Unconventional Success: Investing in Core and Non-Core Asset Classes

Posted on July 30, 2007 // 27 Comments

One of the books I am currently reading is Unconventional Success: A Fundamental Approach to Personal Investment by David Swensen. He is a very successful institutional money manager, having guided the Yale University Endowment to over 16% annualized returns over 20 years. While he has already written a bestselling book about institutional fund management, Pioneering Portfolio Management, this newer book outlines his investment advice as tailored for individual investors. I’m not finished with it yet, but so far I am very impressed. This is one of the few people in the world who could easily say “Here’s how anyone can beat the market!”, but instead he presents a unique argument for building a portfolio using low-cost, diversified, passive components.

One of the ways he separates himself from others is his definition of “core” asset classes in which to invest. Briefly, core asset classes share three main characteristics:

  1. They rely on market-generated returns, not from active management skill (as it is a very rare attribute and hard to separate from luck).
  2. They add a valuable and differentiable characteristic to a portfolio.
  3. They come from broad, highly-liquid markets.

The six core asset classes he identifies are:

Domestic Equity
Foreign Developed Equity
Emerging Market Equity
Real Estate
U.S. Treasury Bonds
U.S. Treasury Inflation-Protected Securities (TIPS)

These are all pretty well-accepted asset classes. The surprise comes when he tells you where you shouldn’t invest. Here are the non-core asset classes which Swensen believes fail to satisfy one or more of the criteria above:

Domestic Corporate Bonds
High-Yield Corporate Bonds
Asset-Backed Securitiesl (like GNMA mortgage-backed bonds)
Tax-Exempt Bonds
Foreign Bonds
Hedge Funds
Leveraged Buyouts
Venture Capital

Many of these asset classes are very popular! Take corporate bonds. While I can’t present the argument nearly as well here, the basic idea is that they don’t satisfy the “valuable and differentiable” requirement above. People buy corporate bonds over Treasury bonds because they can get a higher yield. But Swensen argues that the slight premium is not enough to compensate for the additional credit risk, lower liquidity, and callability of such bonds. One source of this imbalance is the fact that the interests of the bond issuer (the corporation) are inherently at odds with the bond investor. The corporation wants to minimize the cost of it’s debt, while the bond holder wants the opposite. Compare this with the situation of a stock holder, where both want the company share value to increase.

Possible Portfolio Changes? If you invest any bond mutual funds, you may want to find out what percentage of those funds are in corporate bonds and asset-backed securities. For example, the Vanguard Total Bond Index fund (VBMFX) holds almost 45% in mortgage-backed bonds and only 35% in Treasury bonds. Of course, many young folks don’t have any bonds at all, so this may be a low priority.

Personally, my small bond allocation is 100% in corporate bonds. I always thought that bond markets were very efficient in dealing with credit risk, and that duration and sensitivity to interest rates mattered more than the type of bond. I will have to do more reading on this topic, but it may be more prudent to switch to Treasury bonds/TIPS and instead take any additional risk by adding more equities exposure.

Filed Under: Book Reviews, Investing //

Vanguard Group Found To Be Leader In Client Loyalty

Posted on July 26, 2007 // 7 Comments

I know I haven’t finished my 401k rollover series yet, but whenever a family friend asks where they should put their old retirement plan assets, I always say Vanguard. They certainly aren’t the only good company out there, but they do have a lot of things going for them:

  • They are not a for-profit company, so their interests are better aligned with the common investor. For example, this way there are no shareholders who might want to raise mutual fund fees in order to increase profits.
  • They don’t pay advisors to sell their funds through load commissions or 12b-1 fees.
  • They offer a wide selection of low cost mutual funds that track many different asset classes.
  • I also put my money where my mouth is, as I have all of my IRAs there. I am always pleased at the high level of customer service that I get from them.
  • In the end, I feel they offer the best chance at superior performance and low-stress ownership over the long haul.

According to this Wall Street Journal article, Few Firms Earn Loyalty of the Wealthy, I am far from alone. Some excerpts:

Affluent investors say they’re increasingly dissatisfied with their mutual funds’ long-term performance and inconsistent returns. In fact, only 11 of 38 top fund families manage to create meaningful customer loyalty, according to a report released by Cogent Research LLC. The Cambridge, Mass., market researcher surveyed 4,000 mutual-fund investors with at least $100,000 in investable assets.

