Jonathan Clements's Blog, page 460

Not Completely Worthless

INSURANCE IS A WAY to get others to shoulder devastating financial risks that it would be foolish to shoulder on your own. That’s why young parents with few assets need heaps of life insurance—but also why buyers of televisions shouldn’t get the extended warranty. Because the potential financial loss is modest, I’ve often argued that folks should skip not only extended warranties, but also trip-cancellation insurance.

But readers have pushed back, arguing that both types of insurance can make sense—in two particular situations. First, trip-cancellation insurance is a smart idea for seniors, especially when booking expensive vacations, because illness could prevent them from traveling. Second, extended warranties are valuable when buying anything with a screen—such as a phone, tablet or laptop—for a child below, say, age 15. As I look across the living room at my stepdaughter’s cracked iPad, I have to admit it, the extended warranty probably would have been a good idea.

Getting Up There

LIFE EXPECTANCY HAS INCREASED SHARPLY over the past century—if you consider life expectancy as of birth. But if you look at life expectancy as of age 65, which is what matters for retirees, the improvement for the broad U.S. population hasn’t been nearly so impressive, as I discuss in my latest newsletter.

But it’s a different story if you look at more affluent Americans, notes one of my e-mail correspondents, Bob Frey, a financial planner in Bozeman, Mont. He sent along a spreadsheet put together by actuary and financial planner Joe Tomlinson. The spreadsheet details life expectancies as of age 65, but uses data for the wealthy, healthy portion of the population that is likely to purchase income annuities from insurance companies.

The table shows that, as of 2015, the life expectancy for a 65-year-old male is age 88 and for a female it’s age 90. But the real eye-opener is the figure for couples. If both husband and wife are currently age 65, there’s a 50% chance that at least one spouse will live until age 94—and a 25% chance that one spouse will still be alive at age 98.

“While life expectancy increases for the general U.S. population may have slowed a bit, the life expectancies of healthy, well-educated folks have continued to increase at a fairly rapid rate,” Frey writes.

There are two key implications. First, given those life expectancies, it isn’t surprising that income annuities aren’t as generous as many potential buyers would like—but the numbers also suggest that buying more lifetime income could be a smart move for healthy individuals. Second, and most important, the case for delaying Social Security benefits, so you get a larger monthly check, is even stronger than many folks imagine.

Targeting Lower Costs

IN A WORLD OVERFLOWING with mutual funds, I’d like to see Vanguard Group add a few more. How about 12?

I’m a fan of target-date retirement funds, which offer diversified portfolios geared toward folks retiring at or near the year specified in the fund’s name. But Vanguard’s existing 12 funds have a big problem: their annual expenses.

To be sure, the funds’ costs are tiny compared to most others available. Suppose you buy Vanguard Target Retirement 2030, which recently had a mix of 44.8% Vanguard Total Stock Market Index Fund, 29.5% Vanguard Total International Stock Index Fund, 18% Vanguard Total Bond Market Index Fund and 7.7% Vanguard Total International Bond Index Fund. The 2030 fund doesn’t charge any expenses itself, but you incur the expenses of the underlying funds, which come to 0.17%, equal to 17 cents a year for every $100 invested.

Problem is, the 2030 fund owns the Investor Share class of these other funds, each of which typically has a $3,000 minimum investment. But the expenses are even lower for the Admiral Share class, which require a $10,000 minimum investment. The upshot: I can build my own 2030 target-date fund by purchasing the Admiral Shares of the underlying funds, and my weighted average expenses would be 0.09%.

Now imagine that Vanguard offered its target-date funds with an Admiral Share class. To do this, Vanguard would have to launch a new set of funds, rather than adding an Admiral Share class to its existing funds. The reason: As funds-of-funds, Vanguard’s target-date funds pick up the expenses of the underlying funds, so there’s no way to have two share classes with different pricing. 

Setting up new target-date funds might sound troublesome, but Vanguard has done it before. In June, Vanguard launched 12 target-date funds that are available through employer retirement plans. Each fund charges a slim 0.1% a year.

