ING Your Number: Retirement Calculator Assumptions and Factors

I was watching TV this weekend and kept seeing commercials about ING’s Your Number, which is an online calculator that supposedly helps you plan for retirement by telling you how much you need to save. Here’s one of them if you haven’t heard of them before:

After trying it out and finding out my 7-digit number, I wanted to see what was “under the hood”. Monte carlo simulations? Spits out random number to mess with your head? Maybe my Google-Fu is weak, but I couldn’t find anything except this Your Number worksheet [PDF] from ING dated 2009. The final numbers don’t match up, but it does provide some insight into how the current calculator works. Using this information and trying lots of permutations, I tried to backtrack how each question affects the final output.

Factors and Assumptions

Current age. This factor appears to be used solely to calculate how many years you have left until retirement. Since the ING Your Number is the amount of money you need at the time of retirement, it increases every year with inflation. This is an important fact to note, as needing $1 million today would be the same as needing $2 million 30 years from now due to inflation alone. (Inflation is assumed to be roughly 3% annually.)

Marital status. The calculator says “We’re not trying to pry into your personal life, but whether or not your married has an impact on your number.” Nosy or not, it actually doesn’t seem to matter. I tried all kinds of inputs, but I couldn’t find any that changed based on being married or not. Let me know if I missed something here.

Current household income. At first glance, you’d think your current household income wouldn’t affect Your Number necessarily, since it later on asks for the actual income required during retirement. I noticed that making slight changes in your current income doesn’t affect Your Number at all. However, large changes do – it appears that this number is used to estimate future social security benefits. If your current income is really low, then your future benefits will also be low, which increases Your Number.

Age at retirement. This factor is used twice – once along with your current age to find how long you have until retirement, and again with your death age to find years in retirement. The more years you plan to spend in retirement, the greater Your Number will need to be in order to maintain a margin of safety.

Annual income required during retirement. A recommended amount is 80% of your pre-retirement income, but I hate that rule-of-thumb. Instead, this is probably the hardest part of the calculator because it requires the most personal and in-depth thought. Is your house paid off and are you going to stay in it? How much of your current income goes towards work expenses? What activities do you plan to do in retirement?

Provide income through what age? As noted above, this “death age” is used to calculate the amount of years you’ll spend in retirement. I kind of wish they just assumed 100 or something for this, it seems a bit morbid to guess when you’ll die.

In the end, Your Number is essentially your annual retirement income multiplied by a factor ranging from 5 to 30, depending on how long your retirement horizon is. It could have just told people to multiply by 25 and be just as accurate (or inaccurate) . As you might expect with any calculator that tries to help plan your retirement by asking five questions, Your Number is mostly a marketing gimmick designed to connect you with ING-affiliated financial advisors and insurance salesmen. That doesn’t mean you still don’t want to try it, though, right?

What’s yours?

Posted in Retirement, Tools & Calculators | 17 Comments »

2010 Q3 Investment Portfolio Update – Fund Holdings

I’ve already posted my target asset allocation, now here’s my actual portfolio holdings. Again, these are my own choices, governed by the size of my tax-advantaged accounts like IRAs/403b/401ks, the brokerage firms that I use, and my preference of passive management and low fees. Even with the explosion of new blogs, I still don’t see very many people sharing their actual holdings. I hope that if I share, then others will share as well.

Tax-Efficient Placement

One big change for me over the last two years is that I now run out of room in my IRAs and 401ks each year and now have money sitting in taxable accounts. Since each asset class is taxed differently, where you put your assets can make a big difference in your net return. As a result, I’ve moved some things around. Here’s a handy graphic taken from a post about tax-efficient fund placement:

Stocks

US Total Market
I used to own Vanguard Total Stock Market Index Fund (VTSMX) but recently converted that to the ETF share version Vanguard Total Stock Market ETF (VTI) due to the lower 0.07% annual expense ratio. This fund tracks the MSCI US Broad Market Index, and typically holds the largest 1,200–1,300 stocks (covering nearly 95% of the index’s total market capitalization) and a representative sample of the remaining stocks. It currently holds 3,391 different companies. All for $7 a year for each $10,000 hold.

In my 401k, since I have limited options, I hold a mix of 75% Diversified Stock Index Institutional Fund (DISFX) which is basically a S&P 500 fund and 25% Fidelity Spartan Extended Market Index Fund (FSEMX) as it tracks the entire market minus the S&P 500. Together, the track the overall US market very well, at only a slightly higher cost of a weighted 0.25%.

