Monday, May 24, 2010

Have Your Social Security and Eat It Too

There are arguments for taking limited social security benefits as early as possible (age 62). Clearly you will come out ahead financially if you don’t live long enough to take them later. You might also argue that you are more likely to enjoy the money as a 62 year old than you would as a 70 year old.

There are also arguments for taking social security benefits later (as late as age 70). You will receive a much larger monthly benefit at age 70 and if you live a long life, this cost of living adjusted (COLA’d) annuity could be very valuable.

Not as many people know about a third option. You can take the limited amount early, then trade if back for the larger amount later. This is a loop-hole that Suze Orman is now touting for her more affluent clients.

From NJ Times, June 16, 2007: “ . . .Suze Orman, a well-known financial adviser who has written many books and appears frequently on TV to promote her books and videos, pushes her own Social Security scheme involving withdrawal of a Social Security claim. She advises retirees to file for reduced Social Security benefits at age 62. She then tells them to invest every nickel of benefits they receive between ages 62 and 66. Then, at age 66, she instructs her clients to withdraw their original Social Security claim. As part of that plan, they have to repay all benefits received. They should be able to do that with no financial problems assuming they followed her advice and invested all the Social Security money they had received.

The good news is that they (her clients) get to pocket the interest. The SSA does not charge interest when they ask people to repay benefits after a claim is withdrawn. And finally, to close the circle on the "Suze Orman Social Security Scheme," she tells her clients to file a new claim for full (age 66) benefits right after they withdraw the old age- 62 claim.

Although it is totally legal, it couldn't work for most retirees. The reason is that most people need the proceeds from their Social Security check to pay the mortgage or rent or grocery bill. Only the comfortably affluent see their Social Security check as merely another investment vehicle."

Here’s an example of how this might work for someone earning maximum SS benefit if they reached age 62 in the year 2000. The calculation was done by John Greaney (aka intercst) at his early retirement forum.

So at age 70, by withdrawing your application to receive benefits that you made at age 62, you would pay $103,685 back to the federal government. You would keep any interest you earned on that money. And you would re-apply for age 70 benefits. This would result in an immediate increase in your benefit of $1,157 per month (over 76% increase). If instead of doing this, you wanted to buy an equivalent inflation adjusted life annuity, you can check costs of doing this with any company of your choosing. According to Vanguard:
Cost of $1,157/month Vanguard inflation-adjusted life annuity at age 70:  $188,264
Savings for doing SS withdrawal of application ($188,264 - $103,685) = $84,579

Taking advantage of this social security loop hole was worth $84,579 after only 7 short years. This does not include money you earned by investing your benefits during those 7 years.



You don't have to file an amended income tax return for previous years. You recapture the taxes paid in previous years as a tax credit on Form 1040, Line 70.

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Friday, December 18, 2009

Simulating Retirement Investment Survival

It would be wonderful if it were possible to run a computer simulation that would tell you exactly how much money you were going to need in retirement. Unfortunately, retirement investment survival is not a deterministic problem. It is a probabilistic problem. There are simulations, however, that can be used to great advantage in retirement planning.

In order to simulate your financial survival during retirement you need to model:

1) The size of your nest egg (how much will you have invested).

2) The real rate of return on your investments (ie. return minus inflation).

3) How much you will spend and when (a spending model).4) How long you will be retired (or equivalently, when will you die).

You have quite a bit of control on items 1 and 3. In contrast, you have virtually no control of item 4 (unless you are willing to take hemlock at a specific time). You can gain some insight into 4 by examining actuarial tables. This allows you to place probabilities on your longevity. Item 2 can be approached by examining historical rates of return on various investments and asset allocations.

The most simple minded way to approach retirement simulation is to assume a portfolio value, a fixed rate of return, a constant real spending model, and a longevity estimation. This data can be used in a spreadsheet or simple financial formula to determine how much money you need to retire. Unfortunately, this deterministic approach to retirement planning is not very accurate nor useful. Over a 30 or 40 year retirement period, average rates of return, average inflation, average spending, etc. are not good estimates of your actual financial performance. Fluctuations from year to year can be devastating.

One method that addresses the probabilistic nature of the retirement simulation problem is to use Monte Carlo analysis. A computer generates a random number that is used to establish an annual rate of return and annual inflation for a single year. Your assumed nest egg is then modified by the random rates, annual spending is subtracted, and the computer generates a second year's rate numbers. The process is repeated until an entire retirement sequence is created (30 to 40 years typically). The distribution of these rates is forced to be consistent with historical distributions. The multi-year retirement sequence is repeated hundreds or thousands of times and a probability of portfolio survival is computed. Although Monte Carlo methods are powerful techniques, when applied to the retirement investment problem they tend to be pessimistic because they do not account for the correlations between returns and inflation nor year-to-year correlations. An alternative method to deal with the retirement probabilistic problem is to use actual historical data. Data that describes stock returns, bond returns, real estate returns, inflation, etc since 1871 have been tabulated. The historical simulator simply uses this data in historical sequence to examine how a portfolio and spending plan would have survived over the hundreds of historical periods represented by these simulators.