Suppose funds like these were available to individuals who pony up, say, a $10,000 or $20,000 investment minimum, with the funds owning the Admiral Share class of the underlying funds. Suddenly, my financial life would be a whole lot easier. Instead of buying the four underlying funds, I could purchase a single target-date fund and make it my core holding. For added diversification, I would probably add smaller positions in a few other funds, such as investing in small-cap international, real-estate investment trusts and U.S. small-cap value. Still, my portfolio would be notably simpler than it is right now.

Smarter But Homeless

SOARING STUDENT DEBT is putting the kibosh on another major financial goal: buying a home. According to a study by researchers at the Federal Reserve Bank of Cleveland, 40% of those age 18 to 30 have student debt, up from 27% in 2005. For these borrowers, the debt burden is staggering, with student loan payments estimated to devour more than 20% of their income in 2015.

With so much of their income devoted to servicing student loans, these young adults are less likely to buy a house, because they can’t afford to take on a mortgage. Lenders typically don’t want mortgage borrowers to have total monthly debt payments that are above 36% of pretax monthly income. The upshot: The Cleveland Fed researchers found that just 7% of those age 18 to 30 own a home, down from 11% a decade ago.

What’s to be done? Parents may not be able to help with college costs. But they can help by offering sound advice. If your children are unlikely to have high-paying careers, you should encourage them to attend colleges where they are less likely to end up with crippling amounts of debt. For instance, you might suggest they attend a nearby college, so they can live at home and avoid the cost of room and board, which accounts for half of the total tab incurred by in-state students at state universities. Alternatively, you might encourage your teenagers to attend a local community college for two years, and then transfer to a more prestigious college, from which they can then graduate.

It's Twins

THIS IS A DOUBLE birth announcement. First, my latest newsletter is available. It discusses how to measure global wealth, longevity risk, tax extenders, psychic income, Vanguard's new international dividend fund, and more.

Second, the Jonathan Clements Money Guide 2016 is now on sale through Amazon.com. I created this early paperback edition, with data through yesterday's market close, so that it would be available for holiday gift-giving.  An updated version, with market and economic data through Dec. 31, will go on sale on Jan. 1. This later edition will be available as both a paperback and an e-book.  

My Money, Book and Newsletter

HOW DO I HANDLE MY OWN MONEY? Check out my latest article in Financial Planning magazine. This is a topic I tackle more extensively in the Jonathan Clements Money Guide 2016. The early paperback edition, created so that it’s available for holiday gift-giving, should go on sale in the next day or two.

Also this week, my next newsletter will be sent out. I’ll post the content to this site. But if you want to receive my free newsletter directly, send me an email.

Numbers to Live By

CYNICS SAY THERE ARE THREE KINDS of falsehood: lies, damned lies and statistics. Yet the right number can pack a mighty punch—and the financial world is full of them. Here are five examples:

Most folks don’t beat the market. Consider the miserable performance of most mutual funds. Standard & Poor’s found that 75% of actively managed U.S. stock funds failed to beat the market over the decade through June 30.

Stocks create amazing wealth, given enough time. Over the 40 years through Sept. 30, global markets climbed 9.6% a year, as measured by MSCI’s World Index. That’s enough to turn $10,000 into almost $400,000. An obvious conclusion: If you give up self-defeating efforts to beat the stock market, and instead simply capture the market’s performance using index funds, you’ll likely be thrilled over the long haul.

Houses don’t appreciate much. According to figures from Freddie Mac, U.S. home prices climbed 4.7% a year over the 40 years through Sept. 30, not much ahead of the 3.7% inflation rate. Sound grim? It isn’t as bad as it appears: Homes may not climb much in value—but they do give you a place to live.

Money doesn’t necessarily buy happiness. In 2014, 32.5% of Americans described themselves as very happy, below the 42-year average of 33.3%, according to the General Social Survey. Over this 42-year stretch, inflation-adjusted per capita disposable income rose 110%.

Many Americans face a grim retirement. The Employee Benefit Research Institute’s 2015 Retirement Confidence Survey found that 52% of workers age 55 and older had savings of less than $50,000. This figure excludes the value of their home, Social Security and any defined benefit pension plan. Yes, money doesn’t necessarily buy happiness. But make no mistake: Not having money could make you miserable.

