Pay Your Kids To Fund Their Own Roth IRA?

Posted on January 26, 2012 // 32 Comments

You’re probably aware of the wonders of the Roth IRA and how it allows your money to grow completely free from taxes, even upon withdrawal. An added wrinkle is the lack of age restriction, so that even kids with earned income (wages, salaries, tips) can contribute to a Roth IRA up the lesser of their taxable income or $5,000.

Along those lines, I received a PR e-mail from a site called 1417power.com. The idea is that you pay them “tuition”, and in return they pay your kids official job income that makes them eligible to contribute to a Roth IRA. They claim to follow all applicable child labor laws for those aged 14 to 17 (thus the name). Your kids do thing like fill out marketing surveys, but you’re essentially buying them a job. Digging through their fee structure, roughly 50% of what you pay them is skimmed off to go to the site owners.

Naturally, my question was – why can’t I just do this myself? The idea of paying your kids to do things like babysitting, lawn care or landscaping work, or manual labor seems simple enough. However, this Fairmark article argues that paying your own kids for chores is usually not considered taxable income, so you can’t “switch it” to taxable income for Roth IRA purposes when it benefits you. I’m not completely convinced, but for the sake of argument let’s explore other options:

  • Have the teenager earn money via traditional jobs like grocery bagger, cashier, food delivery, waiting tables, etc.
  • The child earns income from other neighborhood families doing things like babysitting, lawn care, or painting. The pay rate would have to be at reasonable market rates. You could even work out a “I’ll pay your kid if you pay mine” agreement, if you find a like-minded parent.
  • If you run your own business, you could pay the child for more clerical or administrative-type duties such as proofreading, delivering documents, or office organization.
  • If the teenager is especially industrious, they could be doing more skilled work like graphic design or making iPhone apps.

There would still be some loss, as their gross income would be subject to payroll taxes like Social Security and Medicare, as well as a small amount of federal income taxes (less than 10%). But if your child has the discipline to not touch the money for decades, the tax-free growth could be enormous. You’d have to be comfortable with the fact that they could do whatever they wanted with the money at age 18 as they can withdraw the money after taxes and penalties.

The Parental IRA Match
Another move taken from this Forbes article for those that are already parents of teenagers with part-time jobs is to match their earned income. If little Jane earns $3,000 being a lifeguard, then let her spend her all or part of her take-home pay, but help her fund a Roth IRA to the full $3,000.

Effect on College Financial Aid
From my quick research, it appears that retirement accounts like Roth IRA are not considered an asset by the generic FAFSA form, but individual universities may deem them as a student asset. This could make for example 25% of the IRA to counts toward the student’s expected contribution, which doesn’t seem too bad.

Here’s a question for the parents out there – have you done anything along these lines? What did you do and why (or why not)?

Filed Under: College & Education, Family, Retirement //

Do I Have An Obsession With Early Retirement?

Posted on January 19, 2012 // 36 Comments

After my post counting down my years until early retirement earlier this week, I received a very thoughtful e-mail from reader Tim:

I’ve been reading and enjoying your blog for a long time, and think it’s one of the best out there for your mix of personality, short-term and long-term financial tips and advice. But one thing bothers me: the ongoing, almost central theme (obsession?) with early retirement. It seems to be the goal around which everything else in the blog revolves and leads toward.

Why is that? Do you hate your job so much, and can’t even imagine a job you would enjoy enough that you would want to do it whether you were paid or not? It doesn’t strike me that someone as industrious, curious and intellectually active as yourself would really ever retire. I understand there may be other activities you’d like to pursue, but my guess is that most of them would be potentially income-generating. So you’d still have a “job.” And if that’s the case, then why not pursue one or more of those things now, rather than delaying them until “retirement?”

It seems to me that “MyMoneyBlog” is likely one of those things, and I’m very glad you’re doing it. And if one reason is the hope to fully monetize the blog to the point of retirement from your nine-to-five job, then I hope you do that too.

But still, something about that recurrent theme of retiring just leaves me with a hollow, dead feeling in the pit of my stomach, as if we’re all inmates marking time on the wall of a dreary prison cell until our release. Maybe it’s the implied resignation to the assumption that joyless jobs are unavoidable – a bitter fact of life – that I reject. I just don’t like to think that as a society we accept a lifetime of delayed gratification as a given, and don’t rouse ourselves to do anything more about it than make sound financial plans to enjoy ourselves when the pain finally stops.

