have enough money to live on. I also saved in the Thrift Savings Plan, expecting to use this money for travel.

The problem is you can only take a one-time partial withdrawal. I took that withdrawal for travel this year. Now I have a decision to make. What is the wise thing to do at this point? Should I roll the remaining money over into an IRA or take a monthly payment until it is used up. I'm a little concerned that if I take a monthly distribution, there might be a problem if we had a financial emergency and needed cash. I am 63 if that makes a difference.

If I roll it over to an IRA, can I take withdrawals before I am 65? Do you have any suggestions about an IRA that would be fairly safe? —V.H., by email

A. Your Thrift Savings Plan (TSP) assets are what many call "the third leg" of retirement security— liquid financial assets that supplement your Social Security and pension income. You are entirely correct in your concern about converting your TSP assets into a lifetime income. You already have that. What you need is flexibility, so rolling to an IRA is a good alternative. And after age 59 ½ you can take withdrawals without penalty or limit.

You will be hard pressed to find an IRA Rollover with investment choices that will be as inexpensive to run as the choices in the TSP plan, but you can avoid a major shock (and waste of money) by using low-cost index funds, such as the mutual funds or exchange traded funds that are used in my Couch Potato portfolios.

If you want to keep it simple and do one-stop shopping— the choice many people prefer— then Vanguard Balanced Index fund Admiral shares (Ticker: VBIAX) are a good choice. Admiral shares require a minimum investment of $10,000.

The fund invests your money in a 60/40 mix of domestic equities and fixed income— a traditional balanced fund. It does this for 0.10 percent a year, a fraction of the cost of managed funds, yet has quite consistently done better than the majority of managed funds. Over the last 3 and 5-year periods the fund has provided a higher return than 89 and 93 percent of its managed competitors, respectively.

Will it perform so well forever? Probably not, but history suggests that it will do better than about 75 percent of the alternatives you might choose. You can invest in this fund by opening an account with Vanguard. You can also invest in it, for a small commission fee, by opening an account at Schwab, Fidelity or TD Ameritrade. All three of these firms have physical offices in major cities. Many people feel more comfortable visiting an office.

Q. With the recent droughts and continuous population expansion, do you think that water, or water rights, should be considered to be a precious commodity, similar to that of oil and gas resources or gold? Do you have any suggestions of how to efficiently invest now in this asset class? —S.S., Dallas, TX

A. In America we think a water shortage is when we are told to reduce automatic lawn sprinkling. But the reality is a lot tougher than that, particularly outside the industrialized world.

Yet even in the United States we face a major collision between water supplies and population growth in the Southwest, witness Philip L. Fradkin's "A River No More: The Colorado River and the West" (paperback edition, University of California Press, 1996). Water is in short supply in Florida and I have been in Rockport, Massachusetts during a water shortage when neighbors with views of miles of ocean reported on other neighbors who watered during a ban.`

Other fairly recent book titles include "Water Wars," "Last Oasis," "Blue Gold," and "Whose Water Is It?” just to name a few. This is an issue that is well researched and documented. Whether that translates into water being an investment is another question. PowerShares, for instance, offers two exchange traded funds that focus on water.

PowerShares Water Resources Portfolio ETF (ticker PHO) and PowerShares Global Water Portfolio ETF (ticker PIO) have expense ratios of 0.66 percent and 0.75 percent, respectively, which makes them relatively expensive for ETF shares but a good indication that lots of people are thinking about water scarcity.

Vote Brisketarian!

admin — Fri, 19 Oct 2012 21:00:00 Z

“Vote Brisketarian,” the T-shirt proclaims, flanked by images of two American flags. The T-shirt appeared last spring during the annual Dripping Springs (Texas) Cook Off. More than 100 brisket teams took the heat to see who made the best brisket.

As with all true competitions, there may have been some disappointed producers among the Brisketarians, but there were no unhappy consumers. Trust me, no one muttered about the lack of two chickens for every pot. I just wish the Brisketarians could be a little more serious about their politics.

Why? Brisketarians may be our only hope. As I see it, if the Brisketarians in the red states could form a coalition with the blue Pastramian states in the Northeast, we’d never hear from the Democrats or Republicans again.

It’s pretty clear today that neither party would be missed if there were an alternative. Skeptics should consider the current 12 percent approval rating of Congress, a tie for the lowest rate in history. If that isn’t enough, consider the choices the parties are providing in November: an Apostle of Apology and a Wizard of Success.

Whatever their differences, the Brisketarians and Pastramians share the same cut of beef, so I think they have a future. What they need is a platform one that could save the country. So here it is. And fear not: Potato salad, coleslaw and pickles come with the plate.

Chuck the Entire Tax Code. Do It Now. Commit any incumbent who defends it, or wants to continue tinkering with it, to life occupancy in the nearest mental institution secure enough to handle the criminally insane. Replace the employment tax, personal income tax, and corporate income tax with a national sales tax. Make it genuinely progressive with a hefty pre-bate based on household size unlike the largely fictional and highly uncertain progressivity of the current system. Stop the insanity. This single action will do more for our country than any other. It will increase tax revenue. It will reduce prices to consumers. And it will tax our ever-growing shadow economy.
Make Bankers Take Risks With Their Money, Not Ours. This can be done through something called “Limited Purpose Banking” which, as the name suggests, limits the amount of risk banks can take. Banks that want to take risks can, but the bankers, not taxpayers, will bear full liability for losses. No more bailouts from taxpayers. Watch how the presence of actual risk will improve attention to loan quality.
Create a Unified Savings Plan for What Workers Don’t Spend. Since money saved is money not taxed under a national sales tax, the current hodge-podge of tax deferred savings plans can be simplified and contributions would be unlimited. It would be handy, however, to have an automatic, low-cost and easily managed plan. With automatic deposit of paychecks this can be done through our new limited-purpose banks offering a wide variety of dirt-cheap exchange-traded-funds.
Restore Social Security To A Pay-As-You-Go Basis. And pay for it with national sales tax revenue. Return fraudulently taken overpayments of employment taxes collected since 1983 to workers as I suggested some time ago.
Cap Medicare As a Percentage of GDP. Remind current and future retirees that 80 percent of all advances in life expectancy were from improvements in public health, not heroic doctors and warm-hearted hospital administrators. Stop allowing the medical/pharma complex to use government to increase its revenue faster than anyone can pay or the economy can grow. Trust me, the result will be innovation, improvement and reasonable use of healthcare, not shorter lives or poorer health. Provide federal funding for medical education of doctors, physician assistants and nurses, increasing the supply of all three and reducing the pressure medical education debt creates to focus on specialties rather than primary care.
Make Friends and Feed the World. Do it by ending subsidies for ethanol and redirecting crops from fuel to food, reducing prices by increasing the available supply of food crops. Couple it with aggressive expansion of all domestic energy sources.
Be Energy Efficient, Produce Domestic Energy and Starve a Terrorist. Set our drillers free; unleash Amory Lovins ideas in “Reinventing Fire.” Every dime we don’t spend importing oil is a dime very well not spent. Anything close to energy independence would allow major reductions in military spending.

Future Medicare Premiums Are Not Going To Soar

admin — Wed, 17 Oct 2012 21:00:00 Z

Q. I am 76 years old. I have followed your column in the business pages for many years. After losing nearly 50 percent of my assets after 9/11 I followed your suggestions about TIPS. I am happy to say that my IRA and savings accounts have remained steady and even gained back some of their losses.

I recently read that Medicare premiums are slated to rise to $120 a month in 2013, and to $247 a month in 2014. Is this true? If so, why has no one made it known to the voting public? This would mean that almost one-third of my Social Security check will go to Medicare. Worse, I still have to pay $292 a month for my Medigap policy.—P.P. from Lockhart, TX

A. Don't believe everything you read on the Internet. The standard premium this year is $99.90, up only slightly from $96.40 in 2008. You have received one of the many totally unfounded chain emails about future Medicare premiums. Don't take my word for it: Read this careful explanation on the politifact website: www.politifact.com/truth-o-meter/statements/2011/oct/27/chain-email/medicare-premiums-going-due-obamacare-chain-e-mail/

Most retirees don’t know that the system has a safeguard built in, the hold-harmless provision.

In any single year the increase in the Medicare premium cannot be greater than the increase in your Social Security benefit. This doesn't protect you from having Medicare premiums absorbing a larger percentage of your Social Security benefit over time, but it does protect you from large increases in any single year. This provision is why Medicare premiums were frozen for existing Social Security recipients in the recent years of zero benefit increase.

Q. About 3 or 4 years ago, I sent you an email and asked if I was eligible for Social Security widow's Benefits. You told me I was and I immediately applied for them and was receiving roughly $926 per month for a year or more. I then turned 62 and my financial advisor strongly suggested that I go ahead and take my Social Security early rather than wait. My social security check at that time (roughly 3 years ago) was $1,646 a month. I did as he suggested and therefore lost my $926 in Widow Benefits but picked up my own Social Security of $1,646. If I had waited until 66 it would have been $2,279 and at 70 - $3,066.

I can't help but wonder if I did the right thing. It just doesn't seem right to me but the investment advisor ran some spreadsheets and claims it was the right decision. What do you think? Did I do the right thing? If not, should I pay back what I have received and wait it out? —M.W., by email

A. There is no final calculus for this because the decision depends on your assets and other income, your life expectancy and the condition of the markets.

Generally speaking you will benefit by each year of delay, even if you spend assets equal to the benefits you defer, because spending the assets will buy you a greater income than what you could buy in the private life annuity market with the same amount of money.

Unless you have a life-shortening health condition, the odds of benefiting are also very good. You would recover the income lost through deferral, in real terms, in about 12 years and the life expectancy of a woman at age 62 is about 21 years. This perspective assumes you are trying to maximize your lifetime income and have minimal concern about leaving an estate.

The best argument for taking the increased benefit early is situational. Our finances are most damaged when we sell assets in a depressed market. The need to make withdrawals in a bad market is the kind of thing that can start an irreversible downward spiral of financial assets. Your financial advisor may have been considering this when he made the suggestion, particularly if he did it in 2008 or early 2009 when stock prices were sinking fast. The Standard & Poor’s’ 500 Index fell about 37 percent during 2008 and fell still further into early 2009.

While the option to change your mind about benefits, pay them back and reset to a new level still exists, it is now limited to a 12 month time period. So that option is closed for you.

OK, How Much Is Your 401(k) Plan Costing You?

admin — Fri, 12 Oct 2012 21:00:00 Z

“Fee disclosure has had an effect. The amount of requests for proposals has increased. Plan sponsors are getting bids to compare offers and plan fees.”

That’s what Joe Valletta, co-publisher of “The 401(k) Averages Book” told me in a recent phone interview.

If all this seems obscure to you, let me assure you that it isn’t. This is the Year of Full Disclosure for 401(k) plans, the first time— ever— that plan providers must disclose all their fees, charges and revenue sharing arrangements to comply with new Department of Labor standards. The new statements are just going out, now, to plan participants.

Some plan sponsors will be shocked. Their employees may be even more disturbed when they learn that 2 percent, or more, can be coming out of their plan assets every year. While 401(k) plans with lower costs have received a lot of media attention in recent years, they were mostly plans offered by large employers: Think ExxonMobil and Texas Instruments. In 2009, for instance, Business Week lauded IBM for “reinventing” the 401(k) plan.

What did reinvention mean? Cutting fees to about 10 basis points— 1/10 of 1 percent— largely by shifting from managed mutual funds to low-cost index funds. As I have pointed out in many columns, cutting plan costs can be as important as having a hefty employer match.

Cutting plan costs can also mean having a much larger retirement nest egg. Here’s an example. Suppose twins Joe and John choose identical careers with salaries of $50,000 at age 30. Suppose both save 10 percent of their income and both receive raises of 3 percent a year. Suppose both also target retiring at age 65 and have plans that have identical returns of 7 percent, before fees. The only difference is that one plan has expenses of 1.5 percent while the other has expenses of 0.5 percent. How big a difference will costs make?

The twin in the high cost plan will accumulate 6.59 years of final income while the twin with the lower cost plan will accumulate 8.85 years of income, a difference of 34 percent. Reduce the cost to 0.10 percent and the amount accumulated will rise to 9.6 years of final income.

It helps, of course, to have the muscle of a very large plan. When Business Week applauded IBM its plan had some $27 billion in assets. That’s a whale of a plan. While expenses have declined marginally for all plans over the last 5 years, the bigger the plan, the greater the likely cost reduction. Here, for instance, is how costs for smaller plans have changed from the 2007 to the 2012 edition of “The 401(k) Averages Book”:

Between 2007 and 2012 the average total expense of plans with 2,000 participants and $100 million in assets fell 15 basis points, from 1.09 percent to 0.94 percent.
Over the same period the average total expense of plans with 200 participants and $10 million in assets fell 8 basis points, from 1.28 percent to 1.20 percent.
Plans with only 25 participants and $1.25 million in assets saw an expense reduction of only 3 basis points, from 1.59 percent to 1.56 percent.

When I asked Mr. Valletta if he had seen any change in the cost of smaller 401(k) plans since the new disclosure law went into effect he said, “We’re not seeing it at the lower end. There has been an increase in the offerings of large cap index funds in the line-up but not across the board… There’s just not the pricing flexibility in the smaller plans.”

One category of small plans he thought would benefit from fee disclosure were those of many small medical groups. These plans, he pointed out, typically have a few doctors with most of the assets and other employees with much smaller amounts.

“With fee disclosures,” he said, “Doctors will have better choices because they will be shown what they are paying.”

Who, I asked him, would be shining a light on plan costs?

“A lot more people (consultants) are specializing in 401(k) plans. And these people know how to use index funds and reduce costs,” Mr. Valletta said. “And if it doesn’t happen at the plan level, individuals can look at the plan fund menu and make choices for lower cost funds, such as the target date funds.”

Sometimes Expenses Overwhelm Possible Tax Savings

admin — Thu, 04 Oct 2012 09:00:00 Z

Q. I'm at a crossroad. I just turned 70, am a woman and have been divorced for many years. I must rely only on myself. For 10 years I've worked, and still do, for the state, but realize that could change at any time. I take home $1,650 a month. If I retired right now, which I could, my retirement check would be about $650 a month, plus free medical benefits. My Social Security is about $2,050 a month.

I have two houses. The one I live in is in a part of town I no longer want to live in. Principal, interest, taxes and insurance are about $1,037 a month, and I have been living here for 3 years.

I have a second house that has been leased for about 7 years because the payments got too big. The rent covers the principal, interest, taxes and insurance but since it's 18 years old it requires expenditures for upkeep— $7,000 last year. Before I could sell it, it would be best to live in it for 2 years to help with the taxes on the capital gain when sold. It has about $150,000 in equity, which would be reduced by taxes on the capital gain and depreciation taken.

I would love to move back in to this house for at least two years, but cannot see how I could afford it. I have $50,000 in an IRA, and will be receiving an inheritance of about $50,000 at the end of the year. I have about $25,000 in credit card debt. What do you think?—F.D., by email

A. It may cost more to move back to the original house for two years than you would save in taxes on the capital gain. You'll only know for certain by doing some close figuring of how much more you will spend to support the older house for the two years you would be living in it. That $7,000 in repair bills, for instance, is about equal to the tax on about $47,000 of capital gains. A better plan would be to focus on your long-term shelter goal and figure out the lowest cost way to get there.

Q. How do you figure your pension and social security in calculating net worth? They are assets. If I were to take a million dollars in assets (I wouldn't) and buy an annuity would my net worth go from a million to nothing? —P.T. by email

A. Having a pension and/or Social Security is very valuable. But they can't be considered "assets" because both are only guaranteed income streams, not assets you can buy or sell. And, yes, if you took a million dollars in financial assets and bought a life annuity, that million would come off your personal net worth. So think of a pension and Social Security as "virtual assets"— income rights that you have that can profoundly influence your personal security and how you invest your money.

You can understand by considering this puzzle. Twin brothers take different career paths. One is a university professor and is entitled to a pension and Social Security that replace his entire final salary so he is wondering how to invest his $200,000 in 401(k) money. The other becomes a doctor in private practice. He earns more than his brother and can retire with Social Security— but it will only replace 15 percent of his pre-retirement income. The remainder of his retirement income has to come from $2 million in his retirement plan.

Which twin should be more conservative?

Answer: the doctor.

The retired university professor can invest in high-risk investments because his lifetime income is already secure. Equally important, whatever the results of his investing his $200,000, odds are his lifetime spending won't change much.

The doctor, meanwhile, will have to be more conservative because 85 percent of his needed income will come from his investments. So he can't play fast and loose. He must be prudent. For him, losses or gains in his portfolio will have a big impact on his lifetime income.

Another factor is debt. If you retire with no debt you can invest more aggressively than if you have a fair amount of debt.

Both of these factors— increases in debt at retirement and fewer guaranteed pensions— are reducing retirement security for younger workers. And that doesn't count the willingness of both political parties to consider reducing future benefits of young workers.

The Yield Famine, Continued

admin — Sat, 29 Sep 2012 09:00:00 Z

Some people hate buying food. They think it is boring, a weekly drudgery they would rather avoid.

Not me. I think buying food is fun. I enjoyed doing it in 1960 as a college student. I enjoyed doing it in the 70s as a young father. And I enjoy it today, trying to figure out what to cook for empty nesters subject to invasion by teenage grandsons. The idea that a true cornucopia of food choices is simply waiting for the arrival of my cart gives me a big rush. There are days when I actually get giddy.

In fact, I put the most recent supermarket receipt in my pocket only an hour ago, all of $90. That $90 bought fresh raspberries, blueberries, strawberries, limes and bananas. It bought two kinds of lettuce and some salad dressing (even though I usually make it myself). It also bought the made-on-the-spot guacamole that H.E.B. does so well, two prime New York strip steaks, some high quality Parmesan cheese, milk, two kinds of cereal, and a bunch of other things too long to list. Yes, more will be spent during the week, but it won’t be another $90. Quicken tells me we’ve averaged about $161 a week so far this year.

Food is one of the great bargains in America.

According to recent Department of Agriculture figures, a family of two over age 50 can be well-fed spending $158.40 a week for food at home. Pinch a bit and the USDA “moderate cost” plan gets it down to $131.60. Squeeze still more and the bill will shrink to $106.30 for the “low-cost” plan and $82.40 for the “thrifty” plan.

In spite of all that, it is becoming more and more difficult for retirees to afford to buy food from their savings. Actually, that’s a gigantic understatement. If you were trying to buy food from the interest paid on your savings accounts, you would have to be rich. Not top 1 percent rich, but pretty close.

This is not hyperbole. It is a fact, one that puts the absurdity of the Federal Reserve zero interest rate policy in harsh perspective.

How do we get from the supermarket to what they call ZIRP in the cake-eating Versailles known as the District of Columbia? Easy. Figure out how much you need to have on deposit in one of our coddled banks to earn enough interest to buy a week’s worth of groceries.

Here’s how you do it. The USDA “Low-cost” plan for a week of groceries was $106.30 in June. In the same month the Federal Reserve Bank of St. Louis figure for the yield on the average one-year bank CD was 0.19 percent. Divide the weekly plan cost by the yield figure and you get $55,947. That’s how much you would need in a one-year CD to buy one week’s worth of carefully chosen groceries. This makes no allowance for state and federal income taxes that you’d have to pay on interest income, so it’s conservative.

Now, multiply that $55,947 by the number of weeks in a year and you get… are you ready?

$2,909,244.

That’s how much you would need to have in CDs to eat for a year, providing you could keep your food costs in line with the low-cost food budget. You would have to nearly double that $2.9 million if your taste in food is closer to the $158.40 a week “liberal plan.”

While food is cheap in the absolute, it is nearly priceless when measured by what our savings earn, all because of a policy that has been supported in both Republican and Democratic administrations.

Back in 2001 the Low-cost food budget required $75.40 a week and a 1-year CD earned 5.13 percent. As a consequence, only $1,470 in savings would support a week of food. A nest egg of $76,440 would keep a retired couple fed all year round.

