Is the Fed Really “Stealing from Savers”?

In a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time.  All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX).  Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading.  Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds.  Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though.  Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

Related Links:

• 6 Reasons Why You Don’t Want to Invest Like a Professional Trader
• Are My Investment Decisions Tax Efficient?
• How Much Am I Paying in Investment Expenses?

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.

Are My Investment Decisions Tax Efficient?

This is the eighth installment in our series on how individual investors can assess their financial health

With investment gains, as with other types of income, it’s not how much you make that ultimately matters, but how much you keep.   In other words, you only get to spend what’s left after you pay taxes.   There are various ways to make your investments tax efficient, and it’s crucially important that you know what they are.

To make sure you don’t incur an excessive tax bill from your investing, take the following steps:

1) Avoid realizing short term capital gains.

2) Make full use of tax-advantaged accounts.

3) Harvest your losses.

4) Match assets to account type.

5) Choose tax efficient mutual funds.

Avoid Realizing Short Term Gains

Selling an investment that you have held for less than a year at a profit triggers short term capital gains, and the tax rate for short term gains is markedly higher than for long term gains. Short term gains are taxed as ordinary income, while long-term gains are taxed at lower rates. The difference between the tax rate on your long term versus short term gains depends on your tax bracket, but it is usually sensible to hold investments for at least a year, although this must be considered in light of the need to rebalance.

Make Full Use of Tax-Advantaged Accounts

There are a number of types of investment accounts that have tax advantages. There are IRAs and 401(k)s, which allow investors to put in money before taxes.   These accounts allow you to defer taxes until you retire, whereupon you will be taxed on the money that you take out.   By paying taxes later, you get what amounts to a zero interest loan on the money that you would ordinarily have paid in taxes.

Another alternative is Roth IRAs and Roth 401(k)s.  In these accounts, you put money in after tax, but you are not taxed on the future gains.   If you have concerns that tax rates will be higher in the future, the Roth structure allows you to essentially lock in your total tax burden.

529 plans for college savings have tax advantages worth considering.  While you pay taxes on 529 contributions, the future investment gains are not taxes at all as long as the money is used for qualified educational expenses.   There may also be additional state tax incentives offered to residents, depending upon your home state.

Harvest Your Losses

If you make a profit by selling a security, you will owe taxes on the gain. However, if you sell security in a taxable brokerage account at a loss, the loss can be used to offset realized gains and can even offset up to $3,000 in ordinary income. If you then wait more than a month, you can buy the same position in the losing security and have reduced or eliminated your tax bill on the gain simply by selling the losing position and then waiting more than a month before buying that security back.   Alternatively, you might buy another similar security to the one that you took a loss on and then you don’t have to wait a month.   The key in this latter approach is that you can buy a similar but not functionally identical security if you want to take a loss and then immediately buy another security back.

It should be noted that tax loss harvesting does not eliminate taxes, but defers them into the future.   In general, paying taxes later is preferable to paying them today.

Matching Assets to Account Type

Different types of investment assets have different tax exposure, so it makes sense to put assets into the types of accounts in which taxes are lowest.   This process is sometimes referred to as selecting asset location.   Actively managed mutual funds are most tax efficient in tax deferred accounts, as are most types of bonds and other income producing assets.   The exceptions are those asset classes that have special tax benefits.   Income from municipal bonds, for example, is not taxed at the federal level and is often also tax free at the state level. Holding municipal bonds in tax deferred accounts wastes these tax benefits.   Qualified stock dividends are also taxed at rates that are lower than ordinary income, so qualified dividend-paying stocks typically make the most sense in taxable accounts.   Real estate investment trusts, on the other hand, are best located in tax deferred accounts because they tend to generate fairly high levels of taxable income.

Choose Tax Efficient Mutual Funds

When mutual fund managers sell holdings at a profit, fund investors are liable for taxes on these realized gains.  The more a fund manager trades, the greater the investor’s tax burden is likely to be.   Even if you, the investor, have not sold any shares of the fund, the manager has generated a tax liability on your behalf.   It is even possible for investors holding fund shares that have declined in value to owe capital gains taxes that result from one or more trades that the manager executed. You can minimize this source of taxes by either investing in mutual funds only in tax deferred accounts or by choosing funds that are tax efficient.   Index funds tend to be very tax efficient because they have low turnover.   There are also funds that are managed specifically  to reduce the investor’s tax burden.   One academic study found that funds engaged in tax efficient practices generate higher returns than peers even on a pre-tax basis.

