Jonathan Clements's Blog, page 401

Heading Home (Part 2)

WHEN I FINALLY made the decision to apply for a mortgage, time was of the essence. Mortgage rates were rising daily and I wanted to lock in a reasonable rate as quickly as I could.

Luckily, I’m one of those people who pride themselves on being well-organized. The loan officer at my credit union sent me a lengthy list of financial documents I would need to provide before she could begin processing my loan application. Having online access to my financial accounts, and digital copies of my tax returns, made the whole process easy. I was able to upload all my documentation to the credit union website within an hour of the request.

A couple of days later, I got a text from my loan officer. I nearly choked when I read the message. She told me I’d qualified for a $403,000 loan, with as little as a 5% down payment. I’d been going on the assumption I’d qualify for no more than a $200,000 loan and was figuring my overall house-buying budget would be no more than $250,000.

In hindsight, I probably shouldn’t have been surprised. I have no debt, a credit score that’s labeled “excellent” and more than $300,000 in my retirement accounts. With about $80,000 in liquid assets that I could use toward a down payment—and a $403,000 loan—I realized I could purchase a house costing nearly half-a-million dollars. But since I make just $71,000 a year, taking out a loan that large seemed ill-advised. Between the mortgage payment, property taxes and insurance, well over 50% of my take-home income would be going toward housing.

In looking at my loan options, and what my monthly payment would be, I ultimately decided to look at homes in the $380,000 range. At that price, I could afford a 20% down payment—thereby eliminating the need for private mortgage insurance—and still be able to find a house in a neighborhood that would allow me a reasonable commute. My monthly payment would be higher than what I was paying in rent, meaning I could put far less money into my retirement accounts than I had been. But it was a tradeoff I was willing to make to have a place of my own to call home.

Kristine Hayes is a departmental manager at a small, liberal arts college. This is the second in a series of articles about her recent home purchase. Her previous blogs include Heading Home (Part 1),  Happy Ending ,   Material Girl.

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Under Construction

TO MY WAY of thinking, it is inexcusable that we’ve reached the point where there’s even the possibility that Social Security may not be able to pay full benefits 16 years from now. Americans are scared by the prospect. Some have even given up hope that the program will continue to exist.

Back in 2000, Social Security’s Trustees urged action: “In view of the size of the financial shortfall in the [Old-Age, Survivors and Disability Insurance] program over the next 75 years, we again urge that the long-range deficits of both the [Old-Age and Survivors Insurance] and [Disability Insurance] Trust Funds be addressed in a timely way. It is important to address both the OASI and DI problems well before any necessary changes take effect, to allow time for phasing in such changes and for workers to adjust their retirement plans to take account of those changes.”

Similar warnings, urging action sooner rather than later, are contained in every Trustees report since 2000. And yet nothing significant has been done to solve the problem. To apply another band-aid, Congress in 2017 authorized the temporary reallocation of the payroll tax from the old-age fund to the disability fund for years 2016 through 2018. That was because the disability fund was running out of money sooner than the old-age trust.

It isn’t hard to craft a balanced combination of changes that will fix the problem. I cooked up my own solution using the calculator on the Committee for a Responsible Federal Budget website. These changes would make Social Security solvent for the next 75 years. You may have better ideas. But the point is, a combination of changes will easily fix Social Security and increase benefits. My proposed fix:

Increase initial benefits by 5%.
Raise the normal retirement age by one year to 68.
Change the index for cost-of-living adjustments to CPI-E, which more closely reflects retiree costs.
Increase the payroll tax by 2.5 percentage points, with half coming from each worker and half from their employers. It could be less for workers, but only if the payroll tax increase was greater on employers.
Apply the payroll tax to 90% of wages, while also increasing benefits for those who end up paying more in payroll tax. This still generates additional net revenue, because today’s Social Security benefit formula favors lower paid workers (or, to put it another way, higher earners effectively receive a lower return on the payroll tax they pay).
Cover newly hired non-federal government employees who currently do not contribute to Social Security. This should allow states to adjust their public pensions and lower long-term liabilities.
Apply the Social Security payroll tax to the cafeteria plans offered by many employers. When employees pay for health benefits offered through their employer, they pay with dollars that are not only income-tax-free, but also escape the payroll tax.
Diversify a portion of the Social Security Trust funds away from Treasury bonds and into other investments, including stocks, with a view to earning higher returns. Given the long-term nature of Social Security’s financial obligations, such a move would involve minimal risk.