So just how high on the hog would you need to be to afford the USDA Low-cost food budget from your savings? Try this. If you compare the $2.9 million figure to my recent Wealth Scoreboard figures, you’ll see something amazing. Only about 5 percent of all people 50 and older have a net worth that high.

This is neither sane nor acceptable.

Want to read more on this issue? Here are links to earlier columns.

The Solvent Senior Chronicle

Worried About the Economy? You’ve Got Lots of Company

admin — Wed, 26 Sep 2012 21:00:00 Z

Q. Your recent column on measuring the true size of the deficit was scary. For folks like me— late 50’s with retirement on the way in four or five years— what do we do to preserve our capital? If and when the inflation day of reckoning comes, and it will, what happens to our savings? What specific investment can prosper in a debt-based, bankrupted environment where the government is just printing money? Should investment be in commodity based ETFs, precious metals etc.? —K. K., Austin, TX

A. There may be no way to preserve all of your capital. The future is most likely about relative loss, not positioning for gain. The best you can do is diversify broadly, reduce investment costs as much as possible, and have a portfolio that leans toward hard assets. In "The Coming Generational Storm" (MIT Press, 2004), the first book on this issue that I coauthored with economist Laurence J. Kotlikoff, we suggested a portfolio that contained Treasury-inflation-protected-securities (TIPS), foreign bonds, REITs, energy stocks and both international and domestic stocks. In this portfolio the energy sector fund works as a substitute for commodities investment.

The performance of this low-cost portfolio, called "Six Ways from Sunday," is reported monthly on my website. This portfolio declined sharply in the 2008-09 crash, as did everything else, so there is no absolute protection. There is only relative performance. In a world where people are lined up to go broke, a well-diversified portfolio should put you well toward the end of the line. The folks who put all their money in CDs will likely be toward the front of the line. Being at the back of the line is about as good as it gets when trying to prepare for a broad disaster. Anything more focused puts you in in a “bet the ranch” position.

Q. Assuming that our “fiscal gap” is real, and I have no doubt that it is, wouldn’t investments in metals be a long-term hedge? If not, how do we protect against the looming disaster? —F.F., Austin, TX

A. Many readers have been asking the same basic questions. What do we do? How can we protect ourselves? The reality is that while a financial crisis isn't a large asteroid heading straight for earth— an inescapable event truly bigger than all of us—the onrushing financial crisis of the United States will affect everyone on the planet. It's an event considerably larger than a shift in asset allocation from paper money to metals. It's a lot bigger than putting gold in your IRA as many advertisements now pitch.

This doesn't mean we should do nothing. As long as the Federal Reserve chooses to reward banks with no-cost deposits, punish savers with yields that are below the inflation rate, print large supplies of new paper money, and tell us they intend to continue doing this for as long as it takes, savers need to vote with their feet.

How do you vote with your feet? You put some money in gold and other resources not related to paper money.

The operative word here is "some." Gold is not a cure for disaster. It is insurance, similar in nature to keeping a supply of batteries, candles, water and canned foods on hand to cope with winter (or summer) power outages.
Without becoming a die-hard "Doomsday Prepper" here are some prudent steps:

Before you buy gold, make your home is a place you can stay for some period of time without going to a store.
See your doctor and ask for a prescription to get a supply of critical medications. Try to keep a 90-day supply on hand.
Sell your gas-guzzler while you can. They were un-saleable after the 1973 OPEC embargo and they will be worthless again.
Pay close attention to energy usage, have a plan to reduce it drastically.
Buy a solar charger or some other means to keep critical electronics functioning.
Create a small stockpile of rough-wear clothing.
When you do buy gold, buy it in small coins and consider buying some silver as well.
Note that all of this, with the exception of precious metals, is what we should do, as a matter of course, as safeguards for natural disasters like hurricanes and blizzards.

Is this extreme? I don't think so. The Boy Scout motto says it all: “Be Prepared."

If You Want To Rebuild America, Start With the Tax Code

admin — Sat, 22 Sep 2012 09:00:00 Z

Houston. He’s lanky, white-haired and calm. Listen to him for a few minutes and you sense rare qualities— great patience and stunning analytical abilities. Even more striking is a sustained passion, untainted by malice. His name is Leo Linbeck Jr. His company has built some of the most striking buildings in America.

But I’ve come to talk about a different kind of construction, our tax system, which is broadly acknowledged to be one of the most wretched things ever built. I’ve come because Linbeck is one of the prime movers behind the idea of a national sales tax, a tax that would replace the entire 73,608-page tax code.

While our tax code has been called “an abomination” it is now clear that both political parties intend to do no more than tinker with the abomination, in different ways, to rebuild America to their vision. Neither party recognizes that our tax code is central to our current economic mess.

Linbeck thinks different. He says that if we want to rebuild America, we need to start with a paradigm shift. We need to start by building a brand new tax system.

When I asked him how the idea came about I was surprised by his answer. Nearly two decades ago he was having lunch with two friends. One, the late Jack Trotter, suggested that the biggest single problem in America was its tax system. Businessmen all, they agreed and decided to do the research and development for a tax system that would work.

They began with a blank page. “We started with research,”Linbeck said. “What do people dislike most? What would they like or not like? What would they like to have?”

Then they asked another question: “If people got what they wanted, would it be efficacious?” Would it work?

That’s where a lunch conversation ended and the heavy lifting began. Finding little academic work on differing tax systems, they selected 25 top economists and asked if they were interested. All 25 were. Then they narrowed the group down to 8, including well-known economists like Martin Feldstein at the National Bureau of Economic Research, James Poterba at MIT, Laurence Kotlikoff at Boston University and Dale Jorgenson at Harvard.

The result was a bold idea: replace the current mess with a national sales tax. Tax consumption and only consumption. Don’t tax investment, education, or income. Eliminate the income tax, the employment tax and the corporate income tax. Just tax consumption.

“It’s very progressive, but on a discretionary basis,” he said. “If you buy a Bentley and I buy a Ford, you’ll have to pay about twenty times the taxes I pay. People that spend more money will pay more taxes.”

Then, just as Procter and Gamble test new products, they spent millions to test “the market” for the tax. Result? Not only would it work, but the name FairTax came out of one of the consumer panels as well. “All I want is a fair tax,” one of the panelists said.

If the people liked the idea and understand it, I asked Mr. Linbeck, why isn’t it the law?

And that’s where I learned, once again, that the problem is called Washington.

To get the FairTax idea, now a piece of legislation, through the Ways and Means Committee they would have to hire lobbyists, one for each party. They would have to support frequent get togethers for Congressional staffers and they would have to provide money to support other political projects.

They first said no, then decided they would try the Washington way. After 6 months they fired everyone, Linbeck said, and decided to try a grass roots path.

“I’ve learned quite a bit over the last 17 years,” he told me. “I’m convinced that what we have for government is a contemporary form of feudalism.”

I asked what he meant.

“We have an elected elite, their staff, lobbyists, the academics. Perhaps 100,000 people. It’s a relatively small number of people, well educated, well-intentioned, not bad people. But they believe they ought to decide. They gravitate toward complexity, not simplicity. This group decides how the rest of us will live.

“If we want something, we have to go to (the king’s) court. We have to find someone (a lobbyist) who has the ear of the king.

“If you accept a simple idea— that complexity creates opportunities for manipulation— then you can immediately see that the largest single tool is our tax system,” he said.

Alas, the idea may make too much sense to go far in Washington.

It Is Easier To Cut Investment Expenses Than to Find Yield

admin — Wed, 19 Sep 2012 21:00:00 Z

Q. I am a 63-year-old elementary school principal. I plan on continuing to work for an additional 3 to 5 years before retiring. My husband is 75. He began drawing his Social Security at age 62. He receives about $1,200 a month. My current salary is about $82,000. If I were to retire this year, my Texas Retirement System monthly stipend would be around $4,500, before taxes. I have listed below savings plans and available monies for both my husband and myself:

403b = (1) variable annuity ($129,165) and (2) American Funds ($44,874)
The 401(a) TERRP Plan for my school district = $18,186
Husband’s Vanguard Retirement 2015 Fund = $51, 258
Federated Funds = $12,555
Savings Account = $109,000

Our house is paid for. We have no outstanding debt other than a car lease payment of $540 a month. We also have Long-Term Care insurance through John Hancock ($214/month). My questions are:

Should I continue to pay into my current 403(b) plan through my school district or would it be more beneficial for me to roll it over into something else giving a bigger return and lowering fees? In other words cut myself off completely from this 403(b) plan and put all existing money plus additional monthly savings into something else that would work better for us.
Where could I put the savings account money that would earn higher interest but not have a big risk?

—S.M., by email

A. There is no guarantee that rolling to a lower cost custodian and investment program— such as Fidelity, Vanguard or Schwab— will result in higher returns. But it will certainly result in lower fees. Those lower fees, in turn, increase the probability that your long-term return will be higher than your return will be if you continue paying high fees.

Long term, the odds are that a low-cost index fund based investment plan will provide a higher return than about 70 percent of the more expensive managed plans. This is particularly true for the high cost insurance-based plans that dominate the products available to Texas educators. Of the 75 certified companies on the TRS list, 42 are insurance companies.

In your 403(b) plan you have an insurance product that is relatively expensive. You also have some American funds, which are relatively low cost, but more expensive than index funds. A rollover would allow you to cash out of the insurance product while retaining the American Funds investments. You could replace the insurance product with a low-cost fund such as Vanguard Wellington or Vanguard Balanced Index and save over 2 percent of assets a year in fees. This is a more assured way to “find” a higher yield on your money than looking for higher interest rates.

A better alternative to doing a rollover would be stay in the 403(b), cash out of the insurance product and buy more American funds. That would probably cut costs by about 1.5 percent a year. You’ll want, I believe, to stay in the 403(b) plan to continue receiving the 401(a) benefits, which are contingent on your 403(b), plan contributions. You should check this with the HR person for your school district.

Another possibility is to move your Federated Funds and Savings Account to another platform. At a later date you will be able to do a rollover and see most of your financial assets in one online statement, make transfers, and have a related checking account.

Sadly, there is no happy answer to your second question. Interest rates are low all over. The only way to get a higher yield is to take risk in non-guaranteed investments. But if you look at your investments as a whole, you've got about $365,000 in financial assets. At a 4 percent safe withdrawal rate for a long retirement this means you might draw about $15,000 a year from your nest egg.

Yet you have a bit over $121,000 in near cash. That’s more than 8 years of your likely withdrawal rate. You could move $90,000 of that money to be invested in a balanced fund. This would increase both the current income and the long-term return— and you would still have 2 years of expected cash withdrawals on hand. That same $30,000 is equal to a cash reserve of 4 months of your annual income of about $84,000 from pension, Social Security and investments.

You can be safe while being less conservative.

Will the Real Federal Deficit Please Stand Up?

admin — Sat, 15 Sep 2012 09:00:00 Z

“When you find yourself in a hole, stop digging.” ***

The latest estimate of the federal deficit is $1.1 trillion. In spite of that, neither candidate for President has talked much about the deficit or offered a detailed plan to close it. The best short deficit discussion I’ve seen is a YouTube video made by Hal Mason, a retired accountant. When I last checked, nearly 2 million people had viewed “United States Budget Dilemma.wmv”.

Mr. Mason suggested it would be necessary to shut down most of our government to close the deficit. Of course, we might miss a few things. Say goodbye Justice. Hasta la vista Education. Bye-bye Agriculture, Commerce, Homeland Security, Housing and Urban Development, Energy, Interior, Labor, State, etc. And, by the way, this also includes the entire Defense department. All together those programs cost $1.2 trillion for 2012.

Make those simple cuts and we’d have enough tax revenue left to pay interest on the federal debt (about $225 billion) and continue printing the checks to support Social Security, Medicare, Medicaid and other “non-discretionary” programs that total about $2.25 trillion.

Alternatively, the budget could be balanced if we all volunteered to pay 46 percent more in taxes than we already pay. So far neither the 1 percent nor the 99 percent has stepped forward.

Sadly, that dismal picture doesn’t come close to showing just how over-promised and broke our country is. Do some studying and you will learn that the budget politicians talk about, the one known as the Unified Budget with the $1.1 trillion deficit, is a fiction. It is convenient for politicians but it is not a true representation of our financial condition. If it were subject to the same accounting standards as our corporations, it would get a qualified opinion from its auditors.

We can get a bit closer to reality by checking the most recent “Financial Report of the United States Government” (2011) from the Government Accounting Office. In it, Comptroller General Gene L. Dodaro observes “The comprehensive long-term fiscal projections presented…show that…the federal government continues to face an unsustainable fiscal path.”

He was being kind.

The reason can be found in the details of those financial statements. The statements include long-term estimates of the amount by which promised benefit payments for Social Security and Medicare exceed estimates of future revenues. The gap depends on the actuarial method used, but filling it would require a deposit, today, of $33.8 trillion to $46.3 trillion. Whichever actuarial method you use, the increase from 2010 to 2011 was over $3 trillion. In other words, government liabilities that are never discussed as part of federal debt are rising three times faster than the official $1 trillion deficit.

But wait, there’s more!

Even these figures are a government-manipulated fiction. The total unfunded liabilities for Medicare dropped by trillions from 2009 to 2010. How? By the passage of Obamacare. It contained major reductions in payments to doctors and medical service providers. There’s only one problem: The chief actuary for Medicare, Richard Foster, doesn’t believe those savings will be achieved. He has already declared, in the 2010 Trustees Report, that the reduction isn’t likely to happen. Basically, we’re still in a political fairyland.

So, is there a measure that we can trust?

I believe there is. Economists call it the fiscal gap, the comprehensive long-term difference between government revenues and government spending based on the most realistic estimates available. The foundation for this measurement is the Alternative Fiscal Scenario, the Congressional Budget Offices most realistic budget projection. The fiscal gap is economics’ standard measure of fiscal sustainability. Using it, economists have tracked the growth of the fiscal gap. It was $60 trillion in 2003, $175 trillion in 2007, $211 trillion in 2011 and $222 trillion in 2012.

Note that $222 trillion is a multiple of our gross domestic product that far exceeds any of the figures that are causing the economic crisis in Europe.

The person I speak with about this— enough to have co-authored “The Clash of Generations” (MIT Press, 2012) with him about this subject— is Boston University economist Laurence J. Kotlikoff. He points out that while the official deficit is $1.1 trillion for 2012, the increase in the fiscal gap for the same year was $11 trillion. That’s 10 times as much as the official deficit.

Can we argue about these numbers?

Not according to Kotlikoff. “No decent economist would use any measure but the fiscal gap to understand our long-term problem,” he said in a recent phone conversation. That means the true financial condition of our country is far, far worse than it is represented in public discussion.

Can you spell b-a-k-l-a-v-a?

To a hammer, everything is a nail.

admin — Thu, 13 Sep 2012 03:00:00 Z

Q. I am 61 years old and anticipate retiring in August of 2013. I have been abused by the stock market for the last 10 years, having lost all of my gains twice in that period. Two years ago I moved my retirement investments to fixed index annuities. I am comfortable with the security of the annuity but I am not certain that what I am purchasing through my adviser is the best I can do. My adviser recommends a 25-year plan with a separate annuity for each 5-year increment. I have funded the first 15 years and I am now waiting to see results before I commit to the last 10 years.

One of the things I did not understand about the annuity was the guaranteed interest. I thought this was an annual guarantee not a guarantee over the life of the plan. I know my adviser is making commission on these sales and I am concerned that his recommendations are not always in my best interest. I thought I would try to find an annuity myself on line but there are so many and it is difficult to tell the good guys from the bad guys. Even the terminology seems to vary. I know you are not a big fan of annuities but is there a place you would recommend to search for annuities? —J.L., Akron, OH

A. You've probably heard the old saying, "To a hammer, everything is a nail." Well, if annuity products are the only tools in your adviser's toolbox, chances are he's going to solve every retirement question with— you guessed it! — An annuity product.

As a practical matter, you have been paying for a substantial life annuity since you started working— the inflation-adjusted life annuity of your future Social Security benefits. For the vast majority of people (the 90 plus percent of all workers who earn less than the Social Security wage base maximum, $110,100 for 2012) the next two steps for building retirement security are (1) the elimination of all debt, including home or condo mortgage debt and (2) building a nest egg of financial assets that is flexible, diversified and liquid.

Adding annuity products to the list is something you consider when your income is near $100,000 or more, when you don't have an employer pension, and when you have the other pillars of security well in hand. At that point you might start thinking about a ladder of life annuities. Conventional life annuities will bring you a relatively high cash income but like Social Security, they die when you do.

Fixed index annuity contracts avoid the immediate loss of estate value in life annuities by reducing the lifetime payout and making future value uncertain. Guaranteed withdrawal rates are now about 5 percent for people between 65 and 74. They appear to offer the possibility of having some value when you die.

If you visit the website immediate annuities.com you will find that a 65 year old male can expect a life income payout of 6.95 percent on a $100,000 life annuity or $579 a month. At age 74 the same $100,000 would bring a payout rate of 8.9 percent or $742 a month. The increase as you age is one of the reasons many advisors suggest buying life annuities over a period of years. Note that regardless of age, the simple life annuity pays out more than the complicated, full of strings and penalties, fixed index annuity.

Warren Buffett has repeatedly said that he won't invest in any business he doesn't understand. It's a simple rule. It has served him very well. That's why the annuity product that you'll read the most about in this column is a simple life annuity. It increases your spendable income in early retirement while guaranteeing that you'll have a monthly check for the rest of your life.

Fixed index annuities, on the other hand, are extremely complicated, difficult to compare, and contain a speculative element— uncertainty about future returns in the stock market. Equally important, while you can research mutual funds and exchange traded funds easily by visiting the Morningstar website and a variety of other sources, there is no comparable data source for fixed index annuities.

Building the Next Financial Crisis, One Loan at a Time

admin — Sat, 08 Sep 2012 09:00:00 Z

The foundation for our next financial crisis is being laid right now. The question isn’t whether we will have another, but when. The biggest clue can be found on websites where you can search for mortgages to purchase or refinance a house. On my last visit to bankrate.com, for instance, a person with good credit (score of 740 or higher) and a 20 percent down payment could expect to pay about 3.5 percent for a 30-year fixed rate mortgage or as little as 3.0 percent for a 15-year fixed rate mortgage.

This is very cheap money. So cheap it expands the pool of potential homebuyers. It allows homebuyers to buy larger homes. It allows home refinancers to reduce their monthly payment burden. It makes debt the new thrift, and refinancing as good as saving. Low interest rates aren’t all bad.

Skeptics should consider this quick exercise. If you have a $200,000 mortgage at 5 percent interest, refinancing it down to 3.5 percent will reduce the monthly payment from $1,074 to $898, a saving of $176 a month or nearly $2,112 a year. (Yes, this is less than the nearly $3,000 of interest saved in the first year, but let’s be conservative.)

To earn $2,112 a year in interest on the highest yield one-year bank CD quoted on the bankrate.com website, a yield of 1.1 percent, you would need to deposit $192,000. To earn that $2,112 a year in what bankrate.com quotes as the national average yield of 0.32 percent you would need to deposit a whopping $660,000. This means careful refinancings— including automobiles— are producing better “yields” than we can get on money saved. Debt really is The New Thrift. (Of course there is a bit of apple and orange in this because we’re moving from 30 year borrowing to 1 year CDs, but the reality is that most of us don’t want to put money away for 30 years.)

This is all good news, at least for borrowers. For savers, not so much.

But you knew that.

What’s worrisome here is what’s going to happen to the market value of all these mortgages when, and if, interest rates return to more normal levels. When that happens, the institution holding the mortgage will be holding a loan whose market value is far lower than it’s face value. Suppose, for instance, mortgage rates rise to 5 percent over the next 5 years. At that point a 3.5 percent 30-year mortgage that is new today will have a term of 25 years and an outstanding balance of $179,768 but its market value will be $153,627.

