All posts by Tom Canfield

Your RMD will likely double in your lifetime: is this a concern?

We retirees with Traditional IRA accounts will record increasing taxable income over time. That’s due to RMD, a big component of taxable income for those over age 70½. At expected returns for stocks and bonds, your taxable ordinary income will DOUBLE in real terms over your lifetime. It will more than double if returns are better than expected or if you (ideally) live well beyond your life expectancy. This post explains why your RMD will double and describes what you do if you that would be a concern.


My quick summary: I don’t think this is a big concern. We’ll have more money and more reported income, but very few of us will be pushed into a marginal tax bracket that we would be passionate about avoiding.


I previously posted on this topic and cited how this doubling could push you to a tax bracket that would be painful. But after working through two examples in this post, I think the doubling of RMD is going to be a big concern only for the rarified few who have an UNUSUALLY large IRA. They may face a step-up in marginal tax rate that they would want to avoid by converting big $$$ of Traditional IRA to Roth.


You still may want to convert some Traditional to Roth – I now think it’s more important to have that flexibility to avoid the tripwires of income that result in higher Medicare premiums – but it’s just not that big of an advantage for ordinary taxes. Let’s review and refresh on this.


== The benefit of converting Traditional to Roth ==


You accomplish two things when you convert $$$ Traditional IRA to Roth. 1) You are lowering the amount subject to future RMD. 2) You have locked in the current tax rate that you pay when you convert; you are ahead of the game when you withdraw from Roth for your spending and otherwise avoid a higher marginal tax.



You never really lose when you convert Traditional to Roth. You never stop the advantage of tax-free growth in your IRA. If your future tax rate is the same as today, Traditional and Roth result in same net benefit to you. I don’t see how it is possible that you’ll withdraw for spending when you are in a lower marginal tax bracket than you are in now – that’s the only case where you lose when you convert Traditional to Roth.


The math of converting makes sense. Our intuition and emotion fights the math: we have a hard time deciding that it makes sense to pay taxes now to avoid taxes in the future.


== Two marginal tax brackets we’d like to avoid ==


We retirees don’t want to waste money. We waste money if we pay taxes at a marginal tax rate that we possibly could otherwise avoid. We get to keep about 10% less of the income that’s taxed after these two breakpoints – $1,000 less per $10,000 of taxable income: 1) the step from 12% to 22% marginal tax bracket and 2) the step from 24% to 32% marginal tax bracket.



Folks facing these two break

points are obviously at very different levels of taxable income: roughly $240,000 difference in taxable income for married joint filers.



The step between the two – from 22% to 24% is one-fifth the damage of the other two. It costs us about $200 per $10,000 for the incremental income that falls into the 24% bracket. I would not be exercised about this if I were in this big range of income. I basically look at that long run of +$240,000 taxable income (married, joint) between the two big breakpoints as one very big tax bracket.


== Might you cross into a painful bracket? ==


You need a simple forecast of future income to answer this question. I think the math is simple but it requires that we think in real, inflation-adjusted returns. I’m assuming you – like Patti and me – have (or will have when you are retired) two big components of ordinary income and All Other is generally in the noise level and won’t change in real terms over time. It’s simpler if we think about just three factors in this math: Social Security income, IRA income (RMD), and the marginal tax breakpoints.



== Two of the three never budge ==


1. Social Security benefits stay at the same real spending power. [Social Security announced 1.6% Cost of Living Adjustment for 2020 in October.]


2. The breakpoints for marginal taxes under current tax law also stay the same. [The IRS recently announced 2020 breakpoints for marginal taxes that also adjusted for 1.6% inflation.]


== Your RMD will double ==


By your early 80s, your expected, real RMD will most likely DOUBLE the amount you will take in your first year. I went into some detail in the post I cited above. For the graph below, I used real expected returns for stocks (7.1%) and bonds (2.3%) and the mix of stocks and bonds that Patti and I selected: 85% stocks. A graph of results using a mix of 75% would look similar.



RMD increases in real terms from the combination of two factors: increasing RMD percentage and real increases in portfolio value.


• My first year RMD percentage was 3.65%. When I am 80 it will be about 50% greater (5.35%). The RMD percentage will be more than double when (if!) I am 87.



• IRA portfolios will continue to grow at expected return rates because the return rate is greater than the RMD percentage for many years. The expected return rate on our portfolio is 6.38%. My RMD percentage first exceeds 6.38% at age 85.



Real IRA portfolio value peaks in my early 80s and then declines. I have the same real portfolio value at age 92 as at age 70. A graph that uses a lower portfolio expected return rate – a lower mix of stocks than Patti and I have – looks similar.



== Use your 2018 tax return to get a snapshot ==


You want to know how much of your future income might be in a tax bracket that you would otherwise like to avoid.


1. Pull out your 2018 tax return and simplify the entries to three. The first two items of ordinary income – IRAs and Social Security – are far bigger than All Other ordinary income for Patti and me. Remember that dividends and long-term capital gains income are taxed differently – 15% rate for Patti and me.



I assume you (or you and your spouse) received Social Security benefits in 2018, so that won’t change in real terms over time. If you are not subject to RMD, you’ll have to estimate your first year RMD. You need to estimate your IRA value for your first RMD. I’d use your current value and its expected return rate from now until then: ~6% rate. I’d use 3.7% of that estimate for your first RMD. Those two assumptions are close enough for this task.


2. Understand the tax bracket you are in and how close you are to the next marginal tax bracket. I’m using the 2019 breakpoints from the table above that you’ll compare to your 2018 return, so this isn’t quite apples to apples. Again, I think this gives you good enough of a picture.




3. Recast your return for what it will look like in the future. Double your first-year RMD, but don’t change the other two. (If you have already taken several RMDs, eyeball on the graph where you are to judge the expected increase: it will be less than double.) You have a new total. Now calculate how much of your income is taxed in the bracket that you would like to avoid. Calculate 10% of that: that’s the potential you could save in a future year if you could avoid that tax bracket. Is this an amount that concerns you?


My guess is that you will fall into one of three categories.


1. You are in a 12% bracket now and cross into a 22% bracket, but the potential dollar impact is not huge, and you just don’t have that much capacity to save on taxes: you have too little capacity to convert Traditional to IRA. This is Case 1 below.


2. You are near or in the 22% or 24% tax bracket and are miles away from the 32% tax bracket. It looks like you’ll never hit the 32% bracket. This is Case 2 below.


3. You are one of the fortunate few with a VERY LARGE Traditional IRA and can see you will have a significant amount taxed at 32%. You do have capacity to convert – you are not near 32% now, and the savings in total tax dollars saved is significant. You are lucky to have this problem!


== Two Cases ==


Case 1: Sue is single. She recorded her first RMD in 2018 on $600,000 in her IRA as of 12-31-2017. She is in the 12% bracket and not far from 22% tax bracket. She can see that when RMD doubles almost $16,000 of her total ordinary income is taxed at the 22% rate. 10% of that taxed at 22% in the future is $1,600. She’d sure like to keep that $1,600 for herself.



What can she do? Sue now is $6,000 from the 22% tax bracket. That’s her capacity to convert Traditional to Roth. She doesn’t have capacity to lock in a 12% rate on the future $16,000. She’s really not going to be able to avoid the 22% bracket in the future, but she can avoid it on the part that she converts this year and in the next several years until she bumps into the 22% breakpoint.


Sue would pay 12% tax on $6,000 when she converts, and avoid paying 22% on it later. She comes out 10% ahead on the $6,000: $600 ahead. 


In my view, that’s not a lot of capacity or big dollar savings. But that’s a value judgment. The math says Sue will save $600, but to save the $600 she has to pay added tax of $720 this year. The computational, logical part of her brain should decide this is the right thing to do. But the intuitive, emotional part of Sue’s brain is going to be pushing back – hard – on this. My guess is she won’t convert. It’s too tough to decide to pay more more tax now to avoid paying much less tax later.




Case 2: The Smiths (Married, Joint filers) also both recorded their first RMDs in 2018 on a total of $4 million in their IRAs as of 12-31-2017. They are at the beginning of the 24% bracket. They now are +$150,000 below the breakpoint for 32%. That’s a lot of capacity to lock in the 24% rate, but they can see that when RMD doubles they’ll still be in the 24% bracket. They won’t fall into the 32% bracket. This is not a compelling case to convert.



Converting Traditional to Roth might make sense if their IRAs were more than $4 million at their first RMD or if they assume returns better than expected: much more of their income would fall in the 32% bracket. If donations are in their plans, they lower their IRA subject to RMD with large donations: QCD and  donations to a Donor-Advised Charitable Fund.



Conclusion: At expected return rates, your RMD will double in real terms over your lifetime. This will push you toward a higher marginal tax bracket. You’d like to avoid two breakpoints of marginal tax rates in our current tax law: the breakpoint from 12% to 22% and the breakpoint from 24% to 32%. This posts suggests that very few of us will be pushed toward those breakpoints and also have capacity to avoid them. But you may choose to lock in your current tax bracket. You do this by converting Traditional IRA to Roth.

Might we all get a real pay increase this year?

Patti and I are +11 months into our performance year for my calculation of our Safe Spending Amount (SSA) for 2020: I use the 12 months from December 1 to November 30. My snapshot in this post tells me that we are just shy of a real pay increase for 2020. If you recalculate your SSA on the same date we do, you probably are just shy of a real pay increase. The purpose of this post is to show how close we – and likely you – are to that real pay increase. 


This year is turning out to be better than I thought. Our performance year started with a steep decline in our portfolio in December: -7.6%. At the six-month mark I wrote that it was almost certain we wouldn’t get a real pay increase for 2020. We’d just increase for a Cost of Living Adjustment. (Social Security announced COLA of 1.6% for 2020.) The market moved up sharply from May: +11% for US stocks, for example. All this is to say that Patti and I are close to a real pay increase on top of last year’s SSA + COLA. We need +1 percent return for the rest of November to get us that real pay increase.


== How do you get to a real increase in SSA? ==


You increase your real Safe Spending Amount in a year when returns are good and you have more than enough portfolio value for your current spending rate. You keep the same target year for no chance of depleting your portfolio, but you can do that at a greater real spending rate – you increase your SSA by more than last year + COLA.


You need to use a spreadsheet to track this calculation. We need to inflation-adjust our results to track what is really happening to the spending power of our portfolio. Remember: Think Real. You can see the spreadsheet I have used for the last four years here. The Resources tab on this site’s home page has a spreadsheet you can download to build your calculation sheet.


Two factors work together to tell us if we have a real increase in our SSA:




• Factor 1 is a good enough return rate this year. This is the big factor. You obviously have more than enough for your current spending amount when the annual return on your portfolio increases its value to more than its previous high-water mark.


Here’s a simple example. You end 2019 with $1 million portfolio value. You withdraw at SSR% = 4.5% or $45,000 for spending in on 2020. You spend or gift all that. During 2020, the real – inflation adjusted – return on your portfolio is +15%. You earn back the $45,000 that you withdrew and then add about 10% more in real spending power. Right before your next withdrawal at the end of 2020 you have $1,100,000 in the same spending power. If you apply the same 4.5% rate, you can with draw $49,500. You get a real 10% pay increase: $4,500 increase/$45,000.


• Factor 2 is the effect of an increasing Safe Spending Rate (SSR%). This is small factor for younger retirees but it’s a much bigger a factor when we hit our mid-70s and beyond. Because our Safe Spending Rate (SSR%) increases over the years, we actually can fall a little short of the past high-water mark and still get a real pay increase. Stated differently: as the years pass, we need less real portfolio value for the same real spending amount.


Our SSR% increases because our life expectancy is fewer and fewer years. [This why RMD percentages increases each year.] We nest eggers logically plan to the same year of no chance of depleting our portfolio – but it’s about one year less than this time last year.


Here’s a simple example. You end 2019 with $1 million portfolio value. You withdraw SSR% = 4.5% or $45,000 for spending for 2020. The 4.5% rate means you have 18 years for no chance of depleting your portfolio – to the end of 2037. (See Chapter 2 and Appendix D, Nest Egg Care.) You spend or gift all the $45,000. During 2020 you’re real return  earn back the $45,000 that you withdrew. Right before your next withdrawal you have the same $1 million in spending power. Your age-appropriate SSR% at the end of 2020 is now 4.6%: that still gives to the end of 2037 for no chance of depleting your portfolio. You apply that 4.6% rate to the $1 million and withdraw $46,000. You get a +2% real pay increase: $1,000 increase/$45,000.


You can read more on this is Chapter 7, Nest Egg Care. I also described how these two factors combined for our 15% real increase in SSA in December 2017.


== Our portfolio return rate for +11 months is ~11% ==


Our portfolio has grown in dollars by 10.8% from December 1 through November 5. that’s a real return of 9.1% when I adjust for inflation. That rate is the combination of the horrible return in December 2018 and the very good 2019 Year-To-Date returns.



You can see that bond returns are close to stock returns. That means total portfolio returns don’t vary much over a range of mix of stocks vs. bonds.



The 9.1% real return isn’t enough to get us to the previous high-water mark of portfolio value. We didn’t just have to surpass the portfolio value on November 30, 2018. That wasn’t the high-water mark. We had to beat the value on November 30, 2017. Patti and I withdrew about 4.8% that December for our spending in 2018; the real return for that year was -1.7%; and last December we withdrew about 4.8% for our spending this year. Those add up to more than -9.1%.


Our age-appropriate SSR% has increased since December 2017, meaning we don’t quite have to reach the prior high-water mark. But that’s not helping enough. The two factors don’t combine to a greater real SSA.


I can plug in return rates in my calculation spreadsheet and find the return rate that would give us a real pay increase. We need a nominal return of at least 12% – a real return that’s a shade over 10% – for the 12 months ending this November 30. That’s about one percentage point more than we have now. If the return for the balance of November is +1%, we’ll pay ourselves a real increase for spending in 2020.


== Your math may work out better ==


My guess is that you are younger than Patti (72): her age and life expectancy determine our age-appropriate SSR%. That means your SSR% has been lower; you’ve been taking less from your portfolio. You need less return to get back to your high-water mark of November 30, 2017. That 10.8% return alone could get you to a new high-water mark.



Conclusion. Returns for the first +11 months of our performance year are good: +11% on our portfolio. That’s not enough for us to calculate to a real increase in our Safe Spending Amount for 2020. We need a return rate that overcomes the withdrawal in December 2017, the negative real return in 2018, and the withdrawal in December 2018. +11% just doesn’t quite do that. If we gain 1% more by the end of this month, we will have enough for a real pay increase in 2020. That would be the third real pay increase in the first five recalculations of our plan.

How do you manage your 2019 income to avoid $1000 (or more) tax landmines?

The purpose of this post is to describe seven hard-to-see tripwires for landmines that can result in taxes that you might be able to avoid. If you stumble on a tripwire and set off a landmine – cross a specific amount of income you record on your tax return by $1 – you could see your tax bill go up by perhaps $2,400. We retirees can avoid the tripwires: we have a degree of control over our taxable income. We choose where we get the money that we want to spend in a year. Our choices have different tax consequences. We can tweak our taxable income for a given gross amount that we want to spend and avoid taxes that we would otherwise pay.


We can accidentally set off land mines that blow away up to $2,400 when we record a just a hair too much Modified Adjusted Gross Income (MAGI) on our tax return. Your MAGI is Adjusted Gross Income with the addition of some items you did not include on page 2 of your tax return. An example is that you add back tax-exempt interest to AGI to get to MAGI. My tax preparer emailed me a .pdf file of our 2018 return and a bunch of supporting schedules. One calculates our MAGI. Patti and I had nothing to add back to AGI to get to MAGI, and that will hold true for 2019. AGI = MAGI for us.



== Three kinds of Landmines: seven tripwires ==


We have three kinds of landmines with specific tripwires that result in a big jump in total tax: 1) two tripwires result in a greater percentage of Social Security that is taxed – jump from zero to 50%  and then 85% taxed; 2) a tripwire that jumps the tax rate on dividends and long-term capital gains from zero to 15% ; and 3) four tripwires each increase Medicare Premiums per year by roughly up to about $1,200 per individual.



[In this table I excluded tripwires at very high MAGI: the ~$435,000 tripwire for 20% capital gains for a single filer; ~$489,000 for joint, married. And the last $500,000 tripwire for greater Medicare Premiums for a single filer; $750,000 for joint, married.]


== Estimate your 2019 MAGI now ==


I estimate my 2019 MAGI using my 2018 return as the starting point. See spreadsheet that I use here. You’ll need to do this to find if you could stumble on a tripwire. I can tweak the three sources of our SSA to adjust MAGI if I think I might stumble across a tripwire described below. This spreadsheet also estimates my total taxes for the year so I know how much to withhold when I take our RMDs in early December. (Patti and I are both subject to RMD.)



== Landmines at relatively low MAGI ==


Retirees who have relatively low income other than Social Security benefits and financial nest eggs generally less than $500,000 per individual may be able to avoid two landmines. Folks with some outside investment income income and larger financial nest eggs – especially when subject to RMD – will blow by these landmines and incur greater taxes.


• Greater MAGI triggers a greater percentage of SS benefits subject to tax. You have to calculate to find your tripwires. Your tripwires are affected by the amount of your SS benefit. This blog post from two weeks ago has a more detailed discussion. This example below shows that a single filer will cross the first tripwire – resulting in 50% of SS benefits being taxed – if MAGI other than the SS benefit exceeds $12,500. They cross the second trip wire at $21,500 of added MAGI.



• Greater MAGI triggers a jump in the tax rate on Dividends and on Long term Capital Gains from the sales of securities. The rate jumps from zero to 15% when total MAGI crosses the trigger point of about $39,000 for a single taxpayer and about $79,000 for married, joint filers. Again, a single taxpayer reaches the tripwire without a large amount of MAGI in addition to the assumed SS benefit.



 == Landmines at high MAGI ==


There’s a big jump in MAGI to reach the next set of landmines. Much greater MAGI trips added Medicare Premium payments. (See here for an earlier discussion.) The first tripwire hits at $85,000 MAGI for a single and $170,000 for married, joint. Tripwires are roughly every $25,000 thereafter for single and $50,000 for married. Each tripwire triggers about $1,000 added annual premiums per person. For Patti and me, increased Medicare Premiums would br deducted from our Social Security benefits because our basic Premium is deducted.



You don’t immediately see the effect if you cross over the tripwire. You see it a year later. Your 2019 return affects your premium penalty payments in your 2021 SS benefits. You send your 2019 return to the IRS in April 2020. The IRS calculates your MAGI. You get your statement of your 2021 SS benefits in late 2020. That statement will reflect the added premium for tripwires you crossed on your 2019 return. The 2021 premium increases will adjust for inflation and  will be a bit higher than I display in the table above.


== Actions to take when near a tripwire ==


Back away when you are near a tripwire! Record lower MAGI! You can fiddle and keep the same gross amount for spending but lower MAGI. You have three choices to lower MAGI: distribute from your Roth IRA rather than Traditional IRA; get more of your gross cash for spending from sales of securities than from your Traditional retirement accounts. You could choose to pay yourself less than your SSA.



If you think you’re going to face the same landmine you want to avoid in future years, you could blow by the trip wire that’s close and get near to the next one. You’d choose to pay yourself more this year with the plan of plan of paying less in future years – you’re prepaying a bit of your future SSA in effect. You gain the same benefit if you convert Traditional to Roth IRA.



Conclusion: $1 of added income on our tax return can trigger up to $2,400 in added tax. The tripwires of Modified Adjusted Gross Income (MAGI) that result in these high costs are not easy to see. This post displays a total of eight trip wires. You need to estimate your taxes for this year to see if you are close to a tripwire. Back way if you are close! You back away by tweaking your reported income: you decide how you will get the cash you want to spend, and what you choose has different effects on taxable income.

Do you have check writing for your retirement account?

If you are over 70½ you want to make contributions from your retirement accounts using QCD – Qualified Charitable Distributions. I wrote about this a year ago. You get the full tax benefit of donations when you make them from your retirement account. You get no tax benefit from donations from your checking account because you will – almost certainly – use the $13,500 Standard Deduction per individual on your tax return; you won’t itemize donations on Schedule A as a deduction from income. This post describes the mechanics Patti and I follow for making donations from our retirement accounts.


== The Tax Benefit of QCD ==


Failure to use QCD is a big mistake. Here is an example of the wrong way to donate when you are over 70½ and subject to RMD. In this example, Patti and I receive no tax benefit from a $5,000 donation.



Here is the right way. In this example the $5,000 of QCD results $1,100 lower taxes. Using QCD gave 22 cents back on each dollar donated. Failure to use QCD is the same as throwing away 22 cents of every dollar donated.



== Donating from our 2019 SSA using QCD ==


I describe these steps, since my brain struggled a bit with the cash flow implications when we first did this.


This is the time of year that Patti and I decide the amount we will donate to each charity and the total. Our spending tends to decrease in the fall. Our monthly deposits from our nest egg continue into our checking account. Our checkbook balance increases. Let’s assume we think $5,000 will be available in December for donations to charities.


I also have a good handle on what our Safe Spending Amount (SSA) will be for 2020; unless the market goes crazy UP in the next five weeks – our Recalculation uses returns for the 12 months ending November 30 – it will be our 2019 SSA increased for inflation. That’s the Social Security cost of living adjustment recently announced: 1.6% for 2020. Let’s assume our 2020 SSA will be about $56,000 net after withholding taxes.


How do I correctly donate before year end and wind up with $56,000 in cash – money market; CDs or short-term bonds – at the end of December? That’s the money I’ll use for monthly deposits in our checking account in 2020.



I don’t donate from what’s left of our 2019 SSA from our bank checking account. I sell securities in our retirement account and donate $5,000 as QCD. I also sell $51,000 of securities from our retirement accounts and from our taxable accounts that goes to our 2020 SSA. The $56,000 SSA for 2020 in cash by the end of December is $5,000 from what’s left over from 2019 + $51,000 new.


== Detailed Mechanics of check writing  ==


Patti and I have our retirement accounts at Fidelity, and it is simple to make donations directly from our retirement accounts. I’ll assume your brokerage house offers the same check-writing privileges.


1. We each implemented check writing on an IRA account. Fidelity asks us to select the withholding amount they will send to the IRS when we write a check. Since all these checks would be for QCD, we picked 0%. We each have a book of checks.


2. We sell $5,000 of securities to make sure we have that in cash when the checks are cashed.


3. We decide on the charities and amounts. We decide which one (or both) will write QCD checks. We write and mail the checks. I’d like to use BillPay – store the name and address of each payee, cycle through and enter our donation amount, and have Fidelity mail the checks, but I can’t do that yet.


4. I need to keep the normal receipts for donations for my tax records. I need to make sure I tell my tax preparer our total QCD donations: Fidelity does not report that on the year-end 1099-R statements of distributions from IRAs.


== I can ask Fidelity to write and send the checks ==


If I have just a few donations, Fidelity will take the names and addresses over the phone and mail the checks. (That sounds too time consuming to me.) I can also use a QCD Withdrawal Form and have Fidelity write and mail the checks, but this is cumbersome. The form requires a Medallion Signature Guarantee that my bank does not provide; I would have to take the form to our local Fidelity investment center and have them provide that guarantee to itself.



Conclusion: You need check-writing privileges on your IRA account for donations you will make when you are over age 70½. You make donations from your IRA account to gain the full tax benefit of your donation. You no longer make charitable donations out of your checking account; if you do that, you are almost certainly throwing money away ­– paying taxes you do not need to pay.

Can you lower the portion of Social Security that is taxed and avoid $1000s in tax?

Depending on the amount of your income, 0%, 50% or 85% of your Social Security (SS) benefits is taxed. Retired folks under age 70½ have flexibility as to how they get the cash to pay themselves throughout the year – what is taxable income on their tax return. They can pay themselves a significant amount for spending – more than $50,000 total in a year – but avoid crossing income points that trigger roughly $1500 or $2,500 in taxes. Folks over 70½ incur RMD that limits their ability to get cash for spending that results in low taxable income. This post explains how Social Security benefits are taxed and how you may be able to avoid tax.


== Tax bite depends on income ==


The calculation to figure the percentage of Social Security that is taxed is as clear as mud to me. This IRS worksheet is almost undecipherable. The percentage that is taxed is based on your “Combined Income,” which is a new term to me. Your “Combined Income” is the sum of income other than Social Security + ½ of your Social Security benefit.



Here’s how it works.



== Example: Pay yourself the wrong way ==


Sue is single and over age 65 but not 70½. She is not subject to RMD. She made the right decision to take Social Security early and will receive $25,000 in 2019; she receives about $1,950 per month after the Medicare Part B deduction. She has a nest egg. She calculates her Safe Spending Amount for 2020 is $30,000. She plans to get this all in cash by the end of this year and pay herself a monthly amount.


How will she get that $30,000 and what will she net after allowing for taxes? Sue decides to take half that ($15,000) from her retirement accounts and half ($15,000) will be the gross proceeds from the sale of shares in several mutual funds; her cost basis is 2/3 of this; her gain is 1/3 of this. She estimates the impact of this for her 2019 tax return. Here’s a summary of her 2019 return.



Sue will pay a total of just under $3,600 in taxes in 2019. She pays tax on 85% of her Social Security benefit because her Combined Income of $34,500 crossed the $34,000 trigger point.


The $3,600 in taxes will be a reduction from the gross $30,000 from her nest egg. Her net monthly pay in 2020 from her nest egg is about $2,200. Her net from Social Security will increase to $1,975 – the combination of 1.6% more for Cost of Living Adjustment and about $10 more/month for Medicare Part B deduction. Her total monthly paychecks will be about $4,175 for 2020.


== The cost of wrong ==


Sue crossed the threshold that triggered taxes on 85% of Social Security by $500. If she had $500 less income, she would have paid tax on 50%. The difference is $1,050 increased taxes on the added $500 of income: +200% tax rate!



== Example: Pay yourself the right way ==


Sue decides to take the $30,000 from her nest egg as the gross proceeds from the sale of shares in a mutual fund and nothing from her retirement account. Here is what her 2019 tax return would look like:



Wow. Sue pays NO TAXES to the IRS. She pays 0% on her Social Security: her Combined Income was less than the trigger point for 50% being taxed. Sue also pays 0% on her Capital Gains because she fell under the trigger point that kicks in the 15% tax rate. (No tax on capital gains if MAGI < $39,375.) Sue’s paying herself – her direct deposits into her checking account from SS and her nest egg – more than $53,000 in 2020 with NO TAX to the IRS.


Relative to the first alternative, Sue pays herself the $3,600 she does not pay to the IRS. Her total monthly pay increases by $300 per month. That’s more happiness, especially since that $300 per month comes out of the pocket of the IRS.


These tactics won’t work year after year. Sue will have to withdraw from her IRA for her spending, and she’ll eventually pay tax on 85% of her SS benefits: she eventually won’t won’t have enough in taxable securities as the low tax-cost source of cash for spending and she’ll have to withdraw more from her retirement accounts; she’ll also have to withdraw more when she is subject to RMD in a few years, and her Safe Spending Rate (SSR%) will increase over time resulting in greater withdrawals. But it’s the smart move not to pay the taxes that she can avoid now.



Conclusion: Some retirees – primarily those who are not subject to RMD – can pay themselves a significant amount from their nest egg and pay low taxes on their Social Security benefit. They may be able to plan taxable income such that they pay tax on either 0% or 50% of their Social Security benefit, not 85%. They can avoid several $1,000s in tax.

How many bad 1-in-350 financial events are in your retirement plan?

We retirees want to lock in a number of years for NO CHANCE of depleting our portfolio. A key decision – our Safe Spending Rate (SSR%) – assumes we will face the most horrible sequence of financial returns in history. We nesteggers use the actual Most Horrible Sequence starting in 1969: I’m almost certain that’s the most horrible sequence that all of us would use following the steps in Nest Egg Care (NEC). That means we nesteggers assume we will hit two extraordinarily remote bad financial events within the first five years of our retirement plan. But only one exceeds 1-in-350 years probable: one is a 1-in-185-year chance event; the other is a 1-in-2400-year chance event. The purpose of this post is to explain those statistical probabilities.


 == How would you answer this question? ==


My friend David officially retired at the end of August. He recently asked, “Aren’t you worried about a recession and what it means for stock returns?” Here’s the answer I’d give David today.


NO! We spend a safe amount from our next egg each year that means we have NO CHANCE of depleting our portfolio through 2035. I may be in diapers then!


“Our spending level is safe, because it’s based on the assumption we’ll face the Most Horrible Sequence of stock and bond returns in history. Starting tomorrow.


“And it won’t be as bad as we’ve assumed because the Most Horrible Sequence is truly Most Horrible: stocks decline by 48% in two years. Bonds decline by more than 60% over a ten-year stretch. Those approach statistically impossible events – one is more than a 1-in-2400-year event.”


== Bombs devastate a portfolio ==


What kills our portfolio – what leads to far lower portfolio value over time – are bombs of back-to-back years of negative stock and bond returns. The bombs evaporate huge chunks of our portfolio. We can work through bombs in our earlier Save and Invest phase of life; time is on our side. But we retirees don’t have the luxury of waiting years for the rebound. We’re withdrawing from our portfolio each year making the bomb crater even bigger. Once the crater is big enough, no pattern of good returns can refill it. Our portfolio spirals down to the point where we can’t keep taking our planned annual withdrawal for spending.



== What’s the Most Horrible Sequence? ==


The Most Horrible Sequence of returns that I found for Patti and me started in 1969, and I think that’s the Most Horrible sequence for your plan. No mix of stocks and bonds will do well over this time period.


Our Retirement Withdrawal Calculator (RWC) used that 1969 sequence to show that our Safe Spending Rate (SSR%) at the start of our plan was 4.40%: if Patti and I spend at $44,000 constant spending power per $1 million initial investment portfolio, we know we can take a full withdrawal for spending for 19 years. That’s the number of years Patti and I picked. It was just 13% probable that both of us would be alive then. (See Chapters 2 and 3, NEC.)


== Details of that Most Horrible Sequence ==


I discussed this sequence here, but here is a fresh recap:



• Cumulative stock returns were -10% for 14 years. This is one of three long periods cumulative stock returns below 0% since 1926: the other two started in 1929 and in 2000.


This sequence kicks off with the largest six-year decline in stocks in history – 10 percentage points worse decline than the second worst sequence. Those six years contain a stock bomb: in 1973 and 1974 stocks declined -48.6% in spending power. This is the second worst two-year decline in history. (The worst is 1931 and 1932.)


• Cumulative bond returns were -61% for 14 years. Wow! This is part of the long, 45-year period of 0% cumulative return starting in 1940.


    The whole sequence for bonds starting in 1969 is horrible but the real bomb is the one that also exploded in 1973: bonds decline in real spending power by 63% over the next ten years. This is an average return of -9.6% per year. We tend to think that bonds are stable ballast for our portfolio, and they are excellent insurance when stocks tank, but this ballast is sinking the ship, not righting it.


    == Economic events during that sequence ==


    I think we know that the return actual return patterns for stocks and bonds are driven by economic events. Here are economic events that shaped the Most Horrible Sequence staring in 1969:


    • Recessions. 1969 was the start of a recession. The economy was in recession for almost half the first five years. We had a total of four recessions in 14 years. We’ve never had that many recessions or months of recession over a 14-year period.




    • Inflation. Inflation was over 5% in 1969 – up from less than 2% per year for the 15 years ending in 1965. It increased to 11% by 1974 and then to more than 13% by 1980. As interest rates rise from inflation, bond prices crater. That’s the primary cause of the steep fall in bond returns



    == Applying statistics to two bombs ==


    Financial folks love statistics. I like statistics, too, but the implicit assumption with statistics is that the data points – annual stock or bond returns in this case – are independent events. I think we can agree that year-to-year stock and bond returns are not independent or random events. I assert that statistics would not reasonably predict the two bombs for stocks and bonds in one 14-year sequence of returns. The real world is worse than the statistical world.


    But we may gain some insight by looking at the statistical chance of these bombs hitting us. I describe the steps to do these calculations here. Here are the conclusions:


    1. Statistics would tell us the stock decline of 48.6% in 1973 and 1974 is .54% probable. (its 99.46% probable that we won’t see returns like that – starting now.) We could describe the chance of being hit with a two-year decline like that as a 1-in-185-year chance.


    2. Statistics would tell us the bond decline of 63% over ten years is a bit more than .04% probable. (It’s 99.96% probable that we won’t start on a sequence like that.) We could describe chance of being hit with a ten-year decline like that as more than 1-in-2400-year chance.



    Conclusions: We use the Most Horrible Sequence of stock and bond returns for our retirement planning decisions. following the process in Nest Egg Care means the Most Horrible actual sequence of stock and bond returns start in 1969. If you like statistics, that sequence has two relatively short periods of returns that are extremely low probability: 1) a two-year negative stock return of -49% is a 1-in-185 year chance; and 2) a ten-year negative bond return of -63% is a 1-in-2,400 year chance.


    Is Fidelity the new king of lowest cost index funds?

    If you follow the evidence in Nest Egg Care (NEC), you know the key to investing when you are retired – really any stage in life – is to keep most all of market returns for yourself. To do this reliably you must solely invest index funds that buy and hold stocks and bonds to mirror the performance of the total market, such as the CRSP US Total Market Index of all ~4,000 tradable securities. (You can own also ETFs that track an index and trade like stocks.) This post looks at fund costs – the Expense Ratio – of key stock index funds. Fidelity holds the current title as THE SOURCE for low-cost index funds.


    Basic conclusion: the cost difference between the largest index funds that try to mirror the US Total Stock market is tiny: you’re keeping about 99.5% of the market return for US Stocks with any of the top three. Other operational aspects of the funds means lower cost doesn’t exactly translate into higher net return to investors. I’m not switching my already low cost index funds for others that are lower in cost.


    == Low Cost is Key for your Plan ==


    Most retirees – most all investors – shoot themselves in the foot by making decisions that result in lower returns than they could easily get. We nesteggers reliably net the most out of the market because we only invest in index funds. The alternative of investing in higher cost, actively managed funds and thinking that they will outperform is a flawed logic. Paying an advisor on top of fund costs makes no sense: the decision of how to invest is straightforward. For more detail on the folly of actively managed funds and the bad effects of high investing cost see Chapter 6 NEC and blog posts here and here. You’ll see the logic and exact mix funds/ETFs that Patti and hold in Chapter 11.


    == Three behemoths offer index funds ===


    The three big providers of index funds are Vanguard, Fidelity and Blackrock. Vanguard offers funds and sister ETFs. Fidelity only offers funds. Blackrock only offers ETFs.



    Vanguard implemented the first index fund in 1976 and is the giant of index funds and ETFs.


    Fidelity was the largest mutual fund company in terms of assets under management until 2009 when Vanguard flew by it. Fidelity grew when investors poured money into several actively managed funds that outperformed other funds by a long shot in the 1980s, 1990s and into the early 2000s. (See last week’s post on Fidelity Contrafund®.) Many of its offerings for index funds – such as those that fit each category of style box – are less than one year old.


    Blackrock offers iShares®, a family of over 800 ETFs, far more than any other company.


    == The war to claim “Lowest Cost” ==


    The Expense Ratio of index funds has fallen over the years. The three behemoths have repeatedly cut the Expense Ratio of funds and ETFs to claim that they are lowest cost. Last summer Fidelity lowered costs on its index funds to well below that of Vanguard and iShares. Vanguard lowered costs on an ETF Patti and I own – VXUS – in February. As a result, Patti and I now pay .05% expense ratio on our total portfolio. That’s less than a third if the default Investing Cost that I used in my favorite Retirement Withdrawal Calculator, FIRECalc, to get to our Safe Spending Rate (SSR%).


    You can see a detailed comparison of Fidelity vs. Vanguard index funds here. I show the differences in Expense Ratio for the two key stock funds we retirees should consider. Fidelity’s Expense Ratio is one-third lower to half the cost of the same kind of fund from Vanguard or iShares. But the difference in cost is small: with any of these you keep about 99.5% of expected US Stock returns and about 99% of expected International Stock returns.



    I don’t think fund costs can get much below these levels. Vanguard would have to cut their Expense Ratio in half on their biggest index funds to merely match Fidelity. That would be a cut of a very big dollar amount – over $30 million in management fees – on just one index fund and this one is not their biggest:



    == Does lowest cost translate to better return? ==


    We can’t conclude that lower cost for an index fund precisely translates to greater return to investors.


    1. These funds and ETFs attempt to mirror an index, but Vanguard mirrors indices that are different from the ones Fidelity and iShares use. I’m guessing that fund companies didn’t pick the index they follow by judging it to be a better index. I’d guess that Fidelity and Vanguard, for example, likely picked different providers for their benchmark indices based on the negotiation of what they pay the companies that provide them: CRSP or SPDJ for US stocks, as an example.



    2. Funds don’t hold all the securities that comprise an index and rely on sampling to capture the performance of many stocks. The total number of US stocks is about 4,000. The three funds hold roughly 90% of them. Funds simplify implementation and lower costs by sampling the stocks with the smallest market capitalization values.



    == Net returns don’t exactly track ==


    I don’t see a consistent pattern that confirms lower Expense Ratio results in greater return for investors. I’d expect Fidelity to return roughly .015% to .025% per year more than either Vanguard or iShares. But the returns over last 12 months ending September 30 and nine months year-to-date wobble from that assumption. FSKAX performed better than its cost difference YTD but worse over the last 12 months; that means it was worse in the last three months of 2018.  Maybe relative performance of the three will settle out to reflect the small cost differences.



    == Two Fidelity funds at 0% Expense Ratio ==


    Fidelity really planted the anchor on low cost with two funds it introduced in 2018. These are incredible: NO Expense Ratio and NO minimum amount to invest if you have your money at Fidelity. I think over time folks are going to look at these anchors because they are so simple to understand. They will ask, “Why am I paying more than 0% for the funds I own?”


    Fidelity did two things to lower its costs: it doesn’t pay a third party for a benchmark it is mirroring, and each of these funds holds fewer stocks than its peer index fund, meaning each fund relies more on sampling for the stocks it does not own.



    The recent net performance of these zero cost funds has been better than the difference in costs. I’d guess this has to do with the luck of the sampling. I’ve not switched to these 0% cost funds. It would be easy for me to do since most of our money is in retirement accounts. I have no tax or transaction costs to change what we hold. (All of financial nest egg is at Fidelity.) I’ll watch until I understand if these zero cost funds will truly put a few more bucks in our pocket.




    Conclusion: The fund cost – Expense Ratio – for index funds that track the total stock market is really low. For the fund that will be the largest holding in our portfolio – US Total Stocks – you should keep +99.5% of what the market delivers from any of three larger funds. The net returns to investors don’t precisely track by the differences in cost. I think you’re good with whichever index fund or you like; over time you’ll certainly be better than about 95% of investors. I’m not switching my already low-cost index funds for others that are lower in cost.

    How does the second largest actively-managed fund – Fidelity Contrafund (FCNTX) – rank against its peers?

    This post puts the second largest actively managed mutual fund – Fidelity® Contrafund® (FCNTX) – in the same barrel that I put American Funds Growth Fund of America (AGTHX) in two weeks ago. How well has FCNTX performed over the recent past compared to its peer index or a peer index fund? Basic answer: a lot better than AGTHX, but not as well as its peer index or peer index fund. Over the last decade, the annual return of FCNTX has lagged its peer index by about 1.5 percentage points per year.


    == The glory days for Contrafund ==


    In the two decades of the 1990s and 2000s Contrafund burnished Fidelity’s reputation for actively managed funds that outperformed almost all others. I pointed out in this post that that overall reputation for Fidelity has faded away: now very few of Fidelity’s actively-managed funds outperform their peer index, and none outperform close to the level that Contrafund did for 20 years.


    The most famous Fidelity fund is the actively-managed Magellan Fund (FMAGX). Its heyday was in the years prior to 1990 when its legendary manager, Peter Lynch, retired. For the decade before he retired Magellan was a rocket ship outperforming the market by more than 10 percentage points per year. Since then it has lagged. After 1990 Contrafund far outdistanced Magellan and the market for two decades: Contrafund beat the market by about 4 percentage points per year over 20 years. $10,000 invested in FCNTX in 1990 accumulated to more than twice that of the market as a whole by 2010.



    [Full disclosure: I was an investor in Contrafund for many of its glory years. I sold my last shares to switch to only index funds in 2014 when I started our financial retirement plan following my advice in Nest Egg Care, Chapter 6.)


    Fidelity tells me I’ve been a customer since 1984. I thought I was a customer earlier. I’m sure the $2,000 that I put in my IRA account at Fidelity each year for many years – starting no later than 1984 – was solely in Contrafund. That’s why I’m sure my IRA investments at least matched the strategy of holding a low cost index fund over the decades that I describe here.


    I had a logic as to why I picked Contrafund: I concluded the only way to beat the market is to invest in a company judging that earnings and profitability will grow much greater than other investors – the market as a whole – expects. That’s a Contrarian Strategy: invest in companies that are out of favor with under-appreciated potential. If they deliver, performance is at a much higher level than expected. Stock price jumps to reflect the new expectations of future performance. I’d like to think I was very smart in picking FCNTX, but that’s just hindsight: one’s memory always places oneself in a good light. Likely reality is that I was just very lucky.]


    Contrafund is a completely different fund from the 1990s. It’s a behemoth in terms of assets under management. It’s essentially limited to investing in companies with very large market capitalization values: it has to concentrate on the top companies in the S&P 500®. Companies at the top of market capitalization value today are clearly in the growth category. As I mentioned two weeks ago, that category – Large Cap Growth – has outperformed others in at least the last five years, and all funds in that category are going to look good relative to many other funds.



    As an aside, Contrafund is an immensely profitable fund for Fidelity. It’s Expense Ratio – the money Fidelity gets – is now .82%. .82% * $85 billion = about $700 million per year! Wow!


    == Recent Performance vs. the peer Benchmark ==


    I use the same Morningstar (M*) data that I used two weeks ago to see how Contrafund has performed. I also include AGTHX for reference.


    1) FCNTX against its peer Large Cap Growth index. This 10-year data shows FCNTX lags the index for Large Cap Growth by about 1.5 percentage points per year. The accumulated value from FCNTX would be about 15% less than the index.



    2) FCNTX against an index fund – actually an ETF – that attempts to mirror the Large Cap Growth index. I only have five-year data for that ETF: VONG. This is a better way to look at relative performance, since you could actually own that ETF rather than FCNTX. You see FCNTX lags VONG by 1.5 percentage points per year.



    == Can FCNTX outperform in the future? ==


    We don’t know but the evidence suggests that FCNTX will not outperform, and clearly that record of 4 percentage points better per year for many years looks impossible. Below I show FCNTX’s stock picking ability over the last decade. I add back the current .82% Expense Ratio for each of the past 10 years; that should be a pretty accurate apples-to-apples comparison to the index, which has no costs deducted. The table here shows no trend of FCNTX to outperform. An investor who paid .82% Expense Ratio per year – about 11% of the real, expected 7.1% growth for stocks – lost on that choice over the past decade and is losing this year so far.




    Conclusion: Two actively managed funds dominate all others in terms of assets under management, AGTHX and FCNTX. This post looked at FCNTX’s performance over the last decade. FCNTX’s performance does not match its peer index or a peer index fund. Over the last five years it has lagged a peer index fund by about 1.5 percentage points per year. The stories of AGTHX and FCNTX confirms many other studies: funds that perform well over a time period just don’t sustain that performance over the long run. These two funds were top performers at one time. Money rushed in from new investors, changing the nature of these funds. Now they lag.

    Is it time to get a mortgage or refinance your current mortgage?

    Is this a crazy question to ask someone who is retired or nearly retired? No! Mortgage rates now are low, low, low. The average 30-year mortgage now is about 3.7%. I summarize data from this graph that shows rates are within .4% of their lowest over the past 58 years. Patti and I want money to give to our heirs now, not after we are dead, and I view taking money out of our largest non-financial asset – our home – as a low cost source of cash. The purpose of this post is to explain my thinking of why you should consider a mortgage or consider refinancing your current mortgage.



    I bet my thoughts about having a mortgage when retired or refinancing to a bigger mortgage is not what most retirees would consider. Most retirees I talk to want to get rid of any monthly payments. They want to own their home with no mortgage. That’s the comfortable decision. I get that no mortgage is comforting, but I make a different choice.


    == Mortgage: always had one. Always will. ==


    When I was in the Save and Invest phase of life, I did not want to invest too much in a non-financial asset – our home – that I thought would grow in real value only about one percent per year. (That turned out to be true.) I knew that over the long run I was going to do much better by investing in stocks that likely would grow somewhere between 6% to 8% real return per year. (That turned out to be true.)


    When I borrowed – got a mortgage – that simply meant we put less of our savings into the 1% growth asset and had more money to invest in the ~7% growth asset. Yes, I had to consider the cost of borrowing, our real interest cost for a mortgage. But I always thought of that as no more than 3% per year, the nominal interest rate adjusted for inflation. 7% real growth (stocks) is more than 3% real cost (borrowing).


    == I refinanced every 10 or 15 years. ==


    When mortgage interest rates declined I’d refinance at a lower rate and always for 30-year term. In this example I use the mortgage rate we obtained in late 1977 and assume I refinanced in 1992. Here is the logic I followed:


    1. Patti and I bought our home in Pittsburgh in late 1977. We had an $80,000 mortgage at 9% interest. That would equate to a mortgage payment of $640 per month. (I use a mortgage rate calculator or Excel® for these calculations.)


    2. I decided we should be happy to keep the same real monthly payment over time. Our income increased by more than inflation over time, so paying the same real amount as in 1977 was easier. An inflation calculator tells me that $640 in late 1977 was the same – in real spending power – as $1,460 per month in late 1992. (Those 15 years were a horrible period of inflation.)


    By 1992 – 15 years – I’d paid a total of about $115,000: $640*12*15. Let’s assume $25,000 of this was principal. That made our loan balance $55,000 in late 1992.


    3. 30-year mortgage rates at the end of 1992 were 8%. Using the $1,460 that I was comfortable in paying, this is a mortgage of almost $200,000. Let’s assume our house appraised such that we could get a $200,000 mortgage.


    4. I refinance. I borrow $200,000. I pay off the loan balance of $55,000. I take out $145,000 in cash to invest – essentially in stocks. If returns matched the long-run average of 7% real return rate per year, that $145,000 doubles every decade following the Rule of 72. That would be about $925,000 today. Yes, taxes on annual gains distributions would take a bite out of that, but if I never refinanced this mortgage, my net after taxes on that would exceed P+I payments for 27 years and the remaining debt balance on that $200,000 mortgage.



    ==Our new mortgage in 2007. My age 63. ==


    Patti and I sold our first home and in 2007 moved into our current home less than one mile away. Our current home is smaller but much nicer; we have much more open interior space and nicer yard. After needed renovations it cost more than we sold our home for. I did not hesitate to get a bigger mortgage.


    I’m not remembering the amount of our mortgage, but as I look back in my Quicken checkbook register I can see that our monthly mortgage payments were $1,650 per month. I can use the graph cited above and see the rate at that time was about 6%. Those two equate to a mortgage of $275,000.


    == Refinance in late 2012. My age 68. ==


    By late 2012 mortgage rates declined to their lowest level in 50 years. I was lucky and froze our rate at 3⅛% interest in December 2012 and finalized our current mortgage a few months later. My 3⅛% rate is lower than on the graph for that month.