US Small Cap Value
Here, I still hold the Vanguard Small-Cap Value Index Fund (VISVX). I could convert to the Vanguard Small-Cap Value ETF (VBR) with identical holdings and a lower expense ratio of 0.14% vs. 0.28%, but since it is only 5% of my portfolio I haven’t yet. In addition, there are good arguments for alternative ETFs such as iShares Russell 2000 Value Index ETF (IWN) or iShares S&P SmallCap 600 Value Index ETF (IJS). They each track slightly different indices and thus hold different stocks. Something to analyze deeper at a later time.

REIT
I still hold the Vanguard REIT Index Fund (VGSIX) as opposed to the Vanguard REIT ETF (VNQ). Both track the MSCI® US REIT Index. I hold this inside my IRA, so I’d rather just have full investment rather than worry about partial shares and such.

International / Total World excluding US
I used to hold Fidelity Spartan International Index Fund (FSIIX) but now hold the Vanguard FTSE All-World ex-US ETF (VEU) which tracks the FTSE All-World ex US Index and holds 2,239 stocks from around the world. There is the equivalent Vanguard FTSE All-World ex-US Index Fund (VFWIX) but since this is a bigger holding for me, the cheaper expense ratio makes a difference.

Emerging Markets
I converted to the Vanguard Emerging Markets ETF (VWO) from the Vanguard Emerging Markets Stock Index Fund (VEIEX). Even though my overall investment here is low, VEIEX has both a 0.25% redemption fee, and a 0.50% purchase fee, which is just too annoying to stay there. Another option would have been the iShares MSCI Emerging Markets Index (EEM), but it is both more expensive and has had more tracking issues. Here’s a EEM vs. VWO comparison post.

Bonds

Short-Term High Quality Bonds
I used to own the Vanguard Short-Term Treasury Fund Investor Shares (VFISX) but it now only yields 0.41% with an average duration of 2.2 years. If you had an IRA at certain banks, you could buy a CD earning 2-3% over the same time horizon. It would be just as safe. There would be less liquidity, but I’m not really concerned about that. The CD would be even better because you can’t lose what you put in.

I’ve actually gone ahead an put this portion of my portfolio in a stable value fund inside my 401k. I explored the risks and rewards of stable value funds, and while they are not of the utmost safety, the worst-case scenario is on the same order of the worst-case scenario of many short-term bond funds. My stable value fund is earning 3.5% for all of 2010.

I’ve also been looking at municipal bond funds such as the Vanguard Limited-Term Tax-Exempt Fund (VMLTX) and Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) since they are mostly rated AA and above with interest being federally tax-exempt. If I lived in California and had a big bond allocation, I’d still consider a partial holding in the Vanguard California Intermediate-Term Tax-Exempt Fund (VCAIX) since the interest is higher and is exempt from both federal and CA income tax. I wrote about VCAIX in late 2009 when the yield was 3.49%. It’s done quite well since then, although California’s still got major issues to work out. If I lived in New York, I’d consider the same for NY funds.

Inflation-Protected Bonds (TIPS)
Here, the only thing to buy is either individual TIPS bonds or a mutual fund/ETF holding TIPS bonds. Usually buying individual bonds is risky because you aren’t spreading the default risk across hundreds of issuers, but in this case every single bond is just as safe and backed by the US government.

I have my Self-Employed 401k at Fidelity, which allows me to buy individual TIPS with no commission (just bid/ask spread). I bought some longer-term TIPS with real yields of 2-3%, and they’ve been doing well since real yields have dropped since. In addition, I hold shares of the iShares Barclays TIPS Bond ETF (TIP) because I can trade iShares ETFs commission-free at Fidelity.

The Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX) was also considered, along with new TIPS ETFs that have different maturities such as the PIMCO 15+ Year U.S. TIPS Index ETF (LTPZ).

Posted in Investing, Retirement | 17 Comments »

Target Asset Allocation for Investment Portfolio

Asset allocation (AA) is an important part of portfolio design, and I like pinning down a target asset allocation for personal reference. This helps keep me focused as my portfolio shifts over time and makes it easy to re-balance back. For some educational posts on this topic, please refer to my asset allocation starter guide.