That’s a loss of 14.5 percent, a loss that would wipe out the equity of most lenders. If mortgage rates rise to 6 percent over the next 5 years, the market value of the mortgage will be $139,390. That would be a loss in market value of 22.5 percent.

The same holds true for shorter-term loans such as the 1.99 percent auto loans that are becoming common . Were interest rates to rise quickly to 5 percent, every $1,000 of new 1.99 percent five-year car loan would sink in market value to $928. That’s a loss in market value of about 7 percent, enough to threaten the solvency of the lender.

Note that we’re not talking financial Armageddon and runaway inflation here. We’re just talking about a return to interest rates that are on the low side of what we’ve seen over the last 50 or 60 years. Indeed, for some readers this will be a case of “deja vu all over again”— rising mortgage rates would be a replay of what was experienced in the 1970s, an event that culminated in the thrift crisis, destroyed the thrift industry and produced a financial crisis that paralyzed the real estate industry for years.

Can we find a silver lining somewhere in this dark cloud? You bet. First, let’s not fret about our financial institutions; they already own Congress and can take care of themselves. The silver lining is for younger families: higher future interest rates amount to a major wealth transfer. Lenders will lose, borrowers will gain. Younger households may be able to recoup some of their losses from the last decade as home prices rise and the true value of mortgages declines.

For Heavy Duty Savers, A Bigger House Can Be a Reward

admin — Thu, 06 Sep 2012 09:00:00 Z

Q. I'm 56, married, with two boys, 21 and 19. My wife and I make $185,000 a year. I max out the 401(k) contributions and put $1,000 into savings every paycheck (paid every two weeks). My wife works part-time and puts all of her check into savings, around $220 a week. We have $375,000 in our 401(k), $100,000 in a REIT, $250,000 in managed funds, and $100,000 in savings. Our home, which is worth about $175,000, is paid for. We have no debt and pay cash for everything.

But I am still worried about retirement. One son still has 3 or 4 years left in college, which we will pay via the $1,000 per paycheck savings. After college is paid for, that $1,000 saving per paycheck will go into some type of investment. At that time I will be around six years from retirement.

We want to have a 'retirement' home in the $350,000 range but I am hesitant to take on any debt. Should we plan on staying put so that we have enough for retirement— or can we afford to take on the cost of a new home and still plan on a healthy retirement? —B.E., Sachse, TX

A. It's really confusing to think about retirement while you are in the middle of paying for college. So let's take a step back and isolate the important numbers.

First, while your combined income is now $185,000 a year, you are saving a great deal of it, paying employment taxes, and paying an income tax bill that will be smaller when you actually retire. My bet is that your actual consumption is well under $100,000 a year. It will be lower still when you become "empty nesters." This is important because the amount of money you need in retirement depends on what it will cost to sustain you and your wife— not you, your wife and two boys.

Second, your total financial assets are about $825,000 and you appear ready to add the maximum every year until you retire. So you now have at least 8 years of retirement spending banked. If the historic averages for investment returns would come back to life, that $825,000 could double by the time you retire, providing a lifetime spending of about $64,000 a year, possibly more. (This assumes a 4 percent annual withdrawal from $1.6 million.)

Third, your combined Social Security benefits should total about $45,000 by full retirement age, bringing your pre-tax retirement income to about $109,000. You'll need to do the fine pencil work, but you're a lot closer to being on track for retirement than most people even with a bigger house and a mortgage.

The house decision is all about what does most for you. The more expensive house is likely to have higher taxes and insurance costs, but could otherwise cost little more than your current house. For example, you could be supporting a smaller, but more expensive house with lower utility bills. The big cost would be taking on new mortgage mortgage debt. If you borrowed $200,000 at 3.75 percent for 30 years it would cost you about $926 a month. Bottom line: Go for it. If it is very important to you, you can make it happen.

Q. As a disabled and unemployed person, I receive about $1,250 a month from VA Disability and Social Security. I probably would be advised not to invest, right? I have an additional $75 monthly going to an ING Direct savings account. What do you suggest? —S.W., Wenatchee, WA

A. I think it is important for people with low incomes— as with all people— to have some amount of money as a cash reserve. Since that reserve would be small, the big question isn't whether it is invested but whether it exists and is liquid.

Having ready cash is how someone with a low income can make his or her dollars go further. It does two things for you. First, it allows you to take advantage of resale shops and other opportunities for very low cost purchases. Second, not having access to ready cash can also be very expensive, witness the high cost of sending cash by Western Union and other cash transfer services, the cost of car title loans, etc. In other words, the most important thing isn’t so much the return on your savings but the expenses your savings will save you from.

Who Lost During the “Lost Decade”?

admin — Sat, 01 Sep 2012 21:00:00 Z

Contrary to popular belief, the young, not the old, were the big losers during the “lost decade.” Indeed, a comparison of net worth changes by age group shows that those 20-39 years old in 2010 have significantly lower net worth than their peers had in 2001.

What’s “significant” you might ask?

Well, try this. Older people generally gained in real net worth while younger people lost real net worth. So we’re talking about different directions, not one group losing or gaining more than the other. We’re talking about real losses versus real gains.

This is not what the conventional view suggests. The conventional view assumes that older people were hit hard by two stock market declines and the crash of residential real estate. And many were. But as a group, today’s twenty somethings have a lower net worth than the twenty-somethings of 2001. During the same period the median level net worth of Americans age 60 and older increased.

The differences can be extreme. Those who were 80 or older, for instance, enjoyed a 53.8 percent increase in real net worth compared with those 80 and older in 2001. Those in their twenties have 21.8 percent less in net worth than their peers had in 2001. The spread here is disturbing.

Compare this to the spot news that we see every day. With Facebook and other hot IPOs there have been dozens of stories of people in their 20s who are sudden multi-millionaires. At the other end of the scale no day is complete without a story about someone in his or her 50s who has been unemployed for a year or more, or retirees who have lost a bundle in the 2008 market crash. The reality— at least in the aggregate— is different.

How did this happen?

The Federal Reserve Bulletin analysis of changes puts a lot of weight on the real estate crash. You can understand this by comparing what happens to a young couple and an older couple who live in the same neighborhood.

The young couple purchased their $250,000 home at the market top with a 10 percent down payment of $25,000. When the housing market declined by 20 percent, they lose $50,000 in home value. This wipes out their $25,000 equity and then some. The additional $25,000 loss is enough to offset the value of their cars and much of their small 401(k) account. Because they are young their smaller 401(k) account is mostly stocks, so that shrinks as well. It’s not difficult to imagine a $100,000 net worth couple seeing their net worth chopped by 50 percent.
The older couple has owned their home for many years. So while it’s also worth $250,000 they have paid the original mortgage down to $25,000. This leaves them with equity of $225,000. When the value of their house declines the same 20 percent as the young couples’ house, they also lose $50,000— but it is ‘only’ 22 percent of their $225,000 equity. Much the same happens with their 401(k) plan. Their losses are smaller because stock market declines were partially offset by fixed income gains.

This doesn’t mean that life is a bed of roses for older folks. The much-discussed issues are still there. Retirement accounts are smaller, there is less time to rebuild them and yields on secure investments are pathetic. Similarly, the sale of highly appreciated homes that some older couples had counted on to provide retirement cash either hasn’t happened— or has happened at much lower prices.

What it does mean is that younger people are even more endangered by changes in our economy than older people. It means we have a growing generational security gap. The social side of this change is well documented in Charles Murray’s “Coming Apart” (Crown Forum, 2012). It’s also well described in Anya Kamenetz’s “Generation Debt” (Riverhead Books, 2006) and Tamara Draut’s “Strapped: Why America’s 20- and 30-Somethings Can’t Get Ahead” (Anchor, 2007). Economist Laurence J. Kotlikoff and I have explored it in “The Clash of Generations” (MIT Press, 2012).

However you slice it, this is yet another subject that is not being discussed as we head toward Election Day. It is more important than Romney’s tax returns; Obama’s birth certificate or wrangling over tax cuts or tax increases that are trivial compared to actual taxes and actual spending.

The Best Way To Do Well Over the Last Decade Was Not To Be Young

Percentage Change in Real Wealth, 2001-2010

Age Group	Top 1%	Top5%	Top 10%	Top 25%	Top 50%
80+	155.6%	69.9%	38.6%	48.6%	53.8%
70-79	28.3%	12.3%	22.1%	-0.8%	14.6%
60-69	22.9%	32.1%	44.1%	53.7%	32.9%
50-59	6.2%	25.3%	32.7%	10.8%	-16.8%
40-49	39.9%	17.4%	2.7%	-17.4%	-33.8%
30-39	-10.9%	-21.5%	-30.5%	-38.4%	-38.9%
20-29	-52.0%	-5.2%	-10.7%	-10.9%	-21.8%
Sources: 2010 Survey of Consumer Finances, Dallas Federal Reserve Bank, Author calculations

To Maximize Lifetime Income, Defer Taking Social Security Benefits

admin — Thu, 30 Aug 2012 21:00:00 Z

Q. I plan to retire soon. I’m 62 and hope to live well into my 90's. I need about $80,000 a year to live comfortably, plus inflation adjustments each year. I have $1.2 million saved in my 401(k). My estimated Social Security benefit will be about $21,660 a year if I take it at 62. It will be $39,288 if I wait until age 70.

To get to my $80,000 goal, the 2 most obvious options are delaying Social Security benefits and using a higher withdraw rate from the 401(k) plan until age 70, or taking Social Security at 62 and using a lower withdraw rate. Which option would give me a better chance of maintaining my standard of living into my 90's? Or is some hybrid of the two a better option? —R.S., Seattle, WA

A. You didn't mention whether you are married or not. If you are, delaying Social Security benefits is a slam-dunk because a joint life expectancy is so much longer than a single life expectancy. As a consequence, a married household is virtually certain to get back more money than was given up by deferring. The decision is a bit harder for a single individual, but the basics still favor deferring for three reasons.

First, the benefits of deferral can't be duplicated in private investment markets. Taking benefits at age 62 rather than full retirement age of 67 reduces benefits. If wait the eight years until age 70 take benefits, the inflation adjusted benefit you finally receive will be nearly double. That’s an annual increase of about 8 percent each year until you reach age 70.

In effect, each year of income deferred buys additional annuity income equal to 8 percent of your starting benefit, with a lifetime inflation adjustment. On immediateannuities.com, I found that a 62-year-old male buying a $100,000 single life annuity would receive an income flow of 6.52 per cent of original investment—- with no inflation adjustment. So drawing down your investment money in exchange for a Social Security life annuity is a good trade.

(Here's a link to check the details: http://www.ssa.gov/OACT/quickcalc/early_late.html#calculator)

Second, you don't have a pension to provide a portion of your retirement income. Deferring Social Security benefits, in effect, is buying pension income— except that it is a better deal than any private pension or private life annuity. It’s nice to have more guaranteed income.

Third, deferring Social Security benefits for 8 years means that you won't pay any taxes on Social Security benefits for the entire deferral period. It may also work to reduce your lifetime tax bill. As I demonstrated in a recent column, the taxation of benefits can increase your tax burden substantially.

I'm sure there are readers snorting, "No, no! Social Security is going broke. You'll never get your money back!" Well, I worry about Social Security too, witness having co-authored two books on underfunded government promises, "The Coming Generational Storm" (2004) and "The Clash of Generations" (2012).

But here are the realities:

First, current employment taxes can, and will, support about 75 percent of benefit commitments.
Second, how do you think private investments of any kind will be doing if Social Security has trouble paying benefits? My bet is that other investments will have lost more of their value than Social Security benefits would be cut.

Q. I would like to invest more of my retirement funds in bonds. If I invest in a short-term bond fund it will be more stable but the interest rate will be very low. What do you suggest that would give me a little more return but still be stable? —M.W., Austin, TX

A. That's a "you can't get there from here" proposition. If your return is safe (i.e., the borrower is good for the money) and the money will be repaid in a short time, the only way you can increase the yield is to either lend the money for a longer period or lend it to a borrower whose credit isn't as good. Either way, the value of your investment will be less stable and more vulnerable.

Everyone hopes there is some secret stash of vintage CDs that are perfectly safe but yielding 8 percent. Millions of naïve investors lose money every year because someone tells them that the equivalent of that vintage stash exists. But let me assure you, it does not exist and no amount of wishing will bring it into existence.

The New Wealth Scoreboard

admin — Sat, 25 Aug 2012 15:00:00 Z

OK, alpha dogs, want to know where you stand in the wealth heap?

Welcome to the Wealth Scoreboard, my effort to provide some notion of where we stand relative to everyone else.

Since starting this more than 10 years ago readers have asked, every year, for an update. Unfortunately, this kind of information isn’t like the national debt. We’re never more than a click away from up to the minute data on how much money the world has lent to our debt-ridden government. Data for the Wealth Scoreboard is a little harder to come by.

It is gathered with a survey, the Survey of Consumer Finances, which is done every three years by the Federal Reserve. The first time we get to see any of the survey results is at least a year after the survey is completed. This can be awkward. Few of us felt, in early 2009, that the pre-crash survey from 2007 was very relevant. The world had changed. Home prices had crashed. Stock market prices were way down. Basically, we were more worried about the end-of-life-as-we-know-it than whether we had a posh stateroom on the good ship Lollipop.

But this time is different. Data from 2010 is a pretty good reflection of how things are in 2012. According to another source, the Federal Reserve flow of funds data, the collective net worth of all American households was little changed in early 2012 from 2010. Some individuals may have become vastly wealthier--- think Mark Zuckerberg, however briefly. Others may have become much poorer (think about the thousands who have gone through foreclosure). But in the big, big picture, we’re collectively a tad better off than we were two years ago.

The Wealth Scoreboard is a bit different from other measures of wealth. Rather than just identify the kind of wealth one needs to be in the top 1 percent or some other level, this measure divides us into wealth groups by age. You can thank the research department at the Dallas Federal Reserve bank for doing the heavy lifting.

When it comes to net worth, a little age discrimination is only fair. Young people haven’t had time to accumulate wealth. Older people have had decades. To be in the top 10 percent of your age group in your twenties, for instance, you only need to have a net worth of $83,000. You’ll need more than 20 times as much, a handsome $1,955,000 to be in the top 10 percent if you are in your sixties.

Another thing to notice is that whatever your wealth level, it peaks in the same decade of life--- our sixties. The top 1 percent enjoy a peak wealth of nearly $11.7 million in their sixties while those in the top 1 percent in their eighties have a net worth of about $5.9 million. Ditto, those in the top 25 percent: Their wealth peaks at $712,000 in their sixties and falls to $514,000 in their eighties.

It’s not the same for lesser wealth levels. At the 50th percentile net worth remains pretty much unchanged over the three decades from the sixties through the seventies and eighties. The likely explanation is that the truly wealthy, having achieved financial security, are more inclined to transfer their wealth to children and grandchildren--- or give it to charity--- as they age. Why? Because they aren’t worried about things like long term care expenses. Running out of money isn’t a big pre-occupation.

Another thing to notice: Each step up the net worth ladder requires a lot more wealth. In your forties $70,000 can put you at the 50th percentile for wealth--- that would be some home equity, cars and a few years participation in a well-matched 401(k) program. Get married, stay healthy, keep working at a good job and being in the top half is pretty much a slam-dunk.

But to move into the top 25 percent at the same age you’ll need to have about $260,000, nearly 4 times as much. And it will take almost $500,000 more to advance another 15 percentile to the top 10 percent. Want to move from the top 10 percent to the top 5 percent? You’ll need to double your wealth to $1.4 million.

And how about getting into the much-reviled the top 1 percent? Fuggetaboutit. That will take $5.8 million if you are in your forties, nearly $10 million in your fifties and $11.6 million in your sixties. Those are big numbers. While many people can get into the top 10 percent through high wages as employees, diligent savings, and fortunate real estate choices, the odds are that you will need to be a business owner--- or an employee blessed with good stock options--- to make it into the top 1 percent.

The Distribution of Net Worth by Age Group (dollar figures in thousands)

These figures show the median net worth (assets less debts) of households in each group. Because the figure is the median--- half have more, half have less--- for each group it is not a "threshold" figure; actual net worth can be less to be in each group.

Age Group	Top 1%	Top 5%	Top 10%	Top 25%	Median
80 and over	$ 5,935	$1,980	$1,098	$514	$220
70-79	$ 9,033	$2,096	$1,315	$483	$199
60-69	$11,683	$3,781	$1,955	$712	$221
50-59	$ 9,611	$3,017	$1,509	$504	$148
40-49	$ 5,823	$1,412	$ 696	$260	$ 70
30-39	$ 1,634	$ 419	$ 245	$ 90	$ 24
20-29	$ 425	$ 155	$ 83	$ 32	$ 6
Sources: 2010 Survey of Consumer Finances, Dallas Federal Reserve Bank Research Department

Next Sunday: Who Really Lost During the “Lost Decade”

Fifty-Somethings: Rent or Buy?

admin — Thu, 23 Aug 2012 15:00:00 Z

Q. Two of my friends are considering buying a home - a first for both of them. They are in their mid-fifties. One recently retired after 30 years from a mid-level staff position at the University of Texas, the other worked many years part-time at UT but now has a full-time position as a biologist with the city of Austin. Neither seems to have a business mind, so I cautioned them to educate themselves regarding all that is involved in homeownership. I explained that they have "lost" 25 to 30 years of asset building and with a 30-year mortgage (which they seem to be planning), they will be 85 when they're finished paying it off.

I don't want to stick my nose where it doesn't belong but I don't want to see them make a decision that may negatively affect their financial position, or their relationship. Neither has much in the way of maintenance skills. The one who is still working is married to his job and wouldn't have the time. Any feedback would be greatly appreciated. —S.B., San Marcos, TX

A. In many cities the rent/own decision is a no-brainer, regardless of ones age. Either the price of houses or condos is so high that buying simply doesn't compute, or rents are so high that buying is a good choice. Austin appears to be on the cusp. It has rapidly rising rents and declining vacancies for apartments. It also has a relatively strong residential market; one most of the country would love to have.

While your friends have missed decades of home appreciation by being such late-life buyers, the basic benefit of homeownership remains—- mortgage payments are fixed, home values tend to rise. The value of the payments they make over 30 years will be constantly declining due to inflation. It also means that a portion of their spending will be fixed, not inflating. Basically, a home purchased with a low rate mortgage is the Everyman-Hedge-Against-Inflation. While they may be 85 when the mortgage is paid off, the odds are they will be building equity year by year as home values rise and they make small payments of principal. As I pointed out in a recent column: Debt is the New Thrift.

Being older also gives them an advantage younger home buyers don’t have: Unlike younger homeowners, a forced move to pursue a career opportunity is unlikely.

The only impediment to their owning is whether owning is important to them. And that’s a very personal decision that’s entirely between them, not you and me. It’s also possible, today, to own a town home or patio home with virtually no exterior maintenance responsibility.

So answer this question: How many UT employees does it take to change a light bulb? If the answer is two or less, owning doesn’t have to be a big chore.

I would not have the same answer for every city in the country. It still costs a lot more to hire a U-Haul to move from Austin to Los Angeles than it costs to do the same thing from Los Angeles to Austin. There is a price difference because more people are moving to Texas than are moving from Texas. Housing prices anywhere in Texas continue to compare well with most of the country, particularly the coasts. As they say, people are voting with their feet.

Let me give you an example. Today, the San Francisco area is hot. High tech is booming. If you visit the Cost-of-Living-comparison-calculator on bank rate.com you will find that a couple with an income of $100,000 a year in San Francisco could maintain their standard of living in Austin on only $57,800 a year, largely due to the difference in the cost of shelter.

So what do you think happens when someone moves from San Francisco to Austin, on the same salary? What do you think will happen to their standard of living? I calculate the improvement at 73 percent. How many years of large raises do you think it would take to accomplish the same thing?

The fastest way for a tech company to give workers a material improvement in their standard of living isn’t by giving them a raise. It is by setting up an office in another tech city, albeit one with lower home prices and lower rents. That would be Austin.