Don’t Pay More Tax Than You Have To

Everyone needs to pay their fair share of taxes.  But if you manage your investments with a consideration of tax consequences, you can avoid paying more tax than is required.   If the various considerations outlined here seem too complicated, a simple allocation to a few index funds will tend to be fairly tax efficient.  That is a reasonable place to start.

An old adage about tax planning is that a tax deferred is a tax avoided. In general, the longer you can delay paying tax, the better off you are.   The various forms of tax deferred savings accounts are very valuable in this regard.

While it is more interesting looking for productive investment opportunities, spending a little time understanding how to minimize your tax burden can help to ensure that you actually get to spend the gains that you make.

Related Links:

• How Much Am I Paying in Investment Expenses
• Am I Effectively Diversified?
• Is My Portfolio at the Right Risk Level?

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

 

How Much am I Paying in Investment Expenses?

This is the seventh installment in our series on how individual investors can assess their financial health.

In my experience, I’ve found that many people have no idea how much they’re paying for the privilege of investing. And survey data supports my observations. Ignorance is not bliss. Analysis of investment expenses suggests that many people are probably losing a substantial portion of their potential lifetime investment gains to these expenses—and a considerable portion of them are avoidable.

To understand the true scope of investment expenses, you first need to know the different forms they can take. You’re not alone if you didn’t know about some of these costs.

• Brokerage fees – Also known as trading commissions, these are what you pay when you buy or sell securities through a broker. Typically, brokerage costs accrue every time you make a trade, though there are a variety of fee structures.
• Mutual fund stated costs – These are the fees that mutual fund management collects for running the fund. They are expressed as a mutual fund’s expense ratio.
• Mutual fund trading costs – The costs that funds incur through trading their underlying securities are not included in the expense ratio. They are additional expenses that are passed along to fund investors.
• Retirement plan administrative costs – In retirement plans, the costs associated with managing the plan itself are over and above the brokerage fees and mutual fund expenses.
• Advisory fees – If you have a financial advisor, he or she may be paid on the basis of sales commissions, a percentage of your assets, or a flat fee.
• Cash drag – Mutual funds tend to keep a certain percentage of their assets in cash to support fund share redemptions. These assets are doing nothing, but are still part of the assets subject to the expense ratio of the fund. This is not an explicit fee but it reduces the return of your investment, so I have included it here.
• Taxes accrued by the mutual fund – Finally, it’s necessary to account for the tax burden that a fund creates for its investors through the fund’s trading.

The Impact of Fund Expenses

A 2011 Forbes article estimates that the average all-in cost of owning a mutual fund is 3.2% per year in a non-taxable account and 4.2% in a taxable account. This estimate is likely on the high end, but it’s certainly possible that it is accurate. A more recent article estimates that the average all-in cost of investing in an actively managed mutual fund is 2.2% per year, ignoring taxes. But rather than debate these numbers, the crucial question is how much you are spending in your own accounts.

While a 1% or 2% difference in expenses may seem small when compared to variability in fund total returns of 20% or more, the long term impact of those expenses is enormous.   Let’s do a little math to show how pernicious expenses can be.

Imagine that you can earn an average of 7% per year in a 60% stock/40% bond portfolio. The long term average rate of inflation in the United States is 2.3%. That means your real return after inflation is 4.7% (7% – 2.3%).  If your expenses in a taxable account are as high as the Forbes estimate, you’ll end up with only 0.5% per year in return net of inflation. This implies that the vast majority of returns from stocks and bonds could be lost to the various forms of expenses.

If you find that implausible, consider the fact that the average mutual fund investor has not even kept up with inflation over the past 20 years, a period in which inflation has averaged 2.5% per year, stocks have averaged gains of 8.2% per year.  The extremely poor returns that individual investors have achieved over the past twenty years are not just a result of high expenses, but expenses certainly must play a role given the estimates of how much the average investor pays.

A useful rule of thumb is that every extra 1% you pay in expenses equates to 20% less wealth accumulation over a working lifetime. If you can reduce expenses by 2% per year, before considering taxes you are likely to have a 40% higher income in retirement (higher portfolio value equates directly to higher income) or to be able to leave a 40% larger bequest to your family or to your favorite charity.

