Financial Independence Heat Map: Starting Age vs. Savings Rate

If you are into podcasts and enjoy long conversations about higher-level personal finance topics (put that in your dating profile!), check out the Radical Personal Finance podcast. I’ve only listened to a few, but I enjoyed Episode 181 on The Impact of Your Savings Rate on Your Time to Financial Independence. If you make $50,000 a year and spend $40,000, then your savings rate is 20%.

Based on math formulas mentioned in the podcast, a commenter named Philip Frey created a “heat map” Google Docs worksheet with starting age, savings rate, and age at financial independence. Green means you retire by age 40, yellow by age 50, red by age 65, and grey… means you’ll be heavily reliant on Social Security. 😉

fi_heatmap

I believe the assumptions include (1) both income and spending numbers are after-tax, (2) once you reach 25 times expenses you reach financial independence (4% safe spending rate), and (3) outside pensions and Social Security are ignored. It’s not perfect and I wouldn’t take hard numbers from this chart, but it’s still a neat visualization.

Savings rate is a great way to measure your velocity towards financial independence. Treating the components of income and expenses as separate, as opposed to intricately linked as most people assume, is the key takeaway.

Achieving financial independence is quite difficult no matter how you do it, but my bet is that at least 10x more people have achieved early retirement through high income and average spending, as opposed to average income and very low spending. This is based on our own observations, including having household income that varied between slightly below average and well above-average. I could be wrong; I’d love to see some good data on this.

My 529 Plan Asset Allocation, Part 1: Extension of Retirement or Standalone Portfolio?

529I’m finally getting around to setting up 529 college savings plans for my kids. It remains my opinion that you should make sure your retirement savings are on track before worrying about college savings. The government let me borrow over $50,000 in student loans for college, but they won’t let me do that again for retirement.

(Related: Top-ranked nationally-available 529 plans and state-specific tax benefits.)

Other than deciding how much money you’ll contribute, the big question is what do you invest it in? The most common default investment choice is an all-in-one fund that adjusts automatically based on the age of the beneficiary. Essentially, a tweaked target-date retirement fund. Under this model, each child of different age would then have their own standalone asset allocation.

However, I ran across an interesting discussion on the Bogleheads forum where some people used their 529 plans as an extension of their primary retirement portfolios. As the 529 offers tax-deferred growth and tax-free withdrawals for qualified educational purposes, you could treat it like an IRA and put some tax-inefficient assets inside. For example, I could squeeze in some riskier stuff like real estate (REITs), small value stocks, and/or emerging markets stocks for a couple of decades. Or safe stuff like TIPS. You wouldn’t have to adjust for beneficiary age, just rebalance things whenever you spend it down.

This gets a little tricky because even if you start early, you’re typically going to save up a bunch of money over 15-20 years and then spend it all within 4 years. Contrast this with retirement, where you typically save up over 30-45 years and spend it over another 20-35 years. Also, if you don’t spend the funds in a qualified manner, your withdrawals may be subject to both income tax and an additional 10% penalty.

In my opinion, an important factor to consider is your personal tuition assistance philosophy.

Are you going to cover a certain percentage of your child’s tuition, no matter what? Some parents will promise to cover 50%, 75%, or 100% of college expenses, regardless of actual 529 balance. In that case, the 529 plan is less of a savings bucket as it is just another way to gain some extra return via tax sheltering. Perhaps then it makes sense to consider your 529 as a piece of the bigger picture.

Let’s say you invest solely in 100% risky stocks for the entire 15 years, and there is a last-minute crash where you lose 50% of your value. If your final 529 balance is much less than expected, the rest of your portfolio probably did better and you can fulfill your commitment with other assets. (The same thing could happen if you invested solely in 100% safe bonds. The return might be so low that your final balance is quite disappointing.)