There are some great questions in there, and really it also showed me that I can improve on explaining my philosophies. I have all these ideas rattling around in my head, and not all of them reach the keyboard. My reply became rather long…

Definition of early retirement. I know that retirement is a very tricky word to use. For too many people, it conjures up images of playing golf and sitting around all day. Financial independence or financial freedom are better terms, and they all mean the same thing to me – I get to do whatever I want. Cook a new dish every day, rebuild a Land Rover Defender or Willys Jeep, volunteer, spend a year abroad, anything. F— You money.

Delayed gratification. Going back to the early retirement curve, a major assumption is that your current expenses are the same as your future expenses. Let’s say your household earns $80k and lives on $40k. Well, that curve assumes you’ll be living on $40k in “retirement” as well. Using a food analogy, getting there is not a crash diet, but requires a permanent change to healthier eating habits. I don’t feel deprived with my current lifestyle as it pertains to spending, otherwise it wouldn’t be sustainable.

A job that I would do forever? I’ve thought about this. Let’s try to design the best job possible. To start, it should satisfy this Career Venn diagram which reminds us to seek the intersection of things that we do well, things that pay well, and things we like to do. In addition, it should provide all the factors that make a job satisfying beyond money: autonomy, complexity, and a connection between effort and reward.

Does my current job cause me pain? Does my wife’s job? Not really, we are white-collar professionals so we have a certain degree of autonomy and challenge to our work. But we also have managers, meetings, clients, and politics.

Is there any such ideal job that exists? Honestly, if it had to pay $50k a year and 40 hours a week, probably not for me. I am the type of person that likes to do something for a while, and then move on to something else. Even self-employment has it’s own set of restrictions. Even though blogging is a sweet gig :), having income that depends on advertising is very volatile.

This is where financial freedom comes in, because it means more flexibility. I have realized over time that I will probably need to do something, and that is a big reason why I am happy with a 4% safe withdrawal rate. All the academic studies that calculate this withdrawal rate stuff assume that a theoretical person blindly takes out 4% inflation-adjusted to the CPI every single year. From reading experiences of real early retirees, they adjust and adapt.

Let’s say we want that 4% withdrawal rate to create $40,000 of income from investments, but it ends up that 3% is a more reasonable number. Now, I need to find a job that pays $10,000 a year. I could do all kinds of things that would be kind of cool for $10,000 a year, and I wouldn’t have to work 40 hours a week either. I could do just about anything – web design, tutor high school or college students, teach English in a foreign country, apprentice with a skilled craftsman, or work as a travel guide.

Indeed, the possibilities are endless. One day, if the stars align, we will have children. At that point, we plan on downshifting to working part-time so that we can both enjoy raising kids without all the financial stress that our parents had. Our portfolio can already cover half of our expenses. Once the kids go to school, there will be more time for work, if needed. In the end, I would say that I am obsessed with freedom and autonomy.

Filed Under: Frugal Living, Retirement, Simple Living //

How Many Years Until You Can Reach Early Retirement?

Posted on January 17, 2012 // 14 Comments

One of the recurring themes of personal finance is that while the concepts are often simple, execution can be quite difficult. A couple of excellent posts from Mr. Money Mustache and The Military Guide (both also mention the Early Retirement Extreme book) provide another example when answering the question “How many years until I can retire?”

Let me summarize. A simple definition of financial independence is creating enough income from your investments to pay for your expenses. Assuming a “safe” withdrawal rate of 4%, this means your portfolio must be 25 times your expenses. So if you spend $30,000 a year, you’ll need $750,000. (If you want “safer” withdrawal rate of 3%, that increases it 33 times expenses.)

Given the rough assumptions of starting with nothing and earning a 5% inflation-adjusted (real) return on investments every year, you can simplify things even further. (5% real return looks plausible based on the past, but I know it’s harder to see it now.) It works out that the only thing that matters is your personal savings rate:

After-tax numbers work better since expenses are usually after-tax. MMM provides a table, which I in turn converted into a single curve:

Notes:

  • The harsh truth is that if you want to retire before Social Security steps in, you’re going to have to save a lot more than 10%.
  • The curve is steepest at lower savings rates. That means increasing your savings rate from 10% to 20% shaves off more time working (14 years!!!) than increasing from 20% to 30% (still 8 years!), and so on.
  • Retiring in 20 years requires roughly a 40% saving rate. Retiring in 10 years requires a 65% savings rate.