The Little Middle Class Tax That Keeps On Rising

admin — Sat, 18 Aug 2012 21:00:00 Z

Both parties talk about “helping” the middle class. But will they actually do it? Don’t count on it.

One reason to doubt the pious declarations of both parties is the fastest rising source of tax revenue our government has— the tax on middle-income retirees.

Yes, I’m talking about the taxation of Social Security benefits. Middle-income earners who save enough to replace most of their pre-retirement earnings can now pay nearly double the income taxes they paid before benefits were taxed.

This is not small change. According to the 2012 Annual Report by the Trustees of Social Security, $22.2 billion of the benefits paid out were taken back in income tax payments in 2011. More important, the amount had doubled from only $11.9 billion in 2002 and that, in turn, was double the $5.9 billion collected in 1992. The same trustees report projects that tax collections will increase even faster over the next ten years, nearly tripling to $61.7 billion by 2021.

If you are still working and think this doesn’t affect you, don’t go away. The unique construction of this tax— based on one of the only formulas in the entire tax code that isn’t inflation indexed— means that more and more retirees, at lower and lower levels of real income, will be sending some of their Social Security benefits back to the Treasury in the future. This is a tax that quietly keeps on growing. The younger you are today; the more it will affect you tomorrow.

To show the impact of this tax on middle-income retirees I visited Randy Van Camp, the Dripping Springs, Texas CPA who does my tax return. I asked if he would calculate typical tax bills for middle-income retirees, with or without taxation of Social Security benefits.

The first thing you need to know is that this isn’t an eyeball guessing exercise. It’s difficult to know how much you’ll pay. The formula exempts at least 15 percent of your Social Security benefits from taxation. But the formula makes different amounts of benefits taxable at different levels of other income. As a consequence, there is no simple rule of thumb for estimating how much the tax will cost you. It must be calculated with software.

But you can get an idea by examining the table below. It shows joint and single returns at different levels of additional income. When he did the calculations Mr. Van Camp found, as you would expect, that the tax bill rises with other income. And the closer you get to replacing your pre-retirement wage income, the greater the burden. It peaks when 85 percent of your Social Security benefits have been added to your taxable income. Once you are over that hump, you’re done. Basically this is a tax surcharge on middle-income retirement. It can double your tax burden.

Here’s an example. Tim and Tina Taxable enjoyed an earned income of nearly $70,000 before Tim retired last year. Tina worked, but at lower wages and for fewer years. So she claims benefits under Tim’s work record. Together, they receive a total of about $35,000 in Social Security benefits. Their combined benefits replace about 50 percent of their earlier earned income. Their income tax bill rises sharply as their income from other sources rises.

With no income from other sources, they would pay nothing in income taxes. Ditto $15,000. But at $25,000 of other income they would pay $1,128, of which $523 is due to the taxation of Social Security benefits. Even though they have replaced only 86 percent of their pre-retirement income, their tax bill has nearly doubled.

With $35,000 of other income, their tax bill is $3,534, of which $1,931 is due to the taxation of Social Security benefits. This nasty and obscure wrinkle in tax law, in other words, has more than doubled the tax bill of a middle-income couple if they save enough to replace their pre-retirement income.

How The Taxation of Social Security Benefits Can Double the Tax Burden of Middle Income Retirees

		Plus other income of:
Household:	SS benefits	$25,000	$35,000	$45,000
Joint Return, Total Tax	$35,000	$1,128	$3,534	$6,309
Joint Return, if SS not taxed	$35,000	$ 603	$1,603	$3,054
Joint Return, SS tax burden	$35,000	$ 523	$1,931	$3,255

Single Return, Total Tax	$23,000	$2,894	$6,281	$9,894
Single Return, if SS not taxed	$23,000	$1,904	$3,404	$5,006
Single Return, SS tax burden	$23,000	$ 990	$2,877	$4,888
Source: Hoke, Van Camp & Associates, LLC

Is this a giant, crippling tax? No. Retirees can expect no sympathy from those still working because their tax burden is still lower at any earnings level. For retirees with savings, the loss of interest income due to the zero interest rate policy of the Federal Reserve is far more punitive.

It’s just hard to understand, another “gotcha” from Washington. Congress slipped it into the tax code decades ago in an orgy of bi-partisan agreement.

Nearing Retirement? Then Try a Shorter Term Mortgage

admin — Thu, 16 Aug 2012 09:00:00 Z

Q. We just bought a new house. We need to decide between a 15, 30 or possibly 20-year mortgage. My wife and I are both 51. We will likely work only another 10 to 12 years at most. At that point we will probably sell the house and move into something smaller (kids should be gone at that time). Any thoughts on how long a mortgage term we should select? ---J.S., by email

A. The answer depends on what you are doing in other areas of retirement preparation. At a minimum, you want to be certain that you are saving enough in qualified plans to capture your employer match (assuming there is one). If the higher payments on a 15-year mortgage would interfere with that, then it would be better to take out a mortgage with a longer term. It would be still better to save the maximum allowed in qualified plans, then take out the shortest mortgage you can handle easily. The operative word here is “easily”--- you don’t want to put yourself into a monthly payment straightjacket, particularly with kids still at home.

Selling the house later will create a nice "liquidity event," allowing you to make a well considered "right-sizing" decision on your retirement shelter, so maximizing mortgage pay-down is a really good idea.

Q. I would like to know what to do with money in an IRA account. I am 77. I have a pension and Social Security. I also have a five-year CD coming due this month in my IRA. This CD has been earning 5.3 percent. Now, the most I can get on a super jumbo CD for one year is 1 percent. I do not want an annuity. And I am not comfortable with the stock market. Is there anything out there that would earn more than 1 percent? I know I am going to have to start withdrawing principal. This is a common problem for seniors and I don't hear anyone addressing it. ---I.V., by email

A. The question isn't being addressed because there really aren't any answers that people will accept. Every investment that provides a higher yield than bank CDs involves some degree of risk. There are lots of ways to get yield out there--- the big telecom stocks come to mind, as do the "dividend aristocrats" stocks, REITs, preferred stock mutual funds and junk bond funds--- but none are guaranteed. And all can fluctuate in value by more than 20 percent a year. That's the way it is. You can thank the Federal Reserve for the policy.

Q. Here is my situation. I am turning 62 years old this year. My plan is to retire at age 65. I have 3 pensions plus a 401(k). I am single, have no dependents and in very good health. I have purchased my retirement home and have a mortgage of approximately $216,000 at 3.75 percent. I will soon be closing on the sale of my prior home and should have approximately $100,000 net proceeds after the cost of the sale.

My question is whether I should take the sale proceeds to apply on my mortgage amount or should I purchase a $100,000 life annuity that hopefully will generate enough income in 5 to 7 years to pay my monthly mortgage? At 3.75 percent, I think I'm better off generating income rather than having a lower mortgage balance. I will still have to pay the same monthly amount, just for a shorter time. Maybe I am way off base and should go in a totally different direction.
What should I do? ---P.B., by email

A. That's an interesting idea but it's not nearly as lucrative as you seem to think. You can see why by comparing payments. According to the website immediate annuities.com, a single male buying a $100,000 life annuity can expect a payout of 6.52 percent a year or $543 a month. In comparison, the monthly payment on a $100,000 mortgage for 30 years at 3.75 percent is $463. That would leave you with about $80 a month in extra spending money for the rest of your life. That's not bad. But if you wanted to pay the mortgage off in 7 years you'd have to make payments of $1,355 a month, which is $812 a month more than the annuity income.

How We Missed Truly Golden Years for the Social Security Trust Fund

admin — Sat, 11 Aug 2012 03:00:00 Z

A single Washington decision, in 1983, would have nearly doubled the value of the Social Security Trust Fund. That decision would also have made the retirement of today’s workers far more secure. With a reported balance of $2.68 trillion at the end of 2011, all invested in special Treasury obligations, the Trust fund would have been worth $4.99 trillion if it had instead been invested in gold.

Of course, that decision wasn’t made.

Gold is, after all, a “barbarous relic.” And the dollar is purported to be Almighty. Building the Trust fund was important in 1983 because the fund contained only $24.9 billion at the end of that year. That’s not much more than pocket change, enough to cover benefit payments for less than 8 weeks. Basically, the Trust fund was more like a checking account with a low balance.

And that’s why it was decided to have all of us worker bees pay more taxes. Paying more than was necessary to pay benefits would build the Trust fund to a respectable amount. Indeed, the idea was to build the Trust fund to an amount large enough to cover the benefits Boomers would have a right to claim when they started to retire in droves.

That would be now.

So our surplus employment tax dollars were invested in Treasury obligations. The obligations earned interest. The interest, in turn, was credited to the Trust fund in the form of still more Treasury obligations. From a small surplus over expenses of only $2.8 billion in 1984, our surplus payments grew to peak at $90 billion in 2001, reaching a cumulative peak of $1.21 trillion in 2009. Add the earned interest and you get the Trust fund total of $2,68 trillion for 2011.

That’s a lot of money. It’s also our money, taken from the wages of every worker in America. It is money we could have used to pay for food, education or invest for retirement.

Instead, our two worthless political parties spent the money to build or maintain their own power. Democrats used it for spending projects. Republicans used it for tax cuts. And today, the Social Security Trust fund is just another creditor of our perpetually cash short Treasury. Recently, the Treasury owed $11.07 trillion in public debt and $4.8 trillion to other government agencies, with Social Security being the largest. Total debt is $15.88 trillion.

If our surplus dollars had been invested in gold, the Trust fund could have bought over 7.7 million ounces with its $2.8 billion surplus in 1984. It could have added to its horde each year, building to a total over 3 billion ounces at the end of 2011. At a 2011 average price of $1,571.52 an ounce (about $40 less than the current gold price) the hoard would be worth nearly $5 trillion.

Would this be a free lunch?

Sorry, there is no such thing. Here are three side effects of building a gold Trust fund:

Without the Social Security surplus to tap for cash, our government would have had to borrow the same amount of money from other sources, such as China. So publicly held debt, with accumulated interest, would be about $2.7 trillion larger.
Our government would be paying actual cash interest on that debt rather than simply issuing more Treasury obligations as interest payments. This would have put pressure on other spending.
And since gold earns no interest and was flat in price for years, a gold Trust fund would have seemed like a really bad choice for many years. The value of the gold fund would not have exceeded the value of Treasury obligations until 2008.
Except for one thing: The world supply of gold is limited. Trying to buy 3 billion ounces would have moved the price higher, earlier. Perhaps much higher.

All of this, sadly, is a “woulda-coulda” fantasy— a road not taken. It can, however, guide us in our personal decision about whether to prefer government promises or gold for our own savings. That guidance now suggests it is time to prefer gold to dollars.

Here’s one indication. According to The Global Debt Clock on The Economist magazine’s website, global government debt now totals about $46 trillion. With the global inventory of gold at about 4.8 billion ounces, that means backing government debt with gold instead of more government promises would put the price of gold a bit over $9,580—about 6 times its current value.

You Don’t Get Higher Returns By Paying More

admin — Wed, 08 Aug 2012 21:00:00 Z

Q. For the past 20 years, I have invested in load mutual funds because I thought I could get a better return on my investment. I recently changed investment companies and was told that I should consider selling my load funds and switch to a no-load fund and save fees. Is this a good investment strategy? I am 50 years old and I plan to retire around the age of 62. —C.H., by email

A. Let's start with a primary truth: You don't get access to some secret sauce by paying a commission. You get access to a financial organization that maximizes its sales revenue by telling people it has a secret sauce that allows it to earn superior returns. In fact, there is no evidence that commissions or higher costs give you access to higher returns. What commissions do provide is an immediate reduction in your assets and an immediate income for the salesperson.

There is only one eternal verity in investing. It is this: Expenses are unending, but performance varies.

Alas, that doesn't mean you will be blessed with higher returns by moving to no-load funds. Some no-load funds have higher expense ratios than similar load funds. In addition, your new investment company may be trying to sell you a "wrap" account so they can charge you an annual fee to manage your lower cost no load portfolio rather than commissions to buy mutual funds.

What counts is that you find a way to manage your money so that the total long-term cost is as low as possible. This was important during our long, but nearly forgotten, bull market. It is even more important today, when fixed income yields are at historic lows and equity returns have been lower than their long-term average.

Since you have already paid the commission on the funds you have, one good test would be to compare the total expense of the funds you have with the total expense of your new offer, which is probably the cost of funds plus a management fee. The person representing your new investment company should be capable, and willing, to do this for you. If they aren’t, move on.

Q. I hope you will address the current long-term-care insurance environment. In my case, I purchased a group long-term-care policy through John Hancock Life Insurance. It looked reasonable and prudent since my family history is to have a long lingering healthcare needs from strokes. But today I opened a letter informing me of a 76 percent premium increase from $211 a month to $371 a month. Such an increase can only be based on astoundingly poor actuarial and cost forecasts. Fortunately I am 58, have only been insured for about 2 years, so changing would not be an issue.

Since pricing is somewhat determined by when you create the contract, choosing the correct —or nearly correct — horse out of the gate seems critical. How do I research this market and mitigate having such an adverse event? Is other other due diligence is needed? —G.H., Galveston, TX

A. While many long-term care insurance premiums were "low ball" premiums that under-estimated policy retention and use, lower investment returns on premium dollars have been the single largest, and most common, reason for premium increases. Insurance companies invest premium income and usually count on investment returns to contribute about 40 percent of the benefit dollars. But insurance companies are no different from other institutional and individual investors — returns in recent years have been poor to negative.

Unfortunately, LTC insurance providers were low balling buyers even when investment returns were at historical highs. So what we have in long term care insurance is a wonderful idea that has been poorly executed for a long time. It is unlikely that more due diligence will improve the odds of having a “no premium surprise” future.

My suggestion is that you explore other avenues of long-term care assurance, such as considering a move to a Continuing Care Retirement Community. These aren't financially perfect, either, but I have yet to receive a single reader letter complaining about costs or what they have experienced.

Beware of Financial Advisors with “Urgent” Investment Opportunities

admin — Sat, 04 Aug 2012 03:45:00 Z

Q. I am not sure whom to contact or if anyone can help. I have an 82-year-old aunt who has a personal friend and financial advisor pressuring her to take out $200,000 in a home mortgage because he has told her he can get a 7 to 8 percent return on her money. While I was visiting today he called. He was very insistent about the urgency of making this investment. I live about one and a half hours away so I don’t see her often.

My aunt has a $3,500 per month annuity, a home valued at $500,000, and an investment account. I don't know the value of her investment account. I am designated as executer of her estate. I told her I felt this was very risky at her age. She told me her money would be invested in "programs." She could not be specific about the details. I have a very bad feeling about this. Is there any thing I can do? I am extremely worried. —C.R., Burnet, TX

A. You're right to be very concerned. You can tell her the facts and show her this column. Anyone who says, with confidence, that he can get a 7 to 8 percent return in today's market is either a fool or a salesman without a conscience. (Possibly both.) Let me outline the risks that this proposal involves.

A 30-year mortgage for $200,000 at 4 percent interest would have a monthly payment of $955. That's a total of $11,458 a year or 5.7 percent of the amount borrowed. Your aunt would be committed to this payment regardless of the income produced by the proposed investment "programs." When someone describes an investment as a "program" they are usually talking about a private, non-liquid investment. So if the investments failed to produce the 7 to 8 percent return, she would have to get the $11,458 a year from another source— such as her annuity or investment account.

Either way, any degree of failure would result in an immediate and permanent decline in her standard of living. Equally important, her potential income gain, if the investment is successful, is not great due to the monthly cost of the mortgage. If the investment actually produces an 8 percent yield, her income would be $16,000, less the mortgage payments of $11,458 a year.

That's a net gain of only $4,542 a year— about $379 a month. She's taking a lot of risk for not much gain. That net gain, by the way, would be taxable, so the increase in her spendable income would be still less.

But suppose she really needs more spending money. Is there any way she can get some additional spending money without taking a lot of risk?

Yes. She can still borrow against her house. She can do this with either a home equity credit line or a reverse mortgage. If her house is worth $500,000 in the current market she could draw $379 a month, tax-free, for a bit more than 25 years before the principal and accumulated interest on her withdrawals reached $200,000. So she can borrow without taking investment risk.

During that time the house may increase in value, perhaps enough to offset the accumulated loan amount. If the house appreciated by only 1 percent a year, for instance, it would increase in value by $142,000 over the same 25-year period. If it appreciated at only 2 percent a year the house would increase in value by $324,000, fully offsetting the growing debt. During that entire period any interest she paid could be a tax deduction. The scenario would be similar for a reverse mortgage. Either way, she would not be taking on the risk of an unknown investment that could decline in value. She would only be taking on an obligation that is likely to be offset by inflation for as long as she lives.

If she really needs more income, it is likely that she is “house-poor” and has to spend too much of her income supporting her $500,000 house. So a still better plan would be for her to "right-size" her shelter, moving to a smaller less-expensive house and investing the difference. Another option would be to move to a continuing care retirement community.

Honey, I Hocked the Car!

admin — Fri, 03 Aug 2012 21:00:25 Z

I have a confession to make. I hocked my car.

Yes, your stalwart, ever prudent, trousers rolled, personal finance columnist borrowed against his car. In 40 minutes I went from being a guy with no car payments — a guy who hasn’t had a payment book in years — to being a debtor committed to 60 equal monthly installments.

The credit union that I visited had advertised, as others have in cities around the country, that they would make 5-year car loans, on not-new cars, at an interest rate of 1.99 percent. That’s close to irresistible.

I had to join the credit union, of course, but that wasn’t exactly a big deal.

The new accounts person asked for a $25 account deposit. Then she held up a small mirror and asked me to breathe on it. It fogged quickly.

“You’re in!!!” she said.

(Just kidding, she didn’t really make me fog a mirror.)

She then had me complete a loan application. It was short. Very short. I found myself wondering if there were some way to communicate this simplicity to the worshippers of Franz Kafka who process mortgage loans.

“How much do you want to borrow?” she asked.

I said, “How about $30,000?” That seemed a reasonable amount for a 2010 Lexus RX 350 with 35,000 miles on it. (Forgive me; our other car is a Prius.)

“Just remember you can’t raise the amount later,” she chided. “But if you ask for more you can always reduce the amount to what can be loaned.”

I raised the request to $35,000.

A few minutes later the request was approved for $33,000 based on an estimated car value of $35,950, a heroic 87 percent of its purchase price 30 months ago. A few minutes after that I was out the door, holding a newly minted cashiers check.

Why did I borrow the money?

Simple: It will save me money. Debt is the new thrift. While the Burns family doesn’t have a home mortgage, we do have a home equity credit line, at 3.99 percent. It was used to buy a lot adjacent to our home. So $33,000 of the 2 percent loan would pay down $33,000 of the 4 percent loan. Not bad for a 40-minute effort.

Several things are worth noting here. First, tax deductions are not a consideration. If your interest bill goes down by 50 percent, who cares if the new interest is tax deductible? Second, the new debt has more risk to the new lender than the old debt had to the old lender. Before, a small amount of money was borrowed against a house worth far more and with no mortgage. Now, a lender was risking the value of the collateral and charging half as much interest.

Go figure.

Sure, this isn’t a big deal. The actual benefits to me aren’t that large. In the first year I might save about $600 in interest. On the other hand, that $600 is enough to make about 30 visits with grandsons to their favorite fine dining venues: Dairy Queen, McDonald’s, Sonic and WhataBurger, all of which happen to be conveniently located in Dripping Springs, Texas.

Paying the remaining interest isn’t a burden, either. At 1.99 percent, anything I pay in interest probably won’t be enough to offset the loss of purchasing power the money I pay back will suffer over the next 5 years. At the end of June, for instance, inflation had reduced the purchasing power of a dollar by 9.9 percent over the preceding 5 years — even though one of those years, 2009, was a rare year of price deflation, the first since 1955.

Indeed, my ancient but trusty Texas Instruments financial calculator tells me that if inflation runs at the 3 percent rate it has averaged over the last 30 years, the $34,674 in payments that I make on this $33,000 loan will only have a purchasing power of $32,161. In effect, I am being paid to borrow money. I’m not being paid much, only $839 in current purchasing power over 5 years, but as I’ve already pointed out, it’s a lot more attractive when measured in breakfasts or lunches with grandkids.

It also compares quite favorably to the free promotional Stick-in-the-Eye now being given to depositors with each new 5-year CD.

Lazy Portfolios Beat Professionally Managed Portfolios

admin — Sat, 28 Jul 2012 03:03:55 Z

Some things change. Others don’t.

Costs matter. This is one of the eternal verities of investing. We know this from John Bogle, the founder of Vanguard and patron saint of index investing. If we act on this simple fact— that costs matter— we can improve our investment results.

This isn’t what Wall Street tells us. The investment community tells us that only their constant attention, their cadres of MBAs and PhDs, and their special knowledge of the world can lead us to good returns. They intimate that the more we pay them, the more likely we will get superior performance. They spend millions of dollars on advertising to convince us.

Alas, it isn’t so.

A simple exercise with the cost factor, however, can improve our results. Let me demonstrate.

At the end of May there were 194 mutual funds that Morningstar categorized as “moderate allocation,” or balanced, funds, with at least 5-year histories. These funds are typically a 60/40 mix of equities and fixed income. Their annualized return over the last five miserable years was 0.94 percent. Their average net expense ratio was 1.17 percent.

The top 25 percent of funds by expense cost at least 1.35 percent to manage, averaged 1.80 percent in expenses and produced an average return of 0.21 percent. If you selected from this group at random, hoping that high expenses would buy better management, you had only a 32 percent chance of doing better than average.

If you went in the other direction and chose from the 25 percent of funds that were least expensive, costing 0.88 percent or less a year to manage, the average return was 1.40 percent a year. You had a 55 percent chance of beating the average for the category. In other words, you’ve got a better shot— not a guaranteed shot, just a better shot— at superior results if you insist on lower expenses.

We can improve our odds a bit by selecting from the 25 largest funds. Doing that gives us an average return of 1.33 percent and a 60 percent chance of beating the average fund. One reason is that the largest funds also tend to have lower expense ratios— the group averages 0.75 percent. We can, in other words, virtually double our chance of above-average performance simply by favoring the large funds that tend to have lower expense ratios. We’ll have a 60 percent chance of above average return rather than only a 32 percent chance.

Not thrilled by those odds? I don’t blame you. This is your retirement money we’re talking about.

Thankfully, there is a better way. Marketwatch columnist Paul Farrell calls it the “lazy portfolio” way. Years ago he started reporting on the performance of do-it-yourself portfolios that could be built with low-cost index funds. These portfolios range from some of my Couch Potato portfolios to Bill Schultheis’ Coffeehouse portfolios, William Bernstein’s “Coward’s Portfolio” and David Swensen’s “Yale Model” portfolio. Today there are quite a few of these funds—trailing performance figures for 30 of them are reported monthly on my website.)

Eighteen months ago I showed that 11 of 14 balanced “lazy portfolios” beat the average for all balanced mutual funds over the preceding 3 years. So taking the lazy way out gives you a 79 percent chance of beating the category average.

The superior performance of these lazy portfolios continues today. If there were ever a period when perceptive selling and wise buying should have made a difference and put managed funds on top of the heap, it has to be the last 5 years. But superior decision making, once again, did not prevail. Measured over the 5 years ending May 31, the average managed balanced fund provided an annualized return of 0.94 percent. Over the same period the 25 largest funds returned 1.33 percent. But the 14 lazy portfolios averaged 1.45 percent and a random choice would have provided an 85 percent chance of beating the average.

What does this mean for you and me?

It means don’t be afraid. If you have fear and anxiety about making your own investment decisions— fear that you don’t know enough, fear that professionals will make much better decisions— it’s time to take a reality bath. The reality is that if you choose just about any “lazy portfolio,” the odds are that you will do better than if you choose the more expensive alternatives.

Would you like certainty?

Yeah, so would I. But there is no certainty. All we can do is search for the best odds.

Do-It-Yourself Portfolios Rule!

This table shows the rank-ordered performance, by five-year annualized return and decile, of 14 lazy portfolios whose asset allocations match what Morningstar calls “moderate allocation” mutual funds.

Portfolio	5 Year Annualized Return	Performance Decile
Vanguard Balanced Index	2.78	1
Yale Model	2.78	1
Coffee House Vanguard	2.54	1
Couch Potato Five Fold	2.32	2
Couch Potato Six Ways	2.12	2
Aronson Family Portfolio	2.06	2
7Twelve Balanced	2.06	2
Coffee House ETF	1.70	3
Ultimate Buy and Hold	1.55	3
Lazy Portfolios average	1.45	3
Avg. of 25 Largest in Category	1.33	3
Cowards Portfolio	1.32	4
Couch Potato Margarita	1.07	4
Andrew Tobias Lazy	1.07	4
Category Average, all funds	0.94	5
Frank Armstrong Index	0.28	8
Coffee House 3 ETF	(0.18)	9
Sources: Morningstar data for 5/31/2012; Craig Israelson; Author calculations

Shelter Is a Big Retirement Planning Lever

Scott Burns — Wed, 25 Jul 2012 03:00:00 Z

Q. I am hoping for a quick reality check on the status of my retirement savings. I am single, 64, with no children. I own my home outright and it is assessed at $475,000. I have no loan liabilities. My two IRAs totaled $265,500 at the end of 2011 (246,593 in regular, $18,910 in Roth). I have another rainy day brokerage account valued at $101,100, a life insurance policy worth $4,000 and $2,500 in a work-related retirement fund.

I have Social Security income of $1,400 and rental property income of $750 per month. I net roughly $15,000 per year from real estate sales. Last year’s expenditures totaled $36,000, so I anticipate working until I can no longer walk, talk or think. —L.B., by email

A. Maybe not. It could be said that you are working to support your house. At a value of $475,000 it is worth far more than the roughly $370,000 you have in financial assets. It probably costs you more than $15,000 a year to support. That reality also makes your house a very big lever on your retirement choices, particularly if you are willing to move to an area where home and condo prices have collapsed, such as Florida or do a significant down-sizing.

Here's an example. If you sold your house, netted $450,000, and bought a $150,000 condo you would still be living mortgage free— but you would have nearly doubled your investment assets, making it much easier for you to decide whether or not you wish to continue working.

The big decision here is about how you want to spend your time. Do you want to work to support a very nice home? Or would you rather have a less nice home and the time and money to do what you want? To put it another way, what has your house done for you lately?

Q. I am a 62-year-old woman, widowed since March of this year. I have some questions regarding my late husband’s two 401(k) plans, totaling about $300,000. I am currently drawing his Social Security. I also have income from his pension plan. I have no mortgage or other debt. A financial planner I have been talking to has recommended putting the 401(k)s, which fluctuate up and down with the market, into an EIA, an equity-indexed annuity. Please give me your thoughts on an EIA and whether this might be an appropriate option for me to consider. —N.C., by email

Q. Equity-Indexed annuities can reduce your anxiety over big market fluctuations because they guarantee no losses in any year. This is done by limiting your return to a portion of the change in value of the equity index and by excluding the dividend yield. As a consequence, you miss the big drops— but you also lose much of the gain in bull markets. In addition, you are subject to major cost penalties if you decide to sell your investment early, so you lose a good deal of financial freedom. If your financial planner is suggesting that you will get equity-like returns with much less risk, he is misrepresenting the product and its potential return. He may also be understating the complexities and limitations of the product.

Relative to most people you already have a great deal of stability in your financial life. You have Social Security. You have a pension. You own your home. And you are debt free. This means you can afford to take some amount of risk in your other assets— your two inherited 401(k) plans. If you move to an IRA rollover account you can consolidate two accounts into one and simplify your life. You could also invest in a low-cost balanced fund that will allow you to redeem shares at any time with no penalties. This would give you flexibility.

If you haven't been presented with this alternative, the probable reason is that your "financial planner" is really a product salesperson who gets 100 percent of his or her income from sales commissions, often for only one kind of product. This is a heavily sold product because it has attractive commissions, not because it is a universal investment solution. FINRA, the Financial Industry Regulatory Authority, has issued an investor alert, which you can read at this link: http://assetbuilder.com/MTACGK.

How Much Is A Future Year Worth?

Scott Burns — Fri, 20 Jul 2012 21:00:00 Z

There are two kinds of people in this world. Spenders. And Savers. There is no middle ground.

The savers prepare for every contingency in life. They have retirement savings. They have a reserve fund. They have long term care insurance. And they never borrow money. They do this by putting off until tomorrow (or much further) what they might do today. Some call them by their technical name: Party Poopers.

Their dilemma is summarized in a single statement: “If you don’t buy that Corvette, you can be sure your grandson will.”

Spenders can usually be recognized by their vacations, the newer model cars in their garage, their restaurant spending and the fact that they drink high-priced California wines with weird names instead of Three Buck Chuck.

Their dilemma is summarized in another statement: “My retirement will be fine as long as I die by Friday.”

Financial planners are savers. That’s why they want us to be 95 percent confident we can finance a 30-year retirement even though, as I have noted a number of times, there is an 82 percent probability of being dead by then. Somehow, it doesn’t seem sensible to be 95 percent prepared for something you only have an18 percent chance of experiencing. Honk if you feel the same way.

So how can we think about the future in a way that allows us to live well enough to avoid remorse for experiences missed on the one hand, while being prudent enough that we don’t have the retiree version of “too much month at the end of the money”— too many years without any money?

One possible solution is to value future years by the probability that members of a group of people just like us will then be alive. Yes, such information exists! It is available for free, like everything else on the Internet. You can get it by visiting the Center for Disease Control website and downloading the National Vital Statistics Reports’ “United States Life Tables.”

Trust me, you will be thrilled at the result. If you loved those wonderful trigonometry tables in high school or the mortgage tables that you may have come to know as an adult, reading the Life Tables will add a new dimension to your life. For one thing, you will realize how fortunate you are to be alive and thinking about this problem.

Why? Because if you are 65 you will realize that you already are a long straw holder. Of every 100,000 people born, the tables tell us that 83,251 are still alive at 65. That means an unfortunate 16,749 drew short straws and aren’t with us anymore.

From the same table we can figure out the probability that people like us— of the same age, gender and race— will still be around. Here are the results for the U.S. population as a whole. (If you are a black male, you’ll probably die sooner. If you are a white female, you’ll probably die later.)

Between age 65 and 66 the group loses 1,137 of its 83,251 people. A 65 year old has about a 98.6 percent chance of surviving the year. So that first year is assigned a value of .986 because that is the probability of living through it.
After that, we calculate the odds of living to any particular year and value the year at that amount. By age 75, for instance, a 65 year old has only a 78.5 percent chance of still being alive, so we give that year a value of only .785.
By age 90 a year is “worth” only .221. (You may, of course, feel differently about the value of that year when you are 90.)
If we add the adjusted values for the 35 years between age 65 and 100, the total is 18.1 years. That’s a lot less than 35 because we’ve put a lower value on each successive year since we may not be alive to live it.

Here are some observations from the figures:

The 10 years from 65 to 75 are “worth” as much as all 25 years from 76 to 100 because of the higher probability of being alive in the first 10. So go for it today.
The 17 years from 65 to 82 are “worth” 4 times as much as the years remaining from 83 to 100.

What does it all mean? Decide for yourself. It tells me that now is a lot more important than later.

Life Annuities Are Most Useful for People Without Pensions

Tue, 10 Jul 2012 21:00:00 Z

Q. You recently addressed a question from a couple whose ages are 75 and 77. You replied “At a later date, you might consider buying a joint survivor life annuity.” Since the couple was in their 70s it got me wondering: what are the tradeoffs to buying a life annuity at younger ages versus older ages? And is there a rule of thumb regarding the most appropriate age to purchase an annuity?

Another question regarding life annuities. My wife and I will retire in a few years. In addition to Social Security and 401(k)s, and some additional savings, we both have defined benefit pensions. Should we consider a life annuity? Or would an annuity be unnecessary if pensions serve a similar purpose of providing reliable income that won’t vary based on market ups-and-downs? —S.H., by email

A. If the combination of your Social Security and defined benefit pensions covers a significant portion of your spending, it's hard to get enthusiastic about adding another life income tool. My own rule of thumb— and it is just that, a rule of thumb— is that if your Social Security and pension income covers your "core" expenses— shelter, transpiration, medical, household and related income taxes— then you have no need for a life annuity. This may be your situation.

But many people— most, in fact—have no pension and Social Security may cover only a small portion of their core spending. In that case, changing their portfolio to include a life annuity becomes very attractive.

At what age you should buy a life annuity is a long discussion. Most advisors suggest buying multiple life annuities over a period of years, letting the increase in age work in your favor to bring higher monthly payments.

Q. I recently graduated college and am looking for good ways to invest. I have been reading about your couch potato method and it seems like a great and easy way I could start preparing for the future. The problem is being a college graduate means I have very little money to use to start a couch potato portfolio. Are there any of index funds I can invest in without the fees or minimum starting balance? Are there any index funds I can directly use without going through a broker? I would like to be able to do monthly deposits into the fund and let it grow over time. —I.T., by email

A. I'm glad you are thinking about investing for your future but you'll need to set some priorities first. As a recent college graduate your primary asset is YOU. That means nurturing you freedom to make choices, negotiate your salary, and move your life forward. All of that requires cash, so focus on having a good cash reserve before you start to invest for a more distant future.

Remember, your ability to negotiate a $3,000 salary increase is a much larger return than you will get on a small account. It's also about the amount you need to invest in many mutual funds. So focus on having a cash reserve that will allow you to be a strong compensation negotiator.

After you've done that you can start with small investments in a low cost exchange traded fund, ETF. With a minimum investment of $1,000, for instance, you can open a brokerage account at Charles Schwab. Once open, you can buy shares of Schwab’s commission-free exchange traded funds. The Schwab U.S. Broad Market ETF, for instance, has an expense ratio of only 0.06 percent. This is less than the 0.07 percent cost of Vanguard Total Market Index ETF and one-third the expense of other competing ETFs. If you are secure in your job and can understand that a market decline is an opportunity for a young person, not a disaster, a simple start would be to go “all-in” in the Broad Market fund.

It is important that your account start with no-commission ETFs. Here's why. Even a small discount broker commission, such as the $8.95 charged by Schwab, can be a burden. On a $1,000 investment, for instance, that $8.95 is equal to a cost of 0.895 percent a year. It's a one-time cost, but it's still a burden you should avoid if at all possible.

How Much Will The Oldster Tax Cost You?

Scott Burns — Sat, 07 Jul 2012 03:00:00 Z

Allow me to introduce the Oldster Tax. It is a tax for which there is no legislation. It is a tax that is not administered by the Internal Revenue Service. Instead, it has been imposed by the Federal Reserve, an institution that has the power to set interest rates.

The folks at the Fed don’t call it a tax, however. They call it a policy—ZIRP, for zero-interest-rate-policy.

Low interest rates are a two-edged sword. It’s great if you are a young borrower. A low interest rate mortgage means you can buy a bigger house. A low interest rate car loan means you can buy a more expensive car. The hope at the Federal Reserve is that young borrowers will splurge and stimulate the economy with their borrowing.

Sadly, the sword cuts the other way if you are a retired saver. After decades of saving, millions of oldsters are discovering that their savings earn next to nothing. Savings earn less than nothing if you consider inflation and taxes. Basically, the Federal Reserve has been trying to boost the confidence and living standard of the young— and paying for it by attacking the living standard of the old.

Can you avoid the Oldster Tax? Yes. Be poor. Have no savings.

You can understand the impact of the invisible tax on the elderly by watching the decline of interest income from $50,000 invested in a 5-year Treasury obligation. As recently as 2000, this would have yielded about 6.15 percent and an interest income of $3,075 a year. Now the same obligation is yielding 0.7 percent and an interest income of $350 a year. This is the lowest yield on this maturity of Treasury debt since the Federal Reserve started keeping an index of the yields in 1953.

But it’s more than a low interest rate. It’s an income decline of nearly 89 percent in just 12 years.

So here’s a tough question: How much would the standard of living of retirees decline if current conditions persisted into the distant future?

To measure this I created an imaginary retiree couple, Mr. and Ms. Pennywise, and used ESPlanner consumption-smoothing software to see how much their standard of living would decline under a variety of investment return assumptions.

Here’s what we know about the couple. They are both 65, just retired from their $45,000 a year jobs. They have regular savings of $90,000 and retirement account savings of $270,000. They own their $240,000 house free and clear. Supporting the house costs them $4,800 a year for taxes, $800 for insurance and $7,000 for utilities, services, repairs and replacements. Each receives Social Security benefits of $1,500 a month.

What does their retirement look like? Well, if their regular savings earn 5 percent and their retirement accounts earn 8 percent in a balanced portfolio and inflation averages 3 percent— figures that (believe it or not) represent historical norms— they would enjoy a constant, inflation-adjusted discretionary income of $35,578. This is the money they would have available to spend every year for the next 30 years after paying for taxes, Medicare premiums that rise faster than inflation, and all of their shelter expenses. At the end of the 30 years their savings would be exhausted, but they would still own the house.

If something like the present continues— a 1 percent yield on savings, 5 percent on a balanced portfolio and 3 percent inflation— their discretionary spending would drop to $26,414, a decline of 26 percent.

If things get worse and we have yields of 1 percent on regular savings, 3 percent on a balanced retirement fund and 4 percent inflation, their discretionary spending would fall to $20,988, a decline of 41 percent.

Is this how it would affect every retiree? No. Retirees with smaller nest eggs would be less affected because more of their income comes from Social Security and less from investments. Retirees with more in savings, however, would be more affected because a larger proportion of their income comes from savings.

How will lower returns affect you?

It all depends on your income, marital status, whether you own or rent, whether you have a mortgage, etc. But you can find out for yourself by going to basic.esplanner.com and using the free version of the consumption-smoothing software I have used as the basis for many columns.

Index Funds Best for Do-It-Yourself Investors

Scott Burns — Thu, 05 Jul 2012 03:00:00 Z

Q. My wife and I have been working with one broker for 30 years. We aren't anywhere near being in the "1 percent." Our portfolio peaked at $460,000 in November 2007. As the market slid the financial advice we got was "The market goes up. The market goes down. You have high-quality funds. Our analysts say you will be fine. You shouldn't try to time the market." (Even though fund managers and brokers do that every day).

Our investments lost 21.5 percent ($97,000). Way too late, I had her put all of the money in CDs, which were still paying 3 to 4 percent. We would have lost more if we had not done that. As our CDs matured we cautiously got back into the market. My wife still refuses to let go of CDs. She figures no growth is better than losing more. I broached the subject of the index funds frequently mentioned in your column. Our broker is staunchly not in favor of selling our American Funds Growth, Bond, and New World holdings to get into the Vanguard index. Can you provide an apples-to-apples comparison of how these four funds have been performing? —D.T., Austin, TX

A. You received sound advice. Don't blame your broker. She is working within the structure and rules of her brokerage firm. Choosing American Funds for a client is one of the best ways a broker can serve her client in the environment of a brokerage firm— she gets a commission (as she must to pay her bills) and you get funds that have expenses that are very low compared to most of the funds sold through brokerage firms. In addition, there have been long periods where American Funds have done very well, including periods where they have done better than index funds.

Index funds like the Vanguard 500 Index are for "do-it-yourself" investors— people who make their own decisions. Some people worry that this takes a lot of time and knowledge but my Couch Potato portfolios have proven that you can manage your own money without any particular knowledge. All you need is the ability to buy a small assortment of index funds in equal amounts and then rebalance back to equal amounts once a year. You can do this with any discount brokerage firm account. Sadly, most of the legacy financial services firms, such as traditional brokerage houses, are still busy suggesting they have a "special sauce" for beating the market.