Are you treating the 529 plan as a piggy bank? “Here, I saved this much money for you. You handle the rest.” In this case, you are setting aside a fixed amount, labeling it “college funds”, and you’re done. It is separate in your mind. So why not invest it separately? You probably do want to make your investments diversified initially and also more conservative as your child gets close to college. Having the value drop in half at the very end could force your child to take on a significantly larger amount of debt.

After some thought, I am taking a hybrid approach. I am committed to covering at least a “good chunk” of my kids’ college expenses, without limiting it to a fixed amount. (I won’t guarantee 100% as I am wary as to how colleges use their huge sticker prices.) First, we have the financial means, even if it means working a little longer. Second, we feel an obligation to pay it forward because my parents covered a big portion of my own tuition and my wife’s parents covered all of her tuition. My goal is to have my kids feel free to take some career risk in their 20s, although I am not opposed to them having a little debt (“skin in the game”).

My plan is to make my 529 a miniature copy of my retirement portfolio. If my retirement portfolio asset allocation is 60% stocks and 40% bonds, then the 529 portfolio will also be 60% stocks and 40% bonds. So the 529 will be a standalone portfolio, but it will grow at the same rate as my retirement portfolio. Once the time comes, I will spend the 529 money and also withdraw from my retirement portfolio if needed (hopefully not). However, in the meantime, I won’t have to constantly rebalance across two additional smaller accounts.

My kids are 1 and 3 right now. I plan on keeping my cloned asset allocation setup for at least the next 10-12 years, and then taper down over the last 5 years so that it is 100% cash or short-term bonds by age 18. This differs from most age-based default options offered, as they taper steadily over the entire 18-year period. More details on why I like my way better in Part 2 tomorrow.

Charlie Munger: The First $100,000 Is The Most Difficult

There used to be a series of ING commercials where people would carry around their “Number”, which was usually over a million dollars. I think such large numbers actually discourage most savers, so what if we had an alternative goal that was both more achievable yet realistic?

I’m currently reading a new book called Charlie Munger: The Complete Investor by Tren Griffin because, well, I like to read anything about Charlie Munger. There is a lot of good stuff related to investing inside, but it didn’t mention one of my favorite personal finance quotes from Mr. Munger. I can’t seem to find an exact reference anymore, so here are two paraphrased sources…

First, here is an excerpt from the 2003 book Damn Right!: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger by Janet Lowe (my review):

Munger has said that accumulating the first $100,000 from a standing start, with no seed money, is the most difficult part of building wealth. Making the first million was the next big hurdle. To do that a person must consistently underspend his income. Getting wealthy, he explains, is like rolling a snowball. It helps to start on top of a long hill—start early and try to roll that snowball for a very long time. It helps to live a long life.

Second, here is another version of the quote credit to Munger, per Conservative Income Investor:

“The first $100,000 is a bitch, but you gotta do it. I don’t care what you have to do—if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000. After that, you can ease off the gas a little bit.”

$100,000 is certainly a nice, round number. But is it a worthy goal? Consider these points:

Most people will never achieve $100k in portfolio assets. Forget a million bucks. Consider this chart from the Quartz article America is full of high-earning poor people. On average, even a person earning close to six figures will struggle to reach $100k in financial assets by age 55.

The figure below plots financial assets held by the upper middle class (household income from $50,000 to $75,000, and $75,000 to $100,000) aged 40 to 55. Financial assets are any assets a household owns that isn’t a house, car, or business, which means it includes all retirement funds.

networth100k

If you reach $100k quickly, that means you have high earning power. Let’s say you start a successful small business or are in a well-paid professional field. Well, you have the saving potential to reach the millionaire level, you just have to keep it by not increasing your spending accordingly.

If you reach $100k gradually, that means you have built up a strong habit of spending less than you earn. Let’s say it takes you a decade of steady saving to reach $100k. That’s okay, as you’ve shown that have both consistent earning power and spending restraint. You’ll be able to save another $100k over the next decade for sure, meanwhile your first $100k is going to keep on growing.