If you’re new to the financial independence community, the idea of saving 40% or more of your income may be incomprehensible. Hopefully you will realize that it is possible, if you wish to pursue it. I have come to the conclusion that some people will happily work for 30 years in exchange for the ability to drive a new BMW every 3 years. Others (gasp!) just like their jobs that much. All that’s fine as long as that’s a conscious decision.

To increase your saving rate, you must either increase income or decrease expenses. While decreasing expenses is actually the more accessible option for most families, it will likely remain unpopular forever. That doesn’t mean you can’t do it, because many people are quietly doing exactly that. Try – you may surprise yourself.

I am also a strong proponent of increasing income. In the end, in our household we did a combination. Both of us earn an solid income after a combination of tuition-based postgraduate education and “DIY education”, but we only live on the lower income. Armed with a 60%+ saving rate, we are on track to achieve financial freedom according to this definition within another 5 years, although we may take a different path by working part-time for a longer period.

I must admit, even though I have known this “truth” for many years, I don’t actively talk about it because we do earn much higher incomes than average. However, that doesn’t change how the numbers work. I applaud all those bloggers and journalists that don’t patronize you and push the idea of higher savings rates, like this article in The Atlantic by Megan McArdle:

If you’re like, well, almost everybody, you’re not saving enough. 15% of each paycheck into the 401(k) is the bare minimum you can get away with, not some aspirational level you can maybe hope to hit someday when you don’t have all these problems.

I mean, obviously if one out of two workers in your household just lost their job, or has been stricken with some horrid cancer requiring all sorts of ancillary expenses, then it’s okay to cut back on the retirement savings for a bit. But let’s be honest: that doesn’t describe most of us in those years when we don’t save enough.

Filed Under: Frugal Living, Retirement //

Goal Update: Investment Portfolio Asset Allocation & Holdings – Nov 2011

Posted on November 9, 2011 // 10 Comments

Time for another update of my investment portfolio, including employer 401(k) plans, self-employed plans, IRAs, and taxable brokerage holdings.

Asset Allocation & Holdings

You can view my target asset allocation here, along with link to other model portfolios. Despite the headlines, I still like to buy, hold, and rebalance. Here is my current actual asset allocation:

Everything is within acceptable ranges, other than I need to buy more TIPS. This is just an overshoot since I have my 401k buying shares in a stable value fund automatically, and my TIPS are mostly stuck in IRAs. Actually, my TIPS holdings have been doing great, due to how low real yields are right now. Last I checked, even 10-year TIPS had negative real yields.

My current ratio is about 75% stocks and 25% bonds. I’ve been thinking about this balance. On one hand, I’m contributing a lot of money into the portfolio, and I hope that I can get my “early” retirement on within the next 10 years. At that point, I’m going to want something closer to a 60% stocks and 40% bonds setup, the classic balanced fund ratio. So I want to shift towards bonds, but bond yields don’t look very appetizing right now. For now, I’m just going to keep up the gradual shift.

Stock Holdings
Vanguard Total Stock Market ETF (VTI)
Diversified S&P 500 Index Fund (DISFX)*
Fidelity Extended Market Index Fund (FSEMX)*
Vanguard Small-Cap Value Index Fund (VISVX)
Vanguard FTSE All-World ex-US ETF (VEU)
Vanguard MSCI Emerging Markets ETF (VWO)
Vanguard REIT Index Fund (VGSIX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX)
Stable Value Fund* (3% yield on past purchases, 1.8% on new)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities

The overall expense ratio for this portfolio is in the neighborhood of .20% annually, or 20 basis points, which is much lower hurdle to overcome than the average mutual fund expense ratio of over 1% annually. This is all DIY, so I don’t pay portfolio management or financial advisor fees.

3% Safe Withdrawal Rate

I’ve also decided to use a 3% theoretical safe withdrawal rate instead of a 4% withdrawal rate. So instead of reaching 25 times our annual expected expenses, we will need to save 33 times. This is due to the fact that we will probably reach early retirement with 10 years, and thus our portfolio will have to last a lot longer than a conventional age 65 retirement. 3% is a more conservative number, and in reality I doubt that we will even go by the 3% number in strict terms. From reading other early retiree stories, we’ll stay flexible and adjust our withdrawals somewhat with market returns.