Below is my updated target asset allocation. Here is my target asset allocation from 2008. It’s not dramatically different, but I’ll try to explain the slight changes below. This is just my own AA, and I think everyone should develop their own based on their own beliefs and learning. If you just copy someone else’s without thinking, when things go awry you won’t have the foundation to stick to your guns. I have been strongly influenced by the writings of Jack Bogle, William Bernstein, David Swensen, Rick Ferri, and Larry Swedroe.

Stocks

I separate things out first into stocks and bonds, and then later it’s easy to go 60% stocks/40% bonds and so on. Here’s my stocks-only breakdown:

• I now do a 50/50 split between US and International stocks. In general, I would like to mimic the overall world investment landscape. On a market cap basis, the US stock market is now about 45% of the world, while everyone else takes up 55%. 50/50 is just simpler, with a slight tilt towards domestic stocks.
• I consider REITs a separate real estate asset class. I used to put Real Estate under US stocks since I only held US Real Estate Investment Trusts (REITs), but in the future I would be open to investing in foreign real estate as property laws improve and investing costs drop.
• On the US side, I add some extra small-cap value companies. Historically, adding stocks of smaller companies with value characteristics (as opposed to growth) has improved the returns of portfolios while lowering volatility. There is debate amongst portfolio theories as to why this happened and if it will continue.

  If you buy a “total market” mutual fund or ETF, you’ll already own many of these types of companies (although many will not be held due to their small size relative to the big mega-corporations). I feel this adds a bit of diversification.

• On the international side, I add a little extra exposure to emerging markets. You may be surprised to know that “emerging” countries like China, Brazil, Korea, India, Russia, and Taiwan already make up 26% of the world’s markets when you remove the US. These are countries that have a greater potential for growth, but also lots of ups and downs. I add a little bit more than market weight for these as well.

Bonds

I try to keep things simple for bonds, partially due to the fact that they are currently a smaller portion of my portfolio.

• I like a 50/50 split between inflation-linked bonds and nominal bonds. Inflation-protected bonds provide a yield that is guaranteed to be a certain level above inflation. Nominal bonds pay a stated rate that is not adjusted for inflation. I like to balance the benefits of both.
• Instead of only short-term US Treasuries for nominal bonds, I added some flexibility. I used to invest only in short-term US treasuries, as they provided the best buffer in my portfolio as they were of the highest quality and had a low sensitivity to interest rate fluctuations. Both TIPS and nominal Treasuries did great during the 2009 crash and the subsequent flight-to-quality, but now the yield on Treasuries is just too low in my opinion. There are trillions of dollars from countries and huge institutions around the world that are tucking their money away under the safe Treasury mattress. By venturing into other places they won’t with my tiny portfolio, I feel I can stay relatively safe yet increase my yield significantly. Possibilities include bank CDs, stable value funds, and high-quality municipal bonds.

Want more examples? Here are 8 model portfolios from respected sources, an updated Swensen portfolio, one from PIMCO’s El-Erian, and Ferri’s personal portfolio. Have fun!

Posted in Investing, Retirement | 22 Comments »

Portfolio Manager Rick Ferri Shares Personal Portfolio and Asset Allocation

In a recent post on the NY Times Bucks blog, portfolio manager and author Richard Ferri shared his own personal portfolio. As a proponent of low-cost, passive investing, it was not surprising to see mostly index funds in his portfolio, but it was interesting to see that his overall asset allocation is 80% stocks and 20% bonds. He is quick to note that he does have a pension and defined-benefit plans which balance out his overall financial picture. Wouldn’t you like to know what all those financial advisors out there actually own?

Asset Allocation

Here is his asset allocation broken down into stocks and bonds separately using pretty pie charts:

Here’s the overall 80/20 breakdown with ticker symbols (based on this Bogleheads post):

34% Vanguard Total Stock Market ETF (VTI)
10% S&P SmallCap 600 Value Index Fund (IJS)
5% Ultra-Small Company Market (BRSIX)
8% Vanguard REIT ETF (VNQ)

6.5% Vanguard Pacific ETF (VPL)
6.5% Vanguard European ETF (VGK)
5% DFA International Small Cap Value
5% DFA Emerging Markets Core
—- [alternative: Vanguard Emerging Markets ETF (VWO)]

12% Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
4% Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX)
4% Vanguard High-Yield Corporate Fund Investor Shares (VWEHX)

Reading his book All About Asset Allocation was very helpful in creating my own portfolio. (Also see Model Portfolio #3 taken from that book.) I haven’t been updating my own own portfolio asset allocation as diligently as I should, although I have been keeping track of it. Here’s the last snapshot I took:

I’ve had some asset allocation drift for sure, although I have been countering this by rebalancing with new funds. I really need an update…

Emergency Funds

It’s also interesting to note that he keeps an emergency fund of two years’ living expenses, and that he uses the Vanguard Short-Term Bond (BSV) with a current SEC yield of 1.08%. Very simple and almost no-maintenance.