At the $100,000 level, compound interest become significant. At 5% return, your $100,000 will grow by $5,000 in just one year. That’s $5,000 for doing nothing but waiting around for a year. The year after that, you won’t just have another $5,000. You’ll have $5,250 due to compound interest. At the end of five years, that $100k is already $127,628.

Add in the additional money from your continuing habit of saving, and things start to improve quickly. Your snowball is growing. I no longer automatically reinvest my dividends from my taxable mutual fund and ETF holdings because I love seeing the money show up in my cash account. A few clicks and I’ll reinvest them, but I like the feeling of “cashing my dividend checks” and knowing that one day I’ll be waiting for them to arrive instead of my paycheck.

Now, I still think savings rate is a better measuring stick than portfolio size, because someone who can earn $60k and spend $30k every year is going to be able to retire much sooner than someone who earns $180k and is stuck in a lifestyle spending $150k. But if you are in the phase of your life where you love watching your account balances grow every day, even by a few dollars (been there, done that), $100k is the biggest goal you need.

Related: Munger: Work For Yourself An Hour Each Day and Munger on Parenting and Childhood.

Early Retirement Portfolio Income Update, November 2015

monopoly_divI like the idea of living off dividend and interest income. Who doesn’t? The problem is that you can’t just buy stocks with the highest dividend yields and junk bonds with the highest interest rates without giving up something in return. There are many bad investments lurking out there for desperate retirees looking only at income. My goal is to generate reliable portfolio income by not reaching too far for yield.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (Taken 11/5/15) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
24% 1.92% 0.46%
US Small Value
WisdomTree SmallCap Dividend ETF (DES)
3% 2.98% 0.09%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
24% 2.83% 0.66%
Emerging Markets Small Value
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
3% 3.44% 0.10%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 3.92% 0.24%
Intermediate-Term High Quality Bonds
Vanguard Intermediate-Term Tax-Exempt Fund (VWIUX)
20% 2.99% 0.60%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
20% 1.31% 0.26%
Totals 100% 2.41%

 

The total weighted 12-month yield was 2.41%. This means that if I had a $1,000,000 portfolio balance today, it would have generated $24,100 in interest and dividends over the last 12 months. Now, that is significantly lower than the 4% withdrawal rate often quoted for 65-year-old retirees with 30-year spending horizons, and is even lower than the 3% withdrawal rate that I have previously used as a rough benchmark. I’ll note that the muni bond interest in my portfolio is exempt from federal income taxes.

Given the volatility of stock returns, the associated sequence of returns risk, and current high valuations, I still like the income yield measuring stick. I feel that the income yield number does a rough job of compensating for stock market valuations (valuations go up, probably dividend yield go down) as well as interest rates (low interest rates now, probably low bond returns in future). With 60% stocks, I am hoping that the dividends will at least keep up with inflation, and that I will never have to “touch the principal”. Over the last 15 years or so, the annual growth rate of the S&P 500 dividend averaged about 5%.

As noted previously, a simple benchmark for this portfolio is Vanguard LifeStrategy Moderate Growth Fund (VSMGX) which is an all-in-one fund that is also 60% stocks and 40% bonds. That fund has a trailing 12-month yield of 2.07%. Taken 11/9/2015.

So how am I doing? Staying invested throughout the last 10 years has been good to me. Using the 2.24% income yield, the combination of ongoing savings and recent market gains have us at 84% of the way to matching our annual household spending target. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years. From that perspective, a 2% spending rate seems like a very conservative number. As such, we are currently redirecting a chunk of our monthly savings into a college savings account. We are doing well and we want to help pay for our children’s higher education, so might as well get that tax-deferral started now.

Early Retirement Portfolio Asset Allocation Update, November 2015

Here’s a (late) Q3 2015 update on my investment portfolio holdings for 2015. This includes tax-deferred accounts like 401(k)s and taxable brokerage holdings, but excludes things like real estate and cash reserves (emergency fund). The purpose of this portfolio is to create enough income to cover household expenses.