Yielding Nothing

IT’S BEEN A ROUGH YEAR for yield chasers. But the damage can’t be blamed on a general rise in interest rates, which would have driven down the price of existing bonds. Today, the yield on the benchmark 10-year Treasury note is barely above where it stood at year-end 2014.

Instead, the dreary results stem from concerns about credit quality. Those drawn to the fat yields on Puerto Rican municipals have been rewarded with tumbling bond prices and the threat of default. This year’s biggest losers also include master limited partnerships, a high-yield play on the energy sector, which are down roughly 30% as oil production has fallen off.

Meanwhile, bank loan funds and high-yield junk bond funds are treading water or worse in 2015, as fat yields have been offset by falling share prices. Take the Fidelity High Income Fund. It’s currently boasting a yield of almost 7%. But even with fat dividend payments, the fund is posting a loss for 2015, down 2.7%, thanks to the slide in the fund’s share price.

Will 2016 be kinder? It’s impossible to say, in part because so much depends on how the economy fares. But for now, the margin of safety doesn’t look great.

Again, take high-yield junk bonds. During 2015, the yield above Treasurys has widened from 4.9 to 6.3 percentage points. That means today’s buyer has a bigger cushion, should we see a wave of bond defaults. On the other hand, the average spread historically has been 6 percentage points, so the current buffer isn’t exceptionally large, plus the spread would look a lot tighter if Treasury yields weren’t so low.

Bonds, Bonds and More Bonds

STOCKS GET ALL THE ATTENTION, which seems a tad unfair. The value of bonds worldwide is some 35% greater than the value of all stocks—plus many other parts of our financial life look suspiciously like bonds. How so? Think about all the streams of steady income that folks collect.

We pull in interest from bank products like savings accounts and certificates of deposit. We collect Social Security retirement benefits. If we’re lucky, we are the recipients of a traditional employer pension plan. Most important, we have our regular paycheck.

The more we receive from paychecks, pensions, Social Security and other bond-like streams of income, the more risk we can take with our investment portfolio, by tilting toward stocks. At times of stock market turmoil, when we’re feeling unnerved, we should focus not only on the money we have in conservative investments, but also on the various streams of income we collect. The key question: How long could we go without being forced to sell shares? In all likelihood, it’s many years, if not decades—which means there is no rational reason to fret over the stock market’s decline.

Our financial life doesn’t just include many bond-like streams of income. We also have negative bonds, otherwise known as our debts. While bonds pay us interest, our debts cost us interest. Typically, our debts charge us a higher interest rate than we can earn by buying bonds, because we’re considered less creditworthy than, say, the U.S. Treasury or IBM. One implication: It often makes sense to pay down debt rather than to purchase bonds, because the interest payments we avoid are greater than the interest we could have earned.

Settling for Six

SINCE RETURNING TO LIFE as an ink-stained wretch early last year, I have been talking about the likelihood of modest stock returns. My best guess: A global stock portfolio might notch 6% a year over the next decade, while inflation runs at 2%.

It turns out that the person I admire most on Wall Street, Vanguard Group founder John Bogle, also has modest expectations. This is no great surprise: How I think about stock returns has been greatly influenced by Jack’s writing.

Back in 1991, Jack presented a delightfully simple method for analyzing stock returns. He distinguished between the market’s investment return and its speculative return. The investment return consists of the market’s initial dividend yield, plus growth in earnings. What about the speculative return? That’s reflected in the varying price put on those earnings, as measured by the market’s price-earnings ratio, or P/E.

When investors are exuberant, the P/E ratio might climb above 20. When they’re fearful, it could fall below 12. But if there’s no change in the P/E, then all you collect is the investment return: You pocket the dividend yield, plus the price of your shares should march higher along with earnings.

So what does the future hold? In an article just published in the Journal of Portfolio Management, Jack and co-author Michael Nolan note that the U.S. market’s initial dividend yield is around 2% and that “earnings seem likely to increase at around 5%, or perhaps even less, during the coming decade.” That would put the market’s investment return at 7% a year. But they say a decline in the P/E ratio toward historical norms might knock one percentage point a year off the market’s return, “reducing stocks’ annual investment return of 7% to 6% per year in nominal terms.”

What should investors do? That’s easy. Americans need to save like crazy to compensate for the market’s likely modest gains—and they should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.