I prefer using a mix of high interest savings accounts and longer-term CDs/rewards-type checking accounts. I figure that index fund investors get so excited by saving 10 basis points (0.10%) on mutual fund, but with a bit of work you could beat a short-term bond fund by 100 basis points (1%) with what I would call less risk.

Bond funds still have risk to principal, meaning you may have to sell for less than you bought in for, while FDIC-insured bank accounts do not. Money market funds are currently averaging less than 0.10% yield.

Posted in Investing, Retirement | 11 Comments »

Stable Value Funds – Exploring Risks and Rewards

The last time I wrote about stable value funds was in late 2008, both before the 2009 crash and a time when most of my 401k was in stocks. This time around, as I was trying to figure out how to rebalance my larger portfolio in a tax-efficient manner, I took another look at this asset class found almost exclusively in defined-contribution plans like 401ks. According to the Stable Value Investment Association (SVIA), approximately 15 to 20 percent of 401(k) assets are in stable value funds.

What are Stable Value Funds?

Generally, stable value funds are a bunch of bonds which have a insurance “wrapper” around them which protects it from interest rate volatility. The intended result is a product that pays the higher interest rates of intermediate-term bonds, with the liquidity and stable day-to-day price of a money market fund. Think “cash but pays higher interest”. A chart from the SVIA [pdf] illustrates:

The Attraction

Here’s my current situation. The stable value fund in my 401k has a guaranteed net interest rate in 2010 of 3.50%. The low-cost Vanguard Intermediate-Term Bond Index Fund Investor Shares (VBIIX) currently yields 3.17%, but will have a moderate amount of price volatility, especially if interest rates rise. The Vanguard Prime Money Market Fund (VMMXX) currently yields 0.11% with its high-quality, ultra-short-term holdings and Vanguard backing.

I could get the stability of money market fund, with an interest rate more than 3% higher! (All yields are net of fees.)

The Risks

Higher interest rates with no price volatility? Free lunch? Not quite. First of all, any guarantee is only as good as the entity doing the guarantee. Check the safety ratings of the insurer of your fund. Mine is Transamerica Financial Life Insurance Co. (TFLIC):

Not the greatest, but not bad. In addition, there are actually several ways an insurer can get “out” of the contract. From the SVIA FAQ:

Are there instances when book value or contract value does not apply?
There are a few, limited instances when participants do not get book value from a stable value fund. These limited instances are typically contractually defined. One such instance typically not covered is security defaults or downgrades. In order to protect the integrity of the stable value fund, most contracts incorporate investment guidelines establishing minimum credit quality requirements for the underlying securities. These contracts have established mechanisms to address downgraded or defaulted securities that fall outside the contractual guidelines.

Corporate-initiated events, which are employer-driven events such as an early retirement program, layoff, or bankruptcy, are also typically not covered. Corporate-initiated events generally cause withdrawals in masse from a stable value fund. These withdrawals can negatively impact investors and plans that choose to remain in the fund.

First up, if the underlying securities turn out to be utter crap via a default or credit downgrade, then the insurance doesn’t apply? Wait, the insurer gets to choose the securities in the first place? Sometimes smells here. In fact, this happened in 2009 to the insurer State Street, although they decided to step in to make investors whole in order to preserve their reputation. Via this CBS Moneywatch article:

In December 2008 and January 2009, State Street elected to provide support – a total of $610 million – to the bond portfolio in stable value funds the company managed. State Street was not contractually obligated to do this. As the company’s 8-K filing (a report filed with the SEC to notify investors of any events that could be of importance to shareholders) stated, “liquidity and pricing issues in the fixed income markets” so affected the accounts that the wrappers “considered terminating their financial guarantees.” State Street’s action to bolster its portfolios kept the wrappers in place.