Target Asset Allocation

aa_updated2015

I try to pick asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I have doubt that I would hold them through an extended period of underperformance (i.e. don’t buy what you don’t can’t stick with).

Our current target ratio is 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With a self-directed portfolio of low-cost funds and low turnover, we minimize management fees, commissions, and taxes.

Actual Asset Allocation and Holdings

1510_port_aa

Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard Intermediate-Term Tax-Exempt Fund (VWITX, VWIUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
U.S. Savings Bonds (Series I)

What’s New? Commentary
Things are still sticking pretty close to my target asset allocation. Before the year ends, I would like to relocate my “spice it up” holdings of WisdomTree SmallCap Dividend ETF (DES) and WisdomTree Emerging Markets SmallCap Dividend ETF (DGS). Mostly because a big chunk of their dividends are unqualified and thus subject to higher income rates. I can also do a bit of tax loss harvesting. But where to move them? I could squeeze them in my Fidelity Solo 401k plan that lets me buy ETFs (displacing either TIPS or REITs), buy similar mutual funds in my Schwab 401k brokerage window (displacing TIPS), or even buy some similar DFA funds in a Utah 529 account and consider it part of my portfolio (smart?). Or I could just liquidate them and just stick with total stocks funds (boring).

As for bonds, I’m still underweight in TIPS mostly due to lack of tax-deferred space as I really don’t want to hold them in a taxable account. My taxable bonds are split roughly evenly between the three Vanguard muni funds. The average duration across all of them is roughly 4-5 years.

A simple benchmark for my portfolio is 50% Vanguard LifeStrategy Growth Fund (VASGX) and Vanguard LifeStrategy Moderate Growth Fund (VSMGX), one is 60/40 and one is 80/20 so it also works out to 70% stocks and 30% bonds. That benchmark would have returned about 1.47% YTD for 2015 (as of 11/4/15). I haven’t bothered to calculate my exact portfolio return, but it should be close to this number.

I like tracking my dividend and interest income more than overall market movements. In a separate post, I will update the amount of income that I am deriving from this portfolio along with how that compares to my expenses.

myRA Starter Retirement Account Launches Nationwide

myra_logoThe U.S. Department of the Treasury announced the national launch of myRA (my Retirement Account), a new starter option for those who don’t have access to a retirement savings plan at work. There have been some improvements and tweaks since their initial pilot launch in late 2014.

No monthly or annual fees. No minimum contribution requirement. No minimum balance requirement. Contribute as little as a dollar every paycheck if you like.

Fund via automatic paycheck deduction, automatic bank transfers, or federal tax refund. Automatic paycheck deductions work through your employer’s direct deposit system.

myra_calc

No risk of loss. Your money is backed by the US government, just like US Treasury bonds and FDIC-insured bank accounts. You earn the same interest rate as the Government Securities fund available to Federal employees, known as the G Fund. The good news is that it earns the higher interest of longer-maturity bonds while maintaining zero principal risk like a bank account. Interest is compounded daily.

The G Fund 1-year historical return for 2014 was 2.31%. Taken from TSPFolio, here is the interest rate history. The current annualized rate for November 2015 is 2.125%.

myra_grate

What does “starter account” mean? There are no stocks or other riskier options here. You can roll over your myRA into a private-sector Roth IRA once you’ve either reached the max balance of $15,000 or the max time period of 30 years.

What do you mean it’s a Roth IRA? I mean just that; it is a Roth IRA. The same rules apply:

  • Tax-fee and penalty-free withdrawal of contributions at any time, if needed.
  • If you make a qualified withdrawal, you’ll pay no taxes on both contributions and earnings.
  • For 2015, the contribution limit per person is $5,500 a year, or $6,500 if you are at least 50 years old by the end of the year.
  • The income limit is based on modified adjusted gross income (MAGI). The 2015 phase-out range for singles is $116,000 to $131,000. For married filing jointly is $183,000 to $193,000.