With portfolio increases and additional contributions, at a 3% withdrawal rate our current portfolio would now cover 43% of our expected expenses. If you recall, I plan to have the house paid off at retirement as well. It might be nice to have a portfolio that yields 3% where we could spend the dividends and interest payments, and I have been tossing around ideas for that as well. I still like the idea of 50% Target Retirement Income (or similar) and 50% Wellesley Income.

Filed Under: Goals, Investing, Retirement //

Goal Update: Home Equity Historical Chart – Nov 2011

Posted on November 7, 2011 // 15 Comments

We closed on our mortgage refinance about a month ago, the old loan has been paid off, and we are just about to make our first payment on the new loan. Still, I always seem to go back and forth between different possible scenarios of paying down the house quickly or according the “minimum payment” as I call it. Technically, I could just about pay off the house now, if I chose to liquidate my taxable investments and empty out my emergency fund reserve.

I decided to go back and reconstruct a chart of our home equity over time, and compare it to a couple of alternate scenarios.

The red line represents our actual home equity, as a percentage of our purchase price. We use the purchase price because our home is currently worth about the same as when the bought it. An appraisal done for our refinance last month came in at 6% above our initial purchase price. Before the big refinance, we did a haphazard combination up of throwing in a few hundred extra bucks each month and one big lump sum prepayment. Currently, we’re right at 35% home equity.

Just for fun, the dotted red line is an exponential trendline of the red line. It has the loan being paid off somewhere around 2020.

The blue line represents our theoretical home equity if paid according to the normal 30-year payment schedule of our initial 6% fixed mortgage, starting from when we bought the house in the start of 2008. This would have had the loan paid off in 2038.

The green line represents our theoretical home equity if paid according to the normal 15-year schedule of our new sub-4% fixed mortgage, starting from this month. This would have the loan paid off in 2026.

I definitely still want to pay it off in under the current 15-year term, but as usual I like the flexibility. If children come into the picture, we’ll probably cut back on work and slow things down. But for now, I’m still hacking away. We hit the 401k cap already for 2011, so we have some extra cashflow.

By the way, I am only a proponent of paying extra towards your mortgage if you are maximizing your available tax-advantaged accounts like 401ks and IRAs as well as have a nice cash cushion. Although now I do think everyone should consider 15-year mortgages. Who wants to take 30 years to own a home? Most other countries don’t even offer 30-year mortgages, and the government support of 30-year mortgages here simply inflates property prices.

Filed Under: Goals, Real Estate, Retirement //

Vanguard Lowers Fees and Improves My Portfolio Performance Again, Offers More Admiral Shares

Posted on October 3, 2011 // 9 Comments

Last week, Vanguard officially announced the addition of the Admiral share class to six of their existing index funds. Admiral shares have a higher minimum investment amount ($10,000 for those listed below) than the usual Investor shares ($3,000 for those listed below), but with lower annual expenses. Every time my costs and fees go down, my future performance goes up! Below is a list of the newly-available funds, along with an expense ratio comparison.

Funds with new Admiral Shares Investor Shares
expense ratio		 Admiral Shares
expense ratio (est)
Vanguard Developed Markets Index Fund 0.22% 0.12%
Vanguard FTSE All-World ex-US Index Fund 0.35% 0.18%
Vanguard Mid-Cap Growth Index Fund 0.26% 0.10%
Vanguard Mid-Cap Value Index Fund 0.26% 0.10%
Vanguard Small-Cap Growth Index Fund 0.26% 0.10%
Vanguard Small-Cap Value Index Fund 0.37% 0.21%

The only one I am converting over this time is the Small Value fund. However, I did notice that this now means that for every single Vanguard stock index fund I choose to own, I can choose between both Admiral shares and ETF versions. I like mutual funds because they always trade at NAV and don’t have bid/ask spreads, as well as the ability to schedule automatic monthly investments. ETFs have the advantage of not having any purchase or redemption fees and the ability to be trade in any brokerage account. I went into more detail on the Vanguard mutual fund vs. ETF decision process here.