Finally, there is the “corporate-initiated event” of a huge layoff or bankruptcy. At the end of 2008, Lehman Brothers infamously went bankrupt, which left their stable value fund managed by Invesco with a negative return of 1.7 percent in December and an annual return for 2008 of 2 percent. In April 2009, a stable value fund for Chrysler employees only paid out 89 cents on the dollar, a drop of 11% due to the company’s troubles.

As you can see, there is a lot of things that can invalidate the guarantee. So, the next step is to understand the holdings, which in the event of a liquidation can help you imagine your worst-case scenario. You should be be able to see at least an overall breakdown of the assets, and a market-to-book-value ratio must be disclosed at least once a year. This will show any discrepancies between what the insurer says is worth $1 and what the market says. My TFLIC stable value fund’s market-to-book ratio was 101.30% as of March 31s, 2010 and here is their holdings summary:

Bottom Line

In good times, the stable value fund has a pretty easy job of maintaining an image of price stability and paying out the stated interest rate. However, when the poo hits the fan there are a lot of ways the insurance wrapper can be worth less than a bubble gum wrapper. The only real good news is that you are still left with some intermediate-term, investment-grade bonds. Even with the upheaval of 2009, the worst example I could find was a drop of 11%. Even Lehman Brothers investors ended up with a overall positive return for the year. These losses are not insignificant, but something the order of the drop in other similar bond funds during that time. The key is to understand the risks that you are taking, which oftentimes people don’t (including me).

As for my personal investments, after doing my bit of due diligence, I am going to put a small percentage (less than 5%) of my total assets in my stable value fund, given the limited alternatives in my 401k. I am willing to take the risk of a small loss in order to earn 3.50% for all of 2010 in this current interest rate environment.

Posted in Investing, Retirement | 9 Comments »

Undo a Roth IRA Conversion For Profit – Tips & Tricks

Did you know that if you do a Traditional to Roth IRA conversion, that you can undo it? This “do-over” process is called recharacterization, and can come in very handy if the value of your investments drop significantly after your conversion since you owe income taxes based on the value of the IRA at the time of conversion. With the recent market volatility, this may apply to many investors as it did previously in 2008/2009.

Take the example below, from a 2009 CNN Money article but still applicable. Let’s say you had a Traditional IRA valued $150,000 at conversion, which later on drops to $100,000. At the end of the year, you’d have to pay taxes on $150k of income and also be stuck with the lower account value. By performing an “undo” and “redo” the conversion, you could pay income taxes on only $100,000 of income instead of $150,000 – a savings of $14,000 at the 28% tax rate. (Find your 2010 tax bracket.)

There are some ground rules, however. The IRS says you can perform a recharacterization until October 15th of the year following the year you converted. So if you converted in April 2010, you have until October 15, 2011. If you want to re-convert, you have to wait either 30 days after the recharacterization or until the tax year after the conversion year, whichever is later. Again, if you converted in April 2010, you’d have to wait until January 1st, 2011 to reconvert. If you wait too long in between, it is possible your account value might be even higher than before. Still, something I’ll be keeping an eye on.

(You must still meet the Roth conversion eligibility rules, previously based upon your modified adjusted gross income. In 2010, there are no income limits. In 2011 and beyond, there currently are no income limits either, but it is unknown if this will remain the case. Also, only for 2010 conversions are you allowed to split the income over 2011 and 2012, which can lower your overall tax bill based on tax brackets.)

More Advanced: Multiple Roth IRAs

How can you set yourself up to best take advantage of this “redo” opportunity? I recently read in a sample issue of Kiplinger’s Retirement Report that you should split your Traditional-to-Roth conversion into multiple IRAs for each asset class you own.

For example, you might split a $200,000 IRA into $100k of stocks and $100k of bonds. If the stocks go down to $80k while the bonds go up to $120k, just to a “redo” on the stock IRA and leave the bonds IRA alone. Assuming the values stay the same upon re-conversion, that would save you income taxes on $20,000 ($5,600 at a 28% tax rate) as compared to not splitting up the IRA since if you just converted it a single IRA, the total value remained $200,000 ($80k+$120k). Tricky!

Posted in Investing, Retirement, Taxes | 1 Comment »

Traditional to Roth IRA Conversion at Vanguard

So, you’ve done your research, read the articles, crunched the numbers, and you want to convert your Traditional IRA held at Vanguard into a Roth IRA. But, how do you actually do it at Vanguard.com? There is no explicit “Convert” button or link to run this conversion. After some fumbling around, I managed to figure it out. But why not just share it here in mind-numbing detail and hopefully save folks some time.