The study showed Vanguard Group with a wide lead in investor loyalty.

The average score was minus-12. The high was Vanguard’s plus-44. Second place went to Dodge & Cox with a plus-29. Schwab came in with 26 points, and T. Rowe Price had 21.

Filed Under: Investing //

Reader Question: Pay Off Credit Cards vs. Invest Your Money?

Posted on July 25, 2007 // 49 Comments

I’ve gotten a few variations of this question recently:

I’ve only got about $5,000 in savings and about $4,000 in credit card debt. I’m not sure if I should pay off my cards first before I decide to invest or what. I’m just looking for a way to make my money work harder. – Michael, New Investor

I indirectly addressed this topic in my post titled You Have Some Money. Where Do You Put It?, where the my top 4 were listed as:

  1. Invest in your 401(k), if you have one, up until the match.
  2. Pay down your high-interest credit card debt.
  3. Create an emergency fund with at least 2 months.
  4. Fully fund your Roth IRA.

If you read through the many thoughtful follow-up comments, you’ll see that many people have differing views on this. I’ll try to clarify my own positions here, but although I will try to provide good reasons behind then, I do agree that this is all very subjective. As usual, the ultimate goal is to present all the arguments in order to help everyone better determine their own personal solution.

#1 Invest in your 401(k), if you have one, up until the match.
Many employers offer matching 401(k) contributions. So if you contribute $100 from your paycheck, your employer will also chip in $50-$100. This is an instant 50-100% return… Some would even call this free money! Unless your credit card interest rates are over 50%, mathematically you are ahead by far. In addition, you have now started your nest egg for retirement.

Exception: The benefit of this match gets a little hazy as often you have to work for a number of years before the matched amount “vests”, or officially becomes yours. You may never actually get to keep much of the match if you only work for a year or two, so take your long-term prospects into account.

#2 Pay down your high-interest credit card debt.
Here we reach one critical debate: Paying Down Debt vs. Roth IRA. On one side, we have high interest (say, over 8% right now) debt. On the other, we have the opportunity for tax-free growth.

My argument here is, again, simple math. If on one hand you have money in stocks growing (maybe) at 10% tax-free, and on the other hand you have money shrinking at 18% with no tax deductions, you’re still losing money! Therefore, I feel the best general decision is put all that money towards your debt. Yes, saving now may mean much larger balances later, but remember, here you are choosing one or the other here, and not paying off the credit cards puts you behind.

The counterargument to this is that you only get to put in $4,000 in a Roth every year and that is precious. You can’t put nothing in this year and $8,000 next year. If you are sure that your tax rate to be higher in retirement than now, and you don’t expect to have access to other similar options like a Roth 401(k) or 403(b) in the future, then I can see how putting money towards the Roth may be better.

(Now that I think of it, another reason might be that Roth IRAs are protected in case you decide to wipe out all your credit card debt in bankruptcy court…)

Exception: One should always try to lower their interest rates if possible by calling the credit card issuers directly or, if your credit is high enough, try to get a low interest balance transfer onto another card.

#3 Create an emergency fund with at least 2 months.
Here is another hard question: Where does an emergency fund play into all of this? Overall, I think people should pay down their high-interest debts as much as possible before saving up 6-12 months of emergency funds.

Why? For one thing, if an emergency does occur, many expenses can be simply be put back onto those same credit cards: utilities, food, clothing, medical bills, etc. Other things like rent can be paid via cash advance. Since it’s most likely an emergency won’t occur, you’ll be saving a lot of interest by paying off the high-interest debt now.

The reason I put 2 months down is because I wanted to designate this a “barebones” emergency fund. The actual amount needed depends heavily on the individual: How stable is your job? Do you have disability insurance? Would your parents or someone else bail you out?

Fully fund your Roth IRA.
Although you can withdraw your contributions out of a Roth if you need to, the Roth should be a last resort. Therefore, you have the “barebones” emergency fund first, and then the Roth IRA. Should a Roth be above even a barebones emergency fund? That’s a judgment call. In my mind, a barebones emergency fund is maybe $2,000. Otherwise, you’re literally living paycheck-to-paycheck, during which I would worry about now first before the future and Roth IRAs.

