Episode: 142
Originally Aired: September 23, 2015
Topic: Jonathan Clements’ Money Guide 2015
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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TOPICS COVERED:
- Introduction of Writer Jonathan Clements, Expert on Personal Finance
- Financial Calculators Are Valuable When You’re Saving for Retirement
- Drawing Down Your Retirement Portfolio Is the Toughest Financial Task
- Flexibility in Withdrawal Rate Allows You to React to Financial Markets
- Preserve Liquidity or Pay Off Mortgage Heading Into Retirement?
- Refinance Large Home Mortgage to 30-Year Loan Before Retirement
- Can You Live Comfortably on 66 Percent of Pre-Retirement Income?
- Second Homes You Live in Are Not Investment Properties
- Low-Cost Variable Annuities Exist, and They Can Benefit High Earners
- Long-Term Care Insurance Doesn’t Helpt Retirees With Less Than $500,000
- ‘Indexting Is Really the Only Way to Win the Stock-Market Game’
- Growth Stocks are Overpriced; Value and Small Stocks Underpriced
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Welcome to The Lange Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
1. Introduction of Writer Jonathan Clements, Expert on Personal Finance
Dan Weinberg: And welcome to this edition of The Lange Money Hour. I’m Dan Weinberg, along with CPA and attorney Jim Lange, and joining us on tonight’s show is someone who’s been on the program before and we’re thrilled to have him back with us: Jonathan Clements. Jonathan is an expert on personal finance. He was the top personal finance writer for the Wall Street Journal before he joined Citibank Personal Wealth Management as its director of financial education. He returned to the Journal last year and now writes a weekly column for Wall Street Journal Sunday, which can be seen in 70 newspapers across the country. Jonathan’s written four books on personal finance, including the bestseller The Little Book of Main Street Money, and his brand new book out this year, Jonathan Clements Money Guide 2015. And Jim and Jonathan have collaborated on more than 30 newspaper columns over the years. Now, let’s say hello to Jim Lange and Jonathan Clements. Good evening, gentlemen.
Jim Lange: Welcome, Jonathan.
Jonathan Clements: It’s great to be with you, Jim!
Jim Lange: And what Dan didn’t say is that if you’re not the top financial writer in America, you’re certainly one of the top two, and I just love your material, and I love your new book. It’s Jonathan Clements Money Guide 2015. This is a no-brainer. People should just buy it and not even think about it, and the only question is, is whether you get a hard copy or whether you get it on Kindle.
Jonathan Clements: Well, thank you very much, Jim. Yeah, the book was a ton of work. It’s the longest book, and I hope that doesn’t put people off. It’s the biggest book I’ve ever written. It’s 112,000 words. It covers every possible financial topic. I like to think of it as an encyclopedia with attitude. And one of the coolest things about the book, and Jim knows a little bit about this because he’s put out books through Amazon himself, is that I was able to wrap up the book on December 31st with all the latest numbers on the economy and the market, and it was available for sale on January 1st.
Jim Lange: Which, I think, is tremendous. On the other hand, with all due respect to the latest and greatest information, I think most of the things that you talk about in the book are somewhat classic and could’ve been written five years ago and probably could be written five years from now. Not to say that it’s not current to literally the month, and you did a fabulous job, but I think that you do offer some timeless advice.
Jonathan Clements: Well, I think that’s correct, Jim. I mean, often, the best advice for what you should do this year is the same best advice that you should be following next year and the year after that. On the other hand, you know, year to year, a lot of things change, not just the markets. As you know, you know, tax rates change, tax thresholds, the state of the economy, the amount that you can put into an IRA or a 401(k). A lot of these numbers get updated every year, so it’s important to stay on top of this stuff.
Jim Lange: All right. And I should mention, you know, I’ve been reading Jonathan Clements for many, many years, and I’d say on probably 98, 99 percent of the time, I’m in complete agreement with him, and I would say the same thing for the book. But I’ve listened to some of my interviews when I have had authors who I basically agreed with, and it was a little bit boring. So, I suggested to Jonathan — and he was OK with it — that we pick some topics that we might not be 100 percent on the same wavelength for, or at least are coming at it from a different angle. And if it’s OK with you, Jonathan, I thought maybe we could talk about a couple of those things, and then we could each say our piece, and then go onto the next one, if that’s OK with you?
Jonathan Clements: Jim, any time I’m happy to point out the error of your ways!
Jim Lange: I appreciate that! All right, so one thing that you like to talk about, and I actually remembered that you actually put this in some of your … or maybe you didn’t. I’ve just known about Dinkytown. But you have a section in there that talks about entering some of your information in some of the online retirement calculators, and my problem with the calculators, no matter how good they are, is you don’t see all the assumptions that they make, and you don’t know what’s really behind that. Now, even you, yourself, after saying, “Hey, it’s a good idea to do that,” you talk a little bit about the safe withdrawal rate, and I think that a discussion of the safe withdrawal rate is really important. On the other hand, I’d like you to put in a little plug for the calculator discussion, and then maybe we’ll have a little discussion of the safe withdrawal rate discussion.
2. Financial Calculators Are Valuable When You’re Saving for Retirement
Jonathan Clements: OK. So, Jim, let’s unpack a couple of things that you threw in there. First of all, in terms of calculators, I think that if you’re saving for retirement, the calculators are pretty useful. Yes, you have to check what the return assumptions are with the calculator, and often, if you look at the defaults, the return expectations are too high. You want to bring them down. I mean, these days, when I talk to people about return expectations for the stock market, I suggest that maybe for the next 10 years, if you have a globally diversified portfolio, you might make 6 percent a year. Meanwhile, with bonds, given today’s low yields, even if you have an investment grade bond portfolio, you’re probably not going to make much more than 2½ or 3 percent a year over the next 10 years. So, definitely, you want to bring down the returns that you put into those calculators. But if you’re saving for retirement, you’re putting away money in your 401(k) and your IRA every year, making some straight-line assumption using a basic financial calculator seems to be just fine to me.
3. Drawing Down Your Retirement Portfolio Is the Toughest Financial Task
Now, and I think this is where you might be going, Jim, come retirement, it’s a completely different ball game. You can’t sit there with a simple financial calculator and say, “All right, I project I’m going to make 60 percent of my stocks 2½ percent of my bonds, and I can withdraw ‘X’ number of dollars because I’m going to be dead by age 85.” That just doesn’t work. Drawing down a portfolio in retirement is probably the toughest financial task out there because there’s so many different moving parts. You don’t know what the markets are going to deliver. You don’t know when the next bear market’s going to hit. You don’t know what the inflation rate is going to be. And probably most important, you don’t know how long you’re going to live. So, come retirement and drawing down a portfolio, I would argue that you should set aside the calculators, and really what you need more than anything else is financial flexibility, and you shouldn’t be locked in to withdrawing a certain dollar amount every year.
Jim Lange: Well, this is what I was afraid of, is that when we got into the details, I was going to agree with you. So here we are. You know, I was reading your material and I thought, “You know? For people about to retire, I really don’t think the calculators are that great. And I want to talk about safe withdrawal rate.” Then, on your own, you basically said the exact same thing. So why don’t we, for the people who are close to retirement, and you do have a section on safe withdrawal rates, why don’t we talk about safe withdrawal rates for a minute? Because I think it’s such a critical issue, and you, yourself just said that that’s one of the toughest things that somebody can do is to figure out how to get from, let’s say, retirement to, and let’s assume that you’re both married, you and your spouse, how do you get from where you are to the end of the second life?
4. Flexibility in Withdrawal Rate Allows You to React to Financial Markets
Jonathan Clements: So, this has, of course, been the subject of much research, and as you know, Jim, and probably a lot of your readers have heard by this point, many financial planners rely on what’s called a 4 percent portfolio withdrawal rate. So, what does that 4 percent portfolio withdrawal rate mean? Essentially, it means that in the first year of retirement, you can withdraw 4 percent of however much you’ve saved for retirement, and thereafter, in subsequent years, you can step up the dollar amount you withdraw with the inflation rate. There are a couple of caveats you throw in at this point, which is one, you’re going to have to pay taxes on the money involved, and two is, when we talk about this 4 percent portfolio withdrawal rate, you have to include any dividends and interests you received towards that 4 percent.
Now, I think 4 percent is not a bad rule of thumb, but you really do have to stay flexible. The fact is, blindly pulling out a certain dollar amount from your portfolio, no matter what’s going on in the financial markets, just doesn’t make a whole lot of sense. Yes, hypothetically, over a 30-year retirement, a 4 percent withdrawal rate is going to work. In reality, who knows what’s going to happen? What if we get 2008 and 2009 twice or more over the next 10 years? Suddenly, all the historical data may be completely useless. So one of the things that I would say to retirees is, you have to stay flexible and you have to use one of the most underutilized but valuable levers that’s at your disposal, which is your ability to vary your spending. If we have a really bad stretch in the financial markets, that is the year that you do not go to Europe. You do not take the round-the-world cruise. Instead, you go to the closest beach you can find, spend a week there in a cheap motel and then head home!
Jim Lange: Well, I agree with you on that, and the research that you’re talking about, which has been the subject of several of our radio shows, the original safe withdrawal guy is Bill Bengen, and you are correct. The classic Bill Bengen talks about a 4 percent safe withdrawal rate for a 30-year period, and theoretically, he says you don’t even have to look at your portfolio every year. But frankly, I agree with you that being flexible is important, and particularly if you have a couple down years — as you point out in another section, I forget which one — at the early part of your retirement, that’s much different than having a couple down years towards the end of your retirement. So, certainly, if you have a couple down years in the early part of your retirement, that 4 percent rule probably can’t be followed.
Jonathan Clements: Yeah. No, I totally agree. What you’re referring to, Jim, and I’m sure listeners know about, is what’s called sequence of return risk, and sequence of return risk can be absolutely devastating to retirees if that bear market hits in the first five years or so of retirement. If that happens, then you really need to throw back your spending, reduce your withdrawals, wait for the markets to come back, and if you do that, you’ll probably be fine from there on out.
Jim Lange: All right. Another area that you talk about that, let’s just say, caused me to stop, although I think that you’re giving classic advice, and you have always been a defender of the consumer. You know, despite the fact that you’re writing for the Wall Street Journal and you think that you’re writing for a bunch of rich cats, you’re actually giving great advice for the average Joe if they were going to listen. And one of the things that you like to tell people is, particularly in your 50s and 60s right before you retire, to pay off as much debt as you can, and you’re telling people pay off their houses, pay off their lines of credit, pay off their home equity loans, and that way, you go into your retirement without having a debt. And that’s probably sound, particularly for people who might have a tendency to overspend, and it would be a good thing for them to have equity in their home so they don’t have a mortgage and, if necessary, they could actually borrow from it.
I’m going to bring up another possibility though. If you don’t pay off your loans, you have the use of that money for the rest of your life, and whether it’s with reverse mortgages or even just not paying down, particularly these days, you might have a 3 or 4 percent mortgage. My inclination would be to have some available money and have other monies invested in a portfolio, and not necessarily go and pay everything off. Why do you like to have people go into it debt-free, and presumably, not with as much liquid resources in order to meet their retirement goals?
5. Preserve Liquidity or Pay Off Mortgage Heading Into Retirement?
Jonathan Clements: There are really three reasons why you want to be debt-free heading into retirement. The first is, as you approach retirement, you’re going to be moving towards a somewhat more conservative portfolio. In other words, a portfolio that’s going to have less in stocks and more in bonds. Look around the bond market today. If you’re buying high-quality bonds, you’re probably not going to be earning much more than around 3 percent. Meanwhile, go out and even if you’ve got a recently refinanced 30-year fixed rate mortgage, that mortgage is costing you 4 percent. The corporate bonds that you own, that interest is going to be taxable. Yeah, the mortgage is going to be tax deductible, but netted out, the mortgage is still costing you more than your bonds are earning. So, you know, look at that arbitrage, you’re probably better off having a smaller bond portfolio and having less debt than keeping that big mortgage.
Second, the reason I like to see people pay off their mortgage is because of an issue I’m sure you’ve discussed on the show in the past, Jim, which is the so-called tax torpedo. What’s the tax torpedo? Essentially, what happens is, if you go into retirement with a substantial mortgage payment you have to make, that’s going to cause you to make even larger taxable withdrawals from your retirement account. Those larger taxable withdrawals from your retirement account, in turn, raise your taxable income, and thus it can trigger higher taxes on your Social Security benefit. So, the net effect of that bigger mortgage payment is you get taxed twice: once on the bigger taxable withdrawal from your retirement account, and two, on your Social Security payment.
The third reason I like to see people pay off their mortgage by retirement is I like to see people in retirement with lower fixed costs. The lower your fixed costs, the less money you need to pull out of your portfolio every year. That’ll leave you in good shape if we get a period of rough financial markets. You don’t want to be compelled to start pulling money out of the stock market at distressed prices in order to make that mortgage payment.
Jim Lange: OK, I understand. For whatever it’s worth, my thinking is, you’re certainly not going to have a hundred percent of your money in a fixed income. Even the safe withdrawal rate is assuming maybe a 50 percent allocation of stocks. So I am hoping after the tax benefits, that you’re going to get maybe a little bit of a higher return. Also, sometimes having that money available can cause you not to have to go into your portfolio, or even not into a taxable portfolio. I would agree, by the way, that if you have to go into your IRA, particularly before minimum required distribution, that isn’t the greatest. But anyway, I will just tell you that I have seen people — and I guess reverse mortgages are a different idea, but I think it’s the same concept — live much better, and then they end up dying in debt. And let’s say you’re 65 years old and you have a 30-year mortgage. That doesn’t particularly bother me if the mortgage payments are clearly doable because that means that the money that you didn’t spend to pay off that debt is available for your purposes, and often, I’m thinking of a couple instances where people literally could not afford their lifestyle had they paid off their debt, but because they didn’t, they had more liquid money.
Jonathan Clements: Well, I’ll throw you one bone, Jim, on this one.
Jim Lange: Grudgingly!
6. Refinance Large Home Mortgage to 30-Year Loan Before Retirement
Jonathan Clements: Grudgingly? Of course it’s grudgingly! What do you expect? No, seriously. If you’re approaching retirement and you have a substantial mortgage and there’s no way that you’re going to get that mortgage paid off in the first 10 years of retirement, if that’s the case, then what I would say to you is, before you quit your job and you still look credit worthy to the bank, go back and refinance your mortgage and take out the longest mortgage you possibly can and get it for 30 years, because that way, instead of having that hefty mortgage that you’re going to carry for at least 10 years, you can have a smaller mortgage that you probably never will pay off. So if you’re not going to be able to pay off the mortgage pretty soon after retirement, you might as well at least minimize the payments that are due every month.
Jim Lange: That idea I like, and Jonathan Clements is, if not my favorite writer, certainly within the first two favorite financial writers anywhere ever, but certainly writing in the English language, and just came out with just a gem of a book called The Jonathan Clements Money Guide 2015. So here you have really just like the top writer who has tremendous wisdom in all these areas, has poured his heart and soul into this very fine book, and for the not much price of … I don’t know. Is it 20 bucks or even less? And if you get it on Kindle, it’s probably like about 6 or 7 bucks. It’s just a great thing that I would recommend all listeners have.
But anyway, Jonathan and I were talking about some of the areas that we didn’t necessarily agree a hundred percent on, because I agree with Jonathan probably 98 percent of the time. But one area that I wanted to talk about is Jonathan, you said that there was a study that people were living on 66 percent of their pre-retirement income and that that was sufficient. Can you tell us maybe where you got that money and whether you think that that is a reasonable thing to count on in the future?
7. Can You Live Comfortably on 66 Percent of Pre-Retirement Income?
Jonathan Clements: So, the studies actually were done by T. Rowe Price. It was done last year, and what it found was that the retirees that they surveyed were typically living on 66 percent of their pre-retirement income, and these retirees who are at that level were saying that they were very happy with their retirement. I know where you’re going with this, Jim. You’re going to say, “66 percent? That’s not enough money. The rule of thumb out there is that people, to retire in comfort, need 80 percent of their pre-retirement income.” And, of course, the answer is, yeah. The more you have, the better, but the reality of retirement is pretty messy. A lot of people don’t get to choose when they retire. The Employee Benefit Research Institute does an annual retirement confidence survey, and the numbers have stayed very similar year after year. On average, people who are in the work force expect to retire at age 65. On average, they actually retire at age 62. In other words, people are typically retiring three years earlier than they expected to, presumably because they were forced out of their jobs, they were in ill health, whatever the reason was, and what happens? Well, whatever money you have at that point, that’s the money you bring to the show. Whatever you have for retirement, that’s the money you have to spend. More would be better, but if you don’t have it, you’ve just got to figure out a way to make do.
Jim Lange: Well, I would agree with that, but let’s say that you are not in that unfortunate position, and let’s say that you have the ability to maintain your job, and the question is, do I want to retire or do I want to keep working? And the reason why I question the 66 percent … now, maybe I’m lucky and I have some people who are very involved and have multiple interests, et cetera. And what I sometimes find is some of these people that are working very hard, I have about, I think, 600 college professors, I have a lot of engineers, I have a lot of people who have some interests outside of their jobs, and I always assumed that one of the reasons that they’re not spending more while they are working is because they’re too busy working. So, if they’re not working, then they have time to go to Paris. If they’re not working, they have time to get involved with expensive hobbies and play golf at expensive golf courses and do things that they couldn’t do. So that was why I was just a little bit uncomfortable with 66 percent.
And then, the other thing is, you have to talk about, you know, are you talking about after taxes and what state do you live in? So, for example, Pennsylvania does not tax IRAs, does not tax pensions, does not tax Social Security, but that might not be true in New York or California. That was my only, let’s say, slight uneasiness, that if you have the choice, I hate to see somebody retire and then have to reduce their lifestyle.
Jonathan Clements: Well, two points on this, Jim. One which, of course, will support you and one that doesn’t quite. I agree with you to this extent. If you think about how much you spend when you go on a vacation for two weeks a year. Now imagine being on vacation for 52 weeks a year. If you aren’t careful, you could spend a ton of money, way more than you used to spend when you were in the workforce. So, yeah. There is a great danger that retirees will overspend if they’re not careful and keep a close eye on what they’re spending. On the other hand, in terms of this replacement rate that is typically talked about as 80 percent of your pre-retirement income, a lot depends on how you managed your finances before you retired.
So let’s take the classic case: You, prior to retirement, were committing 7.65 percent of your income to Social Security payroll taxes. You were also saving 10 percent of your income every year. Roughly speaking, we’re talking about losing 20 percent of your income to those two things. So yeah, to keep your standard of living after you retire, you’d need 80 percent of your pre-retirement income. But imagine a different situation. Imagine that you’re one of those people who’s a great saver, and that your final years running up to retirement were not only kicking in that 7.65 percent to Social Security payroll taxes, but you were also saving 25 percent of your income. It’s entirely possible for you to live on 65 percent of your pre-retirement income and be perfectly comfortable with no cut in your standard of living.
Jim Lange: OK, fair enough. So, now, maybe a slight quibble on the definition of pre-retirement income. But the other thing that you just mentioned is, you know, now, you’re going to be on vacation 52 weeks a year, and the other thing that you didn’t like — and that made me wince a little bit because this is a subject near and dear to my home and particularly right now, with this miserable winter that we’re suffering in the Northeast — you don’t seem to like second homes very much. Is that right?
8. Second Homes You Live in Are Not Investment Properties
Jonathan Clements: Well, there are two different issues here, Jim. The first is, a lot of people buy second homes for their own use and think that they’re making an investment. They’re not. You can take the return from a home and divide it into two parts: there’s the potential price appreciation, and then there’s the so-called imputed rent, which is the value that you get from using the home. If you’re buying a home for your own use, a second home, you’re the one who’s getting all the use out of the place. So that is not a return of the cash variety. You are consuming that part of your real-estate return. So all you’re left with is the price appreciation. Historically, homes have appreciated about 3 percent a year. Barely above the inflation rate. Moreover, homes come with substantial ongoing expenses: maintenance, property taxes, homeowner’s insurance. Once you subtract those costs from the home-price appreciation, most people, over the long run, are probably barely breaking even, and certainly, they’re falling far behind inflation. So, yeah, if you have a place that you like to go to on a regular basis, and you think you’re going to get great use out of this second home, and you do not consider it to be an investment, then by all means, go ahead and buy that second home. Which brings me to my second point, which is, frankly, I don’t want to go back to the same place year after year. I would like to be able to travel around, go to different parts of the country, go to different parts of the world. So, I don’t want to be locked in to going to one place for vacation every year, which is why I never bought a second home for my own use.
Jim Lange: Well, that makes sense, and particularly, if you’re, as you are, a bicycle aficionado and want to see new roads, both in the United States and elsewhere. And I do think that there is a big danger, particularly for people who live up north and they go down to Florida and they have a great time in the winter and they play gold and they’re thinking, “Wow, this would be fabulous! I could have a home in Florida!” And they sell their home and what they don’t know is that a thousand people a day move out of Florida because the summers are so miserable, and the insects are terrible in the summer, and then there’s the hurricanes and then there’s the threat of the hurricanes and you have to leave your house, and then the hurricanes usually dissipate anyway.
On the other hand, I’m just going to put in a little plug for the idea of having a place up north and a place down south. And by the way, I don’t even necessarily think you have to purchase. I think you could even rent for a number of months. But I think that people could be very happy if they didn’t necessarily have to live in the Northeast in the winter and had a place to go, again, whether they buy a second home and … by the way, I would agree with you. It’s not an investment. It’s a cost. But it might very well be worth it, or even just having … maybe that might be something that you would be interested? You could go rent various places, keep the variety up and still get out of the Northeast winters.
Jonathan Clements: Yeah. No, I’m all in favor of that. After the winter we’ve just been through, I’d happily go to Florida for a few weeks!
Jim Lange: All right. The only thing is, Florida wouldn’t do it for you, I think, because the bicycling is too flat there, and I know you like to just charge up mountains, as I do.
And by the way, what we are talking about is Jonathan Clements’ book, Money Guide 2015. This isn’t one that you think about. It’s one that you just go out and buy. Whether you like a hard copy or whether you like it on Kindle, you’re talking about one of the top, if not the top, financial writers in America, who just put his heart and soul into writing this. And by the way, I love the way it’s set up. So, there’s literally 367 well-defined areas that Jonathan writes about, and there’s an easy table of contents to get to those areas. So, you don’t have to read the whole thing. You can just go to the sections that you like; that, I think, is terrific.
The other thing that kind of surprised me, because Jonathan, I always think of you as the champion of the consumer, you know, not the friend of the guy who is selling high-fee commission-type investments, and I always thought that you were kind of the guy who cringed at variable annuities. Now, I’m not talking about immediate annuities because I like immediate annuities also, and that’s a very low-cost, low-profit-for-the-advisor type transaction. But I was kind of surprised that you didn’t cringe at variable annuities. Have you changed your tune, or do you make an exception, or what’s the story with variable annuities?
9. Low-Cost Variable Annuities Exist, and They Can Benefit High Earners
Jonathan Clements: Most variable annuities do indeed make me cringe. I mean, these are incredibly expensive products that tend to be much more lucrative for the salesmen involved than for the people who ended up buying them. You know, a lot of variable annuities out there have total costs approaching 3 percent, and talking about the low-return environment that we’re in, maybe 6 percent a year for a globally diversified stock portfolio over the next 10 years; if you buy a variable annuity, you could be giving up half of your return to those high expenses. Nonetheless, there are low-cost variable annuities out there. They’re not going to be as low-cost as buying a mutual fund in an IRA, but there are low-cost variable annuities out there. They’re available from Fidelity. They’re available from Vanguard. If you’re a high-income earner, and you’ve maxed out your 401(k) and you’ve maxed out your IRA, and you’re looking for additional tax-deferred growth, I could see buying a variable annuity. If you’re going to buy that variable annuity for its tax-deferred growth, and you’re going to buy one of these lower cost investment products, like those from Vanguard or Fidelity, you should only be doing it if you’re going to use it to buy tax-inefficient investments. So what we’re talking about is using the variable annuity to buy taxable bonds, using it to buy an actively managed stock fund that’s realizing a lot of capital gains every year. You might be using it to buy real-estate investment trusts. If you’re in that situation, I could see that a low-cost variable annuity would make sense.
Jim Lange: Well, that makes some sense to me. But you said two things: One, it has to be a lower cost variable annuity, which, by the way, is not the normal course. The normal course is some of these pay commissions of somewhere like 10 percent. I know in my business model, I literally have to do 20 years of work, including calculating Roth IRA conversions and Social Security and meeting people and running numbers, I have to do that for 20 years to make as much money as somebody who sells an annuity. So, the one thing that I want to emphasize is you’re talking about lower cost. The other thing that you said was, it is better for high-income people, and that makes sense to me, but unfortunately, that’s not who it’s often sold to. In fact, I see a lot of people at the lower end, and I’m talking about maybe people with net worths of investible assets of less than $500,000 because, typically, a fee-only advisor is probably not as interested in working with somebody who has $250,000 because the fee on that is not that high. So, for example, I have a $500,000 minimum because we just put in way too much work that we could make any kind of decent money for a $250,000 client, but if I was selling somebody an annuity, and I can make 10 percent upfront and I don’t have to do those 20 years of hard work, then, frankly, I fear that that is what’s going on in the market. So, I will grant you that yes, if you got one of the low-cost variable annuities, and B., it was for a high-income earner, then I’m a little bit more comfortable with it. Is that fair?
Jonathan Clements: Sure. I agree with you. I mean, there are tons of uses that go on with annuities. Unfortunately, you know, the term “annuity” has a bad name. In fact, I recently saw another survey, I think this one was from TIAA-CREF, that said that in the survey, only 29 percent of people had a favorable view of annuities. And so, the vast majority of people thought that annuities stunk, and they deserve to be thought of that way. Most annuities are too expensive. Most of them are mis-sold. Variable annuities are bad enough. The really criminal ones out there are equity-indexed annuities, where the commissions paid to the salesmen are often above 10 percent. But even though these are bad products often, there are some good versions of variable annuities. You mentioned immediate fixed annuities. There are relatively low-cost products. They’d be a great way for retirees to generate retirement income. So, I cringe a little bit when people just simply badmouth annuities without making these distinctions.
Jim Lange: Yeah, and by the way, you just mentioned an example of an outstanding annuity, which is the TIAA side. So, when college professors and employees of other non-profit organizations that have TIAA, and they annuitize, or they, in effect, give up their investment in return for an income stream for the rest of their life, in effect, more or less replacing a traditional pension. I think that’s a great thing. My mother, who was a retired professor, she retired, back then, it was mandatory retirement at age 70, and she had to annuitize, back then, both her TIAA and her CREF, and they probably expected her to live to about age 85, and she lived until age 95 and she did very, very well with it.
The other area, and maybe we’re more in agreement than I thought, was you have a little section on long-term care, and I think a lot of people are interested in long-term care, and I always think of you as, again, the champion of the consumer, not of the commission-based financial advisor. So why don’t you tell us your view on long-term care, and then maybe I’ll chime in on the way I see it also.
10. Long-Term Care Insurance Doesn’t Help Retirees With Less Than $500,000
Jonathan Clements: Long-term care insurance has been a truly problematic product. The insurance companies have not exactly covered themselves with glory. A number of insurance companies came into the market priced aggressively, realized they weren’t making money and then they dropped out of the market and left their policyholders in the lurch. Other insurers have stuck with the market, but they’ve jacked up the premiums, and that’s made these policies not only unaffordable for new customers, but also for existing customers who’ve had the policies for many years, and suddenly, they’re saddled with premiums they can’t afford. So long-term care insurance has been a super-problematic product and I’m certainly leery of it. My advice on this to people is that if you have less than $500,000 in assets, don’t buy long-term care insurance because, in all likelihood, if you end up in a nursing home, you’re probably going to have to deplete your assets and end up on Medicaid. So, even with the insurance, it’s probably not going to help you, and if you’re in that situation, you probably can’t afford the premiums anyway.
Meanwhile, if you’ve got a million dollars or more in investible assets, you probably shouldn’t buy long-term care insurance because you can afford to self-insure. In other words, if you end up in a nursing home, you’re just going to pay out of pocket. In all likelihood, you probably won’t spend more than three years in a nursing home, and so you have more than enough money to pay the bill. But people who are in a tough situation are those with investible assets in between about half a million dollars and a million dollars. These are people who have assets to protect who don’t really want to run down their assets and leave nothing for their heirs, and, to them, long-term care insurance might make sense. But even then, because the insurance companies have not exactly covered themselves with glory, I’m sort of reluctant to recommend the insurance, but I feel like if you could find the right policy, maybe it would be a smart decision. What’s your take on this, Jim?
Jim Lange: Well, there’s a couple things I don’t like about long-term care insurance. One, what if you just die in your boots? You spent all that money. You don’t get anything. The second thing, as you’d mentioned, it’s not a guaranteed price. You know, you can be paying it five, 10 years and get a notice like a lot of people just did two years ago, “We’re sorry, but your premium is going up by 20 percent.” So you have the unpleasant choice of letting it go, which means you paid all that money in for nothing, or just grinning and bearing and paying the extra 20 percent. The other thing is, I think it sometimes, unless you get a special rider, it doesn’t insure for the thing that you most likely want. The thing that at least I would most likely want, if I had problems in my older age and I couldn’t take care of myself, is I would want services brought to the home. I would not want to sit in some type of nursing home or facility, and I see a lot of policies that don’t have that kind of coverage. To me, I would want a hundred percent homecare. So I have a bunch of problems with it. In your book, you actually did have a little discussion about if you do want that kind of protection, the combination of life insurance and long-term care policy. That way, if you buy one of those policies and you die in your boots, your heirs get the money. If you just use some of the coverage, your heirs get the remainder, and if you really need it, then it is still there for you. And one of the areas that Jonathan and I do agree with, that I was very happy to see, is that you are a low-cost index guy, Jonathan. Is that right?
11. ‘Indexing Is Really the Only Way to Win the Stock-Market Game’
Jonathan Clements: I have been a low-cost indexer for so long, readers of the Wall Street Journal are sick of me talking about this! Yeah, indexing, talk about no-brainers. I mean, indexing is really the only way to win the stock-market game. The math of investing is brutal. Before costs, investors collectively earn the market’s return. After costs, investors must, must collectively lag behind. In fact, investors will collectively lag behind the market by the sum total of the investment costs they incur. Now, sure, you know, every year, some small group of investors manage to beat the market, but over time, very few people manage to beat the market as the relentless burden of investment costs drag down their investment returns. Sure, everybody will say, “Oh yeah, Warren Buffett! He beats the market.” And my response is, “And who else?”
Jim Lange: And even Warren Buffett is leaving all his money to be invested in index funds. But the other thing that you did say, and I was actually very pleased to see this because I don’t see this very often, and particularly through a champion of low-cost index funds, is that you talked a little bit about Dimensional Fund Advisors, which uses Nobel Prize-winning academic research, and that you used, actually, the word “enhanced indexing.” And by the way, I should be a hundred percent straightforward with my audience, this is the set of funds that I and my investment-money manager use, and the way we work is our office does the, what I would call, the strategic side. So, we do the Roth IRA conversion advice, the Social Security advice, the how much money you can spend advice, the retirement advice, the estate-planning advice, and we crunch numbers and we meet with people at least on an annual basis, and we do that side, and the other side of the arrangement is, we actually have a money manager. Again, does a fabulous job. He does a full balance sheet, a full income statement, meets with you at least probably twice a year, and he uses Dimensional Fund Advisors funds as the underlying investment. And you talked a little bit about why Dimensional Fund Advisors might be a reasonable alternative, and maybe I could ask you why you think that that might be an alternative? When most people hear low-cost indexing, they immediately think of Vanguard.
Jonathan Clements: One of the things that’s interesting about Dimensional Fund Advisors is that it has a strong academic background. A lot of their funds are based on academic research, and in particular, there have been two big insights that have come out of the academic research over the past 30-plus years. The notion among academics, among anybody who believes in market efficiency, is that in order to get return, you have to take risk. Well, what the academics have discovered is that there are certain parts of the market where if you’re willing to take additional risk, you do seem to be able to enhance returns, and the two particular areas are 1. Smaller-company stocks. If you weight your portfolio towards small-company stocks, you’re going to be taking extra risk, but historically, that has delivered a higher return. And second, if you tilt your portfolio towards so-called “value stocks,” and what we’re talking about here are stocks that appear cheap based on indications of value like price-to-book value and price-to-earnings ratio and price-to-cashflow. If you tilt your portfolio towards value stocks, again, you’re taking more risk, but over the long run, that risk has been rewarded and you should earn higher returns. There are no guarantees that tilting towards small-company stocks and tilting towards value stocks is going to benefit you in any particular year, but over the long run, you know, history tells us and research backs it up, that these areas of the market should deliver superior returns.
Jim Lange: And then, what I would add, is if I look at most of the portfolios of prospects that come in, they are so overweighted with these very large companies with growth stocks, that by diversifying them, having a certain portion of the money invested in smaller stocks and value stocks, that we’re actually lowering the risks because we’re increasing diversification. So there might be an argument that yes, you’re not only getting a higher return because you have some higher return investments in the portfolio, but that you’re actually reducing risk by having greater diversification.
12. Growth Stocks Are Overpriced; Value and Small-Company Stocks Underpriced
Jonathan Clements: Yeah, I think that’s an interesting point, Jim. I think what happens with larger-company growth stocks is that we tend to be most comfortable investing in companies that we know and love, and so these large-company growth stocks, we know the brand names, we like the fact that they seem to be growing more rapidly than the overall economy. We just simply assume that they are good investments. But in fact, what tends to happen is that people pay too high a price for growth stocks and too little a price for value stocks and for small-company stocks, and because small stocks and value stocks tend to be priced too low, that’s why they’re able to deliver superior returns over the long run.
Jim Lange: Well, this has been a wonderful hour. We are ending our discussion with Jonathan Clements, who wrote the book Jonathan Clements Money Guide 2015, and I’m going to give a 100 percent, no-restriction recommendation: Go out and get this book, Jonathan Clements Money Guide 2015. There are 367 well-documented sections very easily indexed, and I think that this is something that all our listeners should do. Jonathan, thank you so much. You have been a terrific guest, and I look forward to working with you again on the Wall Street Journal and perhaps having you as a guest sometime later on.
Jonathan Clements: Hey, Jim, it’s always a pleasure to be on your radio show. There aren’t many places you can go and have an hour of intelligent financial conversation, but this is one place where it always happens.