With the above plan, no current retirees are harmed, while the impact on current workers is modest. Nobody likes higher taxes of any kind. But let’s face it: Social Security is part of our social and economic fabric. Americans will continue to rely on Social Security for a significant portion of their retirement income—and we need to agree on a fix.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous blogs include Get Me the Doctor, Running in Place and Tortoises Needed. Follow Dick on Twitter @QuinnsComments.

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Bouncing Back

IN SUMMER 2005, my 40-year marriage officially ended. My previous world, with its hopes and dreams, was no more. My life as a single individual became the new reality. Part of the new reality was financial in nature. Previously developed long-term plans became fiction. New plans, by necessity, appeared on the drawing board.

My personal net worth had dropped by roughly 50%. I no longer owned my historic neighborhood condo. I lost two of our three cars, and I lost all or portions of our mutual funds and cash investments. But there were two bright spots: I kept my retirement income annuity and I still had my Social Security benefits.

The costs of the unwanted divorce impacted my financial well-being in other ways. I was facing, for the first time in four decades, many of the costs of simply being single again, notably paying taxes at a single rate rather than a joint rate. I also needed to replace items retained by my ex-spouse, including appliances and furniture.

In addition, I lost the built-in efficiencies that couples enjoy with such things as grocery shopping and restaurant two-for-one deals. Other inefficiencies included hotel rooms—they cost the same for one person as two—and cruise lines, which charge a penalty for single occupancy.

But I slowly began to see opportunities for greater financial security. My net worth was at a modern low. I recognized that my two main income sources—my state retirement benefits and Social Security—were both indexed to the cost-of-living. I was also noticing modest increases in my dividends and capital gains from the investments I retained.

The biggest bright spot: My new expenses were substantially lower than my income. What did I do with the money?

I increased my savings. In my initial single years, I saved about 50% of my annual income. Today, it’s still at around 30% to 40%.
I moved my Vanguard Group mutual funds into so-called Admiral shares to lower my fund expenses. I moved my brokerage account to benefit from lower trading fees.
I moved my mutual fund money into index funds and out of actively managed funds.
I limited my number of individual stock holdings. I’m currently at four companies and have never owned more than five. I plan to keep three of the stocks indefinitely; the fourth is on “life support.”
I changed my mind twice about my bond allocation. I lowered my percentage in bond holdings at first, which helped my results. More recently, I have increased my bond holdings, though the percentage allocation is still quite low.

I’ve been pleased with the rebirth of my retirement plan over past 13 years. I successfully weathered the Great Recession stock market drop and have benefited from the long-running bull market that followed. Only in one year did my investment net worth show a loss—a drop of 12.1%. My portfolio’s compound annual growth rate for the entire period, reflecting both investment gains and new savings, has been 18.6%. It’s a nice figure, but it’s unrealistic to expect a continuation at this level. Still, if I should live as long as my late Mom, who died at age 99, I may yet see the day when I become that multimillionaire next door.

Dennis E. Quillen is a retired economic geographer and university professor. In addition to blackjack, he loves long-term investing. His previous blogs were Starting Over and Getting Comped.

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September’s Hits

WHICH ARTICLES were readers drawn to last month? Here are the seven most popular blogs published by HumbleDollar in September:

Buy What You Know
Archie Is Scum
Striking a Chord
Lay Down the Law
That’s Rich
Twelve Rules
Any Alternative?

Last month also saw lots of traffic for HumbleDollar’s mid-September newsletter and for a blog from late August, Bad News.

Follow Jonathan on Twitter  @ClementsMoney  and on Facebook . His new book, From Here to Financial Happiness, can now be ordered from Amazon and Barnes & Noble.