    When I refinanced this time I wanted to lower our monthly payment. I picked $1,250 per month, $400 per month less. That payment and the 3⅛% equated to a 30-year mortgage of $290,000. My mortgage balance on my original $275,000 loan was approximately $245,000. I therefore was then able to take out $45,000 in cash and lower my monthly payments by $400 per month.



    == Would I consider refinancing now? Age 75. ==


    Yep. Interest rates will never – I think – drop to my 3⅛% rate, but that would not be a key consideration. Patti and I have a goal to give more to our heirs now while we are alive. It doesn’t make sense to think that most of what they may get is when they split of the proceeds from the sale of our house after we are dead. The idea is to give them a piece of that non-financial asset now. Let them enjoy the money or invest it for their retirement.


    I also view refinancing as a tax-free source of tax-free cash to give to them. I like the more than two alternatives that shrink our financial assets, and I’m not as comfortable in doing that now: 1) sell taxable securities and pay capital gains to get the net cash to gift; 2) withdraw more from our Traditional IRAs to and pay income tax to get net cash to give them.


    Here’s the approximate math on refinancing now:



    1. I’ll assume we’d be happy with the same real monthly payment now as in 2012. We have a bigger nest egg now even after five years of withdrawals for spending since we’ve had very good returns for stocks since then. That means we would be happy to pay $1,540 now. That’s the same real spending power as $1,250 seven years ago.



    2. At 3.7% borrowing rate, the $1,540 monthly payment translates to a mortgage of about $335,000. Let’s assume an appraisal would support that.


    3. I get $335,000 from the new mortgage. I pay off the loan balance of about $250,000. Patti and I net $85,000.


    == What’s the disadvantage? ==


    We’ve tapped our non-financial assets such that we have diminished a deep, deep reserve to our financial retirement plan. I don’t consider this as a problem: 1) we already have a greater Reserve with our financial assets – more than two years of spending on average. (See Chapter 7 Nest Egg Care and “The Patti and Tom File” at the end of Part 2.). 2) Our Safe Spending Amount (SSA) has increased in real spending power by 20% since the start of our plan. It would be very easy us to lower spending back to our original SSA. Going back to this spending level would buy us a big, added margin of safety – more years of zero chance of ever depleting our Investment Portfolio.



    Conclusion: I’ve had a mortgage and always will. I most recently refinanced in late 2012 and have a rock bottom 30-year mortgage rate of 3⅛%. Patti and I want to give money now to our heirs rather than after we are dead. A good option is to take money from our non-financial asset – our home. We’d do that my refinancing our current mortgage, and now is a good time to consider that option since mortgage rates are very low. If we did that – paying the same real monthly payment that we were happy with seven years ago – we’d net about $85,000 of cash, tax-free, that we could use for gifts.

    Have we reached the tipping point for the demise of actively managed funds?

    This article states that in July the amount invested in passive index funds passed the amount invested in actively managed funds: roughly $4.2 trillion each. The first Index Fund started in 1976. That means it took 43 years for Index Funds to win 50% share of all investors’ money. Is this a tipping point? Will Index Funds continue to gain share? What’s that mean for those of use who invest in Index Funds?


    == Index funds will increase share ==


    The arguments favoring Index Funds are too powerful, and more investors understand the arguments.


    • Actively managed funds in aggregate must underperform index funds by their higher costs. That’s just simple math. The article above says the average cost of Index Funds is 10% of 1% of assets invested (.10%) and is 70% of 1% (.70%) for Actively Managed funds. Index cost = 1/7th of Active. That’s a cost difference of .6 percentage points in return per year. For a portfolio mix with perhaps 5.9% expected real growth per year, that’s about 10% less in annual return.



    A .6 percentage points or 10% lower return rate over, say, ten years accumulates to a larger percentage difference in dollar growth. The difference expands with more years.



    [My total Investing Cost is less than 5% of 1% (.05%). That’s 1/14th of the average for Actively Managed funds. That’s a bit more money in my pocket over a decade.]


    • A rare few actively managed funds can claim to outperform and their outperformance is not consistently better. SPIVA reports show us that: see here and here for my most recent summaries. Fewer than 6% of Actively Managed funds beat their peer index in a decade. Those that do outperform don’t consistently outperform over time. There is no predictive power in thinking that outperformance over one period extrapolates to future outperformance.


    The article above has a link to another article discussing the Capital Group, the fund manager of AGTHX, the fund I discussed last week. It’s a vocal defense of Actively Managed funds. AGTHX did have a very good run in the early and mid 2000s; it did not decline nearly as much as it’s peer index during 2001-2002 and in 2008.  It looks good when you include those years.


    But how relevant is a fund’s performance more than a decade ago? Last week’s post shows its performance against its peer index – Large Cap Growth – has been DISMAL over the last decade. It’s under-performed its peer Index Fund (VONG) by 2.6 percentage points over the last five years. That translates to 20% lower return rate. And AGTHX has a front end 5.75% sales charge that goes to a financial advisor. Add the on-going annual charge to an advisor, and the effect is REALLY DISMAL.


    I like the quote highlighted in the article: “People are too fixated on fees. They should be fixated on their total return after all fees.” Well, yeah. That’s exactly what last week’s post and those SPIVA reports show: it’s almost certain that you keep more money – you have higher return – when you pay less to the financial gurus.


    • The anchor has dropped to 0% cost for index funds. We tend to gage everything against an anchor – our quick simple understanding of the Investing Cost of funds, for example. Investors know the cost of Index Funds is low, but the anchor – what does low cost really mean – was not really clear. Fidelity planted that new, obvious anchor in August 2018 when it started two stock funds at ZERO PERCENT Expense Ratio. FREE. And now there are two more of these ZERO COST funds at Fidelity. An anchor of NO COST is much clearer, much more obvious than LOW COST. An investor has to ask, “What exactly am I getting by paying the financial folks more than ZERO?”



    == Do Index Funds distort prices of stocks? ==


    The article states this argument: investments in Index Funds result in too high of prices for stocks. They don’t react to changes in the market. Index Funds will add volatility to returns. This makes no sense to me. Index Funds just buy at prevailing prices to deploy investors’ money and then they hold; they don’t transact after they’ve deployed investors’ money. Actively Manage funds and individual investors do all the buying and selling after that, and that’s what determines the price of securities. And they’re only buying and selling among themselves. Actively Managed funds create volatility or diminish it. Not Index funds.


    If it were true that the growth of Index Funds results in over-valuation, one would have to conclude that Actively Managed funds must be improving in their performance relative to Index Funds. But this is not the case.



    Conclusion: After their start 43 years ago Index Funds now have more invested in them than Actively Managed Funds. This trend will continue. The arguments for investing in Actively Managed funds are just too poor. They mathematically have to underperform in aggregate by their higher costs. The average amount they underperform – roughly .6 percentage points per year – is a big deal. That is likely 10% of future growth of an investor’s portfolio, and that difference compounds to a bigger dollar difference over time. Only a few Actively Managed funds – perhaps 6% – manage to outperform, and there is no predictive power as to which one today will outperform in the future.