Exceptions: As noted earlier, the Roth IRA is really only better than a Traditional IRA or 401k if you expect your marginal tax rate to be higher in retirement than when you make your contributions. If you expect them to be the same, they are essentially equal, with the Roth taking perhaps a slight edge. Here’s the math showing why… Say you have $10,000 pre-tax income to contribute, 25% marginal income tax rate both now and in retirement, 8% annual return, and a 30 year horizon.

401k (pay tax later):
( 10,000 x 1.08^30 ) [compounding] x ( 1 – .25%[tax later] ) = $75,469

Roth (pay tax now):
( 10,000 x ( 1 – .25%[tax now] ) )x (1.08^30) [compounding] = $75,469

If your tax now > tax later, the 401k comes out ahead. If tax now < tax later, the Roth wins. Please share your thoughts in the comments, if I haven't confused you completely already...

Filed Under: Credit Cards, Investing //

Parental 401(k) Check-up: Do You Know All The Fees You’re Getting Hit With, Mom?

Posted on July 24, 2007 // 14 Comments

It’s time to examine my mom’s 401(k) plan. The first thing that I wanted to do was to get an idea of what kind of fees she was paying. There are three basic types of fees, according to the Dept. of Labor:

  1. Plan Administration Fees – Like the description states, this is for things like record-keeping, mailing statements, and other accounting duties.
  2. Investment Fees – Often the largest and most hidden, these are fees that are wrapped into the investment options that you are given.
  3. Individual Service Fees – These are for specific things like processing loans or for self-directed investments.

Smaller companies often can’t afford a top administrator like Fidelity or Vanguard, which can absorb most administrative costs. Instead, they must find a cheaper firm (at least for them). Guess where the costs get shifted to? The workers. Thankfully, my mom isn’t subject to any administrative fee, at least that I could find. But investment fees…

Types of Mutual Fund Investment Fees
Investment fees for a mutual fund are usually broken down into

  • Front-end loads – Also known as sales charges or just front loads, this fee is charged when you buy a share of the fund. For example, if you have a 5% load and put in $1,000, only $950 worth of shares is actually purchased. Essentially a sales commission, the $50 goes to the salesman (in this case, the plan administrator). Avoid whenever possible!
  • Back-end loads – Also known as deferred loads, this is essentially the same setup, except that it is charged when you sell.
  • Expense Ratio – Also known as annual management fees, these are ongoing fees charged by the mutual fund company for running the fund. It is usually expressed as an annual percentage of fund’s net asset value (NAV), although the fee is subtracted a little bit each day. The expense ratio may also include a sales portion, called 12b-1 fees.
  • Early Redemption Fees – Supposedly to deter market timing, such fees are usually the same as back-end loads, unless the money is direct back into the fund itself and split amongst the shareholders (instead of going to the fund managers).

What is sneaky about all these fees is that they are usually not marked on your account statements as a fee, and in the case of 401k’s I bet many investors are never told about them and how they can seriously hurt your potential returns.

Do You Know What Share Classes You’re Buying?
Now, of course by law they must give you the prospectuses for each fund. You know, those thick booklets that most people file away, never to see it again. But if you don’t know, dig them up and read them! For one, one mutual fund may have several different shares classes, with different combinations of front loads, back loads, and annual expense ratios. Don’t just assume you are buying the cheapest class, either.

For example, the only Real Estate option my mom’s plan is the AIM Real Estate Fund, Class A Shares (IARAX). I was sad to see that this has a fat 5.50% front load and a 1.29% expense ratio. The Investor Class shares of this fund (REINX) had no loads and 1.27% expense ratio. I don’t know how happy she’ll be to find out that 5% of every dollar she put in was being taken away instantly.

I still have to sort through the other details of the funds like investment objectives and asset classes, but by better understanding the fees, she can already start to choose between her available options more wisely. For instance, your 401k might offer a great International Fund with reasonable expenses, and an S&P 500 fund with horrible expenses. If so, you can buy the better fund in your 401(k) and find a good alternative for the bad one in your other brokerage accounts.

Filed Under: Investing, Retirement //

How Often Should I Rebalance My Investment Portfolio? A Brief Article Review

Posted on July 22, 2007 // 19 Comments

I feel like my last post about rebalancing wasn’t as thorough as I’d have liked it to be, so here I go again, adding some quick definitions and including a review of several research articles about the subject.

