Gary Gamma: Hello, I’m Garry Gamma. Welcome to today’s live webcast on how to make the most of your retirement savings. It’s a question we hear from retirees every day at Vanguard: “How do I keep from burning through my retirement nest egg?”
Today, we’ll talk about what you can do to help preserve your savings and minimize taxes in retirement.
Joining us today to discuss these important topics are Michael DiJoseph of Vanguard Investment Strategy Group, and Kahlilah Dowe of Vanguard Personal Advisor Services®.
Good afternoon. Thanks for joining us.
Kahlilah Dowe: Thanks for having us.
Michael DiJoseph: Glad to be here.
Gary Gamma: All right. We’ll spend most of our broadcast today answering your questions. Two items I’d like to point out first. There’s a widget at the bottom of your screen for accessing technical help. It’s the yellow widget on the left. And, if you would like to read some of Vanguard’s thought leadership that relates to today’s material, or view replays of past webcasts, click on the resource list widget on the far right of the player.
Before we get into our discussion, we’d like to ask our audience a question. On your screen now, you’ll see our first poll question, which is: “Do you have plan for withdrawing your retirement savings?” Yes or no? Think about that, respond, and we’ll share your answers in just a few minutes.
But, Michael, why don’t we jump right into the questions until we have some results?
The first question we have is from Michael from Washington: “What are alternatives to the 4% rule of thumb for withdrawals from savings?” So we know a lot about the 4%.
Michael DiJoseph: Sure. Great question to start us off today, as I think that developing a prudent spending rule is the first step to a successful retirement.
And so, when we talk about the 4% spending rule, let’s talk about what that actually means. And so we like to look at spending rules as a type of a spectrum, and I think we just so happen to have a chart of the spectrum of spending rules. And so, 4% spending rule is what we would call an example of the dollar plus inflation method. Meaning you would take a percentage of your portfolio in the first year and then increase it by inflation each year thereafter.
And so kind of the opposite of that on the far end of the other side of the spectrum would be what we would call the percentage of the portfolio rule, which means you take a set percentage of your portfolio every year.
Now the benefits of the dollar plus inflation or 4% rule is that it leads to very stable spending year over year. You’re just increasing your spending by inflation every year. Now the downside to that is it’s completely insensitive to the markets.
Now on the other end of the spectrum, the percentage of portfolio, it’s completely sensitive to the markets but you get very volatile spending year to year.
And so, we’ve also introduced what we call the dynamic spending rule with a ceiling and floor, which is kind of a hybrid of both. We think it allows you to benefit from some of the spending stability of rules like the 4% rule, while also allowing some fluctuations based on market returns. And it basically means that you’re increasing your spending in good years, and in exchange for that, you’re decreasing it ever so slightly in not-so-great years.
Gary Gamma: Well, we have the results to the poll. So, basically, about 51% said, yes, they have a plan, 49% said no. What would you suggest for the people that don’t have a plan yet?
Michael DiJoseph: I would suggest they get a plan.
Kahlilah Dowe: You know, I would say so. Most of the clients that I speak with, they have an idea of what they want to do. And when I say an idea, they have an idea of what they want to spend, but they don’t always know how to go about doing that.
So I know I need to spend let’s say $50,000 per year. Do I take it from my taxable account, do I take it from my IRA accounts? What’s the best way to go about doing that? And I know we’ll get into some of that later, but it doesn’t surprise me that about 50% have some sort of plan.
Gary Gamma: Okay, great. We want to ask you one more question before we go back to our questions. “How many different financial service providers do you use for investing your retirement savings?” “One, two or three, or more than three?” Think about that, respond, and we’ll get to those answers in just a minute.
So let’s take another poll question, excuse me, another question. And this one’s about sequence of withdrawals; something else we hear a lot about. And Bob from North Carolina says, “Pensions/Social Security versus taxable versus tax-advantaged. I asked the same questions for years and never get a great answer. It seems like the pension and Social Security component are not being taken into account.” What’s the thought there?
Michael DiJoseph: All right, well, let’s answer today then for him. So we would say, take a step back before we decide Social Security versus pension versus portfolio withdrawals, potentially. We would say that the Social Security, pension income, maybe other employment income, things like that, should go—kind of what we were talking about with the plan—we should use those to determine, these are my income sources. Take a nice hard, long look at what your expenses are. And to the extent that there is a shortfall there, then we would say, “Dip into the portfolio.” But I don’t think we would say to spend from the portfolio before taking Social Security or pension, because you’re going to get taxed on those anyway. So if you’re reinvesting them, you’re going to end up getting double-taxed.
So, again, to the extent that there’s a shortfall from there, then we would say, “All right, well, let’s turn our eyes to the portfolio now.” And that’s where we’ve kind of developed a methodology for those who are really seeking to maximize income in retirement. We would basically say, “Spend your RMDs first. They’re already required by law if you’re at the age where that’s applicable to you. And, again, if you were to reinvest them and spend them later, you’ll get double-taxed again.”
Now from there we would say, “Spend the flows from the taxable aspect of the portfolio.” So things like dividends, income payments that you might be getting from assets held outside of your retirement accounts. And this is where it might get a little bit different.
So I think the story kind of goes, “Well, I’ve spent my whole life saving for retirement. Where? In my retirement accounts. Right? So, obviously, now that I’m retired, I’m going to spend from my retirement accounts.”
But the key here is that those accounts are often tax-advantaged, emphasis on “advantaged.” And we would say that before dipping into those, again, with the caveat that you’re looking to maximize your lifetime income, we’d say, “Spend from that taxable portion of the portfolio before dipping into those assets. And now keep an eye open for things like tax-loss harvesting to the extent that you can, minimizing gains to kind of minimize the taxes when you actually spend from that portion. But do that, allow the tax-advantaged to compound over longer periods of time before dipping into those retirement assets.”
And then from there, to answer the question about tax-free, tax-deferred, meaning traditional versus Roth, we would say, “To the extent that you can, have some kind of insight into your future tax rates. If you’re going to have a higher tax rate in the future, you probably want to spend the traditional assets first and kind of take advantage of the lower tax rate today, or vice versa.”
The reality is most people don’t know for sure, so we would say, “Maybe practice some sort of tax diversification, where you’re spending a little bit from each type of bucket.”
Gary Gamma: Yeah. And I think it’s important, your first answer, it kind of goes along with this, which is, “If you’re really tight on that income, maybe when the market’s doing well, you can spend a little more, but then keep an eye on how you’re spending when the market’s not so good.”
Michael DiJoseph: Absolutely! To the extent that that’s possible and you have the flexibility.
Gary Gamma: Well, we have the results from the next poll question. So, again, we said, “How many different financial service providers do you use for investing your retirement savings?” It looks like the most popular answer was “Two to three”— about 55% of our audience. Thirty-one percent said they have one provider; 14% said they have more than three. Is there anything that we talk to investors about when it comes to the number of providers they’re using?
Kahlilah Dowe: Yeah. So that’s about what I see. Most investors who work with us have, certainly, more than one. And I would say on average I see about two or three.
One of the things we’re finding is that they’ll tend to consolidate more as they near retirement and, certainly, once they’re in retirement, they start to look for ways to consolidate and often times it’s here with us. But, yeah, not surprising.
Gary Gamma: What are the main reasons that we talk to investors about for consolidating their accounts?
Kahlilah Dowe: Well, simplicity is one of them, because there may be a lot more record keeping, especially when you get to the point where you have required minimum distributions that you have to take at different institutions. And so they may want a more effective way to keep track of the required distribution. And then, also, they may decide to work with an advisor on their portfolio, and they want the advisor to have a better idea of what their overall portfolio looks like. So that’s often a reason why they consolidate as well.
Gary Gamma: So nothing inherently wrong with having more; it’s just going to be more work on their part.
Kahlilah Dowe: Right.
Michael DiJoseph: Yeah.
Gary Gamma: Okay, let’s get back to our questions here, and we’ll certainly take follow-up questions on any of these topics as they might come in. Patrick writes—excuse me, Sue from Michigan writes, “What should I do if my required minimum withdrawal is more than what is needed?”
Kahlilah Dowe: Yes. So we see that quite often, where you have to take a certain amount out of the IRA for the required distribution, but it’s more than what you actually need to cover, let’s say, your day-to-day living expenses. And so, you have a few options.
Of course, you have to take the money out, and you have to pay the taxes, but often times it’s reinvested into a taxable account after the taxes are paid. So you reinvest the difference.
Sometimes they’ll do charitable contributions. So you have the option of taking it out and, in this case, you may even get a tax break, where you can take the money out and rather than reinvesting it, or let’s say spending it, you could gift to a charitable, a qualified charitable institution, in which case you may not have to pay the taxes on that.
And then one of the things that I often look at is, when you think about your day-to-day spending, you may find that you don’t need it to cover your living expenses, but often times I’ll recommend using it to replenish, let’s say, a cash reserve. So if you’ve made a large purchase over the last year and maybe you’re running a little short on cash, that may be a good opportunity to replenish it.
Gary Gamma: Yeah. So we don’t advise taking a trip to [Las] Vegas?
Kahlilah Dowe: Maybe.
Michael DiJoseph: You know, I think this goes back to what we were talking about, about having a plan too. So if you know that you’re going to get to 70-1/2 and maybe not need those RMDs, maybe you could have examined that a little earlier and there could have been some potential first something like a Roth conversion, for example, where you can say, “Well, you know, I have a period of time where my tax bracket’s a little lower, maybe in my sixties, and I can kind of accelerate some of the taxes on those IRAs and 401(k)s that you have to take distributions from.” So that way you don’t actually have to do it when you’re seventy.
Kahlilah Dowe: Right. And often times there are opportunities; I work with investors who retire sometimes before Social Security kicks in, and they may have cash that they live off: they may have portfolio distributions that they live off; and that can be a prime opportunity to think about doing Roth conversions, especially if you think that the RMDs will be more than what you actually need.
Gary Gamma: Yeah. So that’s good. I mean, I think retirees generally are thinking mostly about just managing their money as they’re taking it out, but maybe not thinking so much about managing extra that they don’t need. So there are important considerations at that point.
Okay, well now let’s get to Patrick’s question: “I’m in my early sixties and not yet retired. I’ve always heard to keep the bond portion of my portfolio equal to your age. I have been following that for the past ten years but, as I’m getting older and that percentage is getting larger, I wonder if that’s still a valid strategy. So I know John Bogle talks a lot about that. What are our thoughts around that rule of thumb?
Michael DiJoseph: Well, similar to the 4% rule, it’s a rule of thumb, so I think it’s a really good place to start, but like so many other things, it really depends. It depends on the person’s individual kind of unique circumstances.
So, for example, if someone’s maybe a little wealthier, they’re not actually going to be depending on that portfolio to produce income for them. Maybe they don’t need to reduce their risk as much, because they can afford to weather some poor years and the losses.
And on the other end of the spectrum, maybe that money is so important to them that, if they were to take a loss in the equity portion of the portfolio, it could actually change the trajectory of their retirement, so maybe they should have even more than that. But, definitely, a good place to start. But I think everyone needs to look at it in kind of their own light, in view of their own circumstances, and say, “Is this right for me? What would it look like if my portfolio were to go down by a certain percent based on what percent you have in stocks?”
Kahlilah Dowe: Yeah. And I work with investors who think about your age in bonds; I work with investors who keep their age in stocks. So if you’re 60, 60% in stock, or 65% in stock. And it’s not uncommon because often times investors have goals outside of retirement. So this may be my retirement nest egg, but like you said about the spending, I may not need to spend the majority of this, or I may not anticipate spending the majority of this during my lifetime. And so, sometimes they’re investing to maximize what they pass on to heirs, and that can be an argument for being a lot more aggressive.
Gary Gamma: I know there’s a lot of investors that I’ve talked to who are questioning bonds just in general because it seems like the bond market for the short term might have to experience some issues. But we obviously don’t suggest market-timing, so that doesn’t really play a part in this thought process, right? We’re still trying to find out which is the proper strategy for you and get you to work with that.
Michael DiJoseph: Right.
Kahlilah Dowe: Absolutely.
Gary Gamma: Robert from Ohio writes, “A few years ago, after the great recession, I read of a retirement theory that suggested to be in conservative investments as you enter retirement, and then take more risk after, say, five years or so. What do you think of this strategy?” Who wants to tackle that one?
Kahlilah Dowe: So that’s—I haven’t heard that one, but I’m trying to think, under what circumstances could that work? And so, I guess if you have someone who’s expecting to spend significantly more upfront, that may be an argument for being more conservative upfront, and perhaps more aggressive down the line. But what would concern me about that is, it doesn’t really account for the uncertainty that the future holds, and could you have unexpected expenses that are significantly higher than you’re expecting down the line? So if you’re anticipating being more aggressive, the reality is you may not be able to do that.
So we typically lead with being more aggressive upfront and getting progressively more conservative as you move throughout retirement.
Michael DiJoseph: Yeah, and I think this is a difference between kind of what I do in my day job and what Kahlilah does. So I spend a lot of time doing research, and that’s one of those things that we have heard people put that out there, kind of in academia. And it might make some sense on paper, but for Kahlilah, who has to deal with clients, I think that would be a tough sell. As people are getting older, more into the years and, potentially, even more dependent on the portfolio, I think it would be a hard sell to tell them, “Hey, we’re going to make you even more aggressive, and if something bad happens in the markets, you’re going to lose even more money as you get older.”
So I think it’s something that might make sense in the laboratory in theory, but maybe not so much when it actually comes to sitting across the table from a client and trying to explain it to them and feeling what that would actually feel like.
Gary Gamma: Right. And then, obviously, he starts out by saying, “After the great recession …” That’s a great way to do it if there’s a recession and the market goes up, but you just don’t know.
Michael DiJoseph: Right.
Gary Gamma: The next question I guess kind of gets to my point previously: “Why invest in bonds when their value will decrease when interest rates rise?” We hear a lot in this point about interest rates rising. So, again, what’s our thought there?
Michael DiJoseph: Yeah. And, we hear a lot about this, and we’ve heard a lot about this for quite a while, but two things: First of all, it’s really hard to predict when interest rates are going to rise. We’re not any good at it, economists tend not to be very good at it, and the market in general tends to be not very good at it. I think we’ve all been kind of sitting around expecting for rates to go up year after year, and it hasn’t really happened. So that’s part one.
Part two is that rising rates for a long-term bond investor are not necessarily a bad thing. So, in reality, if rates were to rise, you could take a hit on the capital portion of a bond portfolio. So as rates rise, bond prices tend to come down in value, but what happens is that you’re also getting a higher interest rate on that bond investment. And so, over a period of time, you tend to actually end up ahead of the game.
So, if it’s, say, 2% today and rates rise to 3, 4, or 5%, as a long-term investor, eventually you’ll be getting 3, 4, or 5% of income coming from the bond fund that will, at some point, make up for that loss that may occur.
And then, finally, I think that we believe that bonds should be used in the portfolio as a diversifier for equity risk, and not necessarily so much worried about what the returns of the bonds are going to be. And we firmly believe that in the event of an equity market downturn or volatility in the markets, that bonds will continue to act as a buffer in that portion of the portfolio.
Gary Gamma: So on that topic of a correction, we have a live question from Mary who says, “I have been hearing in the media that a major correction could be coming soon. Even though my Vanguard accounts are well diversified, I worry about losing a lot and not having a lot of time left to recover. How can you calm my fears?” So, obviously, the media likes to talk about these things because that drives up ratings, but you really still have to focus on the plan we’re talking about, right?
Kahlilah Dowe: That’s right.
Gary Gamma: You’ve been hearing this I’m sure.
Kahlilah Dowe: I’ve been hearing this for a while, for quite some time, for stocks and bonds, that we’re going to see a major correction. And you can’t time it. No one really knows when these corrections are going to happen. I would say that the market is cyclical and that we don’t see market corrections as something that investors need to necessarily avoid. We want to get ahead of it. And when I say get ahead of it, I mean, we want to make sure that your portfolio is invested in a way that’s suitable for you before there’s a correction, so that you don’t have to try and make a move because you believe a correction may occur, even if you’re right about that.
And so what I try to communicate to investors is, it’s more about what you do when those corrections occur. And that’s why we focus so much on rebalancing, because I’ve seen instances where clients have had a significant amount in equities, not because they necessarily thought that was the right asset allocation, but because they felt like the market was going to do well for another year. And so you’re taking a chance on that.
And so my thought is, you want to stick with your long-term goals, and if that means having 50% in equities while equities are doing very well, you may have to give up some of the growth potential. But, the main thing is, you’re not going to lose too much when the markets are down significantly.
Michael DiJoseph: And I think you can kind of put yourself in that position. So if you’re a 50/50 investor today, you take your portfolio and say, “What if stocks went down 20% or 30% or even 40% or worse, what would that look like, what would my portfolio balance be, and how would I be able to handle that?” And if you can’t handle that, then I’d say, “Now is the time to actually work on your plan, and figure out what your risk tolerance is, and adjust it during times of relative calm, rather than potentially making decisions that could end in a poor outcome when things aren’t so calm.”
Gary Gamma: Right. And Mary’s question involved not having enough time to recover. We’re always suggesting that their investments be based on their time horizon. So if you’re doing that properly, then you should be prepared for whatever comes.
Michael DiJoseph: It goes back to what we talked about with the rule of thumb of your age in bonds. So if you are going to lose so much in an equity market downturn that it will negatively affect your retirement and you won’t be able to recover, then it may be a chance to kind of reexamine what that asset allocation is in the first place.
Gary Gamma: Yes. We have a couple more live questions, but I do think this next question I have pivots on the diversification idea. This comes from Norman. He says, “I felt that diversification has actually hurt me in the past, and I honestly wonder if more select concentrated positions should be considered.” So I’m not sure what the context is or how it’s hurt him, but do we hear people talking about diversification having drawbacks, other than maybe you don’t have as much money as you’d like in the hot area from time to time?
Kahlilah Dowe: And I think that’s exactly what it is, and I wish I could ask him, “How has it hurt you?” But, generally, when I think about getting hurt, I think about, “My portfolio has returned less than what the overall market has returned.” And I look at that as, “You were hurt by something that took place in the portfolio.”
But when you look at the different sectors that make up the U.S .market or, let’s say, the markets in general, it’s difficult to know which sectors—maybe almost impossible to know which sectors are going to be the hot sectors or that are going to give you the highest returns. And if you’re looking backwards or if you’re looking at, let’s say, what certain sectors have done last year, and you’re saying, “Well, if I had more in this sector, perhaps I would have done better,” the reality is that you could have ended up doing a lot worse because there’s some randomness to how these sectors perform.
And so I’ve heard that from clients, “If I’d had more”—and healthcare is always the hot one that I hear—”If I had more in health care over the last five years, perhaps I could have done better.”
And so my thought is that you want to make sure that your portfolio is market-weighted. And I kind of stress that in the majority of the conversations that I have, because it avoids or it minimizes the chances of you investing in something and being—losing money disproportionately. So I’ll give an example.
If we look at, let’s say, technology, for example. If we look at the U.S. stock market, it’s made up about 16% of it is in technology stocks. It’s not uncommon that I’ll speak with someone who says, “Well, I work in technology, so rather than 16%, I think I’ll put more like 30% of my portfolio in technology stocks.” I think that’s something that could hurt you more so than diversifying the portfolio, and then finding that there were some sectors that you didn’t have a lot of exposure in that may have done better.
So I still think that—and I think I speak for Vanguard on that—that diversification is the best way to go about investing, and it actually minimizes your chances of being hurt in the market.
Gary Gamma: Yeah. And I think Norman has just given the first half of the definition of diversification. Sometimes you won’t do as well, other times you’ll do better. And in the end, we think that you’ll come out just fine.
Michael DiJoseph: This is one of those interesting things about investing. So elsewhere in life, if I go buy a television or a car, you kind of look back and you don’t really know what could have been if you had made a different decision. But there’s this kind of feedback loop in investing, so you can always look back and say, “Well I did this, but if I had done this, I would have done better.” And there’s always going to be something that you would have done better in, so we start to question ourselves.
But the reality is, the numbers show that even the most sophisticated, the smartest folks out there in investing, really can’t do it day after day, year after year over time. And they often end up taking on more risk to attempt to do so.
So I would look at diversification as more of a risk mitigator, where you’re saying, “He asked about a concentrated position.” So by definition, concentrated positions tend to behave differently than broad markets. So while he may lose out on something here and there, there’s also the potential that it could go the other way against you.
Gary Gamma: Yeah. And when I speak with investors, I often analogize market-timing to changing lanes in traffic—you go back and forth. Do you get anywhere faster? Probably not. So I think he’s feeling the temptation maybe to make these kinds of quick changes.
Michael DiJoseph: That’s my favorite analogy. Every time I move over into the right lane, the other lane goes passing by.
Gary Gamma: All right, let’s look at some of these live questions. Paul asks, “Is there really a need to invest anything in bonds versus simply a combination of cash plus the S&P 500?” So it’s probably important to talk about, there is a benefit to bonds because they don’t move in correlation with stocks or necessarily cash investments.
Kahlilah Dowe: So I would say there’s definitely a benefit to having bonds in the portfolio, but what he said isn’t uncommon. The S&P is probably what I see most when investors think about, “What do I need in the portfolio? Can I just invest in the S&P and leave it at that?”
And in cash, again, very popular because investors, like we mentioned earlier, are waiting for interest rates to go up and sitting on the sideline; the thought being, “Not that I’ll never invest in bonds, but I’ll just wait until they decline some and then I’ll invest in bonds.”
So I think investors, for the most part, see the need to have bonds in the portfolio; they’re just concerned about whether or not this is the right time to have them. And I don’t look at cash as a suitable long-term investment.
So if it’s money that you need for living expenses or if it’s an emergency fund, I think cash is right, that’s exactly where you should be.
But if we’re talking about money that you expect to spend throughout your retirement, we’re looking at 20 to 30 years. I don’t think cash is the right place for that sort of time horizon.
And so, even with the S&P, I think that needs to make up a large portion of a diversified portfolio, but there are other areas of the U.S. and the international stock market that I think are also necessary for proper diversification.
Gary Gamma: I think we’ve had some people asking about the supporting slides that we have. So if you actually update your screen, the resource widget should have those slides in there, if you want to take another look at that.
So another question, this one says, “Are municipal bonds ever right for retirees or near retirees?” Probably definitely not in the retirement account, but outside of that?
Kahlilah Dowe: Right. We actually use them quite often for retirees. And it’s mainly based on the income, but also how their assets are structured because, generally speaking, we try and get more of the income-generating investments, like bonds in IRA accounts. But there are times where, just because of let’s say the asset allocation, they have to have some bonds outside of IRA accounts, in which case we will often use a diversified municipal bond fund within the taxable account. And, again, more so for investors who are in higher tax brackets.
Gary Gamma: Since I said it, can you explain it, probably better than me, why you wouldn’t want to hold muni bonds within an IRA or a 401(k) retirement plan?
Kahlilah Dowe: Well, we expect, generally speaking, municipal bonds will yield less than taxable bonds. And so if you have a choice, you want to try and go with taxable bonds. But the yield is less because you get the tax benefit. So anytime you put assets in an IRA account, you kind of lose that tax benefit of the tax-exempt income, because everything that comes out of the IRA account is taxable as ordinary income.
So, again, to preserve the tax benefit of holding municipal bonds to begin with, they’re most suitable to be held in a taxable account.
Gary Gamma: Okay. Greg asks, “Is there a real rate of return that one should shoot for?”
Michael DiJoseph: I would say that the real rate of return that one should shoot for is the one that they need to reach their goals; so let’s start with that. And we call it kind of your desired versus your required return. So instead of kind of willy-nilly investing and saying, “Well, I’m investing to get the highest possible return to just accumulate wealth,” I think it’s about—and all this stuff keeps on going back to the plan—it’s understanding why are you investing.
“Well, if I’m investing for retirement, maybe get a good understanding of how much money I need to spend in retirement, what I have now, what my situation might look like, and kind of understand what returns do I need to accumulate enough wealth to achieve those goals.” And then you can kind of back yourself into, “Well, what asset allocation could generally produce something along those terms?”
So I think that’s how you get yourself in a situation where you don’t end up with the portfolio that’s maybe too aggressive for you, that you’re not going to be able to actually handle when things might go against you.
And, alternatively, maybe you’re not too conservative either, right? You’re actually taking on enough risk that you are giving yourself a chance to reach those goals.
Kahlilah Dowe: And I would just add to that in speaking with investors about how much they need. And that’s always the hot question, “How much do I need to have in retirement?” And they often have a certain dollar amount in mind where they say, “I want to retire at 60, but I also want to have X amount saved in order to do that.”
And so one of the questions that I have is, “Why do you need that specific amount?” Because the next question that they often have is, “Well what return do I need to get in order to get to this amount?” And like you said, Mike, that can often lead to taking on more risk than you actually need to.
So we always kind of back in and say, “Well, what is it that you need?” And then based on that, we can determine how much you need to accumulate.
And I think the important thing with that also is looking at it before you’re up on retirement, because that will give you the option to make some adjustments. Perhaps you are on track to accumulate less than what you actually need in order to cover your living expenses, in which case you have time to make some adjustments.
Gary Gamma: Okay. Mike’s asking a pretty detailed question, so chew on this one for a second: “There seems to be two pieces of advice that conflict. First, for tax efficiency, keep your stock investments in your taxable accounts and your income investments in your tax-deferred accounts. But then, two, we’ve talked about withdrawing your money in retirement in the taxable accounts first.” Do we hear that a lot, that kind of confusion?
Kahlilah Dowe: Yes, yes, absolutely. So most investors look at the money that they’re going to spend first as the part that should be most conservative, and the money that they’ll spend less is the part that should be most aggressive. And if you think about that logic, that’s really an argument for having more of your stock in the IRA account and more of your bonds in the taxable account.
And we do believe that it’s more tax-efficient to have the stock in the taxable account because it doesn’t give off as much income. Generally speaking, the income that it does give off is taxed at a more favorable rate, so we stick by that.
But when you get to the point where you need to spend, and I think this is the part that confuses them, when you get to the point where you say, “Okay, how do I turn this into a source of income?” Well, you’re looking at taking the income from the dividends and interest. But then, what if you need more than that? What if you need to sell some investments? Then you’re looking at selling stock. And I think that’s the part that can be confusing because, “What if I have to sell stocks while they’re down?”
That’s really where it comes down to the rebalancing in the portfolio, because if you have all of your stocks in the taxable account and you sell those stocks to cover living expenses, then you may have to rebalance and get some stock in the IRA account, and you may have to look at selling bonds in the IRA account. But I think the most important thing is that the asset allocation stays intact.
So we wouldn’t want you to now have significantly less in stocks because you’re spending from the taxable account. So you’ll have to rebalance the portfolio in the IRA account to make sure that you’re not changing the asset allocation.
So it’s a little bit more work, but we think, over time, you come out ahead by structuring it that way.
Michael DiJoseph: I would say, too, we’ve talked about kind of decreasing your equity exposure over time—the rule of thumb, my age in bonds, for example. So it’s what we would call a glide path, meaning your asset allocation kind of slowly gets a little more conservative over time. And that’s one way to accomplish it, right?
So it’s not just saying, “When you say keep your asset allocation steady by rebalancing it,” it doesn’t necessarily mean when you started spending this was your asset allocation, and you can’t change that over time because, naturally, it’s going to become a little more conservative.
So by selling off some of those equities, if you have a properly—what we would call “asset located” portfolio, you can kind of naturally do that while minimizing transaction costs potentially as well.
Gary Gamma: Okay. We have a question from Gary: “Should gold, silver, or other precious metals be part of one’s portfolio?” Vanguard has a gold and precious metal fund so, obviously, we think it’s a good investment, but what are the recommendations there?
Michael DiJoseph: I believe our gold and precious metals fund [Vanguard Precious Metals and Mining Fund] invests in kind of broad-market, publicly traded securities as part of the equity market. So as far as the commodity itself—gold, silver, things like that—we generally wouldn’t advise having that in a portfolio, just because it doesn’t behave the way that other investments behave; it doesn’t generally kick off income; it’s not totally predictable as far as how they’re going to do.
For some, it may work as a diversifying asset, but it’s not something that I believe that we would say, “You definitely need this in your portfolio.” And then, for the example of the fund, we would say, “Utilize that as part of a broader strategy.”
And it goes back to what we talked about with a concentrated portfolio, you may think that maybe that will do better and it’s a form of market-timing, which may or may not work out, but it also could go against you very easily as well.
Gary Gamma: Okay, back to these questions. Kahlilah, how can you plan for those unexpected expenses like a medical emergency or the need for a new car?
Kahlilah Dowe: Yes. So that’s a good question, and it’s one of the top questions that I see going into retirement: “Now that I no longer have income coming in, let’s say from earned income, what if something really unexpected comes up, what should I do?”
And I think for that, it comes down to having a cash reserve. That’s the main thing. Making sure that you have enough liquidity that if those types of expenses come up, that you don’t have everything invested in the market. So that’s one thing.
When it comes down to medical expenses, that can be tricky because they can be really unexpected and they could be very high. Many investors will use health savings accounts as a way to save specifically for medical expenses that may come up, and there may be some tax advantages to doing that. So that’s also one thing I’d say to consider.
One of the things I noticed that retirees, or let’s say preretirees—those coming up on retirement let’s say within the next three years or so—they’ll actually have medical expenses as one of the budget line items. So you may, let’s say, just to give an example, $500, for example, $500 a month is allocated for medical expenses.
And you may not have those expenses to come up every month, but it’s almost as though they’re just building up kind of a cash position just in case those things come up. So that’s a few ways that you could approach it.
Gary Gamma: Mike, Shawna from Utah writes, “I have about $100,000 that I want to keep in cash as an emergency fund if the market drops, and we don’t want to withdraw funds during the market downturn. I would appreciate suggestions of a safe and/or liquid place to put this money during retirement.” I know we can’t give advice, but I think we can kind of speak to the spirit of what she’s looking to do there.
Michael DiJoseph: Yeah. So I would say safety and liquidity are relative terms, right. We would say it’s relative to cash. So when you think about that, I’d say look at things like CDs, which are generally, up to a certain amount at least, insured by the FDIC, the federal government. And then look at what we would call money markets. So they’re maybe they’re not quite as safe as cash, but very similar. They invest in extremely short-term, extremely high-quality bonds to the extent that you could afford maybe a little bit of volatility in there. Then we would say maybe look toward short-term bonds.
But, as you kind of move away from cash towards these things, you’re introducing potentially at least a little bit of volatility. But for an emergency fund, I don’t think cash is necessarily the worst place. I wouldn’t say that, again, for an emergency fund specifically, maybe you shouldn’t actually be looking for something with a better return.
Gary Gamma: Steel from Texas writes, “How to minimize taxes using taxable funds, traditional IRA, and Roth IRA investments.” Do we want to pivot and talk about taxes a little bit and how to minimize taxes using those instruments?
Michael DiJoseph: Well I’ll start with this. So if we’re talking about retirement today. So if we’re talking about savings for retirement, I would say, before saving anything in a taxable account, unless it’s part of an emergency fund or anything like that, I would say utilize to the maximum extent possible those tax-advantaged accounts, right. If you can, max them out because that’s money that has an inherent tax advantage to it.
From there, I think Kahlilah got a little bit into what we would call the “asset location,” about trying to figure out, “How tax efficient are my different types of assets,” and sheltering them to the extent that you can. But, I mean, the way I would answer that would be, if saving for retirement, maximize your wealth by taking advantage of tax-advantaged, tax-free, tax-deferred accounts.
Gary Gamma: And you talked earlier about tax diversification. I think that’s important for people whenever they’re looking at Roth IRA versus traditional, Roth 401(k) versus traditional. It’s really, people have a hard time estimating what their tax bracket’s going to be in retirement. So can you talk a little bit more about that concept of tax diversification?
Michael DiJoseph: Sure. And, it’s something I practice personally, right. I have a ways to go for retirement, and I don’t know what the tax structure is going to look like. And I don’t know what my personal taxes will look like. What we do know is that, generally speaking, a traditional IRA, when you take out the withdrawals, you’re going to have to pay taxes on it. On a Roth IRA, you pay your taxes up front and then you don’t have to pay taxes on it when you withdraw it later on.
So if I think that my tax bracket today is lower than it’s going to be in the future, maybe I would say, “All right, well I’m going to pay taxes today on my retirement money, put it in the Roth, and then I can withdraw it later on in life, in retirement, when my tax bracket may be a little lower.”
But, there’s certainly a lot of people out there that just have no idea what that’s going to look like, so we would say, you know, diversify. Just like anything else with investing, with the diversification, you can kind of protect yourself against something going in the wrong direction from you while getting the benefit of it going the right way.
Gary Gamma: Yeah. And you can practice tax diversification with withdrawals too. Take some out of both sources; you talked about that as well.
Michael DiJoseph: Absolutely. Yeah.
Kahlilah Dowe: And that’s one of the things I see fairly often, and we actually work with clients in this capacity where we normally have a draw-down order where we say the taxable accounts first, then the IRA accounts at 70½, and then the Roth IRAs.
But often times there are opportunities to use some of the tax-free money before you have exhausted just the traditional IRA. And some of my clients are trying to, let’s say minimize income in certain years. Let’s say they realize a significant amount of capital gains, or let’s say they are in a situation where they may have Medicare tax premium that they’re trying to avoid, they’re kind of right up against the cusp.
We can use the Roth IRA, and I think that’s really the essence of the diversification. It just gives you more options where you could use the Roth IRA, in that example, to lower the income that you would otherwise have to have to cover expenses.
Michael DiJoseph: Right.
Gary Gamma: Okay. Kahlilah, you’re in Personal Advisor Services, you can maybe toot your horn on this one. This question says, “You have talked about many strategies. Would a personal advisor develop an overall withdrawal plan including all of my investments, both Vanguard and other, and consider my Social Security income; also rebalancing as we withdraw; also reinvest strategy if I do not need the RMD?” So talk a little bit about some of those things.
Kahlilah Dowe: So we do pretty comprehensive financial planning. So we work with investors on a withdrawal strategy for the Vanguard as well as the non-Vanguard investments. Also rebalancing—I’m trying to remember everything that she gave there—but also the rebalancing.
And when we think about the withdrawal strategy, we absolutely consider any income sources that you have, so pension, Social Security, and even, like I said, accounts that are outside of Vanguard.
The rebalancing can be challenging though when you have assets in other locations. And I say that because when we are rebalancing the portfolio, we’re working within the portfolio that you have here at Vanguard.
And so if you want to be diligent in rebalancing your overall portfolio, then you would have to do that in the other institutions.
Gary Gamma: Right. And reinvestment strategy if she doesn’t need the RMD—obviously, that’s part of what we’re trying to do.
Kahlilah Dowe: Right. So that’s part of it in terms of managing the withdrawals, but then also in just managing the overall portfolio because we’ll use that as an opportunity to fine-tune the asset allocation in many instances.
Gary Gamma: Yeah, okay.
Michael DiJoseph: It goes back to our poll question about having your assets at different financial institutions. It really does simplify things, especially if you’re in some kind of advice relationship.
Gary Gamma: Yeah. And on our resource page, the widget, we have a link to Vanguard Personal Advisor services, if any of the audience wants to take a closer look at that.
Back to the questions. Michael writes, “All of my retirement savings are pre-tax dollars. What can I do to avoid paying tax every time I use this money?” I don’t think we can help him avoid it, but we’ll certainly talk about minimizing it, right?
Kahlilah Dowe: Yeah, that’s the challenge. So let’s say you’re already into retirement and you already have this account set up. And I see that often coming out of 401(k)s, where investors may roll over a 401(k). They’ve saved in that account for, really, their lifetimes. And so that’s what they have available to spend from. And it can be a tax burden because of the ordinary income tax that is assessed on those distributions.
Once you get to 70½, obviously you have to take the money out, and there’s really no way of avoiding taxes at that time unless—and we’re seeing this more and more—where investors will do charitable donations with the money if they don’t need it to cover day-to-day living expenses and they are charitably inclined to begin with. So that’s always an option.
Roth conversions, that’s an option as well. It’s not right for everyone but many investors who are in that situation will consider doing Roth conversions where you’re not avoiding the taxes; it’s more of an issue of when will you pay the taxes?
And I think we touched on this a second ago where, if you think you may be in a higher tax bracket down the line, then it may make sense to consult a tax advisor and considering doing a Roth conversion and lowering the distributions, the required distributions, going forward.
Gary Gamma: All right, Mike, I’ve got a good one for you.
Michael DiJoseph: Uh oh.
Gary Gamma: Vince in South Carolina, said, “Why doesn’t anyone address the time value of money when urging people to delay their Social Security to age 66?” And then he goes on to give an example: “If you start taking the money at 62 and invest it, you’ll come out ahead, assuming a reasonable rate of return of 4%–5%.” I guess that’s part of the answer—not necessarily the easiest return if the markets are flat.
Michael DiJoseph: Right, interesting. So Social Security: It’s a question we get all the time; I’m sure you get it all the time and, arguably, one of the most important decisions that someone’s going to make in your retirement. So I’m a math guy; let’s take a look at the math.
So most people have a full retirement age, meaning when your Social Security benefit is at, we’ll call it 100%, right, your standard benefit. And it’s either 66, 67, or somewhere in between. If you take it before the full retirement age, it gets reduced by a half of a percent per month, all the way down.
So if you’re 62 and your full retirement age is 67, your distribution is actually reduced, or your benefit is reduced down to 70% of the full amount.
Now, interestingly, after full retirement age, it actually goes up two-thirds of a percent every single month, up until age 70, at which point you can have as high as—so if your full retirement age is 67, you could have a benefit of 124% of your original, kind of the base benefit, at full retirement age. If it’s 66, it can be as high as 132%.
So, you know, doing the math there, that’s 8% per year guaranteed from the government. Now it doesn’t compound, but even with that it’s 7% and change.
So, I would say that may make sense, but you have to take into account that you’re actually getting a reduced benefit. Not only that, you’ll pay taxes on it, you’ll have to reinvest it. Then you’ll get paid taxes again, and you really just don’t know what the markets are going to do. It may sound like 4% or 5% is a reasonable return, but one or two poor returns in any given year in there could really kind of torpedo that strategy.
So I would say take the 8% guaranteed, to the extent that you can, but not everyone can wait until their full retirement age or age 70. But given that strategy, I would probably say to wait and take advantage of the guaranteed return.
Gary Gamma: And a lot of people end up relying heavily on Social Security, so we obviously don’t want to talk at that point with those individuals about playing with it too much.
Another live question. Jeff asks, “Is there a downside to holding 100% of your retirement assets in a Roth IRA?” Kind of really assumes certain tax brackets to answer that question.
Kahlilah Dowe: Yeah. Okay, so I’ve never seen that instance where everything was in a Roth IRA. I would think that wouldn’t be the worst-case scenario, though. I would look at what you may have given up. So the trade-off in putting everything in a Roth versus the traditional is that you may have given up some tax benefits in the past that may have been beneficial to you.
But once, let’s say, you’re already in retirement and you have everything in a Roth IRA, I can’t think of anything that I would say would be like a real downside to that. But I would want to examine whether or not that that’s the most effective strategy for someone who, let’s say, is in the process of saving for retirement.
Michael DiJoseph: That’s one way to answer the previous question about eliminating taxes in retirement, right?
Kahlilah Dowe: Yeah.
Gary Gamma: I know we used to talk about Roth as especially attractive to younger investors at one end of their pay scale over their lifetime. But then, as you get to a certain point in your older years, you might be in the highest tax bracket of your life, so a lot of times it comes down, again, to what you think your tax bracket’s going to be. And that’s a tough thing to do.
Michael DiJoseph: And you know there’s another benefit to Roth investing, too, that I don’t hear a lot of people talking about. And that’s that because it’s after-tax dollars and it’s the same contribution limit as traditional IRAs, so $5,500 for most people without the catch-up contribution. You’re paying taxes on it first and then investing $5,500 and then you don’t pay taxes on it again, versus putting in $5,500 and paying taxes later. On an effective basis, in theory, it’s actually kind of a higher after-tax contribution, if you will.
So for someone young that maybe doesn’t have access to a 401(k) or other kind of employer-sponsored plans and retirement assets like that, it may make some sense to actually get, regardless of the tax benefit, to actually have a higher effective contribution.
Gary Gamma: Yeah. Kahlilah, we just answered a live question about what Personal Advisor Services can do. This question is similar, but it has another caveat to it that I think is important. Karen from New Jersey, writes, “Can and will Vanguard advisors help us manage our retirement accounts and rebalance our investment mixes over time? We’ve been burned by financial advisors who are more interested in selling products and looking out for their own interests rather than our interests. Or can we manage our long-term retirement accounts ourselves? What happens as we get older and perhaps more feeble?” So I think it’s important with that piece about feeling burned and trying to make sure that the advisor’s looking out for you.
Kahlilah Dowe: Yeah, right. And, unfortunately, we see that too often as well. And oftentimes it’s when investors are transferring assets to Vanguard. So they’ll bring their portfolio here and consolidate. And the good thing is that it’s often because they trust us, and they like the reputation that we have.
And the good thing is also that you have the option here at Vanguard where you can work with an advisor and have an investment professional help you in managing the portfolio, and you kind of have that one-on-one relationship. But you could also self-manage. And if you have a disciplined and prudent investment strategy and you’re comfortable doing that, that could work as well.
One of the things that concerns me in that scenario where someone has been burned, unfortunately, and let’s say maybe has lost quite a bit or maybe paid quite a bit in fees, is what we see most often: They’ll say, “Well, I should manage it myself then.” So this terrible thing has happened to me, and in order to maybe make me feel better about that, I should manage it myself. And so it ends up, at times, being kind of more of an experiment where I’ll see if I can do better, or I’ll see if I can get back some of what I lost, which doesn’t always translate to the right investment strategy.
And so, I would say I think the answer or the right next step, in addition to making sure that you’re at the right place and you’re investing in the right place, is to make sure that you’re using the right advisor—someone whose investment strategy aligns with your goals and your investment principles, that you’re keeping our costs low and that the portfolio was diversified, and that you trust who you’re working with. And we’ll certainly help with that.
Gary Gamma: What about the “feeble” perspective? I’ve been blessed with parents who have maintained their wits about them well into their 80s, but do you ever talk to people that have that concern and maybe talk about having a trusted family member involved?
Kahlilah Dowe: Yes. So sometimes I’ll work with a client who is maybe not at that point; but they maybe see themselves getting to the point where, let’s say, they don’t have the time to do it, they don’t feel as confident in their ability to do it on their own. And, sometimes, it’s the spouse that kind of pushes them to say, “Okay, I think we need to hire someone.” And it can be difficult. It can be a difficult change.
If you’re used to managing your portfolio on your own, you’ve done it all your life, you’ve made great investment decisions, and now you’re getting to the point where, let’s say, you’re questioning what your next step is. Or maybe you don’t have the stomach for it or the same discipline that you were once able to execute. I think consulting with a professional is absolutely the right thing to do.
And what we want to do, especially in those instances where it’s a difficult transition, is we want to partner with investors whereyou kind of handing it over may not be the best step for you at that time, but you can develop a partnership with an advisor where we’ll, of course, manage the portfolio for you, but you can be involved in terms of the direction of it.
Michael DiJoseph: You know, I’ll add, too, my group spends a lot of time working with financial advisors that kind of work with Vanguard. And I think we’ve seen tremendous progress in the financial advice industry as a whole, even over the last few years with fees coming down, some really smart regulation kind of making sure that the interests of the clients are aligning better with the interests of financial advisors. So whether it’s here or somewhere else, we really believe— You know, all the stuff we talked about today is really complicated, and, there’s bad eggs everywhere, but I think there’s a lot of really good financial advisors out there and a lot of institutions that can really help people tremendously.
Gary Gamma: Mike, here’s a question you can sink your teeth into as well. Simply says, “A portfolio consisting of index funds only: Is it adequate?”
Michael DiJoseph: It could be. I mean, it really depends. So I would say more important than whether a fund or a portfolio is indexed or active is whether it’s low cost and broadly diversified. So if you have a low-cost, broadly diversified index portfolio, that could be great. If you have a high-cost, very concentrated index portfolio, maybe not so great. So I would say kind of shift the focus away.
Now we think indexing is certainly a way to gain access to broad diversification, and it’softentimes at an extremely low cost. But I think those are the principles to really focus on, the cost and the diversification benefits.
Gary Gamma: Yeah.
Kahlilah Dowe: And many investors are surprised to hear that we sometimes recommend and use Vanguard’s actively managed funds in portfolios. And I can’t say that we recommend them for everyone, but with index funds, you track the market. You get, hopefully, the market return, which is what we want. But some investors have a concern about not having at least the chance or the opportunity to outperform the market.
And so, going back to what Mike said, we still believe that diversification is the key, and keeping costs low is the right thing to do. But you may be able to use some actively managed funds and still accomplish that goal.
Gary Gamma: Yeah.
Michael DiJoseph: Yeah, and we’ve done a lot of analysis. Low costs are, more than any other metric out there, the best predictor of future success when you look at active funds.
Gary Gamma: Kahlilah, we have a question from Joan that says, “A lot of retirement advice is for how couples manage their resources. Could you address single women who have never married and the suggestions you provide in managing individual resources?”
Kahlilah Dowe: So, for single women, you know, it’s interesting. I don’t think it’s that much of a difference. So our investment principles pretty much apply across the board. Whether you’re single or married or whether you have children or not, when it comes down to being diligent with retirement savings and spending it in a tax-efficient way, those things kind of apply across the board.
I think with single people, in general, if it’s just you, so you have your income to rely on whether you’re working or retired, you may want to have more of a cash reserve because if your income isn’t there, then that could pose a challenge. So that’s one thing.
When it comes down to things like estate planning, and even long-term care, I would focus maybe a little bit more there because when you’re married, and you may have children, it’s almost intuitive in terms of where your assets would go if something happened to you. But if you’re single and something, God forbid, happens to you, the question will become, “Well, who is supposed to get your assets, and how should they be distributed?” And it may not be as obvious. The same thing with things like long-term care. Whereas, if you have a spouse, perhapsyou have someone who could take care of you if something came up. You may not have to go into a facility. So I think it’s important to have, even more so, like I said, a long-term care plan in place, not necessarily insurance—I don’t recommend that across the board—but a plan in place where you say, “Okay, maybe I need to save more to be able to cover those types of expenses at some point in my retirement.”
So probably those three things: So the cash reserve, making sure that you have solid estate plan, and that someone close to you—so that’s the other thing—that someone close to you knows what your preferences are; they know where your documents are. Those are things that a spouse or maybe your children would typically know. So even if it’s a friend or a parent, that someone knows those thing.
And there was one other thing I was going to say—living will. I think that’s the other thing that’s important when you have a single person because someone will have to make end-of-life decisions for you if it comes down to that; and that can be a point of contention, oftentimes, when there’s no clear direction in that area.
Gary Gamma: Well, I think Janis sneaks in the last live question, “Can I have any input regarding choice of assets, stocks, for example, if using a personal advisor at Vanguard?”
Kahlilah Dowe: Yes. And I think the key is what you said: personal advisor. This really is a personal service in that we want to tailor the investment approach to what this money needs to do for you, your goals, and also, to some degree, how you look at investing. And so the very first step, if she decided that she wanted to explore working with an advisor, is that we have to come up with an investment strategy that she’s comfortable with, that we agree on, and that, hopefully, is in line with the goals that she’s set for herself.
And many of my clients say, “Kahlilah, take the portfolio. Invest it in a way that’s suitable for me, and we’ll speak every so often, and that’s it.” But many investors want more of a partnership. They want to be involved in structuring the portfolio. They want to understand why we’re doing what we’re doing, and I think that’s great. I think that’s a great way to go into a relationship because I think it works best when it’s more of a partnership and you’re clear on why we’re doing what we’re doing and the value that we’re adding.
Gary Gamma: Sure, all right. Great discussion. So we’re out of time. Thanks so much for sharing your insights this afternoon. Michael, any final thoughts before we sign off here?
Michael DiJoseph: Yeah, so we like to look at retirement as three principles: developing your prudent spending rule as far as how much to spend; and then implementing a tax-efficient withdrawal plan; and, all the while, keeping a broadly diversified portfolio.
Gary Gamma: Kahlilah?
Michael DiJoseph: I would just say, one of the things that I hear so much, especially lately, is the “what ifs.” What if this happens in the stock market? What if stocks are overvalued? What if interest rates go up? What if different things happen from a political perspective? I would say try and leave the “what ifs” out of the management decisions when you think about how you’re going to structure your portfolio. I think it’s very difficult to take a nonemotional stance if the “what ifs” start to drive the investment decisions. So try to leave that out to the extent that you can.
Gary Gamma: They told me 20 years ago when I started here, focus on the long term.
Kahlilah Dowe: Yes.
Gary Gamma: All right, well, thanks to both of you for your time today. I appreciate it. In a few weeks, we’ll send you an email with a link to view highlights of today’s webcast along with a transcript for your convenience. And if we can have just a few more seconds of your time, please select the red survey widget. It’s the second from the right at the bottom of your screen, and respond to a quick survey. We really appreciate your feedback, and we welcome any suggestions about topics you’d like us to cover in future webcasts.
And from all of us here at Vanguard, we’d like to say thank you very much for joining us this afternoon. Have a great day.
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