How to Get a Handle on Expenses

To estimate how much you are paying in expenses, follow these steps.

1. Obtain the expense ratio of every mutual fund and ETF that you invest in. Multiply the expense ratios by the dollar amount in each fund to calculate your total cost.
2. Look up the turnover of each fund that you invest in. Multiply the turnover by 1.2% to estimate the incremental expenses of trading. A fund with 100% annual turnover is likely to cost an additional 1.2% of your assets beyond the started expense ratio.
3. If you use an advisor, make sure you know the annual cost of the advisor’s services as well as any so-called wrap fees of programs that the advisor has you participating in.
4. Ask your HR manager to provide the all-in cost of your 401k plan.
5. Add up all of your brokerage expenses for the past twelve months.

Collecting all of this information will take some time, but given the substantial potential impact of expenses on performance, it’s worth the trouble. If, when you add up all of these costs, your total expenses are less than 1% of your assets, you are keeping costs low. If your total expenses are between 1% and 2%, you need to make sure that you are getting something for your money. You may have an advisor who is providing a lot of planning help beyond just designing your portfolio, for example. Or you may be investing with a manager who you believe is worth paying a premium for. If your all-in costs are greater than 3% per year, you are in danger of sacrificing the majority of the potential after- inflation gains from investing.

Conclusions

It is hard to get excited about tracking expenses or cutting costs. The evidence clearly shows, however, that reducing your investment costs could make the difference between a well-funded retirement or college savings account and one that’s insufficient.

Future returns are hard to predict, but the impact of expenses is precisely known. The more you pay, the better your investments need to perform just to keep up with what you could achieve with low cost index funds. This is not an indictment of money managers but rather a reminder that investors need to be critical consumers of investment products and services.

For more analysis of the devastating impact of expenses, MarketWatch has an interesting take.

Related Links:

• Am I Effectively Diversified?
• Is My Portfolio at the Right Risk Level?
• Am I Better Off Investing or Paying Down Debt?

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

How Much Do You Need to Save for Retirement?

In the financial advisory business, one of the most pressing and controversial topics is how much money people need to save during their working years in order to provide for long-term retirement income.  The research on this topic has evolved quite a lot in recent years, and a recent issue of Money magazine features a series of articles representing the current view on this critical topic.  These articles, based around interviews with a number of the current thought leaders on this topic, deserve to be widely read and discussed.

The series of articles in Money kicks off with perspectives by Wade Pfau.  Pfau’s introductory piece suggests a difficult future for American workers.  A traditional rule-of-thumb in retirement planning is called the 4% rule.  This rule states that a retiree can plan to draw annual income equal to 4% of the value of her portfolio in the first year of retirement and increase this amount each year to keep up with inflation.  Someone who retires with a $1 Million portfolio could draw $40,000 in income in the first year of retirement and then increase that by 2.5%-3% per year, and have a high level of confidence that the portfolio will last thirty years.  It is assumed that the portfolio is invested in 60%-70% stocks and 30%-40% bonds.  The 4% rule was originally derived based on the long-term historical returns and risks for stocks and bonds.  The problem that Pfau has noted, however, is that both stocks and bonds are fairly expensive today relative to their values over the period of time used to calculate the 4% rule.  For bonds, this means that yields are well below their historical averages and historical yields are a good predictor of the future return from bonds.  The expected return from stocks is partly determined by the average price-to-earnings (P/E) ratio, and the P/E for stocks is currently well-above the long-term historical average.  High P/E tends to predict lower future returns for stocks, and vice versa.  For a detailed discussion of these relationships, see this paper.  In light of current prices of stocks and bonds, Pfau concludes that the 4% rule is far too optimistic and proposes that investors plan for something closer to a 3% draw rate from their portfolios in retirement.  I also explored this topic in an article last year.

Estimating the Real Costs of Investing

One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio.  In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small.  Over long periods of time, however, the ups and downs of the market tend to average out.  The effect of those costs  however is persistent and continuous. 

There are a range of costs associated with investing in funds beyond the stated expense ratio.  In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds.  Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising.  He has written similar pieces in the past.  In this article, he provides updated numbers, backed up by a range of academic analysis.  His summary of costs is provided in Table 1 of his article:

 

There are three types of expenses, in addition to the standard expense ratio.  First are transaction costs, which are simply a fund’s trading costs.  This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses.  Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds.  He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio.  The second source of additional cost for active funds is cash drag.  Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash.  To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance.  Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year.  The final additional cost that Mr. Bogle includes is sales charges / fees.  This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees.  Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate. 

