Are My Investment Decisions Tax Efficient?

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

Am I Tax Efficient?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.

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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.

Hidden CostsIn 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.

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Am I Effectively Diversified?

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

Diversified FolioDiversification is a perennial topic among investors, and if it seems controversial at times, that may be due to the fact that people don’t always share the same understanding of what it means. But diversification isn’t about investing in a certain number of securities or funds. And it’s not about investing in every possible security under the sun.

 

Diversification and Risk

Simply put, diversification is the process of combining investments that don’t move in lockstep with each other. For example, Treasury bonds tend to do well when stocks are falling, and vice versa.  Combining stocks and bonds thus helps to limit risk.  Bonds also reduce the risk of a portfolio because they tend to be less risky on a standalone basis than stocks.

This brings us to an important point: the aggregate risk/return properties of a portfolio depend not only on the risk and return of the assets themselves, but also on the relationships between them.  Determining the right balance among these three factors (asset risk, asset return, and diversification benefit) is the challenge of diversification.

A Diversification Self-Assessment

The starting point in the determining whether your portfolio is properly diversified is to come up with a risk level that matches your needs.  I discussed risk estimation in last week’s blog.  Assuming you have a target risk level for your portfolio, you can then attempt to determine how to combine assets so as to achieve the maximum expected return for this risk.

The word “expected” is crucial here.  It is easy to look back and to see, for example, that simply holding 100% of your assets in U.S. stocks would have been a winning strategy over the past five years or so.  The trailing five year return of the S&P 500 is 15.7% per year and there has not been a 10% drop in over 1,000 days.  Over this period, holding assets in almost any other asset class has only reduced portfolio return and risk reduction does not look like a critical issue when volatility is this low.  The problem, of course, is that you invest on the basis of expected future returns and you have to account for the fact that there is enormous uncertainty as to what U.S. stocks will do going forward. Diversification is important because we have limited insight into the future.

Many investors think that they are diversified because they own a number of different funds.  Owning multiple funds that tend to move together may result in no diversification benefit at all, however.  A recent analysis of more than 1,000,000 individual investors found that their portfolios were substantially under-diversified.  The level of under-diversification, the authors estimated, could result in a reduction of lifetime wealth accumulation of almost one fifth (19%).

Additional Diversifiers

Aside from a broad U.S. stock index (S&P 500, e.g., IVV or VFINX) and a broad bond index (e.g., AGG or VBMFX), what other asset classes are worth considering?

  • Because the S&P 500 is oriented to very large companies, consider adding an allocation to small cap stocks, such as with a Russell 2000 index (e.g. IWM or NAESX).
  • There is also considerable research that suggests that value stocks—those stocks with relatively low price-to-earnings or price-to-book values—have historically added to performance as well. A large cap value fund (e.g. VTV, IWD, VIVAX) or small cap value fund (e.g. VBR, RZV) may be a useful addition to a portfolio.
  • In addition to domestic stocks, consider some allocation to international stocks (e.g. EFA or VGTSX) and emerging markets (e.g. EEM or VEIEX).
  • Real Estate Investment Trusts (REITs) invest in commercial and residential real estate, giving investors share in the rents on these properties. There are a number of REIT index funds (e.g. ICF, RWR, and VGSIX).
  • Utility stock index funds (e.g. XLU) can be a useful diversifier because they have properties of stocks (shareholders own a piece of the company) and bonds (utilities tend to pay a stable amount of income), but have fairly low correlation to both.
  • Preferred shares (as represented by a fund such as PFF) also have some properties of stocks and some of bonds.
  • Another potential diversifier is gold (GLD).

 

Diversification Example

To help illustrate the potential value of diversification, I used a portfolio simulation tool (Quantext Portfolio Planner, which I designed) to estimate how much additional return one might expect from adding a number of the asset classes listed above to a portfolio that originally consists of just an S&P 500 fund and a bond fund.

Diversification

Risk and return for a 2-asset portfolio as compared with a more diversified portfolio (source: author’s calculations)

The estimated return of a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index fund is 6.4% per year with volatility of 13%.  (Volatility is a standard measure of risk.)  Compare that to the more diversified portfolio I designed, which has the same expected volatility, but an expected return of 7.3% per year, as estimated by the portfolio simulation tool.  The diversified portfolio is not designed or intended to be an optimal portfolio, but rather simply to show how a moderate allocation to a number of other asset classes can increase expected return without increasing portfolio risk.[1]

The process of analyzing diversified portfolios can get quite involved and there are many ideas about how best to do so.  But the range of analysis suggests that a well-diversified portfolio could add 1%-2% per year to portfolio return.

Conclusions

I have observed that the longer a bull market in U.S. stocks goes on, the more financial writers will opine that diversifying across asset classes is pointless.  We are in just that situation now, as witnessed by a recent article on SeekingAlpha titled Retirees, All You Need is the S&P 500 and Cash.