Vanguard even has a cost comparison tool for mutual funds vs. ETFs. But long-term expenses for me are no longer a concern because they are almost identical with all these Admiral shares. (I suspect the Small Cap Value differential is only temporary.) Here’s the list:

Funds In My Personal Portfolio ETF
expense ratio		 Admiral Shares
expense ratio (est)
Vanguard Total Stock Market Index Fund 0.07% 0.07%
Vanguard Small-Cap Value Index Fund 0.23% 0.21%
Vanguard Total International Stock Index Fund 0.20% 0.20%
Vanguard Emerging Markets Stock Index Fund 0.22% 0.22%
Vanguard REIT Index Fund 0.12% 0.12%

I wrote previously about why I invest in the Vanguard Total US and Total International market funds. Want to convert your Investor shares to Admiral shares before they are automatically converted eventually? It just takes a clicks online – here’s a quick guide [pdf]. Want to convert your mutual funds to ETFs? Check out this post on Vanguard mutual fund to ETF share conversions. It turns out you can also do so easily with minimal tax implications.

Filed Under: Investing, Retirement //

Build A Complete Stock Portfolio With Just Two ETFs: Vanguard Total US (VTI) and Total International (VXUS)

Posted on September 27, 2011 // 18 Comments

If you are constructing your own portfolio and like the idea of low-cost, passively-managed index funds, you should definitely be aware that just two ETFs that can provide you diversified exposure to stocks worldwide and all at rock-bottom fees. Given how many choices there are out there today, I can’t assume that everyone knows about these already.

The Vanguard Total US Stock index fund invests in over 3,000 stocks that represent the entire U.S. stock market, from small-cap to large-cap companies. The smallest company on their holding list is 100 shares of Qualstar Corp, worth a mere $200. The entire company is worth about $20 million. Compare that to the largest holding of Apple, worth $380 billion (that’s 19,000 times larger). The ETF and Admiral shares have a mere 0.07% expense ratio ($7 annually per $10,000 invested), which is taken out in tiny amounts daily out of the fund’s net asset value. That’s just 6% of what the average mutual fund charges. There are three versions:

  • Vanguard Total Stock Market ETF (VTI)
  • Vanguard Total Stock Market Index Fund Investor Shares (VTSMX)
  • Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)

The Vanguard Total International Stock index fund invests in over 6,000 stocks that covers 98% of the world’s investable markets excluding the US (“ex-US”). This includes 44 countries from the “European, Pacific, and emerging market regions, as well as Canada.” The fund also includes both small-cap and large-cap companies from these countries. The ETF and Admiral shares charge a 0.20% expense ratio. Three versions as well:

  • Vanguard Total International Stock ETF (VXUS)
  • Vanguard Total International Stock Index Fund Investor Shares (VGTSX)
  • Vanguard Total International Stock Index Fund Admiral Shares (VTIAX)

This graphic shows you how these two funds relate to other Vanguard ETFs you may already be aware of:


(Source, brighter red text is added by me)

(I should also mention that there is the Vanguard Total World Stock ETF (VT), which covers the entire world in one tidy fund. However, it only holds 2,904 stocks total, which is nearly 2/3rds less than a VTI/VXUS combo. On top of that, it charges a 0.25% expense ratio, which is nearly double how much a VTI/VXUS combo would cost when weighted appropriately. I personally think the added diversification and lower cost is worth the hassle of owning two separate funds.)

Implementation

As of August 31, 2011, the world market value breaks down to about 42% US and 58% Ex-US. For simplicity, I chose to own VTI and VXUS in a simple 50/50 ratio as part of my target asset allocation. I rebalance back to 50/50 regularly using new cashflows, and also at least once annually. Bonds are a separate discussion.

Side note: The reason I thought of writing this is that I previously held Vanguard FTSE All-World ex-US ETF (VEU) as my primary international holding, which as you can see above is a subset of VXUS, but realize that VXUS only arrived earlier this year. I’ve shifted most things over already, but I have been hesitant to sell some of my taxable holdings because I’d owe capital gains taxes. I noticed yesterday that I am actually at slight loss now (yay?), so I am able to do some tax-loss harvesting by selling my VEU and swapping it for VXUS. Since they are not “substantially identical” funds, I am not subject to wash sale rules.