Although you may not be the target audience, you can still use myRA if you have a 401k or previous IRAs. Again, myRA is a Roth IRA so you’d have to direct part or all of your annual contribution to this Roth IRA instead. The G Fund is something that I would invest in if it was an option for me, but it is somewhat inconvenient to open another account just for one investment option. For example, if you are 90% stocks and 10% bonds, a $5,000 total contribution would only direct $500 towards a myRA.

Commentary. As I noted when it first came out, myRA is kind of a Frankenstein cobbled together from the parts bin. Existing Roth IRA vehicle. Existing Thrift Savings Plan G Fund. Comerica Bank quietly manages the backend (they’ve done previous work for the Treasury). It’s a bit clunky as you have to tell your employer to direct deposit some of your paycheck into your myRA, which a is basically a Comerica bank savings account and routing number (111925074). If you employer can’t handle split direct deposits, you must contribute via bank transfer or tax refund.

Will this combo convince someone who’s not saving today, to start? My guess is that the popularity will be relatively low. While I personally wouldn’t mind having the G Fund as an investment option, but I don’t know that someone who’s not saving now will be enticed by a 2% interest rate. (Maybe if rates rise.) But hopefully I’m wrong and the opportunity to have a “retirement plan of your own” is enough.

To me, what’s missing is super-easy auto-enrollment (auto opt-in, voluntary opt-out). So the best case scenario is if small businesses without 401(k) plans actively encourage their employees to sign up for myRA, as we’ve seen that automatic deductions are a good trick to save more for retirement. For more information, visit the myRA.gov employer FAQ.

Your Employer Took Your Money, Invested For Retirement, and You Liked It

Below is a chart taken from this WSJ article about employer-run 401(k) retirement plans and how the default settings have changed over the last decade:

wsj_vg_savings_full

The trend: Employers are making you save more initially by default, making you save a little more every year by default, and putting it in a pre-mixed target-date fund of stocks and bonds. Employees can opt out of any of these things at any time. But they aren’t.

Credit Suisse braced for complaints last year when it upped its initial automatic savings rate for new employees to 9% from 6%. It did so after years of experiencing lackluster interest from the firm’s roughly 8,500 employees—specifically younger workers—in the U.S. when meeting to discuss increasing retirement savings, said Joseph Huber, chairman of the bank’s pension-investment committee.

But Mr. Huber said the bank heard concerns from only two people, who weren’t previously putting any money into their 401(k) plans. Credit Suisse also decided to automatically increase the default rate by 1% a year until an employee reaches 15%. It doesn’t match contributions up to the highest rate, although it contributes $3,000 to $10,000 for each employee annually.

“It’s companies’ biggest fear and it was radio silence,” he said.

Well, perhaps I shouldn’t be pointing this out because the current inaction may be a good thing. The only problem is that nearly half of US workers don’t have an company-sponsored retirement plan. The bigger your company, the more likely you have one as an option.

wsj_vg_bw

The takeaway? Try using this behavioral psychology trick on yourself. Commit to saving more through automatic, recurring transfers. Use a savings account or an IRA if you don’t have a 401(k) match. Set the amount such that it hurts a bit. You can always change it back later (but hopefully you won’t need to).

Andre Agassi Interview: Typical Day in Retirement

agassi_logoAndre Agassi became famous for being a professional tennis player, but his greatest legacy may be through his work in charitable and social causes. He now oversees both a charitable foundation and the Andre Agassi College Preparatory Academy, a tuition-free charter school for at-risk K-12 children. As both a tennis and education enthusiast, I’m a big fan. As part of their “Life’s Work” series, Harvard Business Review interviewed Agassi.