You can gain free access to all three types of simulators at:

Basic input data and analysis results are also presented.

Friday, October 30, 2009

Withdrawing from your IRA before age 59 1/2

Many financial advisers and financial advice columns state that you cannot withdraw funds from your IRA without paying a penalty prior to the age of 59 1/2. Thanks to an important loophole in the IRA legislation, that’s not strictly true.

The loophole is known as a "72t exception". The name is derived from current tax law (Internal Revenue Service Code Section 72t). That section of the tax code states that you can avoid the 10% penalty tax if you take "substantially equal periodic payments." You have to use an IRS bulletin (Notice 89-25) to calculate what the IRS considers to be "substantially equal periodic payments". You must take those payments for a specific number of years (at least 5). The formula to compute acceptable payments is not simple, but if you need to access your IRA stash, it’s worth the effort (ie avoiding a 10% penalty) to compute your acceptable withdrawal rate. A web search for “IRS 72t calculator” will provide a number of online calculators to compute acceptable 72(t) withdrawals for your IRAs.

The IRS term “substantially equal periodic payments” is often abbreviated as SEPP. To take a series of SEPP from your IRA without penalty, you must withdraw money at least once a year, and you must keep taking withdrawals for five years or until you reach age 59½, whichever is longer. As an example, a 40-year-old would need to take withdrawals for twenty years (until age 59-1/2). Anyone over 54-1/2 years old would need to take them for five years (for 5 years which would be past age 59-1/2). Once SEPP is started, you cannot take unlimited withdrawals from your IRA for 5 years and a day. That’s a limitation for people who start SEPP after the age of 54-1/2. It means they can only withdraw their IRA funds consistent with SEPP rules until all 5 years of SEPP withdrawal have been taken. If SEPP withdrawal rules are not followed exactly, you face a 10% penalty and retroactive interest charges.

SEPP and 72(t) rules do not apply to a 401(k) account, but this technicality can be side-stepped if you rollover your 401(k) into an IRA. You need to consider all of the specific details of your 401(k) plan and rollover rules before you do this. Some company 401(k) plans allow more liberal withdrawal rules than those allowed by IRA regulations. Also, some company rollover rules are limiting. But the rollover strategy can be very valuable in many cases.

For more information see Section 8.3 at:

Tuesday, August 18, 2009

More on Higher Order Asset Allocation

Consider the 60/40 – stock/bond asset allocation (AA) plan of my comments from March 6, 2009, “Fundamental Asset Class Definitions and Asset Allocation. First, it is important to understand that a simple 60/40 asset allocation plan is a very good plan that is very easy to implement. Historically, it will beat the performance of most other investors provided you use low fee investment instruments to construct the portfolio (ie low cost index funds or Exchange Traded Funds) and you consider a time frame of about a decade or more. Many investors would like to improve on the simple two asset class allocation by including a more sophisticated allocation analysis. There is no guarantee that consideration of additional asset classes will improve performance, so there is no optimum way to construct a more sophisticated asset allocation plan. But historical analysis can help to produce plans that would have performed better under certain economic conditions in the past. What follows are two examples of how to develop a more complex asset allocation plan.

An investor might start by observing that many broad stock market indexes are overweighted with large-cap and underweighted with small-cap stocks. That means that large companies are over-represented in the index as compared to smaller companies. By splitting the stock allocation in half, a second order allocation plan with three components is achieved. The new allocation includes 30% large cap stock, 30% small-cap index, and 40% bond. Introduction of small cap stocks in the allocation historically provides greater long-term returns but also introduces greater volatility (based on 130 years of US stock market history). If an investor is nervous and does not feel comfortable with increased volatility, the second order AA plan would not be advised. If the investor is more experienced and able to maintain the plan through small-cap downturns that may last several years, the second order plan is likely to result in greater long-term returns. Notice that additional appropriate funds must be identified and purchased for this more complex asset allocation plan. In fact, with each addition of a new asset class, additional funds must be used.

Another AA alternative would be to partially replace the small-cap fund with a Real Estate Investment Trust (REIT) investment. REIT returns have been weakly correlated to large cap stock returns in recent years, but tend to exhibit less volatility than small-cap funds during most periods of time.

Further sophistication of the allocation plan can be added by differentiating between value and growth funds. Both the large-cap and small-cap portions of the stock investment can be further split to include large-cap value and small-cap value funds to complement the general large-cap fund and general small-cap fund. The additional weighting of value stocks in the stock portion of the portfolio has historically both decreased volatility and increased long-term return (although not in every historical period). The resulting third order allocation plan includes as many as six components: 15% general large-cap stock, 15% large-cap value fund, 10% general small-cap stock, 10% small-cap value fund, 10% REIT, and 40% short-term bond.