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Not for You

MY GRANDFATHER was from Queens in New York City. He was a great guy and taught me a lot. He was also a native New Yorker, so he was street smart and tough.

One day, while we were walking together down 47th Street, near Times Square, I stopped to look at the jam-packed window of an electronics store. My grandfather waited patiently, but cautioned me, “Careful, they’ll take the eyes out of your head.”

It was a funny expression, but I understood: Be careful of shiny objects, he was saying, and be even more careful of the salesmen peddling them.

That was more than 30 years ago, but I was reminded of it when I heard a financial industry insider offer similar words to the wise. In this case, the shiny objects in question were private investment funds, like venture capital funds and hedge funds.

Andy Rachleff is one of Silicon Valley’s most successful venture capitalists. In 1995, he founded the firm Benchmark Capital. Over the course of his career, Rachleff achieved an enviable record, including making a fortune as an early investor in eBay.

Needless to say, if you had been an investor in Benchmark’s funds, you would be very happy today. Indeed, it might seem logical to try to find the next Andy Rachleff. After all, who wouldn’t want to get in on the ground floor of the next generation of successful startups?

This is where Rachleff’s warning comes in. In an interview, he explained why, as an individual investor, you shouldn’t try to find the next Benchmark. “The only venture capital funds that will let [the big wealth management firms catering to individual investors] invest in their funds are the ones that are desperate for capital. They suck…. So by definition, if [a wealth management firm offers to] give you access, run away.”

Strong words, but an important message: The problem isn’t that you can’t find great investment funds. The problem, in Rachleff’s view, is that—as an individual—you simply can’t get in. Instead of settling for second-best, it’s better to take a different approach entirely. Here are two recommendations:

First, remember that asset allocation is what matters most. What we’re talking about here is your basic mix of the four major asset classes: stocks, bonds, cash investments and alternative investments. Research has shown that it’s much more valuable to spend time thinking through the types of investments you own, rather than endlessly deliberating over the choice of specific investments.

Second, recognize that the most powerful—and easiest—way to diversify is with stocks and bonds. Historically, stocks and bonds have exhibited a negative correlation with each other. In other words, when one goes up, the other goes down, and vice versa. That’s why I don’t think you need to get too clever and choose other investments. You might see advertisements for gold funds, currencies, commodities and the like. But the data indicate that these don’t provide the same diversification benefit as a simple stock-bond mix. Yes, they sound sophisticated, but they aren’t much help.

Culturally, 47th Street seems a long way from Wall Street. Scratch the surface, though, and I don’t think they’re that different at all. Wall Street’s salespeople look professional, with their pinstriped suits and fancy offices. But don’t let that fool you. Regardless of the venue, always be wary of shiny objects.

Adam M. Grossman’s previous blogs include Off Target, Just Like Warren and Any Alternative . Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter  @AdamMGrossman .

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Budget Busting

WHO SHOULD DIET? This isn’t exactly a tough one: It’s people who need to lose weight.

Who should budget? If you listen to conventional wisdom, this is another easy one: It seems we all should. Creating a written budget, and then tracking our spending against it, is considered a sign of high financial rectitude.

I think this is nonsense. I have never created a written budget and I don’t track my spending—because I don’t need to. I suspect many readers of this blog are in the same camp.

Let’s say you’re in the workforce and save at least 12% of your income. Or assume you’re retired and each year you withdraw no more than 4% or 5% of your portfolio’s beginning-of-year value. In either case, you clearly have your spending under control, so why does it matter exactly how you spend your dollars?

I’m not the only one who feels this way. You would be hard-pressed to find a group of people who are thriftier than the Bogleheads, devotees of Vanguard Group founder John C. Bogle. A recent discussion on the Bogleheads’ forum focused on the need to budget. Among those who commented, an overwhelming majority said they don’t bother.

In other words, budgeting really is the same as dieting. The only people who should budget are the people who need to budget—those who save too little and spend too much. And my hunch is, like so many dieters who fail to lose weight, those who budget often make scant financial progress.