According to the Morningstar website, American Funds Balanced Fund A shares have been in the top 25 percent, or better, in the last year, 3 years, 5 years and 15 years. Over the last 10 years they dipped below that and were in the top 26 percent. Unfortunately, your particular funds have not done so well and have had periods when their performance was in the bottom 50 percent.

They may not remain there forever, but the possibility is one of the reasons that I have focused on low-cost index funds for many years— if you stick with the major indexes, you'll almost always be in the top 50 percent and you'll often be in the top 25 percent for equity funds. And with bond index funds you'll almost always be in the top 25 percent.

Q. My wife and I are in our seventies. In the next 6 months, we are going to have about $200,000 in CDs mature. The current rate is not acceptable to us. Please offer us some better alternatives with better rates, that are secure. We have been using the returns on these CDs to pay our property taxes. Today the same CDs won’t pay a quarter of our real estate tax. —J.M., by email

A. We'd all like to find the fabled "Lost Mine of the High Yield CDs" but, like the Fountain of Youth, it does not exist. The best you can do is shop for the occasional bank that is offering a yield that is somewhat higher than other banks. Recently, for instance, bankrate.com showed 8 banks that offered 1 year CDs with yields slightly over 1 percent. This is about 3 times as much as the national average rate of 0.33 percent. You could also get about 1.70 percent on a 5-year jumbo CD compared to the national average rate of 1.14 percent.

It’s 2012: Do You Know Where Your First Million Is?

Scott Burns — Sat, 30 Jun 2012 03:00:00 Z

Work. Some people love it. Others are addicted. Still others find it amusing: they can watch it being done for hours. But here’s the big question: How much money would you really need to have a choice about working?

The answer: It depends.

This is why I created the Life of Riley Index, my annual attempt to nail down how much money one would need to live well without submitting to the inconvenience of work. Achieve this and you will also receive a lifetime membership in the Big Lebowski Fan Club.

Note that we are not talking about being rich. While having $1 million was once a clear sign of being rich, millionaires are now so numerous that, well, it’s kind of common, if you know what I mean. In fact, those with only $1 million to $5 million are now identified as “entry level millionaires.”

But who cares? If your interest in money is like mine, it’s a purely practical concern. You want to know how much money you’ll need to live with some comfort after you’ve told your boss the final destination for your job. Having the cash to own an Aston Martin, your own private island or a house with a wine cellar larger than a Walmart has never been on your radar screen.

That’s why the Life of Riley Index is based on income figures from the Internal Revenue Service. Every year they study our tax returns. This allows them to see where the money is and how much it takes to be in the top 50 percent, top 25 percent, top 10 percent, top 1 percent and top 0.1 percent of all household incomes. (Yes, they were tracking the top 1 percent long before Occupy Wall Street existed.)

In 2009, the last year for which the data is available, you needed an adjusted gross income of at least $66,193 to be in the top 25 percent of households in America.

What’s so special about the top 25 percent? It is a rough proxy for the amount of income you need to be happy.

Studies have shown that most of us judge our well being relative to others. If our income is higher than most, we compare well and feel pretty good. The same studies have shown there is a limit to how much happiness you can buy with money. Once we’ve got food, clothing, transportation and shelter, improvements don’t do much to increase our happiness.

Yes, quite a few people didn’t get that memo. That’s why they are still out there, striving for more money, building bigger yachts and avoiding the indignity of airport security by having private jets. It’s also why publications like Forbes Life, Town & Country and the Robb Report regularly suggest that our life will be so much better if we have a (fill in the blank).

In fact, most of us truly don’t care. (Everyone in favor of a lifetime sabbatical from the Kardashians, please raise your hand.) That’s why I set the income threshold at being in the top 25 percent of households. Your personal number may be higher, or lower. Feel free to quibble.

From there, we examine the yield on common stocks and 5-year Treasury securities. Then we use those figures to calculate how much money we’d need if we lived on dividends and interest or a 4 percent annual withdrawal rate.

“The number” this year is a hefty $3,966,000. This assumes you are young and live on your dividends and interest only. The amount is so high because stocks are yielding only 2.35 percent. And the 5-year Treasury, which was yielding 5.77 percent only 15 years ago, is now yielding a pathetic 0.76 percent. (Send a thank you note to Chairman Ben at the Federal Reserve.)

Are you a bit older and willing to risk running out of money? Then you can bet on taking 4 percent a year from your money. That chops your number by more than half— to about $1,769,828. But it’s still a lot of money.

And what about retirees? If you are retired, you have Social Security benefits. According to the Social Security Trustees annual report, an above average worker can expect Social Security to replace about 40 percent of his or her income. That means a Life of Riley retiree would need to have 40 percent less money. That takes the number down to $1,061,897.

Hey, call it a million.

(If you’d like to see how incredibly this index has changed in each year since 1985, visit my website or see the table below.)

The Life of Riley Index, 2012

Year	S&P500 Yield	5Yr Treasury Yield	50/50 Portfolio Yield	Top 25% AGI Threshold	50/50 Rentier	Nest Egg needed @4% withdrawal rate	Nest Egg needed after 40% SS
1985	4.25%	10.12%	7.19%	$30,928	$430,452	$773,200	$463,920
1986	3.49%	7.30%	5.40%	$32,242	$597,627	$806,050	$483,630
1987	3.08%	7.94%	5.51%	$33,983	$616,751	$849,575	$509,745
1988	3.64%	8.47%	6.06%	$35,398	$584,608	$884,950	$530,970
1989	3.45%	8.50%	5.98%	$36,839	$616,552	$920,975	$552,585
1990	3.61%	8.37%	5.99%	$38,080	$635,726	$952,000	$571,200
1991	3.24%	7.37%	5.31%	$38,929	$733,817	$973,225	$583,935
1992	2.99%	6.19%	4.59%	$40,378	$879,695	$1,009,450	$605,670
1993	2.78%	5.87%	4.33%	$41,210	$952,832	$1,030,250	$618,150
1994	2.82%	6.68%	4.75%	$42,742	$899,832	$1,068,550	$641,130
1995	2.56%	6.77%	4.67%	$44,207	$947,631	$1,105,175	$663,105
1996	2.19%	6.07%	4.13%	$45,757	$1,107,918	$1,143,925	$686,355
1997	1.77%	5.77%	3.77%	$48,173	$1,277,798	$1,204,325	$722,595
1998	1.49%	5.15%	3.32%	$50,607	$1,524,307	$1,265,175	$759,105
1999	1.25%	5.54%	3.40%	$52,965	$1,560,088	$1,324,125	$794,475
2000	1.15%	6.15%	3.65%	$55,225	$1,513,014	$1,380,625	$828,375
2001	1.32%	4.55%	2.94%	$56,085	$1,910,903	$1,402,125	$841,275
2002	1.61%	3.82%	2.72%	$56,401	$2,077,385	$1,410,025	$846,015
2003	1.77%	2.97%	2.37%	$57,343	$2,419,536	$1,433,575	$860,145
2004	1.72%	3.43%	2.37%	$60,041	$2,533,376	$1,501,025	$900,615
2005	1.83%	4.05%	2.58%	$62,068	$2,410,408	$1,551,700	$931,020
2006	1.87%	4.75%	2.94%	$64,702	$2,200,748	$1,617,550	$970,530
2007	1.86%	4.43%	3.31%	$66,532	$2,010,030	$1,663,300	$997,980
2008	2.37%	2.80%	3.15%	$67,280	$2,139,269	$1,682,000	$1,009,200
2009	2.40%	2.20%	2.59%	$66,193	$2,560,658	$1,654,825	$992,895
**2010	1.98%	1.93%	2.30%	$67,186	$2,921,126	$1,679,647	$1,007,788
**2011	2.05%	1.52%	1.96%	$69,201	$3,539,717	$1,730,037	$1,038,022
*2012	2.35%	0.76%	1.79%	$70,793	$3,966,000	$1,769,828	$1,061,897
Sources: IRS data, Economic Indicators, Federal Reserve, Author calculations *=income estimated by application of increase in CPI for 2010 to 2012 = yields estimated for 2012 using most recent figures

You Can Reduce Investment Anxiety, But You Can’t Eliminate It

Scott Burns — Wed, 27 Jun 2012 21:00:00 Z

Q. My husband and I are both retired, ages 65 and 70, respectively. Two bear markets have hit us hard— 2000 and 2008. Our financial assets are down to about $1.4 million (two IRAs, two Roth IRAs and a joint account). We are getting nervous about staying in the market. We have a mix of short-term bonds and stocks in companies with good dividends. But we are thinking of selling at least a million. The problem is we don't know where to invest if we decide to sell.

We receive $2,769 a month from Social Security (taken at age 62), but no pensions. We owe about $98,000 on our mortgage (we refinanced last year at 4.5 percent and pay an extra $100 toward the principal each month). My husband does not want to pay it off. We have no debt other than the mortgage. We feel that we should no longer be taking the risks we are taking now with the stock market. What do you suggest? —J.K., by e-mail

A. Having a mortgage balance is a reasonable risk proposition for a couple with your financial assets— the mortgage is small compared to your net worth. The mortgage may also be a good hedge against inflation since you are likely to be paying back dollars that are worth less in the future. If that is the argument for the mortgage, then I don't understand why you would be paying an extra $100 a month to lose your inflation hedge sooner.

On the other hand, the need to make the mortgage payment puts pressure on your portfolio assets to produce income. So if you really want to sleep at night, paying off the mortgage would be a good thing to do. It will decrease your need for income.

Now let’s think constructively about your $1.4 million in financial assets. If you withdraw at a 4 percent annual rate, that would be an annual withdrawal of $56,000. If you kept $560,000 in a 10-year ladder of CDs and CD-like annuities, you would not have to touch the $740,000 remaining (after paying off the mortgage) for 10 years. In addition, while you would be spending $56,000 from a matured CD each year, your actual interest income and dividends would be added back to the portfolio. The investment income would be less than you withdrew, but your rate of loss would likely be relatively small.

You could also increase the ladder to $840,000, enough for 15 years of income coverage. During that 15-year period you have a 45 percent chance of dying. It's kind of tough to think this way, but the mortality tables suggest you've got a nearly 50 percent chance of having transcended any concern for money.

Can you avoid anxiety? No. But you can reduce it.

Q. I have successfully implemented your low cost philosophy with my IRA investments. I am retired and looking for yield. I currently own the Vanguard Total Bond Market Admiral shares (VBTLX) fund and am seriously considering switching at least half to Vanguard TIPS (VAIPX) since I'm concerned about future inflation. Do you view this as a wise move, or is it simply rearranging the deck chairs on the Titanic? —J.H., Garland, TX

A. It’s a very reasonable move. It would reduce your inflation risk and credit risk. Some observers are concerned that so many investors are piling into TIPSs that inflation protected securities are becoming overvalued. Many TIPS are priced at a premium. This means your return to maturity will be the inflation rate less the premium you pay when you buy the securities. Recently, for instance, even 10-year TIPS were priced at a small premium.

When first offered in 1997 TIPS were priced to provide a return of 3 percentage points over the inflation rate, a real bargain. Today you’ll be fortunate to keep your purchasing power. The Vanguard Inflation Protected Securities fund has been used in the basic Couch Potato portfolio for many years.

The big difference between Vanguard Total Bond Market (and other equivalent funds) and the TIPS fund is that Total Bond Market reflects the entire bond market. According the Vanguard website 43.6 percent of the portfolio was invested in Treasury or government agency obligations while nearly 26.1 percent was in mortgage-backed securities. Another slug was in corporate bonds. Because of this, most analysts would say there is more interest rate and credit risk in the Total Bonds fund than in the TIPS-only fund.

Consumers: Some Light in a Long Tunnel

Scott Burns — Fri, 22 Jun 2012 21:00:00 Z

As we all read a few weeks ago, household net worth has been set back 20 years. But scant attention is being paid to some good news from the consumer economy. We’re pushing debt back, way back.

This is a big deal. The consumer economy accounts for 70 percent of all economic activity.

The Federal Reserve’s “Household Debt Service and Financial Obligations Ratios” track how committed (or overcommitted) we are. In the last quarter of 2011, these figures show, our household debt service ratio was 10.88 percent of disposable personal income, down from a peak of 13.96 percent in the third quarter of 2007.

If this seems trivial, it’s not. The last time our obligations were so modest was in 1994, 18 long years ago. And even that period was brief. You have to look back to the early 1980s to find a period where the debt service ratio was consistently that low.

A broader Federal Reserve figure tells the same story. The financial obligations ratio starts with the debt service ratio. Then adds other commitments, such as property tax and insurance payments for homes, rent payments for renters, and automobile lease payments. That ratio peaked at 18.85 percent in the 3rd quarter of 2007. It fell to 15.93 percent at the end of 2011.

Again, that may seem trivial, but it’s not. The low since 1980 is not much lower, only 15.45 percent.

We are getting stronger. We’re in much better shape than we were 5 years ago. Virtuous saving, alone, did not do this. The financial obligations ratio has declined as some have defaulted on debt. Nearly 5 percent of households have made a painful, often involuntary, transition from homeowner to renter. Others refinanced their homes and, sometimes, their automobiles. Still others moved to lower interest rate credit cards. Today’s lower interest rates are hellish for savers, but they have provided a lot of relief to borrowers.

So, are we ready to go back to the mall? Can we be counted on to consume and borrow more? I doubt it.

Here’s why: It is a misnomer to call our economy “the new normal.” In fact, it’s a crazy-making economy. Everything about our economy is geared to our being active consumers and willing borrowers. Unfortunately, most of the circumstances that made us willing to take on debt have gone away. You can understand this by taking a quick look at history.

Our consumer society can trace its origins to a series of powerful events. One was the creation of a well-paid labor force. That happened in 1914 when Henry Ford doubled workers’ wages to $5 a day. Another was the creation of consumer finance. That happened when General Motors decided to finance cars rather than force buyers to pay cash. Others were the creation of job security by the powerful labor unions and the creation of worker pensions and health insurance.

And let’s not forget the government insured 30-year home mortgage. That same mortgage, with an interest rate that was often lower than the rate of home appreciation, fueled the growth of net worth for middle class families— even if they didn’t save. Basically, consumers consumed while home appreciation, pensions and Social Security took care of the future.

All that is history.

Today, most of that security has gone away. There is no need to search for experiences of job loss, job security loss, health insurance reduction, pension freezing or elimination, etc. Whether you consider the discussion of lowering future Social Security benefits, restructuring Medicare, recent moves to trim public employee pensions, the difficulty of obtaining home mortgages, or the continuing flatness of the housing market, it’s quite clear that the foundation for the consumer economy has eroded badly.

So how should we adapt to our tougher circumstances?

The answer, regardless of age, is that we need to continue paying down debt and reducing those financial ratios. This will give us flexibility with our income. Flexibility is a substitute for security.

How is this good news? For one thing, we can sleep better. More important, every percentage point reduction in those ratios represents income that can be spent on personal consumption.

We just won’t be borrowing to do it.

Pensions: When a Bird in the Bush Can Be Worth More than a Bird-in-Hand

Scott Burns — Wed, 20 Jun 2012 21:00:00 Z

Q. The subject of whether to take a company pension or a life annuity is slim pickings when surfing the net. I plan on retiring within the next 12 months. I have the option of a $560,000 lump sum payment or a $37,200 annual pension (no cola). My spouse would get half that income upon my passing.

If I take the lump sum I would have a total of $1,200,000 in assets. Using a 4 percent draw down rate, that would allow me to retire with a projected income of $48,000. If I take the $37,200 pension and draw on my $640,000 retirement account at 4 percent the income would total about $62,800 ($37,200 pension plus $25,600 from the investment account). With the exception two fee-based advisors everyone says take the lump sum.

What am I missing? —W.V., Flower Mound, Texas

A. You're not missing anything. This is not an easy decision. It has a lot of moving parts and all kinds of uncertainty. Provided that your pension fund is well funded— that it has assets to back its promise of a lifetime income— the prudent decision is to take the pension, not the lump sum.

Here's why. That $37,200 annual income amounts to a 6.66 percent annual distribution from the $560,000 lump sum. While it won't increase, it will mean that you won't be so dependent on your other financial assets. To have a $48,000 annual income from your pension and investments, for instance, you would only need an additional $10,800 a year in income from the $640,000 you have, or 1.7 percent a year.

That's less than you could earn in a broad index of common stocks. This means you could enjoy a rising income as dividends increase, regardless of the ups and downs of stock prices. More important, it means you would not be trying to squeeze 4 percent out of $1.2 million and, very likely, selling stocks to do it. It means you could avoid the need to sell equities in the early years of your retirement. This works, studies have shown, to increase the odds that you won't outlive your money.

A 2002 study for TIAA-CREF by John Ameriks, Robert Veres and Mark J. Warshawsky showed that using a portion of your retirement assets to buy a life annuity would increase the probability of being able to make withdrawals from the remaining assets for 30 years. A balanced portfolio without an annuity investment, for instance, was estimated to have a 76.3 percent chance of survival. But if 25 percent of the money was invested in a life annuity the probability rose to 85.1 percent. Invest still more and the survival probability for most portfolios rose to about 95 percent. (You can read the earlier column on this here.)

There are psychological benefits as well. If the combination of your Social Security benefits and the corporate pension is enough to cover all your basic expenses (including your income taxes) you will experience a remarkable freedom. You will also be able to use your financial assets with greater flexibility. Retirees who depend on their savings for every dime over their Social Security income are having a very tough time coping with the current zero interest rate policy of the Federal Reserve. It amounts to an indirect tax on people with savings, who tend to be older people.

Q. What is the "break even point" of when to take Social Security monthly benefits when I reach full retirement benefits at age 66? —W.L., Houston, TX

A. Once you reach full retirement age your benefits will increase by 8 percent for each year of deferral. Since future benefits are also adjusted for inflation, this means your break-even in real purchasing power is about 12.5 years— that’s when you’ll have received as much in additional benefits as you gave up by delaying them. At age 66 the life expectancy of the average American (all races and both genders) is 17.8 years. Life expectancy for a 66-year-old white male is 16.3 years. As a consequence, deferring benefits is a good bet. You may also enjoy some tax savings since deferring benefits for a few years can help you avoid the their taxation.

The Lower Ninety

Scott Burns — Fri, 15 Jun 2012 21:00:00 Z

Raw numbers can be striking. While Occupy Wall Street has focused on the 1 percent versus the 99 percent, the recently released Federal Reserve report on the Survey of Consumer Finances clearly shows that the Lower Ninety— the 90 percent of all households that are less well off that the top 10 percent— were hard hit by the housing bust that started in 2006 and endures today.

The study, which shows how our finances changed between 2007 and 2010, also confirms all the piecemeal reporting on foreclosures, job loss and the 401(k) plans that became 201(k) plans. And the losses aren’t limited to the housing wipe out. Most households are worse off today than they were in the survey done for 2001, before the housing bubble. Here are some of the findings from the report:

The decline in net worth goes well beyond 2007.

From 2001 to 2010 the bottom 20 percent of all households went from a modest net worth ($1,400 in 2010 dollars) to a negative net worth. While the largest percentage decline in net worth was for households in the second quintile (between 20 and 40 percent from the bottom), every household category but the top 10 percent suffered a decline in net worth. If most Americans feel poorer, it is because they are.

The major source of loss was the housing bubble.

But you knew that. The loss was large because home values dominate the personal balance sheets of most households. Worse, the lower you are on the net worth scale, the greater the size of your home mortgage as a portion of home value. The same leverage that made people quickly rich during the bubble worked to destroy net worth very quickly in the downturn.

The housing bust hit the South and West hardest, largely because those areas were experiencing the largest population growth and development.

Some changes were contrary to expectations.

The median real income for most age groups fell from 2001 to 2010. The only age group to enjoy an increase in real income was those 65 and over. The AARP may need to consider this. (This may reverse in the 2013 report. It will show the impact of the Zero Interest Rate Policy from the Federal Reserve over the period.)