Starting again with a first order 60/40 – stock/bond AA, an alternative asset allocation example can be developed. An investor might decide to split the general stock allocation into large-cap domestic stock, international stock, and small-cap domestic. Over some periods, international stocks have shown low correlation to US-based stocks. The inclusion of 15% to 25% international stock in a portfolio has helped produce both greater returns and reduced volatility during these periods. A second order asset allocation plan designed to address this might include 20% large-cap domestic stock, 20% international stock, 20% small-cap stock, 20% short-term bonds, and 20% intermediate term bonds. In this example, the bond asset allocation has also been sub-divided to provide stability over shorter periods of time.

Both of the above second order asset allocation plans can be rationalized and neither can be proven to be “optimal” for the future. Still other plans can be developed based on examination of alternative subdivisions of the general stock/bond asset classes and historical correlation and volatility data. Before subdividing the general stock/bond allocations and adding an asset class, you should understand what that asset is, the cost of owning it (fees), the risk it brings to your portfolio, and how it may correlate with the other assets in your plan. Adding asset classes without this basic understanding can hurt rather than help your investment portfolio. The number of assets in an investment plan is not an indication of sophistication. If you don’t understand an investment, don’t buy it. An investor that maintains the simple first order stock/bond allocation has historically outperformed most other investors. This is often done with as few as two market-tracking index funds. The simple stock/bond allocation plan, when coupled with a reasonable spending model and regular saving, will get you to a comfortable retirement.

More on Asset classes and Investment Options:

More on Asset Allocation (see Section 6.2):

Some material is from Golio, Engineering Your Retirement, Wiley, 2006. (see

Tuesday, June 2, 2009

Bond Basics

A bond is a loan for which the investor is the lender. They are like IOUs. When you purchase a bond, you are lending money to the government, a company, or some other organization. Bonds are sold in fixed increments, normally $1000. The organization that sells a bond is known as the issuer. Like other loans, there is an amount borrowed (face value or par value). There is an applicable interest rate (coupon rate), and a specified time when the bond must be paid off (maturity date). Bond maturities can range from days to decades. The bonds that typical individual investors purchase have maturity dates that are years to decades in length. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months, although quarterly or monthly payments are sometimes specified. Because the cash flow from them is fixed, bonds are also known as fixed-income securities. On the maturity date, the face value of the bond is returned to the bondholder.

(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)
Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.

Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.

Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.

Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.

How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.

Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.

A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.

The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.

In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.


adapted from Engineering Your Retirement, Golio, Wiley, 2006.

Friday, March 6, 2009

Fundamental Asset Class Definitions and Asset Allocation

Asset allocation (AA) focuses on managing investment risk while accepting that an investor is not likely to be able to predict what will happen next in the markets. An asset allocation plan involves choosing the asset classes that will comprise the plan and setting target percentages of the overall portfolio that should be invested in each class. Studies show that the asset class choices for an investor are the primary indicator of both performance and risk when considered over long periods of time. The actual specific investments within those asset classes are far less important. An AA plan requires periodically (typically once per year) rebalancing the portfolio as one asset class outperforms another. Rebalancing maintains the portfolio risk at a fairly constant level.

What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.

A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: An asset class can also be defined using any or all of these distinctions.

Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.

An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.

Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.

Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.

For more on asset allocations, refer to Section 6.2.
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Sunday, February 15, 2009

Asset Allocation vs Market Timing

The underlying, fundamental principle that describes investments is that greater return comes with greater risk. The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. A U.S. Treasury bond, for example, provides lower return than a corporate bond. The reason for the difference in returns is that the risk of a corporation going bankrupt is higher than the risk that the government goes bankrupt. The corporation has to pay a higher rate than the government to entice investors to buy their bonds rather than government bonds. The risk-return continuum that applies to government and corporate bonds also applies to stock, mutual fund, real estate and commodity investments. All investment choices need to consider an individual’s comfort level with risk and his/her requirements for reward.

Investment strategies can be classified along a continuum between asset allocation and market timing. Asset allocators are investors who focus first on managing risk by maintaining fixed percentages of their portfolio in various asset classes – each associated with that class’ risk. For example, a simple asset allocation plan might be to keep 30% of investments in US stock market investments, 30% in international stock investments, and 40% in short-term bonds. A pure asset allocation strategy would involve establishing a portfolio with this mix of investments, then periodically (once a year, for example) re-balancing the overall portfolio to maintain the asset classes at the same levels. Asset allocators accept that they cannot predict what the markets will do and choose instead to manage risk.

In contrast, market timers focus first on return. Buy low; sell high is the goal of the market timer. Market timing is a seductive strategy. Engineers who are used to optimizing performance understand that maximizing yield must involve picking equities and bonds when they are underpriced and selling them when they are overpriced. Unfortunately, this is easier said than done. In order to successfully time the market, the investor must 1) identify a bargain correctly before anyone else has done so. Once others identify the bargain, the market will immediately increase the price until it is priced appropriately. 2) buy the bargain at the right time. 3) sell the bargain at the right time. If a market timer misses on any of the above tasks, they can completely eliminate their profit advantage.

Countless studies have looked at various investments strategies and compared the resulting performance. Over periods as short as 5 years, most asset allocators outperform market timers. As the time period gets longer, the performance advantage of asset allocation grows. For periods of 2 or 3 decades, only a small fraction of market timers are comparable to pure asset allocation strategies.

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