You’ll need to have both a Traditional and Roth IRA set up at Vanguard first (mutual fund only). If you don’t have the Roth yet, click on the “Open an Account” link on the black bar on the top of every page and open an account first. Be sure to indicate that the funds you’ll use to open the new account are “At Vanguard”.

After you already have both a Vanguard Traditional IRA and a Vanguard Roth IRA:

1. Log in to your account online. Click on “My Portfolio” so that you can view all your accounts.
2. Under your Traditional IRA section, click on “Buy & Sell”.
3. Next, click on “Exchange” on any of your funds.
4. Now, you can choose to Exchange from all your Traditional IRA funds, to funds in your Roth IRA. You may need to add a new fund.
5. For the exchange amount, if you are doing a complete conversion, chose All. You may be asked to verify and accept any redemption fees.
6. You’ll also need to choose your tax withholding options. In order to maximize my balances in these tax-deferred accounts, I chose not to withhold and to pay the taxes separately myself later from a taxable account. Also, I can spread the taxes due for a 2010 conversion over two years.
7. At the end of the next available business day, your mutual funds will be exchanged into your Roth at their net asset values. Your Traditional IRA will still show up with zero balances, which you can hide from displaying.
8. Your conversion is complete! Keep your transaction confirmations for tax time.

Keep on reading below for some of the warnings and notifications that you’ll encounter during the conversion process.

A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP-, or rollover IRA into a Roth IRA.

When you convert to a Roth IRA, you may elect to withhold Federal and certain state taxes. You can get the most benefit from the conversion if you don’t have taxes withheld and instead pay taxes from a separate nonretirement account. Keep in mind that the money withheld for taxes isn’t part of the conversion, and, if you’re under age 59½, you may have to pay a 10% federal penalty tax on it. You also can’t “recharacterize”, or restore to a traditional IRA, the amount you withhold. If you choose not to withhold, you may need to make estimated tax payments to avoid an underpayment penalty.

We encourage you to consult a tax advisor about your individual situation. For 2010 conversions only, you have the option of postponing the tax due and paying it off over two years. If you choose this option, taxable income from the conversion gets split evenly between 2011 and 2012. Alternatively, you can choose to pay all the conversion income in 2010.

Moving money out of a retirement account is a distribution, and all or a portion of your distribution may be subject to federal or state tax. You can elect to have either no federal income taxes withheld from your Vanguard IRA® distribution or a percentage between 10 and 100. If you don’t elect to have income taxes withheld from your IRA distribution, you’ll remain liable for income taxes. Tax penalties may also apply if your estimated income tax payments or income tax withholdings are insufficient under federal or state rules.

Posted in Retirement, Taxes | 9 Comments »

Is Generic Financial Advice Helpful or Hurtful?

Good financial advice is hard to come by. There are so many variables, such that you have to find the balance between providing enough information, and making things digestible enough that peoples’ eyes don’t glaze over.

Check out this advice column found in the newsletter that comes in my 401k statement each month. Can you spot what’s missing?

There is no mention of what investment vehicle you should be sticking your money in, or even how much they estimate your future returns to be. Is it 100% stocks? 50% stocks/50% bonds? Orange juice futures? 6% returns? 12% returns? Who knows. Is this pre-tax or post-tax? Is it all in tax-sheltered accounts? Is my annual income supposed to rise as sharply as the chart seems to imply? I selfishly hope so!

Yet, I feel like this is what a large percentage of workers want to read. One impossibly simple chart that defines your retirement needs. So someone gives it to them. Maybe it gives them a general idea of where to start. But is a vague, possibly wrong answer better than guessing? I feel another poll coming on…

Is Such "One-Size-Fits-All" Financial Advice Helpful?

• Yes, something is better than nothing.
• No, on the whole it does more harm than good.
• It doesn't matter, we're all doomed anyway.

View Results

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Posted in Investing, Retirement | 16 Comments »

Net Worth & Goals Update – July 2010

Time for another net worth update… last one was back in April.

Credit Card Debt
I used to take money from credit cards at 0% APR and place it into online savings accounts, bank CDs, or savings bonds that earned 4-5% interest (much less recently), keeping the difference as profit while taking minimal risk. (Minimal in regards that the risk was under my control.) However, given the current lack of great no fee 0% APR balance transfer offers, I am currently not playing this “game”.