What is Rebalancing?
Let say you examine your risk tolerance and decide to invest in a mixture of 70% stocks and 30% bonds. As the years go by, your portfolio will drift one way or another. You may drop down to 60% stocks or rise up to 90% stocks. The act of rebalancing involves selling or buying shares in order to return to your initial stock/bond ratio of 70%/30%.

Why Rebalance?
Rebalancing is a way to maintain the risk/reward ratio that you have chosen for your investments. In the example above, doing nothing may leave you with a 90% stock/10% bond portfolio, which is much more aggressive than your initial 70%/30% stock/bond mix.

In addition, rebalancing also forces you to buy temporarily under-performing assets and sell over-performing assets (buy low, sell high). This is the exact opposite behavior of what is shown by many investors, which is to buy in when something is hot and over-performing, only to sell when the same investment becomes out of style (buy high, sell low).

However, in taxable accounts, rebalancing will create capital gains/losses and therefore tax consequences. In some brokerage accounts, rebalancing will incur commission costs or trading fees. This is why, if possible, it is a good idea to redirect any new investment deposits in order to try and maintain your target ratios.

How Often Should I Rebalance My Portfolio?
Some people rebalance on a certain time-based schedule – for example, once every 6-months, every year, or every 2 years. Others wait until certain asset classes shift a certain amount away from their desired targets before taking any action. A good source of research articles about which method is optimal can be found at the AltruistFA Reading Room. I’ve been reading through them the past few days, and I’ll try to provide a very general overview of the articles here.

So what is best? You may be surprised by the fact that not only is there no clear agreement on the answer to this question, but many of the articles actually contradict each other! For instance, compare this Journal of Investing article:

Over this period, regular monthly rebalancing returns dominated less active approaches. Should one infer that daily rebalancing is better still? Our data cannot say, but it seems plausible.

with this excerpt from an Efficient Frontier article:

So, what can we conclude from all this? Monthly rebalancing is too frequent. There are small rewards to increasing one’s rebalancing frequency from quarterly up to several years, but this comes at the price of increased portfolio risk.

Eh? I believe that this is because their results vary significantly with the time period chosen and asset classes being used in their back-tested scenarios.

Then there is this paper from Financial Planning magazine, which used the 25 year period from Oct. 1977-Sept. 2002 and a 60% Stock (S&P 500 Index) and 40% Bond (Lehman Bros. Gov’t Index) as the starting/target allocation. Here are the results for various rebalancing frequencies:

altext

The various rebalancing periods showed minimal performance differences, although annual rebalancing held a slight return margin and a higher risk margin.

Because the risk-adjusted performance differences among the portfolios were small, the answer to the question of when to rebalance–monthly, quarterly, semi-annually, or annually–depends mainly on the costs to the investor of rebalancing.

Efficient Frontier’s Bernstein also agreed in the this last respect, stating “The returns differences among various rebalancing strategies are quite small in the long run.”

In the “wait for a significant shift before taking action” camp is author Larry Swedroe, who I think also presents a very reasonable solution. From a WSJ article:

With major holdings like U.S. stocks, foreign stocks and high-quality U.S. bonds, consider rebalancing whenever your fund holdings get five percentage points above or below your targets, suggests Larry Swedroe, research director at Buckingham Asset Management in St. Louis. For instance, if you have 40% earmarked for bonds, you would rebalance if your bonds got above 45% or fell below 35%.

Meanwhile, for smaller positions in sectors like emerging markets and real-estate investment trusts, Mr. Swedroe recommends a 25% trigger. So if you have 5% targeted for emerging-market stocks, you’d rebalance if emerging markets balloon above 6.25% or fall below 3.75%. “You definitely want to be rebalancing, but you don’t want to be doing it too often,” Mr. Swedroe says. “You want to let stocks go up a bit before you sell, but not so much that you lose control of risk.”

Summary
Since it seems that there is no concrete right answer, I think the most important thing is to just make sure you set up some way to rebalance that does not involve any emotions or market timing. Don’t worry about the details, but don’t let your portfolio run off on its own either. I think the subtitle of one of the articles above sums it up quite well… ‘Tis Better To Have Rebalanced Regularly Than Not At All.

I have personally chosen to rebalance annually. This method keeps it simple while still controlling risk and offering potential extra return. If I recall correctly, it is also recommended in Ferri’s book All About Asset Allocation (review).

Filed Under: Investing //

Note To Self: Rebalance Your Portfolio!