Why not? A written budget is no competition for our human failings. We all have weaknesses. It might be smoking, drinking, gambling, failure to exercise, infidelity or overeating.

But for many, their big weakness is spending too much. A minority of folks—like those found on the Bogleheads’ forum—are supremely disciplined about money. But most people aren’t: Controlling their spending is a daily battle and, more often than not, it’s a battle they lose. A written budget could potentially help the spendthrift. But I suspect it serves mostly to deepen their sense of failure.

How can we win this fight? My advice: Forget budgeting—and do what many of the Bogleheads do, which is to “pay yourself first.” That might sound trite. But it works—and the best way to put it into action is to automate your savings program. That might mean making payroll contributions to your employer’s 401(k) or 403(b) plan, or it could mean signing up for mutual-fund automatic investment plans.

Both strategies helped me get started as a saver. Indeed, when I was a young, penniless reporter at Forbes magazine, with a newborn at home and a wife in graduate school, I didn’t initially sign up for the 401(k). To my surprise, I got a call from the company’s treasurer, telling me I ought to contribute and saying I’d never miss the money. He was right.

These automatic savings programs are effective, because they get money out of our paychecks and bank accounts before we have a chance to spend it. We’re then forced to live on whatever remains. Yes, there’s always a risk we’ll keep spending recklessly and rack up the credit cards instead. But if we can resist that urge and stick with our automatic savings program for maybe a dozen years, we’ll likely be astonished by the results.

While I don’t think there’s much virtue in budgeting, I do believe there’s great value in knowing one number: How much we spend each month on mortgage or rent, utilities, groceries, car payments and other fixed living costs. That’s crucial information if we find ourselves out of work and it should guide the size of our emergency fund. What if our fixed living costs are consuming a large portion of our income? That may be the reason we find it so hard to save.

Follow Jonathan on Twitter  @ClementsMoney  and on Facebook . His new book, From Here to Financial Happiness, can now be ordered from Amazon and Barnes & Noble. Jonathan’s most recent articles include All Better, Archie Is Scum and My Favorite Questions.

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A Word of Advice

THERE ARE CERTAIN things in life that remind you you’re getting old: You receive mail from companies offering their cremation services. You realize your house was made for a younger person. You have this urge to throw and give away things as if you won’t be here tomorrow. You feel it’s time to hire a financial advisor.

Actually, I’m not sure hiring a financial advisor is a sign of getting old, but that’s the way it struck me. I turned 67 this year, which I don’t consider old. But I believe there could be a time when I can no longer manage my investment portfolio. If I had a pension that covered my living expenses, I might have felt differently. But I rely on my savings for the majority of my retirement income—and I believe hiring a financial advisor is the right decision for me.

Today’s high stock-market valuations and low interest rates make it challenging to figure out the right way to draw down a retirement portfolio. That was another factor in my decision to hire a financial advisor—and it wasn’t the only one.

Having someone I can trust to give me reassurance and emotional support is important to me. I’m an investor whose emotions can sometimes derail a perfectly good investment plan. A good advisor could bring stability to my portfolio—and that should translate into better returns.

In addition, if something should happen to me, there will be someone to help my significant other navigate my finances. And finally, it’s become something I just don’t want to deal with. I used to like managing my money. Not anymore.

After much thought, I decided to go with Vanguard Group’s Personal Advisor Services. Here are seven reasons I chose Vanguard:

I trust the folks there. I have had a relationship with Vanguard for many years. I feel comfortable with the firm.
Its service is inexpensive. Vanguard charges 0.3% of assets each year to manage my investment portfolio. The funds in my portfolio average approximately 0.08%, so the total cost is about 0.38%. By contrast, the industry average for a financial advisor is almost 1%, while some major fund companies charge close to 0.5% for just a short-term domestic bond fund.
According to Barron’s, Vanguard was ranked No. 1 among the robo-advisors that the publication reviewed. Some of the metrics Barron’s used to evaluate this type of service were: customer experience, cost, performance, access to advisors, financial planning and account minimum.
I feel the improved performance of my portfolio will more than make up for the 0.3% management fee.
I like the stock, bond and cash allocation that Vanguard selected for me. It meets my financial requirements and risk tolerance.
I like the way Vanguard manages its advisory service. A financial advisor cannot recommend an investment plan without getting it approved. It’s reassuring to know my plan meets Vanguard’s requirements.
Vanguard’s service fulfills all my financial needs. I wanted someone to allocate my funds, rebalance my portfolio, tell me how much I can spend each year and update me on my progress in meeting my target goals. Vanguard does just that.