Most credit cards don’t require you to pay the charges built up during a monthly cycle until after a grace period of about 14 days. This theoretically provides enough time for you to receive your statement in the mail and send back a check. As this is simply a real-time snapshot of my finances, my credit card debt consists of just these charges.

Retirement and Brokerage accounts
We recently converted our Traditional IRA balances to Roth IRAs, as the income restrictions were lifted this year. The choice to convert was rather simple for us, as we had non-deductible contributions that will now be able to be withdrawn tax-free. (We still owe taxes on very modest gains.)

Our total retirement portfolio is now $289,277 or on an estimated after-tax basis, $249,976. At a theoretical 4% withdrawal rate, this would provide $833 per month in after-tax retirement income, which brings me to 33% of my long-term goal of generating $2,500 per month.

Cash Savings and Emergency Funds
We are now a bit below a year’s worth of expenses (conservatively estimated at $60,000) in our emergency fund. This is after withholding some money for paying taxes on the Roth IRA conversion above, and also for undisclosed, one-time recent expenses. It’d be fun to say that we picked up a convertible or something, but the reality is much less exciting.

Our cash savings is mostly kept in a combination of a rewards checking account (with debit card usage requirements), a SmartyPig account at 2.15% APY currently, or in a 5-year CD from Ally Bank, which despite the long term still provides a very competitive yield even if you withdraw early before the 5 years is up. (See here for more details.)

Home Value
I am still not using any internet home valuation tools to track home value. After using them for a year and finding them unreliable, I am back to maintaining a conservative estimate and focusing on mortgage payoff. If we get some positive cashflow after retirement savings, I do want to pay it down faster.

Posted in Goals, Investing, Real Estate, Retirement | 19 Comments »

Total Stock Returns = Fundamental + Speculative Returns

Another theory of predicting future stock market returns states that there are three main components to long-term stock market performance. Amongst many others, I learned this from authors and investors Jack Bogle and William Bernstein.

Part 1: Dividend Yield
If your stock distributes 2% in dividends each year, then you will have a 2% contribution towards of return. This is what dividend investors love to see coming in each quarter, and is relatively easy to track for a large group of companies. Here it is over time for the S&P 500, courtesy of Multpl.com:

Part 2: Earnings Growth
If earnings stay constant, then all other things equal, one would expect the share price of your company to stay constant as well. If the earnings grow by 5% every year, then your share price will grow by 5% per year. Thus, earnings growth rate is a vital component of total return.

If your portfolio was all of the stocks traded in the United States, like that of a broad-based index fund, this would create a connection between the growth rate of the nation’s Gross Domestic Product and the earnings growth rates of all US companies. In other words, the fundamental return is based on GDP growth. In turn, the GDP growth rate is connected to population growth and productivity per person.

These two parts added to together are coined the fundamental return:

Some bad news: Now, from 1950-2000, fundamental returns were 10%: 4% dividend yield and a 6% earnings growth rate. These days, the S&P 500 has a dividend yield of only about 2%. Earnings growth rate estimates are subject to debate, but they hover around 5-6%.

Part 3: Changes in P/E Ratio
The price-to-earnings (P/E) ratio is the price per share divided by earnings per share. In other words, it is how much investors are willing to pay for each unit of earnings. If they are willing to pay 20 times annual earnings, the share price of the stock will be twice as high as if they only paid 10 times earnings. This part is denoted the speculative return, as it has changed throughout history. Here it is again for the S&P 500:

In 1950, the P/E ratio was less than 10. As of right now in mid-2010, it is 20. It is very unlikely that this more than doubling of price-per-share will happen again, with the historical average being around 15. (During the dot-com bubble, the P/E ratio was over 40. In 2008, it was over 25.) This will lead to a zero, and quite possible negative, future speculative return!

Summary

Source: Little Book of Common Sense Investing, Exhibit 7.1

When predicting future returns, you have to look at all the sources of those expected returns. Fundamental return is still a solid reason why stock prices will go up on the long-term, especially if you are not investing only in one country or economy. Some people call it a belief in capitalism, that economic growth will continue and GDP will continue to increase. I simply believe in the passion and motivation of all the people out there, from Sweden to China to Brazil. However, there is good evidence that you might not be getting 10% historical returns due to P/E ratio contraction.

