Ask The Expert with Larry Swedroe, June 2008 Issue

This is the 7th issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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Question from Laurie:

I am retired and I use globally diversified DFA funds for the equity side of my portfolio. I’m weighted more for small and value. My taxable personal Trust account has $650,000 and my Roth account has $500,000. I am 51 years old. I own a $1,000,000 house with a $200,000 mortgage. I need about $50,000 a year of income from this portfolio. I want to be at a 70 equities/30 bond mix.

Is there any difference in the type of bond funds you should have in your portfolio if your are in the withdrawal phase? Should you just go with bonds that help out our total return on your entire portfolio, rather than bonds or other higher fixed income instruments made for “higher” income? My advisor is recommending American Funds “F shares” (IFAFX) Income Fund of America and “F shares” American Funds Capital Income Builder (CIBFX) for my bond side and ongoing income needs.

I think it might be better going with a bond mix that maximizes my total return and then rebalance if needed over and above the income achieved by interest/dividends/distributed cap gains. I’m thinking about a combination of DFA Intermediate Gov’t Fix Inc (DFIGX), Vanguard Limited Term Tax-exempt (VMLTX) and Vanguard Intermediate Term Tax-Exempt (VWITX) in my taxable account for my bonds (at 60% equity/40% bond mix). And a combination of (DFIGX) Interm Gov’t Fix Income, (VFISX) Vanguard Short-Term Treasury and (DIPSX) DFA inflation Protected Securities for my Roth at a 85% equity/15% bond mix. I’m at a very low, approximating zero, Fed tax bracket, with no state income tax.

Also, on my DFA equity side of both my Trust and Roth I’m at only 30% international/emerging markets. I want to increase that upwards to 40% or perhaps to 50%. Would you recommend that?

Your mortgage is actually a negative fixed income allocation.

Laurie. Lots of issues here. The first is related to your asset allocation. You have total financial assets of $1,100,000. With 30% desired bond allocation that would suggest a fixed income allocation of $330,000. However, that would be incorrect because your mortgage is actually a negative fixed income allocation. And thus if you had $330,000 in fixed income assets your net fixed income allocation would be just $130,000, not $330,000. And your total net financial assets are just $900,000.

But almost certainly you will be better off paying down the mortgage instead of holding more fixed income

It is highly likely that the amount you can earn on your fixed income assets will be less than the rate on your mortgage and thus it is highly likely that the first step you should take is to pay off the mortgage. The only advantage the mortgage might have is if it is a fixed rate, then you have some inflation protection. That protection comes because your fixed income assets would be able to be invested at higher rates while your mortgage rate is fixed. And of course if rates fall you can refinance. This is a simple mathematical calculation. But almost certainly you will be better off paying down the mortgage instead of holding more fixed income (unless the cost differential is small in which case the inflation hedge might be worth the incremental expense).

The second issue is also related to your asset allocation. At your age I would urge that you withdraw a maximum of 4% a year from your portfolio (less if you have no options to cut expenses or move to less expensive area or go back to work) and then adjust that upward for inflation. Assuming you do pay down the mortgage then 4% of 900,000 is just $36,000 a year. And that is well below the $50,000, though if you pay the mortgage down your expenses would fall. However, even if you assume a portfolio of $1,100,000 that would still only provide $44,000. That is the bad news.

And even 4% a year is a bit aggressive at your age as those funds have to last a very long time. You might want to consider downsizing the home to both reduce expenses and provide more capital to generate income. Another consideration might be to move where the cost of living might be lower.

Do you have provisions for insurance needs like medical care. And have you thought about the issue of long-term care insurance.

But there are other issues that concern me. For example, in your costs do you have provisions for insurance needs like medical care. And have you thought about the issue of long-term care insurance. If you were to have a need (it is estimated that 60% of Americans will have a need at some point). A need for extended care could devastate your portfolio. Thus you should consider a LTHC policy at some point.

The third issue is related to the DFA funds. I would hope that your advisor is using the new DFA Core funds as they are the most efficient way (lowest cost and most tax efficient) to access the various asset classes. And since you are in very low bracket if you are not holding them it is at least worth looking at selling your existing holdings to buy the core funds. For many people the Domestic Core and the new TA World ex-US are sufficient and that keeps rebalancing costs down and tax efficiency high.

Why pay for active management when there is no evidence of ability to add value without taking risks.

The issue on your fixed income funds. I see absolutely no reason to own any of the American Funds. Why pay for active management when there is no evidence of ability to add value without taking risks. The greatest risk to you (besides equity risks in general) is likely inflation and thus I would urge you to use your fixed income allocation to hold TIPS. The academic evidence is very clear that TIPS should dominate the fixed income portion of your portfolio. And there is really no reason to even pay a mutual fund. Though DFA and Vanguard funds both have expense ratio of 20bp. You can buy TIPS directly and avoid the manager fee. The only benefit of the funds is convenience as there is no need for diversification as there is no credit risk. At my firm we buy individual TIPS for our clients, avoiding the money manager fee. And with your income tax bracket you could even hold the TIPS in taxable account if need be. Though this raises another important issue.

You should consider raising your foreign allocation to 40 or 50%. The US is now only 41% of the global markets. And raising your international allocation will diversify the economic and political risks of investing solely in the US.

Asset Location is an important issue. I agree that you should consider raising your foreign allocation to 40 or 50%. The US is now only 41% of the global markets. And raising your international allocation will diversify the economic and political risks of investing solely in the US. I do believe that some home bias is warranted as you will be spending your dollars here, but with the US now at 41% of the global equity markets I think that 40 or even 50% international is appropriate.

And you should be sure to hold your foreign assets in taxable account, otherwise you will lose the benefit of the foreign tax credit. Also foreign assets are more volatile and that makes the option to harvest losses more valuable (though with 0% tax rate that may not be much of an issue).

I would also add this. I believe it is a mistake to look to your fixed income assets to generate cash flow. You should take a total return approach to generating cash flow. In other words the amount needed each year should come from the entire portfolio. For example, you could use the fund distributions each year to help fund your cash flow needs. Also the proceeds of rebalancing can be used.

I hope the above is helpful. If you have further questions you can feel free to email me directly.

Best wishes
Larry Swedroe

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Past Issues of Ask The Expert

• 05/2008 - Ask The Expert with Larry Swedroe, May 2008 Issue
• 04/2008 - Ask The Expert with Larry Swedroe, April 2008 Issue
• 03/2008 - Ask The Expert with Larry Swedroe, March 2008 Issue
• 02/2008 - Ask The Expert with Larry Swedroe, February 2008 Issue
• 01/2008 - Ask The Expert with Larry Swedroe, January 2008 Issue
• 12/2007 - Ask The Expert with Larry Swedroe, December 2007 Issue

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.