We have seen commission-free exchange traded funds and no-fee index mutual funds. Will Vanguard’s type of advisory service be the next revolution in bringing affordable financial advice to the masses? If so, how low can these fees drop?

This is not a recommendation for Vanguard’s Personal Advisor Services. Everyone has different needs and requirements. But I’m at a point in my life where I don’t want to be thinking about my investment portfolio. I’d rather be thinking about my next vacation. I believe hiring a financial advisor and selecting Vanguard will help me achieve that goal.

Dennis Friedman retired at age 58 from Boeing Aerospace Company. He enjoys reading and writing about personal finance. His previous blogs include Friendly Reminder, First Responders and Truth Be Told.

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Hitting Home

OWNING A HOME is getting more expensive, thanks to the Tax Cuts and Jobs Act (TCJA) enacted in December 2017. The new law is the most comprehensive overhaul of the Internal Revenue Code since the Tax Reform Act of 1986. The legislation includes provisions that curtail long-cherished write-offs for mortgage interest and property taxes.

It also abolishes deductions for casualty and theft losses claimed by individuals whose homes, household goods and other property suffer damage due to events like burglaries, fires, landslides and storms. The new rules apply to returns filed for calendar years 2018 through 2025. After 2025, the new rules are scheduled to go off the books. Here’s a look at three key provisions:

1. TCJA shrinks the mortgage-interest tax deduction. The old rules allowed homeowners to claim itemized deductions for interest on as much as $1 million of mortgage debt for a main home and a second home used as a vacation retreat. The cap of $1 million applies to married couples filing jointly and single persons. It drops to $500,000 for married persons filing separate returns.

TCJA grandfathers the old rules for homeowners with existing mortgages. They remain entitled to write off interest on mortgages of up to $1 million. Homeowners also are grandfathered should they opt to refinance their remaining mortgage debt.

The revised rules for post-2017 years decrease the allowable deduction for new buyers from $1 million to $750,000 for married couples filing jointly and single persons, and to $375,000 for married persons filing separate returns. As with the old rules, buyers get just one bite at the apple: The new limits apply to the combined total of loans used to buy, build or substantially improve a person’s main home and second home. Interest on home-equity borrowing for other purposes, such as buying a car, is no longer deductible.

2. TCJA caps write-offs for state and local taxes. The old rules for 2017 and earlier years allowed individuals to take itemized deductions for all of their state and local taxes, including state income taxes, city income taxes and property taxes.

The new rules for post-2017 years impose caps on those deductions. The ceilings are $10,000 for couples filing jointly and single persons, and $5,000 for married persons filing separate returns. These thresholds aren’t indexed for inflation.

An added consideration: Because TCJA sharply increased the standard deduction, many families will find it’s no longer worth itemizing—and hence they’re getting no tax benefit from either their mortgage interest or the state and local taxes they pay. What if you find it’s still worth itemizing? The true tax benefit of your various itemized deductions may be modest, because your total itemized deduction may be barely larger than your standard deduction.

3. TCJA deep-sixes deductions for casualty and theft losses. For 2017 and previous years, there were already severe limits on deductions for such losses.

The big barrier: Losses generally were deductible only to the extent that the total amount in any one year surpassed 10% of a taxpayer’s adjusted gross income. The IRS defines qualifying losses as those caused by identifiable events that are “sudden, unexpected or unusual.”

Under the new law, those tight restrictions got even tighter. For post-2017 years, casualty losses are generally allowable only for losses attributable to natural disasters like hurricanes and floods—plus those losses must occur in disaster areas declared by the president to be eligible for federal assistance.

J ulian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). His previous blogs include No Touching, Doctor’s Orders and In Your Debt. Information about his books is available at JulianBlockTaxExpert.com. Follow  Julian on Twitter @BlockJulian.

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Get Me the Doctor

BEGINNING IN 1961—and for the 48 years that followed—I administered, designed, managed and negotiated health plans covering some 40,000 employees. In the late 1970s, cost became a growing issue. Over the years, we tried every trendy thing to control costs, from HMOs to wellness programs to shifting costs to employees. Nothing worked then and nothing seems to work today.

Before you jump to the most common conclusion, there was no insurance involved in any of the plans I managed. Instead, they were all self-funded by the company. The claims administrators we hired were at no financial risk from claim payments, had no incentive to deny claims and didn’t set premiums.

Today, a common focus is on insurance premiums and insurance companies. Indeed, many people see insurance as the problem. It isn’t. Our problem is how we use health care. That’s what drives premiums and that’s what we must deal with. Changing how Americans use health care and their expectations for the health care system isn’t easy.

It has been estimated that up to $25 billion annually is spent on health care that’s low value or unnecessary. Sound high? Maybe not. The Institute of Medicine estimates that $210 billion is spent needlessly on medical testing and medical care annually in the U.S. Who knows what the right number is? But one thing is certain: Unnecessary care—often expected, if not demanded, by patients—not only costs money, but can also harm patients.

Americans are desperate for an answer to high costs. A growing movement sees a universal health plan in the U.S. as the solution. You might even have heard the popular acronym M4A—Medicare for All. As we debate our next move, however, we shouldn’t think we can merely apply European solutions to Americans, because there are major differences in attitudes toward health care spending.

The cost of M4A is frequently stated as a cost to the federal government. But we all know where the government gets its money: through taxes or borrowing. What I think most people don’t understand is that no matter the cost, including any overall savings, most Americans will be trading today’s highly variable health care costs for fixed costs—in the form of higher taxes.

The reality is, in any given year, most Americans have no significant health care expenses. For example, in 2015, half the population accounted for 97% of health spending. The 5% of people who are  the biggest consumers of health care spend an average $51,000 annually. People in the top 1% have average spending of more than $112,000. At the other end of the spectrum, the 50% of the population with the lowest medical expenses accounted for just 3% of total health spending. The average amount spent by these folks was $277.

That brings me to two health plans offered on the health care exchange in my area. As you’ll see, there’s a tradeoff between monthly premiums and potential out-of-pocket (or OOP) costs—the key word being “potential.” If you had high medical bills, which plan would you choose? Many people will look at the Gold plan’s lower deductible and OOP limits, and conclude that’s the plan they need. People are overly afraid of health care bills and incorrectly believe that there’s a high risk of such bills.

Plan                            GOLD            BRONZE

Family Deductible    $2,000          $6,000

Family OOP               10,000           13,000

Monthly Premium     1,867.88         643.28

But the fact is, even if a family incurred $1 million in bills, the Bronze plan is still the better deal. They save $14,695 in annual premiums, far more than the potential additional OOP costs. If they chose the Bronze plan and, in the first year, saved the premium difference, perhaps in a Health Savings Account, they could easily manage routine OOP costs for several years and still save lots of money. For most families, the Bronze plan is the right choice.

What’s my point? Americans want access to top-notch health care and worry greatly about medical bills—but, in the end, most don’t spend very much. Now, imagine we implemented an M4A-type plan. There may be overall cost savings. Still, most Americans will end up paying more each year in additional taxes than they currently pay in premiums plus OOP costs. This is especially true if their premiums today are subsidized by their employer. They’ll effectively end up paying for the Gold plan, regardless of their health care needs.

To be sure, an M4A-type program has the very important advantage of universal coverage. But there must be tradeoffs to make it affordable and sustainable. To manage costs would require managing health care in ways quite similar to what insurers do today. Americans who believe they can pay a little extra in taxes and get free, unlimited health care are likely to be disappointed.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous blogs include Viva Las Vegas, Running in Place, Tortoises Needed and That’s Rich. Follow Dick on Twitter @QuinnsComments.