Filed Under: Investing, Retirement //

Social Security, Ponzi Schemes, and Realistic Expectations

Posted on September 16, 2011 // 56 Comments

Recent political debates have brought up comparisons between Social Security and Ponzi schemes. (Have you read the book about the real Ponzi?) Even though seemingly every single economist on Earth has weighed in, this discussion has been around for so long that the Social Security website already has an entire page dedicated to addressing it. To summarize, yes Social Security shares some traits with Ponzi schemes in that money from new participants goes to earlier participants. However, it relies on a rather straightforward transfer and does not depend on an exponential growth of new participants to be sustainable. It is, however, sensitive to demographics.

Social Security is a pay-as-you-go system. What I pay into Social Security today goes straight to a current retiree’s Social Security check. When I retire, my paycheck will be supported by a younger worker’s taxes. It is not an investment. It is not a savings account. The problem is, that the ratio of workers to retirees is getting rather low. In 1950, there were 7.3 working-age people for each person over 65; now, the ratio is 4.7 to 1, and it is scheduled to drop to 2.7 to 1 by 2035. [Source]

Since people are living longer as well, the reality is that for a 30-something like me, the math works out that there is little chance that we will get the same level of relative benefits that current retirees get. However, there will be no sudden Ponzi-like implosion. Now, the government could smooth this transition out even more if they do the hard thing and do some combination of higher taxes, extending retirement ages with higher life expectancy, or lowering benefits. But politicians are usually reactive as opposed to proactive, so don’t count on it. That’s too bad, because people are more dependent on Social Security than ever. 70% of all eligible folks can’t even wait until 65 to start taking benefits, many as early as 62, even though that means lower payments and likely a lower total benefit. This is why in general financial experts say you should wait as late as possible to get a higher payment for the rest of your life.

Of course, Medicare is even worse. Take this analysis via this WaPo article:

Consider an average-wage two-earner couple together earning $89,000 a year. Upon retiring in 2011, they would have paid $114,000 in Medicare payroll taxes during their careers. But they can expect to receive medical services – including prescriptions and hospital care – worth $355,000, or about three times what they put in. […] The same hypothetical couple retiring in 2011 will have paid $614,000 in Social Security taxes, and can expect to collect $555,000 in benefits.

Filed Under: Insurance, Retirement //

Vanguard Target Retirement Income Fund vs. Vanguard Wellesley Income Fund

Posted on September 14, 2011 // 17 Comments

There’s a ways to go, but we’re still aiming to retire within the next 10 years. As such, I’ve been thinking about what happens when we want to live off of withdrawals from our retirement portfolio. According to the passively-managed Target Date funds by Vanguard, if you reach retirement you’re directed to the Vanguard Target Retirement Income fund. Another popular option for retirees is the Vanguard Wellesley Income Fund, which has been around for over 40 years, and is actively-managed by Wellington Management Company, an advisory company that has been around since the Great Depression. Let’s take a quick look to see how these two funds compare.

Vanguard Target Retirement Income Fund (VTINX)

This fund seeks to provide “current income and some capital appreciation”. The approximate asset allocation is 30% stocks, 65% bonds, and 5% cash. It is a fund of funds, holding the Vanguard Total Bond Market II Index Fund, Vanguard Total Stock Market Index Fund, Vanguard Inflation-Protected Securities Fund, Vanguard Prime Money Market Fund, and Vanguard Total International Stock Index Fund. Here is the current asset allocation per Vanguard as well as the equity and bond style boxes from Morningstar.

Number of stocks held: 9,958 (3,323 US + 6,635 Foreign)

Number of bonds held: 4,486 (4,450 nominal bond + 36 TIPS bonds)

Expense ratio: 0.17% ($170 a year on a $100,000 balance)

Vanguard Wellesley Income Fund Admiral Shares (VWIAX)

This is an income-oriented balanced fund, which is another way of saying the same thing as above. The approximate asset allocation is 35% stocks, 65% bonds. I am choosing the Admiral shares as opposed to the Investor shares because the great majority of people using this for their retirement will reach the $50,000 minimum balance. Here is the current asset allocation per Vanguard as well as the equity and bond style boxes from Morningstar.

Number of stocks held: 60

Number of bonds held: 559

Expense ratio: 0.21% ($210 a year on a $100,000 balance)

Commentary

The overall asset allocation of the two funds is very similar, especially since you could consider cash/short-term reserves as bonds. However, how they are constructed is very different. Target Retirement is passively indexed on a market-cap weighted distribution and holds nearly 10,000 stocks from around the world. Wellesley is actively-managed to include only 60 selected dividend stocks from primarily large, US companies.