When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year. 

The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference.  The ICI also reports that the most expensive funds can have much higher expense ratios.  They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%. 

Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year.  This number is highly uncertain.  The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%.  A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%.  Because of compounding, the long-term impact of these costs increases over time. 

The average costs from Mr. Bogle’s article are not unreasonable.  There are probably many investors paying this much or more.  On the other hand, there are plenty of investors in active funds paying considerably less. 

Where does all of this leave investors?  First and foremost, it should be clear that costs matter a great deal.  There will always be expenses associated with investing, but they vary widely.  Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings.  Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio. 

Related Links:

• It’s Different This Time for Tech Stock Valuations
• Why Investing in Stocks in the Headlines Is Not a Good Idea
• The Inflation Paradox at the End of 2013
• The Facebook IPO: Why Gambling with Your Portfolio Rarely Pays Off

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Folio Investing Celebrates Its Target Date Folios’ Five-Year Record of Outperformance

Folio Investing’s Successful ETF-Based Alternative to Legacy Target-Date Funds Offers Superior Diversification, Risk Targeting and Flexibility; Firm Seeks Distribution Partner to Broaden Availability

Folio Investing announced today that, over the five years since they were brought to market in December 2007, its Target Date Folios have significantly outperformed traditional target-date funds. The Folios have provided both higher returns and lower volatility than the competing funds during this tumultuous period.

Getting Help in Choosing and Managing a Portfolio

There is currently $5 Trillion invested in Individual Retirement Accounts (IRAs), $4.7 Trillion invested in self-directed retirement plans provided by employers (401(k), 457, and 403(b) plans), and $2.3 Trillion invested in traditional pension plans offered by private companies.  These numbers are stunning for a number of reasons.  First, self-directed retirement plans (IRAs, 401(k)’s, etc.) dramatically dwarf the amounts invested in traditional pensions.  This is part of a long-term trend, as employers move away from traditional pensions, but the magnitude of the shift is striking.  With the assets in IRA’s surpassing the $5 Trillion mark earlier this year, the amount of money in individual accounts is moving ahead of employer-sponsored plans.  What’s more, it is anticipated that IRA’s will continue to grow relative to employer-sponsored plans as people retire and roll their savings from their ex-employer’s plan into an IRA.  This matters because investors in IRA’s have even less help in creating and maintaining their portfolios than investors in employer-sponsored plans. 

Saving and Investing for Retirement: Part Five

Effective Actions in an Uncertain World: Part Five of Our Special Five Part Series

There are a number of factors that we need to predict in order to come up with saving and investing strategies for retirement.  The values that we assign to these factors will have a huge impact on whether or not we will be able to meet our goals.  First, there is the expected return that investors will make on their retirement savings.  Second, there is the common estimate that people will need about 85% of their pre-retirement income to support them once they stop working.  Finally, there is the potential impact of behavior on savings rates, investing, and spending. 

Tax Loss Harvesting: Five Tips to Keep More of What’s Yours

Here at the Portfolioist, we frequently turn to Steve Thorpe, founder of Pragmatic Portfolios, LLC to share his insights on the topic of Tax Loss Harvesting. Here are 5 of his Tax Loss Harvesting Tips to help keep more of your money when tax time rolls around.

It’s impossible to reliably predict future changes within the investment markets, however there are numerous ways for investors to favorably influence their own results. Important areas to focus on include developing an investment plan, saving regularly, diversifying widely, adhering to an appropriate asset allocation, and paying attention to all forms of costs – including taxes. For many investors, tax loss harvesting can improve their after-tax bottom line, sometimes to the tune of thousands of dollars per year.

Tried and True Money Advice from Warren Buffett

Guest post by Contributing Editor, Janet Al-Saad, Mint.com.

When it comes to financial wisdom, few people merit as much attention as Warren Buffett. The man renowned as the “Sage of Omaha” built a billion-dollar empire from scratch, all the while maintaining modest spending habits that are the envy of every frugal person everywhere. Liz Claman of the Fox Business Network spoke with Buffett recently, and shares some of his wisdom with Mint Life: