Would Meeting Your Future Self Make You Save More?


Behavioral economists are constantly trying to find ways to convince us do the “right” things like save for retirement. Why is it so hard to give up short-term perks for larger, long-term rewards? For example, take my True Cost of Holiday Shopping calculator and this Warren Buffett anecdote from a 2011 WSJ article:

Warren Buffett is one rare—and extreme—example. When he was a young man, according to Alice Schroeder’s biography “The Snowball,” Mr. Buffett often asked, “Do I really want to spend $300,000 for this haircut?” He was thinking about the vast amount of money he wouldn’t have decades in the future because of the small outlay he might make in the present.

I think it’s fair to say that most people don’t think like that. (It appears he did get haircuts at least once in a while.) According to Stanford researchers, one big reason is because we struggle to identify with our future selves. The researchers are quoted in this Wired article:

To people estranged from their future selves, saving is like a choice between spending money today or giving it to a stranger years from now.

In their study, they used advanced virtual reality goggles make some people see older versions of themselves. Afterwards, the test subjects who saw their elderly avatars stated they would save twice as much as those who didn’t. Merrill Edge, the brokerage arm of Bank of America, has created an online version of this aging process called Face Retirement. It takes your picture via webcam and ages your face to help you better visualize “old” you. I got to see myself at age 47 to 107, in 10-year increments.

Will it work? I’m not sure. My wife says I just look like a zombie, especially at 107. Maybe there would be more shock value if it showed me eating dog food or something.

2013 401k, 403b, 457, TSP Contribution Limit Increases – Historical Chart


The IRS recently announced increased contribution limits for various qualified retirement plans for tax year 2013. The limitations are indexed to increases in cost-of-living (inflation) as per section 415 of the tax code. In particular, the elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $17,000 to $17,500. However, the additional catch-up contribution allowed for those age 50 and higher remains $5,500.

The limits are the same for both Roth and “Traditional” pre-tax 401k plans, although the effective after-tax amounts can be quite different. Employer match contributions do not count towards the $17,000 elective deferral limit. (Although technically the total annual defined contribution limit is $51,000 for 2013… let me know if you have an employer that is so generous!) Curiously, some employer plans set their own limit on contributions. A former employer of mine had a 20% deferral limit, so if your income was $50,000 the most you could put away was $10,000 a year.

Here’s a historical chart and table of recent contribution limit increases:

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2013 IRA Contribution Limit Increases – Historical Chart


The IRS recently announced the Traditional and Roth IRA contribution limits for tax year 2013. The limitations are indexed to inflation, but only in $500 increments (as of 2010) which are triggered when the cost-of-living calculation reaches a certain threshold. The threshold was finally met, so the limit on annual contributions to an Individual Retirement Arrangement (IRA) increases to $5,500, up from $5,000. However, the additional catch-up contribution allowed for those age 50 and higher remains $1,000.

The limits are the same for both Roth and Traditional IRAs, but each one has their own unique set of eligibility requirements. IRAs are “individual” accounts by definition, so the limits are per person. The deadline for 2012 tax year contributions is the same as the 2012 tax return filing deadline: Monday, April 15, 2013. Tax return extensions won’t apply to this cutoff.

Since I like visual aides, here’s a historical chart and table of recent contribution limits. I’m proud to say that we’ve both done the max since 2004. Have you been taking advantage of your potential IRA tax break?

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Retirement Rule of Thumb #537: Age-Based Targets at 35, 45, and 55

Here’s yet another retirement rule-of-thumb, this time by Fidelity Investments.

[...] the average worker may replace 85 percent of his pre-retirement income by saving at least 8 times his ending salary. In order to reach the 8X level by age 67, Fidelity suggests workers have saved about 1 times their salary at age 35, 3 times at age 45, and 5 times at age 55.

As usual, these number are based on a long list of assumptions. Start saving at age 25, retire at 67, nice gradual income growth, nice gradual portfolio growth, and so on:

The company’s 8X savings guideline is based on a hypothetical worker saving in a workplace retirement plan, such as a 401(k), beginning at age 25, working and saving continuously until 67, and living until 92.