In a recent column, Larry Swedroe shares that the forecasts that he has read are predicting a 5% total annual growth in earnings and 2% dividends for a total return of 7% (similar to above). Inflation is predicted at 2.5%. However, he points out the current minimal-risk return is pretty low as well, so you need consider the big picture:

The bottom line is that while the expected nominal return to stocks is lower than the historical return, so is the expected return to Treasury bonds. You should decide if the expected risk premium for stocks is sufficient given your unique ability, willingness and need to take risk.

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Portfolio Solutions 30-Year Stock/Bond Market Forecast

Every year, the low-fee investment advisor Portfolio Solutions, LLC founded by Rick Ferri provides a 30-year market forecast based on their analysis of several factors. In their own words:

Each year, we analyzed the primary drivers of asset class long-term returns including risk as measured by implied volatility, expected earnings growth based on expected long-term GDP, market implied inflation based on the spread between long-term Treasury Bonds and TIPS, and current cash payouts from interest and dividends on bond and stock indexes. These factors plus others are used in a valuation model to create an estimate for risk premiums over the next 30 years. In a sense, we believe these expected returns reflect what the market is estimating will be a fair payment for each asset class over T-bills over the long-term.

You can view all the asset classes on their site, but I have included some of the major ones below for preservation and reference. Another set of estimates to throw into the mix.

*The estimate of risk is the estimated standard deviation of annual returns.

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Future Stock Market Returns: Price-Earnings Ratios as a Long-Term Predictive Tool

As part of gathering the data needed to go beyond net worth, I’ve shown ways to track find your personal savings rate by tracking your current spending with your current after-tax income. For now, I’m skipping ahead to estimating your portfolio’s long-term investment returns.

There are a lot of ways to estimate future stock returns. You’ve probably heard of the P/E ratio, which is usually the price divided by last year’s earnings. This is one measure of “value”. Here is a plot of historical values of the inflation-adjusted S&P 500 index, along with its annual earnings (source).

Historical Price & Earnings Separately

Historical P/E Ratio

As you can see, there is a lot of volatility in P/E ratio. The “P/E 10″ ratio is the share price divided by the average earnings over the last 10 years. By taking a long-term average, you smooth out the noise and bumps.

Professor Robert Shiller of Yale University, which provided the above data as well, spoke about the usefulness of this ratio in his book Irrational Exuberance, and provided the data for the following chart. The x-axis shows the real “P/E 10″ of the S&P Composite Stock Price Index (inflation adjusted price divided by the prior 10-year mean of inflation-adjusted earnings). The y-axis shows the geometric average real annual return of the same index, reinvesting dividends, and selling 20 years later.

Price-Earnings Ratios as a Predictor of Twenty-Year Returns

You can definitely see the relationship that a higher P/E10 usually leads to a lower future return. However, there is still a great deal of scatter for any given P/E10 ratio.

What about today? As of June 2, 2010 the P/E10 is 19.99 with the S&P 500 index at around 1,098. Historical average is about 15. Back in March 2009 when everything was looking bleak, the P/E10 was 13.32. (P/E10 is also referred to as Cyclically Adjusted Price Earnings (CAPE) ratio.)

The Early Retirement Planning Insights website provides a calculator that forecasts future returns based on the current value of P/E 10, again using historical returns. I’m not sure exactly how they did all the regression. Here’s their return forecast for a P/E 10 ratio of 20.

Future Returns Prediction (P/E10 = 20)

For a 20-year forecast, it shows an average outlook of 4% returns, on a real (after-inflation) basis. Of course, the range indicates that the actual returns could look much worse. As the time-horizon lengthens, the range gets smaller due to the phenomenon of reversion to the mean. Kind of scary to look 60 years ahead!

Warnings

To me, this stuff is useful as a general Big Picture planning tool, not as a short-term trading tool. These are just predictions based on the past, which is often the best we can do, but still far from perfect. Many people use P/E10 as a tool for market timing, shifting their asset allocation as it rises and falls. Shiller himself states that his plot above:

confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low.

That may be true, but market timing systems can really test an investor’s faith when they seem to be wrong for a long period of time. On a personal basis, I’d probably limit any asset allocation moves – if any – to if the P/E10 ratio moved to an extreme, for example dropped below 10 or above 25.

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