Another surprising change is that the only group by level of education to enjoy an increase in real income from 2001 to 2010 was those without high school diplomas. Their median income rose from $20,800 to $23,000. The median real income for those with college degrees fell from $83,100 to $73,800, an 11 percent decline.

The used car market is really important.

Used car prices have been rising. That’s a good thing because about 75 percent of all households have more invested in their cars than they have in CDs or individual common stocks. It also appears that nearly 50 percent of all households have more tied up in their cars than in their retirement accounts.

We truly are a consumer economy. The report also found that only 52 percent of all families saved money over the preceding year, the lowest proportion since the data started being collected in 1992.

So, how are you doing? Where do you stand? The report can help us with that: It provides percentile data on wealth and income. It may be some relief to know that your financial health has declined but your status hasn’t— you’re still in the same percentile group. Or not.

You’re in the Lower 90 percent if your 2010 income was under $142,300 and your net worth was under $952,500.

If your net worth is over $77,300 you’re in the top half of all households. You’re in the top 25 percent if your net worth is over $301,700.

If your income is over $94,600 you’re in the top 20 percent of all households. You’re in the top 40 percent if it is at least $57,800.

Are We Having Fun Yet?

The Decline of Wealth and Income Since 2001

Percentile of Income	2010	2001
20th	$20,400	$20,600
40th	$35,600	$37,800
60th	$57,800	$63,000
80th	$94,600	$100,800
90th	$142,300	$145,600
Percentile of Wealth
25th	$8,300	$15,700
50th	$77,300	$106,100
75th	$301,700	$351,800
90th	$952,500	$907,000
Source: http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12.pdf ,pg. 77

Index Funds Can Have Major Tax Advantages

Scott Burns — Wed, 13 Jun 2012 21:00:00 Z

Q. Just read your article about the costs of variable annuities. Is 0.17 percent a year the only cost for the Vanguard 500 Index Fund? Does this charge reduce my return? Are there any taxes due each year? Do these taxes reduce my net return? By how much? Seems to me that you left quite a bit of info out of your article. — A.R., by email

A. There are a number of sources of funds that replicate the S&P 500 index. Some of them have even lower costs than the 0.17 percent you mention. Vanguard, Fidelity and Schwab, for instance, all offer mutual funds or exchange traded funds (ETFs) with expenses as low as 0.05 percent. The only cost other than the annual expense ratio cost is the cost of transactions, a cost that all funds have. Such transaction costs are tiny for broad index funds compared to typical managed funds. As in all mutual funds, annual returns are calculated net of the annual expense ratio.

Each year index fund investors, like managed fund investors, are subject to income taxes on both dividend income and realized capital gains. Historically, that burden has been light, but that description doesn’t really tell you how tax efficient they are. So consider these figures.

Dividends are now taxed at 15 percent. The S&P 500 index now has a dividend yield of about 2 percent a year. So if you pay a 15 percent income tax rate against that, it will reduce your gross return by 0.30 percent (.15x2.00) of your investment each year.

Capital gain distributions are even less of a concern. Using Morningstar Principia I found that over the 15-year period ending 12/31/12, and based on an initial investment of $100,000, the SPDR S&P 500 index exchange traded fund (ticker: SPY) had distributed $0 in capital gains. The Vanguard 500 Index fund had distributed $1,977 in capital gains over the same 15-year period. That would bring the total tax cost, over 15 years, to about $150 or 0.15 percent or 0.01 percent a year.

In other words, the largest cost of these funds would have taken 0.31 percent a year off the pre-tax return. This is a fraction of the typical 1.00 percent, or more, charged every year for the insurance wrapper of variable annuity funds. As a consequence, the tax burden on a broad index fund doesn't slow down the growth of your money nearly as much as the fee burden of a variable annuity product.

During this long period of major ups and downs the index fund beat about 60 percent of its surviving managed peer group. The word “surviving” is important because mutual funds are quietly buried every day, usually because their track records are poor. So that outperformance figure is understated.

In addition, when you withdraw money from your index fund and realize capital gains by selling some shares, part of the sale will be your cost basis, which is not taxed. Part of it will be capital gains, which are currently taxed at 15 percent. When you take money out of a variable annuity account, all dividend and capital gain income comes out first, original cost basis comes out last. Worse, it is all taxable at ordinary income rates. The only way to avoid high taxes on withdrawals is to have lost money and be retrieving your original principal.

Note that much of this cost advantage is unique to broad index funds. The index funds that duplicate large indexes, such as Vanguard Total Market or S&P 500, have low portfolio turnover, low transaction costs, and very limited capital gain distributions.

This is not the case with index funds that reproduce small and obscure indexes. They have more turnover and more capital gain distributions. Ditto managed funds. They have higher expense ratios, more transactions and related costs, and their higher portfolio turnover reduces their tax efficiency. Many have both short-term and long-term capital gain distributions. This reduces their return.

Some observers have made the case that the higher costs and tax inefficiency of managed funds make the tax deferral features of variable annuities a better choice. I believe that is a long and fruitless discussion because simple, low-cost index fund investing trumps both.

If you would like to learn more, visit my website, assetbuilder.com, you will find an archive of past columns that go into great detail about variable annuities.

What Las Vegas Can Teach Us About Mutual Fund Investing

Scott Burns — Fri, 08 Jun 2012 21:00:00 Z

When you go to Las Vegas one of the important things to know is what the “vig” is for whatever game you choose to play. The vig, or “vigorish,” is the amount the house takes out of the pot. Play where the vig is high and it is likely you will lose your money quickly. Play where the vig is low and you’ve got a shot at staying in the game longer. Whether the vig is high or low, someone may leave with more money but most will leave with less.

Play the slot machines and, according to professional gambler John Patrick, the vig is about 13 percent. This means the house takes about 13 cents from each dollar played and redistributes 87 cents to the players. In essence, each dollar played is immediately worth only 87 cents.

Tempted to complain about being ripped off? Don’t. If you’ve ever bought a state lottery ticket, you’ve played a game where the house vig is 50 percent and the intrinsic value of a $1 lottery ticket is, you guessed it, 50 cents.

Want a low-vig casino game? Try blackjack. Pay close attention to what’s called basic strategy and the vig can be as low as 1.5 percent. You may not win at slots or blackjack, but the low vig in blackjack means you can stay in the game longer. Get a good run of cards and you might even go home with some money in your pocket.

Why am I telling you this?

Because there is a vig in mutual fund investing, too. It’s called the expense ratio. If you bought shares in a low vig fund such as the Vanguard 500 Index Fund 15 years ago, you earned an annualized 5.57 percent over the period after annual expenses of 0.17 percent. It was not a wonderful period for the Index because it only provided a better performance than 60 percent of its surviving higher vig managed competitors. (Over the 3, 5, 10 and 15 year periods it did better, on average, than 70 percent of its competitors.)

Just 40 percent of funds in what Morningstar calls the “large blend” domestic equity category provided higher returns than the index fund. They averaged an annualized return of 6.82 percent and averaged expense ratios of 1.17 percent. In other words, if you took a chance and paid a higher vig, you had a chance of increasing your return.

But was it worth it?

If you committed to paying a full 1 percentage point more in expenses, you had a chance of increasing your annualized return by an average of 1.25 percent. Unfortunately, you only had a 40 percent chance of gaining that 1.25 percent, taking its real value down to 0.5 percent. So you were certain to pay 1 percentage point more each year to get a return that would likely be only 0.5 percentage point higher.

A bet on a managed fund was about as bad as buying a state lottery ticket— the intrinsic value of the managed fund “ticket” was worth only half the gain. (It isn’t quite that bad because stocks tend to have positive returns, so they are a positive-sum game. Gambling is always a sum-zero game in which a fixed pot of money is redistributed.)

This is not a stacked-deck example. Focus on fixed income investing and, as I suggested in a recent column, the house vig is just crazy. In one of the largest fixed income categories, intermediate bonds, there was virtually no chance of beating the Vanguard Intermediate Term Bond index fund over 15 years. The index fund was in the top 5 percent, earned 7.08 percent a year and cost 0.22 percent while the average managed fund cost 0.89 percent but earned only 5.79 percent. Funds that did better than the index averaged a 7.58 percent return, only 0.5 percent more than the index fund. In effect, managed fixed-income fund investors were paying 0.67 percent a year more for the privilege of having a 5 percent chance of gaining an average increase in return of 0.5 percent. What a deal!

Is all this new to you? Well, don’t feel badly. It’s new to most people, whether they are playing on Wall Street or in Las Vegas. But in both places, you’ve got better odds if you play where the vig is low.

All-Or-None Thinking Is Seldom Good Investing

Scott Burns — Wed, 06 Jun 2012 21:00:00 Z

Q. I plan to retire from full-time work next year when I will be 65 and qualify for Medicare coverage. I will likely work part-time until at least 66, when I plan to begin drawing Social Security. I have no debt ($375,000 home is paid for). I have $500,000 in balanced funds in my retirement account. I also have $125,000 in a brokerage account (mostly stocks) and about $320,000 in cash and CDs.

I am concerned, like most everyone else, about the European debt crisis, as well as other potential problems such as Israel-Iran. I'd rather miss out on potential gain from my investments than go through another meltdown like 2008. What do you think? Is it too early to pull out of the market and play it safe? —J.H., by email

A. All-or-none decisions—like being entirely in, or out, of the stock market— are usually bad decisions. Making such broad decisions assumes that you know the future and know how it will unfold. As a practical matter, I can't remember a year without worry about some possible world shaking event. We live in a world of upheaval and calamity.

I have yet to meet anyone, however, who knew when to get back in once she was out of the market. Worse, numerous studies have shown that most people buy when it feels good (at market highs) and sell when it feels bad (at market lows), so their long-term return is significantly below the return they would have earned if they had simply bought and held. The people who argue for market timing are usually selling a newsletter or another form of crystal ball reading.

So what you can do? Take a min/max approach. Select a “normal” equities/fixed income ratio, such as 60/40. Then allow yourself to hold as much as 70/30 when you think equities are undervalued. Or to sell down to 50/50 when you think equities are vulnerable or overvalued. You won’t be able to market a newsletter doing that, but you'll feel better. You may even make a good call from time to time.

Your current portfolio is about 40 percent equities, which makes it pretty conservative. Look at it this way: If you assume an annual withdrawal rate of $40,000, your current cash and CD holdings are equal to 8 years of withdrawals. So you are a long, long way from having to sell equities in a bear market.

Q. My question concerns staying in the home we own versus renting. Our house payment, including taxes and insurance, is $996 a month. Of that amount, $590 is principal and interest. This leaves $406 a month as the tax and insurance payment. Our home will be paid off in two years. I am 62 and plan to retire at 65. I have not been able to understand how I would be better off renting when my homeowner cost would be less than half of what my mortgage payment is now. I understand tax and insurance will continue to increase and I am responsible for up keep of my home. Say I rent a place for $1,200 a month: How can I benefit when my initial cost would be $794 a month more? —G.S., by email

A. You might not be better off renting, and your basic figures suggest that you would not be. But to do the calculation you'd need a sharper pencil: Your addition would have to include things like services, maintenance and long-term replacement costs compared to renting. And since apartments are generally smaller than houses, your utility bills as a renter are likely to be smaller than your utility bill as a homeowner.

Many retirees keep their shelter costs down by scrimping on updates and repairs. This reduces their out-of-pocket costs. But it also works to reduce the sale value of their house when they finally decide to sell. Older people who have neglected updating and repairs are selling most of the “fixer-uppers” and “handyman specials” on any market.

The reallocation of home equity strategy discussed in a recent column will work best for people who own houses that are more valuable than the national average. Someone who lives in the Boston suburbs, for instance, can sell a fairly small house and still come away with $300,000 or $400,000, then move to Arizona, Florida or Texas to rent a recently built apartment whose rent and utilities will cost less than they paid in operating costs for their Massachusetts house. And they would have all the equity to invest for income.

Reverse Mortgages--- at last, a Tool for Retirement Income Planning

Scott Burns — Fri, 01 Jun 2012 21:00:00 Z

The Age of Reverse Mortgages, which I wrote about in April, is here. We can credit a new form of reverse mortgage, the Saver Home Equity Conversion Mortgage (HECM), for getting the ball rolling. The Saver HECM reduces the front-end mortgage insurance costs by lowering the credit limit for the mortgage.

How could a small change open a floodgate of interest?

Simple. First, it’s not such a small change. Second, millions of retired homeowners are looking for ways to increase their retirement income. As a practical matter, I don’t see the cost reduction is that big a deal. Using an online calculator, I found that a reverse mortgage on a $250,000 house would cost $11,626 in fees for the earlier form and $8,151 for the new Saver form. To learn more, visit the HUD website.

What is happening is that reverse mortgages are becoming a financial planning tool rather than an emergency loan service. John Mitchell, CEO of Reverse Mortgage of Texas, characterized the change this way: “Nine out of ten borrowers take the full lump sum when they take out a reverse mortgage. One reason is that most borrowers still have a mortgage or a home equity credit line. By the time they have that paid with the HECM, there isn’t much left. But if this changes from a need-based market to a want-based market where people are looking further ahead, it would be different.”

A reverse mortgage can be a new tool for annuitizing wealth, turning the equity in our homes into a lifetime cash income stream. The number one question readers asked after my April column was this:

“Will I have any home value left when I leave the house or die? I’m really hoping to leave the money in it to my kids.”

So let’s do some back of the envelope calculations.

Robert and Robin are 65 and own a $250,000 house with no mortgage. They are looking for more retirement income. Using the ibis online reverse mortgage calculator, they find that they can get a principal limit (the maximum amount they can borrow) of about $159,000. This will net them a credit line $147,624 after paying fees of $11,626. That, in turn, will provide them with a tax-free monthly payment of $822 for as long as they occupy the house.

Twenty years later, at age 85, one dies and the other goes to a nursing home. Is anything left for their kids?

It all depends on what has happened with home values over the period. The amount owed (principal advanced plus accumulated interest) will have compounded to about $380,000 over the 20 years. If the house appreciates (or inflates) at 3 percent a year it will be worth about $450,000. At 4 percent the house would be worth about $550,000.

If they die or leave the house earlier, the accumulated debt against the house will be smaller. In any case, what’s left will be a roll of the dice, but they have some upside. Not a lot, but some.

Now lets compare it to two more common life income alternatives.

Life Annuity. If the couple tries to get a joint and survivor life annuity for $822 a month, immediate-annuities.com indicates that they would need to make a payment of $165,000. If the money came from a retirement account, every bit of income would be taxable. If the money came from a taxable account, they would pay taxes on a portion of their life income. Equally important, once they purchased the life annuity, the financial assets in their estate would be reduced by $165,000.

Variable Annuity with Living Benefits. To get a lifetime income guarantee of $822 a month from a variable annuity contract with living benefits the couple would have to deposit nearly $200,000 to a contract that promised a 5 percent payout, a fairly typical rate for an age 65 married couple. The cash value of the contract after that would depend on how a total withdrawal rate of about 8 percent (payout plus product expenses) affected the value of the underlying account assets. The amount left would be another roll of the dice, but the ups and downs of markets would make a significant reduction in end value likely.

Since both the life annuity and variable annuity would have to be purchased from existing financial assets, the couples’ financial flexibility would be reduced compared to using a reverse mortgage. Used for long term planning rather than emergencies, reverse mortgages are likely to become a major tool for the millions of Americans who have a lot more equity in their homes than in their retirement savings.

How To Understand Required Minimum Distributions

Scott Burns — Wed, 30 May 2012 21:00:00 Z

Q. How are Required Minimum Distributions derived? I have seen the published tables, but there is no explanation as to where or how these amounts are derived. I'm retired and trying to adhere to the commonly held view that a retiree should try to limit his withdrawals from his retirement portfolio to about 4 percent annually. Are these government required withdrawals aligned with this same type of guideline? —J.H., San Antonio

A. Yes, they are. When IRAs were created the intention was to encourage people to save for their retirement. It was not to create a large pool of tax-deferred assets that could be passed on to the next generation. So Required Minimum Distributions are keyed to life expectancy. The distributions increase as life expectancy declines. As a result, the value of the account should decline over time.

According to a recent U.S. Life Table from the National Vital Statistics Reports, the life expectancy of all Americans at age 70 is 14.9 years. This figure combines both sexes and all races so it is possible to have a significantly longer, or shorter, expectancy depending on your race and gender.

The required distribution for a single 70 year old from the Uniform Life Table used by the IRS is based on a longer life of 17.0 years. That requires a distribution of 5.88 percent (100/17). This leaves a fudge factor for the actual time people are to live. By age 80 the RMD factor is 10.2, or a distribution of 9.8 percent. Since the distribution is always figured from the amount in the account at the end of the previous year, the account should be close to empty by the time of death.

The distribution requirement is lower for couples because the life expectancy of a couple is longer than the life expectancy of a single individual. The joint life expectancy of a 65-year-old couple (when the last is expected to die) is 26.2 years. The same figure for 70-year old couples is 21.8 years. This is significantly shorter than the 27.4-year figure used in the IRS Uniform Life Table for calculating RMDs. It would require an initial distribution of only 3.65 percent.

One consequence of the rising distribution rate is that if you have a reasonable return on your retirement account money, both your income and your asset balance are likely to increase for quite a few years before they start to decline. You can see this for yourself by using the RMD calculator on the Fidelity website and checking the projection of annual distributions and remaining assets. Assuming a 7 percent return, for instance, a couple would see their assets top out at age 85. Their income would top out at age 98. Barring dismal returns or annual distributions far in excess of the required amount, retirees should be able to plan on a rising retirement income for many years.

Q. I found your recent column on "good life decisions" very interesting but I am not sure how you worked up the numbers about powerful shelter decisions. My wife and I are retired, age 75 and 72. We have about $700,000 plus our house. The house is free and clear, and we have no debts, but don’t see how I could sell my $125,000 house, rent a house or condo or buy an RV and increase my savings or discretionary spending funds. Can you tell me how you came up with your numbers? I am a simple man so when I see figures I need to understand where they came from. —D.W., by email

A. The shelter opportunity may not apply to you because the value of your house is only a small part of your net worth. It is also about half the value of the median home— so shelter isn't the big lever on your retirement that it can be for many people, particularly those who live in high cost urban areas. The annual operating costs on your house (taxes, insurance, utilities, services, maintenance and replacements) probably don't exceed $8,000 a year. So it would be difficult for you, I think, to find a rental that would cost that little when utilities were included.

A more typical example would be a couple with a $300,000 house that cost about $18,000 a year to support. If they sold it they could pay up to $18,000 a year for a rental including utilities and have $300,000 to invest— more than the vast majority of workers have saved. If they drew on those savings at 4 percent a year it would increase their spending money by $12,000 a year.

The Forty-Year Train Wreck

Scott Burns — Fri, 25 May 2012 21:00:00 Z

The cover of the 2011 annual report for Amtrak, our government-owned passenger train service, celebrates its 40th anniversary as a business. Well, kind of. It can certainly celebrate its endurance as an organization drawing unending support from the U.S. Treasury and its many, many bondholders.

But as a business? I don’t think so.

In every year since 1971 Amtrak has lost money. Real businesses don’t lose money for 40 consecutive years. When they lose money for a year or so the top dogs get heaved. If the losses go on much longer the company is taken over, dismembered and sold for parts. While capitalism can be as dumb, arrogant and shortsighted as government, no one can say capitalism is sentimental. Bad or outmoded products and services die. Good products and services thrive. We benefit.

Sadly, it doesn’t work that way when the enterprise is supported with tax dollars. Amtrak executives have appeared before Congress with plan after plan, swearing to approximate a break-even, but it never materializes. In the late 1970s, when there was pressure to shut it down, Amtrak survived by claiming that pension costs would exceed any benefit in closing shop. Today, an entire generation of workers later, it is still losing money.