Posted on July 20, 2007 // 14 Comments

It’s been over a year since I came up with my current asset allocation mix, and I should really rebalance my current portfolio to match those percentages again. It really should only take a few minutes of spreadsheet math and some clicking online, but I’ve been plotting out a few long-term asset allocation changes in the meantime and I’ve been putting it off. I really must do one or the other soon.

Rebalancing is a way to maintain the risk/reward balance that you have chosen for your investments, and also forces you to buy temporarily under-performing assets and sell over-performing assets (buy low, sell high). How often one should re-balance their portfolio depends on a few factors. In taxable accounts, rebalancing will create capital gains/losses and therefore tax consequences. In some brokerage accounts, rebalancing will incur commission costs or trading fees. As for me, the vast majority of my retirement portfolio is in tax-sheltered accounts and in mutual fund accounts which are not subject to transaction fees. Some of my funds have redemption fees, though.

After that, some people rebalance on a certain time-based schedule – for example, once every 6-months, every year, or every 2 years. Others wait until certain asset classes shift a certain amount away from their desired targets. I will dig up some good articles on this topic later (here is one math-intensive article to start), but after my previous research I had settled on an annual rebalancing schedule. Of course, that was almost 15 months ago. 😳

If you rebalance, what is your criteria?

Filed Under: Investing //

401k/403b Rollovers: Should You Move Your Old Retirement Plan To Your New Employer?

Posted on July 19, 2007 // 14 Comments

Let’s continue with the 401k/403b Rollover discussion. Previously, I explored some possible reasons to keep your old employer’s plan. The next option to consider (if only briefly) is to transfer your 401k/403b assets into your new employer’s retirement plan. You can only transfer after-tax contributions between the same type of account (401k » 401k, or 403b » 403b), but more common pre-tax contributions should be able to be transferred between different types as long as the new plan allows rollovers.

The reasons you might want to do an employer-to-employer transfer are very similar to before:

Special investment options
Maybe your new employer plan has some desirable options that aren’t available to a retail IRA investor. The average 401k has something like 7 mutual fund choices though, so this is probably unlikely. Ask your new HR department for details.

Lower minimum balances or fees
If you have a small balance and figure you might as well cash it out as you don’t meet other account minimums, don’t! Your new employer will probably have no minimum requirements and you can continue to build on what you have already contributed.

Ability to take out loans
Your new 401(k) may allow you to take out loans against your savings, which you can’t do with an IRA. In addition, if you already have a loan from your old 401(k), your new one may allow you transfer over that loan. Otherwise, most plans make you pay back the balance immediately or risk having it penalized as an unqualified withdrawal.

Still not sure? Another alternative is to roll your plan into a Rollover IRA, keeping it separate and not merging it with any other IRAs, and then see how you like your new employer’s plan. If somehow you do, then you can transfer the Rollover IRA assets into your new plan.

References: SmartMoney, American Funds

Filed Under: Investing, Retirement //

Hedge Funds: Too Sexy For My Money

Posted on July 19, 2007 // 25 Comments

You have probably heard of hedge funds, which are investment funds somewhat similar to mutual funds in they pool together money from different investors, but with the very important difference that they have virtually no limitations on what they can invest in, and also have no requirements to disclose their holdings.

In order to invest in a hedge fund, you are usually required to be an accredited investor, which means that you either have a net worth of at least $1 million or have made at least $200,000 each year for the last two years (or $300,000 joint combined). Supposedly this is to show that you are savvy enough to navigate these loosely-regulated waters, but to me it seems like they just want you to be able to lose a ton of money on these sexy-sounding investments and not make a big fuss about it.

I was reminded of this when reading about the most recent big-name hedge fund failures:

Investors in two troubled Bear Stearns Cos. hedge funds that made big bets on subprime mortgages have been practically wiped out, the Wall Street firm said yesterday, in more evidence of the turmoil in this corner of the bond market.

Bear said one of its funds was worth nothing and another worth less than a 10th of its value from a few months ago after its subprime trades went bad, according to a letter Bear circulated and to people briefed by the firm. The Wall Street investment bank — known for its bond-trading savvy — has had to put up $1.6 billion in rescue financing.