• The employee will make continuous annual salary contributions to a workplace plan beginning at 6 percent and escalating 1 percent per year until 12 percent, plus receive an ongoing 3 percent annual employer contribution during their career.
• The calculation assumes a lifetime hypothetical average annual portfolio growth rate of 5.5 percent.
• Social Security payments are factored into the replacement income ratio of 85 percent.
• The employee’s income grows by 1.5 percent per year over general inflation with no breaks in employment or savings.

Focusing on the positive, these age-based targets are meant to be more helpful when setting goals than big, scary numbers. Also, these rules reinforce the idea that starting early is very important as it gives compounding time to work.

But again, we see the same-old assumption that you will constantly spend a certain % of your working income. Why? The implicit acceptance that spending should be linked to salary keeps you from ever getting ahead. Think about it; Your spending can be completely independent of salary. Instead, you earn more, you spend more, and the hamster wheel goes ’round and ’round:

Image credit to Polyp.org.uk and FOEI.

The reason why I write is that working 40+ hours a week for 40+ years is unacceptable to me. Retirement rules should be based on your spending, not salary. Salary is important, but your spending determines how much money you need to save. Your spending is also much more under your control than most people admit. 25 times your annual spending; That’s my guidepost.

Schwab vs. Vanguard ETF Expense Ratio Comparison

Schwab recently announced lowered expenses on all of their 15 Schwab-branded ETFs, undercutting everyone else’s comparable ETFs in every category, including Vanguard. Quite a bold move! Here is a limited comparison of comparable Vanguard and Schwab ETFs. The asset classes are picked to include the common asset classes as mentioned in many passive investing books and articles, but admittedly biased towards the ones that I like to use in my own portfolio. This way, I can also note which asset classes are not covered.

Briefly, an expense ratio of 0.01% means that on $10,000 invested you would be charged $1 a year in fees. The fees are taken out of the ETF’s share price, or net asset value (NAV), a tiny bit each day. So a difference of 0.03% (3 basis points) on a $10,000 investment would add up to just $3 per year.

Asset Class Schwab ETF
New Expense Ratio Vanguard ETF
Expense Ratio
Broad US Stock Market SCHB 0.04% VTI 0.06%
Broad International Stock Market - - VXUS 0.18%
Developed International Stock Market SCHF 0.09% VEA 0.12%
Emerging Markets SCHE 0.15% VWO 0.20%
REIT (Real Estate) SCHH 0.07% VNQ 0.10%
Broad US Bond Market SCHZ 0.05% BND 0.10%
US Treasury Bonds – Short-Term SCHO 0.08% VGSH 0.14%
US Treasury Bonds – Intermediate-Term SCHR 0.10% VGIT 0.14%
US Treasury Bonds – Long-Term - - VGLT 0.14%
TIPS / Inflation-Linked Bonds SCHP 0.07% - -

My comparison differs from the Schwab-provided version in the area of Treasury ETFs, with what I think are more appropriate Vanguard pairings. As Vanguard does not have a TIPS ETF, I should note that the Schwab TIPS ETF compares favorably to the popular iShares TIPS ETF (ticker TIP) with an expense ratio of 0.20%.

If you already have your money with Schwab, this is great news and a good sign for the future that they are committed to building up some decent-sized assets and trading volume on their ETFs. (Vanguard’s higher asset sizes and volumes mean lower bid/ask spreads and smaller NAV deviations, resulting in lower overall trading costs.) In a Schwab brokerage account, you can trade Schwab ETFs commission-free.

However, if you’re already investing with Vanguard, I don’t think these small expense ratio differences are enough to warrant moving assets especially if you have unrealized capital gains. (You can also trade all Vanguard ETFs commission-free inside a Vanguard brokerage account, and also many of them free at TD Ameritrade.) Vanguard has a long-standing commitment to “at-cost” investing and passing their savings onto the retail investor. In contrast, Schwab is almost certainly losing money on many of these ETFs, and thus using the low expense ratios as a temporary loss-leader “sale” to attract assets. For example, their bond ETF (SCHZ) currently has $316.5 million in assets and thus only generates around $158,000 a year in fees. That’s probably less than one employee salary at Schwab. In other words, I don’t think a substantial savings margin is sustainable over the horizon of many decades. I’d still recommend Vanguard for new investors, especially as Vanguard also has cheaper stock commissions for outside ETFs and individual stocks ($7 or less vs. $8.95).