On the other hand, there is a large body of research that demonstrates that, over longer periods, diversification is valuable in managing risk and enhancing returns.  That said, a simple allocation to stocks and bonds has the virtue of simplicity and can be attained with very low cost.  Diversifying beyond these two assets can meaningfully increase return or reduce risk, but an increase in average return of 1%-2% per year is not going to take the sting out of a 20%+ market decline.  What’s more, a diversified portfolio is quite likely to substantially under-perform the best-performing asset class in any given time period.

But over long periods of time, the gain of 1%-2% from diversification is likely to increase your wealth accumulation over 30 years by 20%-30%.  This is consistent with the analysis of 1,000,000 individual investors cited above, from which the authors concluded that under-diversified portfolios were likely to reduce lifetime wealth accumulation by 19%.

For investors seeking to diversify beyond a low cost stock-bond mix, there are a number of simple portfolios that include a range of the asset classes discussed here and that have fairly long track records.  These are worth exploring as a template for further diversifying your own portfolio.

[1] For details on how the model estimates risk and return for different asset classes and for portfolios, see the whitepaper I wrote on the subject.

 

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Is My Portfolio at the Right Risk Level?

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

RiskAt every stage of investing, you should periodically ask yourself how much risk you can realistically tolerate. The primary way to measure the risk level of your portfolio is to look at its allocation of stocks vs. bonds.  Although some stock and bond ETFs  are riskier than others, your first decision has to be how much of your investments to put in stocks and how much in bonds.

One standard rule of thumb that’s a good place to start is the “age in bonds” axiom. According to this guideline, you invest a percentage of assets equal to your age in a broad bond index, and the balance of your portfolio in a diversified stock portfolio.  The idea here is that your portfolio should become more conservative as you get older. This makes sense for two reasons:

  1. You tend to get wealthier as you age, so any given percentage loss from your portfolio represents an increasingly larger dollar value.
  2. You are gradually converting your human capital (your ability to work and earn money) into financial capital (investments) as you age. And as you get older, your financial assets represent a larger and larger fraction of your lifetime wealth potential.

For these reasons, it makes sense  to manage this pool of assets more conservatively as time goes by.

Beyond “Age in Bonds” – Choosing Your Allocation of Stocks and Bonds

The past decade provides a powerful example of the tradeoffs between risk and return.  The table below shows the year-by-year returns for portfolios comprising different mixes of an S&P 500 ETF (IVV) and a broad bond ETF (AGG).  The returns include the expense ratios of the ETFs, but no adjustment is made for brokerage fees.

2004-2013 Allocation Performance

Source: Author’s calculations and Morningstar

Over the 10-year period from 2004 through 2013, a portfolio that is entirely allocated to the S&P 500 ETF has an average annual return of 9.2%.  In its worst year over this period, 2008, this portfolio lost almost 37% of its value.  As the percentage of the portfolio allocated to stocks declines, the average return goes down. But the worst 12-month loss also becomes markedly less severe.

We cannot say, with any certainty, that these statistics for the past ten years are representative of what we can expect in the future, but they do provide a reasonable basis for thinking about how much risk might be appropriate.

Ask yourself: If these figures are what you could expect, what allocation of stocks vs. bonds would you choose?  Would you be willing to lose 37% in a really bad year to make an average of 9.2% per year?  Or would you prefer to sacrifice 1.5% per year to reduce the potential worst-case loss by one third?  If so, the 70% stock / 30% bond portfolio provides this tradeoff.

Planning around Improbable Events

One might object that 2008 was an extreme case, and that such a bad year is unlikely to recur with any meaningful probability.  One way to correct for this potential bias towards extreme events is to assume that returns from stocks and bonds follow a bell curve distribution, a common way to estimate investment risk.  Using the data over the last ten years to estimate the properties of the bell curve (also known as the “normal” or Gaussian distribution), I have estimated the probabilities of various levels of loss over a 12-month period.

9-30-2014b

Estimated 12-month loss percentiles for a ‘normal’ distribution (Source: author’s calculations)

When you look at the figures for the 5th percentile loss, you can see what might be expected in the worst 5% of 12-month periods for each of the five portfolio types. For example, the 100% stock portfolio has a 1-in-20 chance of returning -21% or worse over the next twelve months. Note that a loss of 35% for stocks, similar to 2008, is estimated to have a probability of 1-in-100.

It’s important to point out that the ability to calculate the probability of very rare events is very poor.  Perhaps 2008 really was a 1-in-100 probability event, but we don’t know that with any certainty.  The most catastrophic events (what Nassim Taleb has famously dubbed “Black Swans”) are so severe and outside our normal range of experience that they tend to catch us totally off guard.

Moshe Milevsky, a well-known retirement planning expert, suggests that rather than thinking in terms of probabilities, it’s sensible to set your portfolio’s risk to a level that ensures that the worst case outcomes are survivable. Based on that, it’s prudent to choose a portfolio risk level that won’t ruin you if there’s another year like 2008. If you can survive a 12-month loss of 23% (the average of the worst loss for this allocation over the past ten years and the estimated worst-case 1st percentile return), for example, you can afford to hold a 70% equity portfolio.