Oops! I guess they didn’t hedge their credit risk exposure very well. For more reading, just run a search for Long Term Capital Management or see the Wikipedia entry:

Initially enormously successful with annualized returns of over 40% in its first years, in 1998 it lost $4.6 billion in less than four months and became the most prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

Here is an example of hedge fund fraud:

An Atlanta hedge fund manager under suspicion of defrauding a group of investors that included several NFL players now faces criminal charges in connection with the collapse of funds that investors believed held up to $180 million.

While I plan to meet the requirement to become a accredited investor, and wouldn’t mind working for a hedge fund, I’m pretty sure I’ll never sink a penny into one. I just don’t see the need to take such risks.

Filed Under: Investing //

401k/403b Rollovers: Reasons To Stay Put With Your Old Employer’s Plan

Posted on July 17, 2007 // 36 Comments

One of the most common questions I get from people when they find out that I like personal finance is “What should I do with my 401k/403b/457 plan from my old job?” My own 401k rollover decision process was one of my first blogging topics. I eventually settled on rolling my 401(k) balance into an IRA at Vanguard, although I have since changed my specific investment choices. This time around, my wife has the ex-401k that needs to be addressed, and so I think it’s a good time to do a more in-depth series on 401k (and similar) rollovers.

To start off, should you really move your retirement plan somewhere else? I think you’ll see that in most cases the answer is yes, but there are some possible benefits to staying put. Here are a few:

Special investment options
While many 401(k) plans offer very limited or expensive options, some of them actually offer investments that you may not be able to get anywhere else. For example, your plan may give you access to a mutual fund that is normally closed to new investors, a special institutional or pooled fund with super-low expenses, or the ability to buy your company stock at discounted prices.

Lower minimum balances or fees
One benefit of many 401(k) is that there are often no minimum balance requirements to invest in an offered fund. For example, my wife might have as little as $10 in a Fidelity Spartan index fund with a tiny 0.10% annual expense ratio while it is in her 401(k), but in an IRA the minimum would be $10,000. At the same time, the account may continue to waive all maintenance fees even after you leave (check with your administrator.) Depending on where you move your money to, other brokers may charge fees for low balances.

Together, it may be a good idea to keep smaller portfolios in such a 401k until the balance grows enough to consolidate with other investments.

Ability to take out loans
Although not necessarily a good idea, many plans do offer the option of being able to borrow money temporarily from your 401(k). This option is not available in an IRA.

I probably missed something, so if you have some more reasons not to move your retirement plan into an IRA, please share in the comments below.

Filed Under: Investing, Retirement //

Stock Picking Contests Are Stupid

Posted on July 14, 2007 // 11 Comments

Why do stock-market contests continue to exist? I even had them in my high school Economics class, as if they were a useful learning tool. The goal is always to have the most money within just a few months. Since it’s always done with fake money, there is no punishment (like say, poverty?) if you lose everything. Only the top 0.01% win, and the rest lose. How is this applicable to real life at all?

I was reminded by how much I dislike such fake contests when I read about how CNBC’s Million Dollar Portfolio Challenge ended with a whimper. A quiet announcement revealed that waitress who’d never owned any stock before beat out 377,000 other participants to win the $1 million prize. But what got the most attention was the fact that people figured out a loophole in the system (being able to trade after the markets had closed) and cheated their way to great gains.

What have I actually learned? First,such short-term stock picking contests are about luck, not skill. A slot machine pull would be both faster and easier. Second, there will always be people trying to cheat the system, and many will get away with it. I find it very hard to believe that the SEC catches the majority of insider trading or other short-term manipulations of the market (you know, like Mad Money guy Jim Cramer used to do.)

I continue to ignore short-term variations of the real stock market as a result, and I often urge my family and friends to do the same. It feels like a lost cause though, as watching stock market gyrations has become America’s new favorite pastime and water-cooler material.

Added: The Motley Fool also has a nicely written article on what they term the CNBC’s “Portfolio Challenge” Fallacy.

Filed Under: Investing //

Dad’s Retirement Plan: Learning About The TIAA-CREF Traditional Annuity

Posted on July 9, 2007 // 67 Comments

While visiting the parents, I was also asked to provide some input on their retirement savings. I don’t want to invade their privacy, but I’m sure they share common concerns with others out there. My father, who is in the non-profit/education sector, has much of his retirement money with TIAA-CREF (Teachers Insurance and Annuity Association – College Retirement Equities Fund). They are one of the biggest financial services companies in the U.S., and are operated on a non-profit basis.

As you might guess from their name, a very popular option for members is the TIAA Traditional Annuity, holding over $163 billion. I was not at all familiar with this beast, so I decided to learn more about it. Here’s a quick rundown from the website:

A guaranteed annuity backed by TIAA’s claims-paying ability, TIAA Traditional guarantees your principal and a minimum interest rate, plus it offers the opportunity for additional amounts in excess of the guaranteed rate. TIAA has credited additional amounts of interest every year since 1948.

The annuity primarily invests in publicly traded bonds, commercial mortgages, direct loans to business, and real estate. It has no loads, no surrender charges, no maintenance fees, and very low annual operation expense ratios of about 0.25%. (Sources: SURS, Dixie State Univ. )

Accumulation Stage
So you invest in this annuity, your account value will never decrease as long as TIAA is around. In fact, it will go up in value by at least 3% every single year, and most likely more depending on market conditions. Think of the savings on antacids during the next stock bubble! There are two tiers of performance – From what I understand, the higher paying tier is for money that is contributed directly by the employing company or group, whereas the lower paying tier is for voluntary contributions from the individual. Here are the historical returns:

altext

For comparison, the venerable Vanguard S&P 500 Index Fund (VFINX) has a 10-year trailing return of 7.05%, and the Vanguard Total Stock Market Index Fund (VTSMX) has a 10-year return of 7.60%. The Vanguard Total Bond Market Index Fund (VBMFX) has a 10-year return of 5.74%.

Withdrawal Stage
When you reach retirement and are ready to start take money out of your annuity, you have a variety of options. There are one-lifetime income options, two-lifetime income options, fixed-period (ex. 10-year) income options, interest-only payments, and also a few others involving taking a lump-sum or just the required minimum distributions.

Of course, all annuities are simply a promise, not a 100.00% guarantee. In this regard, TIAA does have the highest possible credit ratings from all the major agencies: A++ by A.M. Best, AAA by Fitch, Aaa by Moody’s, and AAA by S&P.

Summary
Overall, it was very interesting learning about this additional investment option. Here were my tentative opinions:

  • There is an expected trade-off of lower long-term performance in exchange for a guaranteed minimum return if you purchase this annuity. For those with longer time horizons and the discipline to ride out the market’s ups and downs, it may be better to invest in low-cost stock/bond mutual funds or ETFs instead. Those that are very risk-averse will love this investment.
  • The lifetime income options are nice and reliable, but you could also do the same with a portion or all of any retirement portfolio. Just cash out your stocks and bonds, and go buy an immediate annuity with a lifetime payout option.
  • Still, if you’re going to buy such an annuity, TIAA-CREF offers some of the best and safest returns along with the lowest fees available in the annuity marketplace.
  • As my father is nearing retirement and I think the safety of this investment is very comforting to him, I think this option will work adequately for him. The majority of his annuity holdings are also in the higher-paying tier. I am, however, providing him some guidance in the rest of his portfolio to provide some diversification, as well as telling him what questions to ask his group’s financial advisor.
Filed Under: Investing, Retirement //

Adding Gold To My Investment Portfolio… Kind Of

Posted on July 9, 2007 // 35 Comments

While I’m back home, my parents took the opportunity to transfer possession of some family gifts. Included in them were two one-ounce 24 karat gold bars. I don’t know much about them, except one was given to me when I was born and the other when I graduated high school. The have the words “Swiss Bank Corporation” (now UBS) and a serial number on one side, and here is a picture of the other side:

altext

At about $650 per ounce, my two ounces would be worth $1300, or about 1.6% of my current investment portfolio. Some sources indicate I may even be able to charge a slight premium for my minted bars. In truth, I’m probably going to end up passing them along to future generations. Is it okay for me to just store these in safety deposit boxes?

I know there is heavy debate in this area, but I personally have no plans to buy any more gold. This is not to say they can’t be a useful part of a portfolio, but I’m still not really convinced of the long-term utility of buying any inanimate objects, including other precious metals and commodities. I’m keeping an open mind, however, if people want to make reasoned arguments either way.

If you are into Modern Portfolio Theory and mean-variance optimization, you might be interested in this Efficient Frontier article on gold:

Make no mistake about it: over the very long term, precious metals equity should provide your portfolio with a mean-variance boost. Just be sure that you?re prepared for the long term?the very long term?behavior of this asset class.

Filed Under: Investing //
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