A good point brought up in the Bogleheads forum is the ability of some people to gain access to these Schwab ETFs in their 401(k) retirement plans through the Schwab Personal Choice Retirement Account® (PCRA). If your retirement plan offers such a brokerage window, you may be able to trade these cheap Schwab ETFs for free with your tax-deferred money. Most PCRAs charge an annual fee of around $30-$50. Unfortunately, I found out that due to silly regulations, if you have a 403(b) plan your PCRA account is limited only to mutual funds. However, Schwab does have a small selection of low-cost index mutual funds as well.

How to Pay Zero Income Taxes in Retirement With Mixed IRAs

How about another mental exercise on taxes? I usually enjoy Christine Benz’s articles on Morningstar, and When Taxes Collide With Your Asset Allocation was no exception. She presents the following scenario:

Let’s say a 65-year-old woman is prepping her portfolio for retirement. Her assets are ultra-streamlined, with a $500,000 Roth IRA account containing stocks and $500,000 in a traditional IRA portfolio consisting of bonds.

Is her asset allocation:
a) 50% bonds and 50% stocks
b) Heavier on stocks than bonds
c) Both of the above statements are true.

The basic premise of the article is that because she has to pay taxes on withdrawals from her Traditional IRA accounts at ordinary income tax rates, while not owing any taxes on her Roth IRA accounts, the woman effectively has more exposure to stocks than bonds. I agree that taxes are an important facet to consider.

However, Benz makes a quick assumption that her federal income tax rate is 25%. Here we meet the difference between marginal and effective overall tax rates, as well as the difference between gross and taxable income, in our progressive tax system. While the woman’s marginal tax rate may be 25%, unless she has a lot of outside income, her effective tax rate on those bond withdrawals would be much less. In fact, my wife and I would like to pay zero taxes in retirement with a similar portfolio.

How? Let’s say we are a couple both age 65 as in the example, which is over 59.5 we can start taking withdrawals without penalty. We have no pensions to rely upon. Like above, we have $500,000 in Roth IRA and $500,000 in Traditional IRA. With 401k plan rollovers and regular IRA contributions, this is not unrealistic. With a 4% withdrawal rate that is $40,000 a year, let’s say $20,000 from both.

What taxes do we owe? The $20,000 Roth IRA withdrawal is tax free. Now onto the $20,000 Traditional IRA withdrawal. Well, since this isn’t earned income, you won’t have to pay any payroll taxes like Social Security and Medicare taxes. For 2012, the standard deduction for a married filing joint couple is $11,900 plus $1,150 per person for being 65+ and the personal exemption is $3,800 per person. That adds up to $21,800. That’s more than $20,000, so our taxable income is zero! In fact, the first $17,400 of taxable income is taxed at the 10% bracket, so your total withdrawals could total up to $39,200 and still owe an overall percentage less than 5%.

As always, there are things that could skew the math. You might have a pension. There’s also the possibility of state income taxes, although if we take California the effective tax rate would less than 1%. Finally, Social Security benefits could create a greater tax liability, although it might be wise if you’re healthy to defer Social Security until age 70 to maximize the payout of what is effectively an inflation-adjusted lifetime annuity.

When you contribute to a Traditional IRA, you take the tax break upfront and pay taxes later. When you contribute to a Roth IRA, you pay taxes now and take withdrawals tax-free after age 59.5. Keep in mind this example when choosing as by carefully mixing the two, your effective tax rate in retirement may be lower than you think.

Online Investment Portfolio Manager Comparison: My Wish List

An increasingly-crowded space is the online investment portfolio manager, which promises to help you invest better while costing a fraction of what conventional financial advisors would charge. Here is an incomplete list, including several services that I’ve tried and reviewed:

I support the overall vision and enjoy seeing all the new developents, and I think that many of them show promise. Selfishly, I figured that I’d put up my personal wish list of features as a DIY low-cost investor. Many of the services listed above do one or more of these things, but so far none have done enough to replace my current method of using a manually-updated Google Docs spreadsheet.