How much money? In 2011, in spite of rising ridership, Amtrak collected $2.7 billion in revenue but lost a bit over $1.3 billion. The good news is that the loss is less than double its $763 million loss in 1984, which was a long time ago. So relative to all the other losses our government has, Amtrak is moving toward the accounting obscurity of becoming a federal rounding error.

Then why am I writing about this?

Because a comparison of Amtraks figures with a real business may tell us something about turning this country around. And next time someone running for the Congress or Senate tells you they want to end “waste, fraud and abuse” in Washington, you might ask how they intend to vote, when this perpetual drain comes up.

Here is a thumbnail comparison of Amtrak with a real business that I love, Southwest Airlines. Buckle up. Get those drink coupons out.

Output: Employment from Assets. When I examined this in 1984, Amtrak had total assets of $3.6 billion. Today it has assets of $11 billion. During the same period, its employee count has declined slightly from 21,000 to 20,156. So Amtrak is now using 3 times as much capital to support a modestly lower employment. Good job!

Southwest Airlines assets, meanwhile, have grown from $646 million in assets to a stunning $18.1 billion as its employment grew from 3,934 to 45,392. Massive growth and they are still providing more employment per dollar of capital.

Output: Passenger Seat Miles. Amtrak clocked 4.5 million passenger seat miles in 1984, just under the 4.7 billion of a very young Southwest Airlines. Today Amtrak is pulling some 6.5 billion-passenger miles. That 44 percent growth is not far ahead of our total population growth of 32 percent. Southwest passenger miles, meanwhile, are nearly 21 times larger, a stunning 97.6 billion passenger seat miles, dwarfing Amtrak.

If you divide passenger seat miles by total assets for each enterprise you will find that a dollar of capital employed by Southwest Airlines produces nearly 10 times the passenger seat miles as a dollar of capital used by Amtrak.

Profit and Loss. Amtrak lost $1.3 billion while delivering 4.5 billion passenger seat miles, a loss of about 21 cents a passenger mile. Amtrak also collect $2.7 billion for the same passenger seat miles, indicating passengers paid about 41 cents a passenger mile toward Amtraks total cost of about 62 cents a passenger mile.

Southwest made a small profit while collecting 15.1 cents a passenger mile. Southwest, in other words, costs less per mile than Amtrak loses per mile.

Needless to say, one is a railroad and the other is an airline. But it’s time we stopped running a hobby railroad. If the commuter lines make a profit, keep them or sell them at a profit. If the long glamour trips lose money, sell them off to a private company that will price them to make money. (Are you listening, Orient Express?) When private businesses get in trouble, they divest themselves of money losing operations. It’s time our government did the same.

How the Social Security Trust Fund Was Supposed To Work

Scott Burns — Wed, 23 May 2012 21:00:00 Z

Q. This question is about your recent column on Social Security and Medicare. I'm an accountant in Austin. I will turn 60 in November. I have what I think is a fair amount put away in a 401(k) and an IRA.

It has been my understanding that our Social Security deductions were paid into Social Security and then loaned out. The federal government gives the Social Security fund an IOU. It has been well known that the Social Security fund would start collecting on those IOUs when the bulk of the baby boomers started to retire.

Since the government gets most of its money from income taxes (not Social Security taxes), when the Social Security fund starts collecting the money it is owed, then everyone's income tax rates will have to rise to make good on the IOUs and to make up for the shortfall in revenue from the employment tax. This is the reason, if I understand this correctly, that most of us don't think this is a problem.

Now I understand that in today's political climate this change will be something that will gag the Tea Party folks even though it was designed this way from the start.

Am I missing something? Making good on the IOUs will make income tax rates rise or make the deficit larger, or both— but isn’t that the way the program was designed from the beginning? —J.E., Austin, TX

A. No. Social Security has always had a "trust fund." Its contents were measured in a few months of benefit obligations. The fund could be used as a backup for recession periods when tax collections were down. It wasn’t adequate for big changes in benefit payments.

The purpose of the 1983 reform was to build a larger trust fund balance. The idea was to deal with the major increase in benefit commitments that would come when the boomers retired. Accumulation of a large amount— like the $2.6 trillion now in the fund— would make the program safe for the 75-year projection period.

With no actuarial deficit over that 75-year period there would have been no need to discuss raising the employment tax—or any other tax— to pay the benefits, if the government had not over borrowed for everything else. If we had had a balanced budget, the Social Security surplus could have paid down other federal debt. Then that credit could be used later to redeem trust fund assets.

But that didn’t happen. While retirees have a preemptive call on federal spending because of the trust fund, the only choices for making good on those promises will be to raise taxes, reduce benefits for future retirees, or print money. Worse, fixing the problem isn't just a matter of increasing the employment tax (or the income tax) to bring in the needed revenue. Check this paragraph from a summary of the recent Trustee reports:

"The projected 75-year actuarial deficit for the combined Old-Age and Survivors Insurance and Disability Insurance (OASDI) Trust Funds is 2.67 percent of taxable payroll, up from 2.22 percent projected in last year's report. This is the largest actuarial deficit reported since prior to the 1983 Social Security amendments, and the largest single-year deterioration in the actuarial deficit since the 1994 Trustees Report."

Since the employment tax is 12.4 percent (employer and employee portions combined and not including the current 2 percent break for workers) we're talking about a 21.5 percent increase (2.67/12.4) in the employment tax to get the necessary money coming in. This would, in theory, make the program sound over the next 75 years. You don’t have to be a Tea Party member to rebel at the idea of that big a tax increase.

So there is also active discussion of cutting future benefits. As a result, today's workers could be paying higher taxes and getting less in future benefits. That’s not a very good "compact between generations." Worse, we've been told this before: 1983 reforms were supposed to make Social Security financially sound until 2060.

We should all remember that this is a wonderful problem to have. We have it because fewer children die, do we have smaller families and because we are all living longer. In "The Clash of Generations" (MIT Press, 2012) economist Larry Kotlikoff and I describe this as "Catastrophic Success."

We've succeeded beyond our wildest dreams in extending the gift of life. What we haven't done is find the courage to pay for it, either collectively through Social Security or individually through personal saving.

There Is Nothing Quite Like the Assurance of Failure

Scott Burns — Fri, 18 May 2012 21:00:00 Z

Should any of us own a managed bond mutual fund? Should any of us ever own a managed bond fund?

These rude questions came to mind as I read the most recent SPIVA report— that’s the regular report from Standard and Poor’s that examines the performance of managed funds against their chosen benchmarks. The most recent report, covering the period to the end of last year, shows that managers of intermediate term government bond funds failed to beat their target index by a mind boggling 93.62 percent over the last five years. They also failed 89.8 percent of the time in the five years from 2002 through 2006.

We’ve learned to expect that about 70 percent of equity fund managers will fail to beat their index benchmark. We’ve also learned to expect that bond fund managers are likely to do slightly worse.

But really, how can they stay in business with a 90 plus percent fail rate?

To be fair, there were some categories where managed bond funds did better. The best was the category “general short (term) funds” where only 60.54 percent of managers failed to beat their index over the last five years. But that was the best in the last five-year period. So in the best performing category, the majority of managed bond mutual funds still failed to beat their index.

Was there any light, anywhere? Yes. Of the 9 categories considered over two five-year time periods, a slender majority of emerging markets debt fund managers beat their benchmark from 2002 through 2006, the previous 5-year period. So it can be done. There is an exception to the rule.

So tell me: Can you name another area in life where we voluntarily pay a premium for a virtual guarantee of failure? That’s what we do when we buy managed bond mutual funds.

Now consider the portion of the return on your money that goes to the managers who are so adept at failure. Morningstar calls the largest category of bond funds general funds, with intermediate maturities. There are about 1,263 of them, of which 219 sell through front-end load commissions that average 4.12 percent and annual expense ratios that average 0.93 percent. At the end of March these same funds were providing an average yield of 2.36 percent. In other words, your commission cost exceeded your yield for nearly two years. After that, the managers got 39 percent of the yield on your money through fund expenses.

Another 219 of these funds had deferred sales loads. These are expenses that are recovered through high 12(b)-1 charges. The average 0.91 percent 12(b)-1 fee took the average expense ratio up to 1.62 percent. The current average yield on these funds was 1.65 percent. Here, annual expenses are about equal to annual yield, 1.65 percent versus 1.62 percent. This means the managers get the income while the investor gets 100 percent of the risk.

The remaining funds— no load funds that had neither front-end nor deferred sales commissions— had a lower average expense ratio, 0.74 percent, and a higher yield, 2.41 percent, than the funds available through the traditional brokerage sales channels. Even so, the management expenses absorbed 31 percent of the income.

What happens when you opt for a fixed income index fund? Things get better for you. You still have the risk of buying bonds at historically low yields. But without the burden of sales and management expenses, you get a better deal for income.

How much better? Lots. Averaging all 87-index funds in the category, the expense ratio was 0.33 percent and the yield was 2.44 percent. The cost of investing was only 13.5 percent of income. Invest with the larger and better-known bond index mutual funds or exchange traded funds and expenses could be as little as 5 percent of interest income.

In spite of these realities (which you won’t be told by your friendly salesperson because they are not encouraged to examine the statistics) millions of savers and investors still depend on commissioned sales people because they are afraid to make decisions for themselves.

Well, don’t be.

With a virtual guarantee of failure to beat an index from heavily marketed managers, we have no reason not to “go for it” and select a fixed income index fund. Chances are about 9 out of 10 that you will do better.

Managing Your Money Can Cost a Lot--- or Very Little

Scott Burns — Wed, 16 May 2012 21:00:00 Z

Q. We have been retired for 6 years. We are beginning to question the fee for our rollover IRA. What should we expect as an average fee for fund management by a fee-based financial planning firm? Ours is a diversified portfolio of about $300,000. We also have a 10-year $200,000 annuity due to double by 2017. —M.D., Torrance, CA

A. In theory, what you pay will vary with the level of service you receive. But what you pay is also higher for smaller portfolios than for larger portfolios. Major brokerage firms like Merrill Lynch, for instance, are now discouraging brokers from handling accounts under $500,000 by reducing the commission payout brokers receive on such accounts. What you pay will also depend on whether your advisor is working in a fiduciary capacity or in a sales capacity. In general, those working in a sales capacity— earning some or all of their income from sales commissions— will cost more than those working in a fiduciary capacity. Here is a list, in descending order, of expenses you can expect:

The Insurance Sales Channel. Products like variable annuities and insurance sold mutual funds tend to be expensive. Typical costs run well beyond 2 percent a year, not including sales commissions. Your annuity "due to double" in 2017 is a sales driven product. If you check the illustrations you were provided you’ll find that the actual cash value of your annuity is not going to double. The amount that doubles is used to determine your annual withdrawal rate. Such products have total costs of about 3 percent a year.
The Legacy Brokerage Channel. The traditional brokerage houses— Merrill, Morgan Stanley, etc.— generally target making 2 percent on client assets a year. This can be done in commissions for trades. It can also be done with "wrap accounts" where you pay a percentage of assets under management to cover all expenses of the account. A $300,000 account would likely be charged about 2 percent a year.
The Traditional Registered Investment Advisor Channel. RIAs are supposed to function as fiduciaries, always putting client interests first. Typical charges run from 1 percent to 1.5 percent but are negotiable, particularly for large accounts. RIAs may build portfolios of individual stocks but they are increasingly likely to build mutual fund or exchange traded fund portfolios. When this is done you need to watch the total cost.
The Low-Cost Registered Investment Advisor Channel. These advisors seldom provide financial planning services, arguing that financial planning needs vary and should be done on an hourly basis rather than rolled into the cost of asset management. Some of these firms are Internet based. All-In expenses with these firms can be under 0.70 percent. This is the same as the expense ratio for some of the larger lifecycle mutual funds offered by firms like Fidelity, T. Rowe Price and American Century. These outfits will not walk your dog, but they do manage the assets.
The One-Stop-Shopping Channel. Cost-conscious investors can also buy a single mutual fund that will give them a broadly diversified portfolio. The lowest cost options here are Vanguard Wellington and Vanguard Wellesley, both high performing, well-rated managed funds that cost less than 0.20 percent for Admiral shares. Some brokers in the legacy brokerage channel will offer you a similar fund from the American Funds family, such as American Balanced A shares which costs 0.62 percent a year but also involves a front end commission.
The Do-It-Yourself Channel. The self-motivated investor can get asset management costs down to 0.10 percent, the cost of Admiral shares for the Vanguard Balanced Index fund. The same investor can build and manage a variety of "Lazy Portfolios" built with index mutual funds or with more widely available exchange traded index funds. These portfolios can be built at a cost of 0.15 to 0.30 percent a year, the average cost of the underlying funds.

With typical balanced funds now providing dividend and interest income of about 2 percent of portfolio value it is good to be very concerned with the total expenses your retirement nest egg faces. Basically, it comes down to a choice of who gets the income— you, or your money manager? Since there are major and well-known mutual funds that will manage a broad portfolio for you for less than 0.70 percent while showing long track records of superior performance, the burden is on anyone who costs more to demonstrate that they offer something to justify their additional cost.

Too-Big-to-Fail Banking Has Got-to-Go

Scott Burns — Fri, 11 May 2012 21:00:00 Z

The protestant reformation began in October 1517. That was when Martin Luther nailed his 95 theses to the door of a church in Wittenberg, Germany. Among other things, Martin Luther was protesting the sale of “indulgences” by the Roman Catholic Church. Pay enough and ones’ sins would be forgiven.

A similar— but entirely economic and secular— protest may have occurred with the publication of the annual report of the Federal Reserve Bank of Dallas. The report calls for the end of Too-Big-To-Fail and the breakup of our largest banks. TBTF has led the big banks and those who run them to receive gigantic indulgences (not to mention economic salvation) at taxpayer expense.

Richard Fisher, the bank’s President, has given speeches about the TBTF problem since 2009. But in this report he states the problem and his position very clearly, right under his picture:

“The too-big-to-fail institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism. It is imperative that we end TBTF.”

No waffling or wimp talk there.

The 20 page essay that follows, “Choosing the Road to Prosperity: Why We Must End Too Big to Fail Now,” written by Senior Economist Harvey Rosenblum, lays out how the asset concentration in the top 5 banks has tripled from 17 percent in 1970 to 52 percent in 2010; the weakness of recovering and undercapitalized banks; why that has resulted in a weak economic recovery; and the likely failure of the Dodd-Frank legislation to end TBTF.

In one small text box, “TBTF: A Perversion of Capitalism,” Rosenblum summarizes the moral hazards and public damage caused by having institutions that are deemed too big to fail.

“An unfortunate side effect of the government’s massive aid to TBTF banks has been an erosion of faith in American capitalism. Ordinary workers and consumers who might usually thank capitalism for their higher living standards have seen a perverse side of the system, where they see that normal rules of markets don’t apply to the rich, powerful and well connected.

“Here are some ways TBTF has violated basic tenets of a capitalist system:

“Capitalism requires the freedom to succeed and the freedom to fail. Hard work and good decisions should be rewarded. Perhaps more important, bad decisions should lead to failure— openly and publicly. Economist Allan Meltzer put it this way: ‘Capitalism without failure is like religion without sin.’
“Capitalism requires government to enforce the rule of law. This requires maintaining a level playing field. The privatization of profits and socialization of losses is completely unacceptable. TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful.
“Capitalism requires businesses and individuals be held accountable for the consequences of their actions. Accountability is a key ingredient for maintaining public faith in the economic system. The perception—and the reality— is that virtually nobody has been punished or held accountable for their roles in the financial crisis.”

The left and the right of American politics don’t agree on much but there is one thing the Tea Party and Occupy Wall Street (not to mention the voting public) would joyously agree on— Too Big To Fail has got to go. The idea of breaking up the big banks is adored by everyone but the bankers and the more conventional politicians the bankers so generously fund.

Are there alternatives to breaking up the big banks? Two come to mind.

One is for the boards of directors of the big banks to establish big time claw-backs on executive compensation so the top dogs can lose it all if they take excessive risks. Grant’s Interest Rate Observer editor, James Grant, advocated this idea in a recent speech at the New York Federal Reserve Bank.

Another is to adopt “limited purpose banking” in which banks are paid fees to connect borrowers and enterprises with lenders and investors, without taking risk. This is very much like what mutual fund firms do. Limited purpose banking would end the privatization of profit and the socialization of loss. This idea is advocated in “The Clash of Generations,” a new book I co-authored with economist Laurence J. Kotlikoff.

Finding Places for Cash Involves Taking Risk

Scott Burns — Wed, 09 May 2012 21:00:00 Z

Q. My wife (75) and I (77) have approximately $800,000 in CD's. We are debt free and receive about $3,000 a month in Social Security benefits. We both work part-time earning a combined total of about $70,000 a year. Should we consider putting some of this money in the stock market? Could you advise me of the track records of the various investment companies and what percentage of the $800,000 would be prudent to invest. —D.T. by email

A. "The track records of the various investment companies" is a rather long subject. My personal position is that low-cost index fund investing is the path most people should take. It virtually guarantees we'll enjoy results that are better than 70 percent of the managed choices. You can do low-cost index investing through Vanguard, the leader in index mutual funds. You can also do it through any discount brokerage firm by using Exchange Traded index funds from a number of firms.

A simple, one-decision starter investment would be the Vanguard Balanced Index fund, Admiral shares (ticker: VBIAX). This fund is 60 percent domestic equities, 40 percent fixed income. The Admiral shares, which require a minimum initial investment of $10,000 rather than the standard $3,000 initial investment, have an annual expense ratio of 0.10 percent according to the Morningstar website. The fund returned 6.53 percent in the 12 months ending 4/27/12, better than 94 percent of its managed competition. This is exceptional, but not a fluke: Over the last 15 years the fund did better than 77 percent of it’s surviving managed competition.

Since your experience has been in CDs the big question is what portion of your $800,000 should be invested this way. If you committed half of your entire portfolio it would be 50 percent CDs, 20 percent bonds and 30 percent equities. That's a very conservative portfolio.

At a later date you might also consider buying a joint survivor life annuity. This would provide you and your wife with a guaranteed income for life. It would also mean you had retirement income from three distinct sources: Social Security, life annuity and investments. According to immediateannuities.com, for instance, you could add $18,000 a year to your lifetime income with an annuity commitment of $236,000. While it would take 13 years to get your original investment back, the joint life expectancy of a couple your ages is 16.8 years.

Q. My husband and I have $175,000 in CDs that matured this month. They represent almost 1/3 of what we have in savings, 401(k) s and IRAs. My husband will retire in a few years at age 66. Our retirement income will be $75,000 a year from his pension and Social Security. I plan to start taking Social Security in seven years when I am 62. This will be an additional $13,000 a year. Our house payment is $1,200 a month ($159,000 mortgage, to be paid off in 14 years).

Medical insurance is available through my husbands company after he retires (current retirees pay about $350 a month per couple). We own a rental property in California (owe $38,000 on mortgage) with a payment of $625 a month and association dues of $449 a month. The rental income is $1,600 a month. This is a potential retirement home for us. We have no other debt. We only have about $65,000 of our 401(k)/IRA savings in the stock market (mostly ETFs and blue chip dividend-paying stocks).

Due to our lack of faith in the market, we are reluctant to put any more money into it. Given that 5-year CDs are paying only 2 percent we don't know what to do with the $175,000. Any suggestions you have would be very much appreciated. —SW, Lakeway, TX

A. With what appears to be $525,000 in financial assets, having only $65,000 in equities strikes me as ultra-conservative. With a long-term base income of $88,000 (total of pension and both Social Security incomes), you've probably got a lot of your expenses covered, so you can afford to take more risk with your financial assets. But you'll need to think about that. In the meantime, consider things you can do to lower the interest costs on your debt— such as refinancing the first mortgage on your home and using a portion of that $175,000 in CDs to pay off the $38,000 of debt on your rental property. You might also consider buying new issues of 15 year Treasury Inflation Protected Securities as substitutes for CDs. While 10 year TIPS are priced to provide no yield over the rate of inflation, the rate of inflation is likely to exceed the yield on 5 year CDs or 10 year Treasuries.