I especially liked this quote about his typical day in “retirement”, as my ideal schedule is starting to look the same. Maybe not work every morning, but at least some mornings. Hiking, sports, or some other outdoor activity otherwise.

At the C2 Montreal conference earlier this year, you said a typical day for you now involves working in the morning but finishing by 2:30 in the afternoon to pick up your kids in the carpool line.

I have the luxury of tweaking the balance now, of never missing a baseball game or a dance competition. If I’m feeling like I need a business outlet, I plan work. But yes, I engage much harder with my kids because they grow up fast. By the time you’re qualified for the job, you’re unemployed.

The whole point of financial freedom is to do whatever you want, whether that means zero work, only charitable work, part-time work, or even more. Consider this quote from the man who has spent thousands of hours editing Wikipedia (over a million times)… for free.

Everyone should do work that is not for money. I believe that when you have free time, you shouldn’t spend it idling. I’m able bodied; globally speaking (though not at all locally speaking), I’m rich. I have a lot of resources other people don’t have — an internet connection, free time, the ability to speak English — and it’s incumbent upon me to use them to make the world a better place.

But back to Agassi – here he is on taking ownership of your career. I would expand this to perhaps your savings and investments?

What do you regard as your biggest career mistake?

I wish I had taken ownership of the business side of my career years ago instead of trusting certain people. Nobody cares more, or represents you better, than you do yourself.

Finally, he explains his intensive approach to changing the lives of children.

What sets your school apart?

One difference is time on task. There are no shortcuts. We have longer school days—eight hours versus six. If you add that up, it’s 16 years of education versus 12 for district peers. There’s also an emphasis on accountability, which starts with the kids themselves. They know this is a privilege: There are 1,000 kids on the waiting list. So they take ownership. The teachers have annual contracts; there’s no business in the world that could succeed if employees who worked for three years got a job for life. The parents are accountable too. They need to acknowledge, accept, and embrace the objectives set for their children. They come in, they volunteer time, they sign off on homework assignments. You have to cover all the bases.

Do Financial Advisors Really Keep Portfolios and Clients Disciplined?

I written about Dimensional Fund Advisors (DFA), a mutual fund family that is powered by top academic research. Another things that makes DFA unique is that they are only sold through approved financial advisors. You can’t buy them with just any old brokerage account. (Exceptions are certain 401(k)-style retirement plans and 529 college savings plans.) Allan Roth has new article about DFA funds in Financial Planning magazine, which is a trade publication targeted to financial professionals.

Why not sell directly to Average Joe investor? Here is David Butler, head of DFA Global Financial Advisor Services:

DFA has no intention of bypassing the advisor channel and offering its funds directly to retail investors. “We think advisors help keep investors disciplined,” Butler says.

In my previous post The True Value of a Real, Human Financial Advisor, I wrote about this concept. A good client advisor will help you keep your cool when the next disaster comes. Vanguard says that the biggest “value add” from good advisors is their “behavioral coaching”. A good financial advisor keeps you from making the “Big Mistake” that derails your plans.

onepage_bigmistake

But later in the same Allan Roth article, the idea of advisors as disciplinarians is called into question.

But do investors get better returns? I tested Butler’s claim that DFA advisors help keep investors disciplined by asking Morningstar to compare the performance gap between the two fund families. The performance gap is the difference between investor returns (dollar weighted) and fund returns (geometric).

Over the 10 years ending Dec. 31, 2014, the DFA annualized performance gap stood at 1.28% versus only 0.22% for Vanguard. When I showed these figures to Butler, he responded, “It’s hard to make an argument about the discipline of advisors based on these figures.

Here’s a primer on investor returns vs. fund returns. Investor returns are the actual returns earned by investors, based on the timing of their buying and selling activities.

The next step was to compare the investor returns of DFA’s largest fund, DFA Emerging Markets Value I Fund (DFEVX) with $14B in assets with the closest Vanguard competitor, Vanguard Emerging Markets Index Fund (VEMAX) with $54B in assets. I personally think a better comparison would be with their DFA Emerging Markets Core Equity I Fund (DFCEX), so I’m throwing that in as well.

DFA fund returns are often higher relative to index fund competitors. Here’s a Morningstar chart comparing the growth of $10,000 invested 10 years ago in each of the three funds. You can see the DFA funds do slightly better in terms of fund returns. Click to enlarge.

dfa_em_vg_10k

But what about investor returns? I took some screenshots of their respective Morningstar Investor Return pages.

dfa_em1b

dfa_em_vg

dfa_em3

We see that after accounting for the timing of actual cashflows, the average investor in the DFA fund actually lost money with an annualized return of -1.01% and -2.04%! Meanwhile, the average Vanguard investor earned over 6% annualized.

The three mutual funds don’t have the exact same investment objective, but they do both all pull from the overall Emerging Markets asset class. The DFA funds try to focus ways to earn greater long-term return by holding stocks with a higher “value” factor, but it also has a higher expense ratio. The Vanguard fund just tries to “buy the haystack” and passively track the entire index.

Let’s recap. The stated reason why DFA is only sold through advisors is that they offer more discipline. We are told that such behavioral coaching is where human advisors provide their greatest value. However, the evidence available suggests that DFA advisors are less good at trading discipline than when a similar fund is completely open to retail investors.

I found this rather surprising. I used to think that restricting my potential advisors to those were affiliated with DFA was one way of getting an “above-average” advisor. But after doing my own research, I found that even though DFA investments are generally lower-cost, the additional fees charged by individual advisors ranged widely from reasonable to quite expensive.

I am confident there are financial advisors that can provide the proper behavioral coaching that makes them well worth the cost. At the same time, clearly many are not providing the advertised guidance and discipline. The problem remains – how does Average Joe investor find the good ones? I still know of no clear-cut way.

Retirement Income Risks: Longevity, Sequence of Returns, and Stupidity

annuity_puzzleOne of the first things that pops up when doing research on retirement annuities is the “annuity puzzle”. Essentially, economists have done their calculations and shown that simple, immediate income annuities are theoretically the best fit for many people. You give up some things like liquidity and upside potential, but in exchange you get the most monthly income for the rest of your life. But in the real world, only a small fraction of such people actually go out and buy such annuities.

Bob Seawright wrote a nice article at ThinkAdvisor.com that lists three main risks with managing withdrawals from your own lump-sum portfolios. An income annuity can help address these risks. I’ve added my own comments as well.

Longevity risk. People are living longer on average. Enter your age(s) into this Vanguard longevity tool. Here is a short snippet from a previous longevity risk post:

For an individual that is 65 today, there is roughly a 50/50 chance they will reach age 80. For a couple both at 65, roughly a 50/50 chance that at least one person will reach age 90.

The extreme ages are getting higher as well; quote below taken from the Seawright post:

Moreover, the distribution of longevity is wide — a 22-year difference between the 10th and 90th percentiles of the distribution for men (dying at 70 versus 92) and a 23-year difference between the 10th and 90th percentiles of the distribution for women (dying at 72 versus 95).

Sequence of returns risk. Two retirees can start with the same initial portfolio balance and experience the same average return, but if one experiences highly negative returns in the first few years of withdrawals they can end up with very different outcomes. Here is a previous graphic illustrating the sequence of returns risk.

sor_risk

Stupidity risk. If you do-it-yourself, what if you aren’t very good? The idea of safe withdrawal rates is a starting point, but even that assumes a theoretical 60/40 you-didn’t-panic-when-stocks-dropped-50-percent portfolio. I like the idea of adding some robustness with more flexible dynamic safe withdrawal rates, but “safe” is still a relative term.