Import my existing portfolio automatically. Similar to Mint, I should simply provide my login details and have all my portfolio holdings and activity imported and synchronized automatically on a daily basis. Security is a concern here, and it would be really nice if brokers created a “read-only” access protocal, similar to what Capital One 360 has set up for its savings account. SigFig (formerly WikInvest) does this aggregation part reasonably well for many popular brokers.

Track asset allocation across entire portfolio. Many folks have investments spread across various places – 401k, IRA, SEP-IRA, taxable account, etc. I want to know my overall asset allocation across everything. Stocks vs. Bonds, US vs. International, Large-cap vs. Small-cap, Growth vs. Value, please break it down as fine or as broadly as I’d like. This may take some learning by the software in the case of some niche investments like stable value funds or individual bonds. I’ve seen Personal Capital learn asset classes quickly, so it’s definitely possible.

Customized rebalancing alerts. I want to be able to set my own target asset allocation as well as tolerance bands, and have the software send me an alert when I need to rebalance. They could even tell me “buy $X,XXX of Large-Cap US stocks” or “sell $X,XXX of Corporate Bonds”. This is a critical feature of my Google Docs spreadsheet, as it tells me where to invest new cash inflows. MarketRiders provides rebalancing alerts for a fee, but they don’t import data automatically.

Detailed performance stats vs. benchmarks. Even though I’m mostly a passive investor, my actual performance will still depend on the timing of my investments. I’d like to know my “personal rate of return”, which some brokers like Fidelity and Vanguard are pretty good at showing me. But again, I want to see numbers across my entire portfolio. How does my return compare with various benchmarks?

Reasonable cost. Some services are ad-supported or charge based on asset size, but I would be willing to pay around a flat $100 a year or $10 a month for such a product. That’s not much, but I think all of the above can be done with software and thus should scale easily. 10,000 people paying $100 a year is still $1,000,000 a year. Perhaps a company like Morningstar could offer access as part of their premium service, or it could be licensed to an E-Trade or TD Ameritrade.

What features are you looking for that haven’t been met?

Retirement: Saving More vs. Higher Investment Returns


Vanguard’s research department released another study [pdf] comparing ways to increase retirement savings for individuals. Here’s one illustrative example; take the following baseline scenario:

  • Investor begins working at 25, but starts saving at age 35.
  • 12% savings rate
  • Moderate asset allocation (50% stocks and 50% bonds)
  • Salary starts at $30,000 but increases with age

Now, here are three ways in which a worker could increase their final savings balance at retirement (age 65).

  • Option #1. Invest more aggressively with an asset allocation of 80% stocks and 20% bonds, while keeping your 12% savings rate and starting age of 35.
  • Option #2. Raise your savings rate to 15%, while keeping your starting age of 35 and 50/50 asset allocation.
  • Option #3. Start saving at age 25 instead of 35. while keeping your 12% savings rate and and 50/50 asset allocation.

Which single option do you think has the most impact? The results are based the median balance found after running Monte Carlo computer simulations based on 10,000 possible future scenarios for each option.

Scenario Median Balance at age 65 % Increase vs. Baseline
Baseline $474,461 -
Option #1
(Aggressive asset allocation)
$577,133 22%
Option #2
(Raise savings rate)
$593,077 25%
Option #3
(Start saving earlier)
$718,437 51%

Here’s another chart comparing the median retirement balances (inflation-adjusted) for (1) someone with a 6% savings rate and 80/20 aggressive portfolio and (2) someone with a 9% savings rate and 50/50 moderate portfolio.

(click to enlarge)

The title of the paper is “Penny Saved, Penny Earned”, which matches their suggestion that saving more is more reliably effective as compared to reaching for better investment returns. This information should be helpful for those that would like to avoid stock market stress but worry about giving up those potentially higher returns. If you save more, you can take less risk and sleep better at night while still reaching your goals. Hopefully this will also encourage folks to start saving as early as possible, even it is not an especially high amount.

Stable Value Funds Safe In Rising Rate Environment?

If you have a 401(k) or other tax-sheltered retirement plan, one of the investment options may be a stable value (SV) fund. In today’s low interest rate environment, stable value funds have been popular as they offer the stable price of a money market fund but with a higher yield. This is due to the fact that they are basically intermediate-term bond funds wrapped in an insurance contract that guarantees it maintains a “stable value”. This means the book value that you see can differ from the actual market value.