Final Thoughts

If your investments in stocks don’t approximate the S&P 500, the stock portion of your portfolio may be considerably riskier than the table above implies.  Allocations to emerging markets, small companies, and technology stocks can be very volatile. The examples shown here provide a starting point in determining risk.  Combining a wider range of asset classes can provide important diversification benefits beyond their individual risk levels, but this topic is beyond my scope here.

The past ten years have provided examples of very high returns and very low returns from stocks. This period gives us a useful basis for testing our tolerance for volatility.  Many readers, I imagine, will find that their risk tolerance—self-diagnosed from looking at the tables above—corresponds reasonably well to the “age in bonds” rule. If your choice of risk levels is too far from these levels, a closer look is needed—and perhaps a talk with an investment advisor.

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Am I Better Off Investing or Paying Down Debt?

Emergency Fund vs. Paying Off Debt - Which should you contribute to first?This is the fourth installment in our series on how individual investors can assess their financial health.

A common dilemma in personal finance is whether to use funds to pay down debt faster or to invest more. The question crops up in various forms:

 

  • Should I pay off all credit card debt or make smaller payments while saving more for retirement?
  • Should I pay extra on my mortgage or invest in securities?
  • Should I pay down my student loans faster or invest more?

Financial health requires both savings and control over debt. But when these two goals seem to be in conflict, what’s the best way to balance them? Consider these six ways to prioritize.

  1. Make sure you get your employer match. If you’re lucky enough to have an employer that matches your contributions to the workplace 401(k) plan, your first priority is to maximize the employer match. It’s too good to pass up. Contribute any less than what’s matched, and you’re refusing the offer of free money.
  2. Tackle costly credit card debt. Once you are saving enough to secure your entire employer match, you can focus on paying down debts faster. The goal is to pay off all credit card debt as quickly as possible. The interest rates on credit card debt are typically so high that nothing else you do with your money is likely to be as profitable.
  3. Beef up your emergency fund. When you’re beyond the hurdle of credit card debt, consider building out your emergency fund.  If you don’t have sufficient emergency savings to cover a serious car repair, a trip to the emergency room or other not-so-infrequent disasters, this is the next focus.
  4. Save enough in retirement accounts. Assuming you have no credit card debt and decent emergency savings, you can move on to the next set of priorities. If you are saving less than 10% of your pretax income in retirement accounts, ramping up your contributions is probably a better bet than paying extra on your student or auto loans or mortgage. Contributions to retirement accounts are tax advantaged, and it is almost impossible to catch up if you delay retirement savings.
  5. Decide whether to save more or pay down your mortgage. Only when you have no credit card debt, a healthy emergency fund, and you’re saving at least 10% of your pretax income should you consider making additional investments or speeding up your mortgage payments.

But when you compare the cost of having a mortgage to the possible returns from investing elsewhere, don’t forget the tax deduction on mortgage interest. Because of that deduction, your effective (after-tax) interest rate on your mortgage is lower than your actual mortgage rate. There are handy online calculators that can quickly calculate the effective interest rate on your mortgage, accounting for tax benefits.

If you are confident that you can invest at a rate of return that’s at least as high as your effective mortgage rate, you may want to hang on to the mortgage and invest more.  Over the past few years, many consumers have taken out mortgages with effective interest rates of 3% or less.  At this level of interest, there are investment alternatives that make more sense.

Also remember that extra principle payments come with liquidity risk. That is, if you need a source of cash, it may be easier to sell a security investment. To take cash out on your mortgage, you will have to refinance or open a line of credit.  Either of these may come with a higher cost than your current mortgage, not to mention origination fees.

  1. Decide whether to save more or pay down college debts. If your income is below $75,000 per year ($155,000 for a couple filing jointly), some or all of the interest that you pay on college loans may be tax deductible. So the effective rate of interest on your college loans may be lower than the actual rate. Take that into account when you compare your loan interest with potential investment earnings.

An additional consideration may be whether a parent or grandparent cosigned your student loans.  If you become disabled or die—or you’re simply unemployed for a long period of time, your consignors may have to pay your college loans.  That risk may make it worthwhile to pay off college loans faster.

Accounting for Uncertainty

If you could be sure that you’ll never lose your job and that you’ll always be able to open a low-cost line of credit, the decision to pay off debts would be much easier.  But you have to look beyond comparing interest rates on debt to the expected returns from investments. You have to consider that credit may not always be available at today’s rates.

With mortgage rates as low as they are now, paying down a mortgage does not look like the most attractive choice. Once you’ve paid off all high-cost revolving credit (e.g. credit cards), have a solid emergency fund, and you’re saving 10% of your income in retirement accounts, however, it’s worth considering paying down college debts.

Putting non-retirement money into risky investments like stocks before you have accomplished the milestones listed above makes your overall financial situation more risky.  Whether or not this is too much risk depends on you.

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Am I Saving Enough to Reach My Goals?

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

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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