As for bonds, Target Retirement follows another market-weighted index of the Barclays Capital U.S. Aggregate Float Adjusted Bond Index. There is a large chunk of US Treasury, US Treasury Inflation-linked, and US Agency mortage-backed bonds. Wellesley is mostly in corporate investment-grade bonds.

Wellesley is produces more of it’s returns as income through stock dividends and the higher bond yields from corporate bonds, with a current SEC yield of 3.28%. This allows the psychological benefit of possibly spending only the dividends that the fund distributes every quarter. However, there is the concern that 60 stocks is not enough diversification, or that their bond analysts might drop the ball. Here is the growth chart of $10,000 (click to enlarge):

At least historically, the managers of Wellesley have added value. Will it continue? Unknown. The good news is that with such low costs, there’s one less reason to expect underperformance in the future. These are just an example of what is out there, although on some early retirement forums I see folks simply holding a 50/50 split of these two exact funds. Sometimes I think everyone should just start with these kind of low volatility funds in the first place, and just reinvest dividends.

Filed Under: Investing, Retirement //

U.S. Savings Bonds Have Outperformed Stocks Since 1998?

Posted on August 31, 2011 // 24 Comments

A reader recently told me that he was no longer investing in the stock market after seeing the chart below from the Savings Bond Advisor. It shows the total portfolio value after investing equal monthly amounts in either the S&P 500 stock market index or Series I US Savings Bonds. The time period is from September 1998 (when “I Bonds” started being sold) through August 1, 2011. My comments follow.

The past returns of savings bonds are indeed pretty good, but not likely to be repeated. Series I Savings Bonds (I Bonds) were the new thing in 1998, and the government offered some really enticing interest rates on them. I Bonds have a fixed component that lasts for the duration of that specific bond and an variable component that adjusts with inflation every 6 months. From 1998 to May 2001, the fixed component was always between 3% to 3.60% above inflation (source). However, since May 2008, the fixed rate has been between 0% and 0.7%. For the past year, the fixed rate has been a big fat zero. I would love to have a savings bond paying 3% plus inflation (currently 2.30%), as some current bondholders have, but I don’t expect that to ever happen again.

Now, that doesn’t mean that they aren’t still a competitive investment, especially for the short term. Since interest rates are so low, I still buy savings bonds even at a 0% fixed rate as part of my emergency fund cash reserves.

Savings Bonds are being slowly killed by the government. Even though savings bonds have historically encouraged people of all income levels to save, it appears that the US Treasury is slowly killing the savings bond. As recently as 2008, you could buy $30,000 worth of each type of savings bonds a year, per person. For a while, we were able to even use credit cards to buy them without a fee. Today, you can only buy $5,000 of paper I-bonds and $5,000 of electronic I-bonds a year, and even paper savings bonds are being phased out in 2012. (You can still overpay your taxes and buy paper bonds with a tax refund in 2012.) There was even a NY Times article last week entitled Save the Savings Bond. Basically, even if you wanted to create your retirement portfolio with savings bonds, you can’t.

Investing solely in inflation-linked bonds is actually recommended by some financial authors. The thing is, the government has so much debt that it greatly prefers US Treasury bonds which can be sold by the billions. Printing a $50 savings bonds is not even a drop in the bucket, it’s closer to a H2O molecule in the bucket. What you can invest in is Treasury Inflation Protected Securities (TIPS), which like I Bonds are backed by the government and pay an interest rate linked to inflation. Economics professor Kolitkoff in the book Spend ‘Til The End recommends your entire portfolio to be TIPS. The problem? You’re gonna have to save a lot. TIPS yields are very low, currently offering yields of negative 0.7% above inflation (!) for a 5-year bond to a meager 1.1% above inflation for a 30-year bond. If you’re okay with saving 50% of your income every year for 30 years, then this plan might work for you.

There is no easy answer as to the best place to invest right now. I am sticking with a diversified low-cost portfolio with both stocks and bonds (including a nice chunk of TIPS inside, which has done quite well recently), and you can see with this chart that it has also done pretty well the last decade.