In my case, I invest some money in them because they offer a 3% yield on previous contributions (current contributions earn 1.25% on which I passed). Compare that with a money market fund earning 0.01%, or the Vanguard Intermediate Bond fund with a 6.4 year duration and only a 1.78% yield.

However, if interest rates were to rise quickly, this would lower the market value of those bonds (as interest rates go up, bond values go down) at the same time that there may be a rush of redemptions. Would the fund be able to cash people out at the higher book value as promised? A recent Vanguard research paper ran some scenarios based on historical periods of rising interest rates (1986-1990 and 2004-2008). They used Vanguard’s pooled fund, the Vanguard Retirement Savings Trust, with an average duration of underlying investments of ~2.6 years. Read the paper for details, but the overall conclusion was that the stable value funds would survive such scenarios:

Although stable value funds in general have performed well through past market cycles and crises, in the current environment of low interest rates both stable value investors and contract providers have been concerned about the effect rising interest rates would have on the funds and the ability of the funds to continue to perform well when further stressed by cash outflows.

[...] …in our simulations, the funds’ MV/BV ratios demonstrated resiliency, and crediting rates fluctuated within a band far narrower than that of market yields, even in extraordinary scenarios.

While the paper’s findings provide some reassurance, I’m reminded that lots of people “stress tested” mortgage-backed securities in 2007 as well. Based on the Vanguard analysis, here are some additional cautionary steps to take for potential investors in stable value funds:

  1. Remember the basics of stable value funds. SV funds are intermediate bonds wrapped in an insurance guarantee, so if the insurance fails then you’re just left with bonds. This isn’t the end of the world, but make sure you’re okay with that. See previous post on stable value funds risks and rewards for real-life examples.
  2. Understand your specific withdrawal restrictions. There are usually some form of liquidity restriction attached, but they can vary greatly. In some cases, you have to give a full 12- to 24-month notice to withdraw at book value (guaranteed principal). In my plan, I am not allowed to transfer into any other fixed income (bond) funds at all. I can transfer at any time into a stock fund, but then I have to wait 90 days until I can transfer again to another bond fund. This Reuters article reports that some providers have been cutting back on guarantees.
  3. Be aware of scenarios where your stable value fund will be under stress. Usually, this results from rapidly rising interest rates. For example, if the yield on money market funds rise, people will prefer those to stable value funds. Also, the market value of the underlying bonds will fluctuate, even though only the book value is reported on your statements. If the market-to-book ratio on your SV fund drops below 98% (see updated prospectus), people may panic and start to withdraw.

Comfortable Retirement = Saving 11 Times Working Income?


Via the NY Times, benefits consultant Aon Hewitt released their 2012 Real Deal study about workers at large companies and their readiness for retirement. The study assumes that an employee will work at least 30 years with some large company, not necessarily the same one, and then retire around age 65 with Social Security kicking in. It does not reflect savings or other retirement assets outside of the employer-sponsored plans (IRAs, taxable brokerage accounts, etc). The key findings of the study are summarized below:

85% replacement ratio. Using various assumptions, they find that the average worker will need about 85% of their pre-retirement income to maintain their standard of living. I suspect that most of this number comes from the finding that you need to save about 15% of your income for retirement, and it assumes you spend everything else. Thus, after retirement you have the remaining 85% to cover.

Average employee needs to save 11 times pay. The amount needed at “retirement age” (~65) to cover retirement expenses through an average life expectancy (age 87 for males, age 88 for females) is 15.9 times pay. Social Security is estimated to cover 4.9 times pay. Therefore, the employer needs to save 11 times pay.

Average employee is expected to have 8.8 times pay. This is the sum of pension benefits, employer contributions to 401k/403b-type plans, and employee contributions to those plans. This leaves an average shortfall of about 2.2 times pay. 30% of people are on track or better, 20% are very far behind, and the rest are somewhere in in the middle.

I’m hoping that this study will have nothing to do with me as the idea of working full-time in a large corporation until 65 sounds quite horrendous. :) The overall takeaway is that retirement will still happen for most people as long as they work until Social Security, even if it might not be as nice as they’d like it to be. 11 times final income seems a reasonable rule-of-thumb for this traditional definition of retirement, but using income as a multiplier is annoying to me because it locks you into the assumption of a 15% savings rate.

In terms of non-traditional early retirement, I still prefer the rough rule of saving about 30 times our annual spending for early retirement. Your savings rate will have to be much higher than 15%. If you spend $50k a year, you’d need to save $1.5 million. If you own your house and otherwise spend $2,000 a month, then you’d need to save about $720,000. Using this metric, lots of people could retire on less than a million dollars even today.

Financial Independence Day Thoughts


Since I spent July 4th trying to build my own cornhole board (until the batteries in my drill ran out), hanging out with family members sharing their opinions on every girl baby name in the world, happily eating hot dogs with beer, and watching fireworks that didn’t last just 15 seconds, I didn’t spend much time on the computer today.

Instead, since a certain bank already used this holiday to refer to financial independence, I found myself thinking about how my view of financial independence and “early retirement” has changed over the years. Just my opinions. I apologize in advance for the rambling.

  • Early retirement. I believe it’s just as possible as ever. However, you’ll have to be different than most people. You’ll have to either earn more than others, or spend less than others. Preferably both. But most people don’t want to be different than most people. It’s hard, you stick out, you get called cheap a lot, and you tend to just keep quiet so you don’t stick out as much.

    Very few people will retire early. Many of them don’t even think of it as an option. Some will consider it, and just come to realize they’d rather just spend more and work more. I don’t necessarily see anything wrong with that.

  • Post-retirement jobs. (Oxymoron?) If you’re good at saving money, you may be afraid of being broke. (I am.) But that also means that you may still worry about “what if I run out of money” no matter how much money you have. (I do.) However, if you’re disciplined and motivated enough to retire early, you’ll probably be able to find some sort of work that will pay you decent money for a flexible 5-20 hours a week, 3-9 months a year. Keep your eye out for that kind of job, it will help you retire earlier and with less stress.
  • Investing. I have come around to believing that some people can invest wisely and beat the return of the general market. I believe it’s a skill, but with so much noise that separating skill and luck is hard. It’s very easy to fool yourself into thinking you’re beating the market if you’re not keeping score carefully. Low-cost passive investments guarantee you above-average results, and for most people that’s the best bet to take.

    Old fashioned retirement is mostly about saving a big chunk of money, and then spending a big chunk of money without running out. Early retirement is more about living off of dividend and bond interest income almost indefinitely, but remember that even dividends can drop by 30% in any given year. As long as you don’t reach for yield too much, you should be able to design a portfolio whose dividends should rise with inflation. I don’t pay attention to mainstream retirement calculators anymore (Monte Carlo simulations) by Fidelity, Vanguard, ING, etc. I don’t feel they approximate real-life reactions to a dropping portfolio.

  • Rental property. More people I know actually retired early with rental property than by stock market returns. Fixed rate mortgages come with fixed payments, while rental income rises with inflation. This doesn’t necessarily mean that rental property is better stocks and bonds, but perhaps there is something special about this asset class. I’m seriously considering rental property again, but don’t know if I want to deal with it while raising young kids.
  • Home ownership. If you’re geographically stable, I highly recommend homeownership with a 15-year mortgage. It doesn’t cost double a 30-year mortgage. Paying extra towards my mortgage feels much more warm and fuzzy than placing money in the stock market. It allows you to see the effect of compound interest. Simply putting an extra $100 a month towards principal regularly will shave years off a typical mortgage. See prepayment calculator.

    I expect to pay off our mortgage within the next 5 years, before our portfolio is ready to support full financial independence but the lowered stress levels due to the huge drop in monthly spending will be awesome. I see the appeal of borrowing money for 30 years at 3.XX%, but for my primary home I’d be happier owning it free and clear. I’ll take the low interest rate on rental property, though.

My Money Blog Portfolio Update – July 2012


Here’s a mid-year update of our investment portfolio, including employer 401(k) plans, self-employed retirement plans, Traditional and Roth IRAs, and taxable brokerage holdings. Cash reserves (emergency fund), college savings accounts, and day-to-day cash balances are excluded.

Asset Allocation & Holdings

Here is my current actual asset allocation:

The overall target asset allocation remains the same, based on my own preferences and research:
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