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Off Target

ALBERT EINSTEIN reportedly once said, “Everything should be made as simple as possible, but no simpler,” or words to that effect.

When it comes to investing, I have always believed that the simplest approach is the best approach. But in recent years, a new type of investment has, I believe, crossed over into the “too simple” category.

This new type of investment: target-date mutual funds. If you aren’t familiar with them, target-date funds are mutual funds that typically buy other funds. For example, a target-date fund might be comprised of stock funds and bond funds, with the specific mix geared to one’s expected retirement date, which is the target date specified in the fund’s name. For workers early in their career, the mix might be 90% stocks and 10% bonds. But over time, as the worker gets closer to retirement, the composition will shift, automatically becoming more conservative. Owing to their simplicity, target-date funds have seen sharp growth over the past 10 years.

In theory, this type of all-in-one offering is very appealing. But there are four reasons I would be cautious about investing in one:

First, target-date funds make it difficult to know what you own. Research has shown that the most important driver of a portfolio’s risk and return is its asset allocation—that is, the mix of stocks, bonds and other assets. As a result, asset allocation is arguably the most important portfolio metric to monitor. But target-date funds make it difficult to track this key metric because they contain a mix of asset classes—and, worse yet, a mix that’s constantly changing.

Second, the composition of these funds may be a poor fit. Choosing an investment based on your age is like choosing clothing based on your age. It might be okay when you’re an infant or a toddler, but it makes little sense as you get older. Yes, there is some correlation between age and investment needs, but your age is just one piece of the puzzle. Other factors include: the size and composition of your other assets, your eligibility for Social Security or a pension, your spouse’s retirement timetable, whether you expect an inheritance and much more.

Third, they complicate tax planning at every stage of your career. Suppose you have a 401(k) and a taxable account and you want to purchase $1,000 of stocks and $1,000 of bonds. Should you put the stocks in your 401(k) and the bonds in your taxable account, or the other way around?

Even though you would be purchasing the same investments in either case, the decision would have a big impact on your tax bill. In many cases, investors will find they’re better off pursuing tax-efficient stock strategies in their taxable account, while holding bonds in their retirement account. This sort of asset location is a valuable tax planning strategy. But by creating an inseparable link between stocks and bonds, target-date funds hamper your ability to employ it.

These tax problems become especially thorny as you get older—assuming you hold a target-date fund in a regular taxable account. The funds assume you’ll want to sell stocks and buy bonds as you get closer to retirement. For many people, this will make sense. But suppose you don’t want to do that. Maybe your portfolio is large enough that you can afford more risk. Or maybe you have a pension or other secure sources of retirement income. In all of these cases, the target-date fund will be working against you, selling assets and generating unnecessary tax bills.

Target-date funds might also work against you once you enter retirement—again, assuming you hold your fund in a taxable account. Suppose you want to withdraw $50,000 to meet your expenses this year. To minimize the tax impact, you would want to sell investments that have the smallest unrealized gains, and perhaps simultaneously donate to charity those investments with the greatest unrealized gains. For most people, this might mean selling bonds and donating stocks. This is a powerful strategy. But when you own a target-date fund, your ability to do this is limited because of that inseparable link between stocks and bonds.

Finally, target-date funds often carry higher fees. In many cases, target-date funds are no more expensive than their component parts. That’s as it should be. But I have seen several cases in which target-date funds were considerably more expensive than their constituent parts. Like paying $3 to buy two $1 bills, this sounds illogical and I would even call it unfair, but it happens.

Fortunately, there’s a solution: If you are considering a target-date fund, instead simply purchase the constituent funds independently. While this will require a little more effort, I believe it’s well worth it.

Adam M. Grossman’s previous blogs include Just Like Warren, Any Alternative and Buy What You Know . Adam is the founder of  Mayport Wealth Management , a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter  @AdamMGrossman .

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