Filed Under: Investing, Retirement, Savings Bonds //

Swensen Portfolio 10-Year Total Returns: Low-Cost Diversified ETF Portfolio Results

Posted on August 23, 2011 // 11 Comments

Last week, I shared a chart that showed how a diversified portfolio that was rebalanced regularly still managed to nearly double in value over the last decade. Here’s another similar finding based on the David Swensen portfolio as compiled by an advisor group called ETF Portfolio Management.

Swensen manages the Yale University endowment and wrote an excellent investment book called Unconventional Success (my review) directed towards individual investors. Even though he does active management himself, he explains why low costs and low turnover are critical, how certain asset class are better than others, and why rebalancing regularly is important. He ends up providing a model portfolio made up of what he calls “Core” asset classes. Here’s the slightly updated David Swensen Portfolio with his recommended 70% stocks / 30% bonds breakdown. Actual low-cost index ETFs are included via ticker symbols.

30% Domestic US Equity (VTI)
15% Foreign Developed Equity (VEA)
10% Emerging Markets (VWO)
15% Real Estate (VNQ)
15% U.S. Treasury Bonds (IEF)
15% Inflation-Protected Securities (TIP)

Instead of the Total Bond Index from last week, which include everything from Treasuries to corporate bonds to mortgage-backed securities, the Swensen bond allocation only has nominal and inflation-linked Treasury bonds. The chart below shows the growth of $1,000 invested this way (eMAC) at the start of 2001 until the end of July 2011. (Last week’s chart included the start of 2000 to end of 2009.) The ETFs listed above were bought and rebalanced annually. eMAC stands for “efficent multi-asset class”.

Again, we see that the diversified and rebalanced portfolio has done well over the last 10 years, more than doubling in value. Check out their annual returns breakdown (summarized below), and you can see how in any single year different asset classes will have different returns. Some go up, some stay steady, some go down. This lack of strong correlation is what helps smooth out your portfolio, and makes you feel better that at least something is doing okay at any given time.

Now, this may not be the ideal portfolio going forward. Nobody knows the future, you can only do what you think gives you the best odds for success. But it does serve as another real-world example of how low-cost diversification works and that you should have good reasons for holding each of the asset classes that you buy.

(The “HF Index” indicated stands for the Dow Jones Credit Suisse Hedge Fund Index, which claims to track ~8,000 hedge funds and thus tracks overall hedge fund performance. After poking around their website, the returns seem to be net of manager fees.)

Filed Under: Investing, Retirement //

Buy, Hold, and Rebalance! How Patient Investors Still Quietly Grow Their Money

Posted on August 17, 2011 // 15 Comments

There is a lot of uncertainty in investing, and it always seems like especially now. Buy and hold has been called dead many times. However, if you look carefully, you’ll find that there are many people who have quietly grown their portfolio over the last decade using the boring principles of diversification, low-costs, and regular rebalancing. I would also add proper tax planning helps as well.

Here is some data from a WSJ article by Burton Malkiel (author of Random Walk Down Wall Street) that helps illustrates this. (Can’t view the article? Use this Google the title trick and click the first link.) The article is from several months ago, but the S&P 500 index back then was almost exactly the same as yesterday: 1,193 vs. 1,195.

The chart below shows the growth of $100,000 invested at the start of 2000 until the end of 2009. As you can see, a 100% stock investment (in green) would have ended up at $93,717. Thus the term “lost decade for stocks”.

But what happens when you mix in some other assets, and rebalanced them annually? The red line is a portfolio consisting of 67% stocks and 33% bonds, all in low-cost index funds. The stock breakdown was 27% US, 14% Developed International, 14% Emerging Markets, and 12% REITs. The result was a ending balance of $191,859, which means an investor in 2000 could have, without special psychic powers, nearly doubled their portfolio over the same “lost decade”.

The diversified portfolio above matches rather well with my own asset allocation. For one, my AA also has 50/50 US/non-US split plus a chunk in REITs. Although I started out 85% stocks/15% bonds, I am now closer to 75% stocks. I have also rebalanced annually to maintain that ratio, but I do feel that my portfolio has still grown past my contributions even though I haven’t tracked my personal returns as well as I’d like.

Regular rebalancing is key. That is, keeping your target asset allocation by buying what is going down, and selling what is going up, in order to keep your desired risk profile. Both in early 2009 and last week, I was buying stocks. While there is debate on this, I believe that there is a reversion-to-the-mean effect that boosts your returns.

Filed Under: Investing, Retirement //
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