Eventually, I plan to put a portion of my money into a single premium immediate annuity (SPIA). I’ll probably wait until around age 65, with a joint life rider so that it will keep paying out as long as either my wife or I are alive. I like the idea of having enough guaranteed income to cover all basic needs like housing, food, and utilities. Considering that we have no mortgage and assuming no major cuts to Social Security, I am hoping that number is not too much in excess of state-specific insurance guaranty coverage limits.

Lifetime Income vs. Lump Sum Payouts: You May Live Longer Than You Think

My parents are in the midst of planning their retirement payout structure. I don’t know about everyone else, but in my mind I tend to plan to live to pretty much exactly age 80. Early death is depressing to think about (even though I have term life insurance), but what about the other end? The Statistical Ideas blog had a timely post about longevity risks and lump-sum payouts which contained a “death table” (horrible name) for people born in 1950. I’m going to paraphrase the explanation in a way that makes more sense to me.

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  • Out of every 100 people born in 1950, roughly 1/3rd are expected to die by age 65. (Blue)
  • If you are in the group alive at 65, your life expectancy is now age 79. That is, half of that group will die before 79. (Green)
  • But, that also means you have a 50% chance of living past 79. If so, you will live to somewhere between 80 to 110. In other words, possibly a really long time! (Red)

If you are a couple, then the odds of at least one of you living a really long time is even higher. Let’s take a couple, one male and one female, who are both age 65. According to this Vanguard longevity calculator, there is an 89% chance at least one will reach age 80, and a 45% chance at last one will reach age 90. If you are younger, your life expectancy is even longer; enter your age(s) into the calculator.

Here’s my mental shortcut. For an individual that is 65 today, there is roughly a 50/50 chance they will reach age 80. For a couple both at 65, roughly a 50/50 chance that at least one person will reach age 90. Putting it this makes make either scenario equally likely and would push me to plan accordingly. On one side of the coin flip, you have to enjoy life now! On the other side, you need to be prepared.

This longevity risk needs to be accounted for when you give up pensions or annuities that offer you a guaranteed income for life. A lump sum payout may sound attractive, but be very careful. Have any annuity and pension buyout offers analyzed and checked by an unbiased third-party. It is a big decision and may be worth paying an expert for their time.

Here’s a sad story of lowball buyout offers for lead-paint victims. Not to say all lump-sum offers are this bad, but it serves as a warning to make sure you understand what you are giving up.

Combining Maslow’s Hierarchy of Needs & Personal Finance

Updated. You may or may not be familiar with Maslow’s Hierarchy of Needs, which is part of one theory explaining human behavior by psychologist Abraham Maslow. It suggests that there are five general levels of needs:

  • Physiological
  • Safety
  • Social
  • Esteem
  • Growth

These are often represented as a triangle due to their relative importance. Lower needs must be satisfied before the higher needs can be addressed. For example, one must first obtain food and water (physiological) before worrying about what might happen if they get in a car accident tomorrow (safety). It’s just a theory, but an interesting one.

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While not all of these needs can be explicitly bought with money, it’s not too much of a stretch to see the relationship between this triangle and finances. We usually worry about paying for rent and food first before worrying about giving to charity or that long distance telephone bill.

In the book Retirement Income Redesigned, the authors make a close correlation between the hierarchy of needs and planning for retirement. Here is a figure from the book:

maslowmoney600

The new levels:

  • Survival income. How much do you spend simply to survive?
  • What-if income. You will want to protect your life. This could mean health care costs, health insurance, and/or proper portfolio planning so you don’t outlive your money.
  • Freedom income. Money needed to do the things that bring joy and fulfillment to your life. Could be travel, education, or fine wine.
  • Gift income. Money for people and causes that deserve your help. This is the replacement for “love”.
  • Dream income. This is the elusive “self-actualization” level where you find true happiness and meaning.

By breaking down your income needs, this could be another way to track your progress towards financial freedom. You can make covering your bare necessities your first smaller goal, and move on from there. This would involve both measuring your expenses and also deciding how much you’d need to save to create that much income.