Education, advice, and evasion

Become a Patron!A few years ago I wrote about one of the curious fixations I observed among the wealthy denizens of the finance industry: the need for "personal finance" education. In this telling, the problems troubling American civilization are not the result of financial deregulation, or corporate consolidation, or employee misclassification, or wage theft, or race and gender discrimination, but rather a simple lack of knowledge. If high school students were instructed in how to balance a checkbook, no other changes would be necessary to usher in the gleaming, gilded, capitalist paradise of Galt's Gulch.I already explained why this conceit is absurd, but I've recently been thinking about how to break down the different layers of communication that are passed off under the mantle of financial education.

Financial education

I consider financial "education" the most elementary layer of personal finance communication. People aren't born knowing what a 529 college savings plan is, what the contribution limits are, or what expenses are eligible for tax- and penalty-free distributions, and many people die without knowing what they are. That makes education the pure transmission of information: 529 college savings plans exist. Individual retirement accounts exist. 401(k) and 403(b) workplace retirement savings plans exist.This information may be interesting, but it's not useful on its own as anything more than dinner party conversation, and we're not allowed to hold dinner parties any more.However, when financiers say personal finance "education," what they usually mean is generic financial advice.

Financial advice

The difference between financial education and financial advice is the difference between saying "there is such a thing as individual retirement accounts" and "you should maximize your annual contribution to your individual retirement account."Financial advice, unlike financial education, is tailored to the individual's circumstances. IRA's exist whether or not your income makes you eligible for deductible contributions, Roth contributions, or non-deductible traditional contributions. But whether or not you, personally, should make deductible, Roth, or non-deductible traditional contributions depends on your personal circumstances — and even worse, it changes as your circumstances change! At the most basic level, the more lucrative your non-IRA investment opportunities are, the less inclined you should be to make IRA contributions.Unfortunately, most financial advisors don't know what they're talking about, because they aren't actually trained in giving financial advice: they're trained in tax evasion.

Tax evasion

I once researched, but never published, a post about the role taxes played in post-war Britain on the global export of British music, as performers were required to spend most of the year outside of the United Kingdom in order to avoid taxes on their worldwide income. There's even an anecdote about a Beatle (or was it a Rolling Stone?) insisting his private jet circle over Heathrow until midnight so that he didn't exceed his allotted days on English soil.This is the category of advice financial "advisors" tend to provide: tax evasion stands in as a substitute for actual financial advice. Without knowing anything else about a person's situation, you can tell them to maximize their IRA contributions, maximize their 401(k) contributions, harvest capital losses during high-income years and capital gains during low-income years, strategically name 529 plan beneficiaries, and front-load contributions to donor-advised funds.But it's absurd to call this financial advice. Someone who tells you how to make more money is offering financial advice. Someone who tells you how to spend less money is offering financial advice. But someone who writes a letter for you to the IRS explaining that actually comparable salaries in your industry are $30,000 so you shouldn't be liable for FICA taxes on your sales of $5 million isn't offering financial advice, they're evading taxes on your behalf.You may think that's a service worth paying for, or you may not, but when financiers promote the benefits of financial education, don't forget they're talking about spending scarce classroom time teaching kids how to evade taxes.Become a Patron!

Five profitable things to do with low-interest loans

Become a Patron!I've written many times about my fondness for low-interest, and especially low-fee, balance transfer and cash advance credit cards, which allow consumers to borrow large — sometimes very large — sums of money for a fixed period of time and pay nothing to the bank if the loan is paid off by the end of the promotional period.This is a form of what I think of as "institutional arbitrage," which is possible when different categories of institutions are able to borrow and lend across what should be, but are not, airtight boundaries. This kind of institutional arbitrage is the underlying mechanism for a lot of both travel and personal finance hacking.

My five favorite uses for low-interest loans

1. Swap secured for unsecured debt. A classic example here is something like a car loan that is secured by the vehicle itself. While interest rates on car loans aren't particularly high right now, you might prefer to extinguish your secured car loan with an unsecured, loan-interest credit card loan, so you can keep your car if pressed into default on the unsecured credit card debt. In an even more complicated version of this strategy, you might use unsecured, low-interest credit card loans to pay off student loan debt, which in most jurisdictions is undischargable even in bankruptcy!
2. Make or accelerate "use it or lose it" retirement contributions. I've written before that "use it or lose it" is the most important feature of retirement accounts. When you let a calendar year's contribution deadline pass (usually that year's tax filing deadline), you've permanently reduced your ability to shield dividends and capital gains from annual tax assessment. Taking out a low-interest loan to maximize your annual contribution allows you to lock in guaranteed tax savings, and work out the details later.
3. Meet intermediate financing needs. Some businesses, like resellers, find deep discounts on merchandise while it's out of season or out of favor. Swimming trunks in January, fur coats in August, and so on. They may want to hold onto the merchandise until it's back in season or back in fashion, and low-interest loans are one way of financing that intermediate-term inventory.
4. Meet high balance or deposit requirements. Earning the highest possible interest rate on your cash savings has always required a bit of legwork. I assume back when interest rates were kept artificially low, our ancestors would open bank accounts all over town in order to collect as many toasters as possible to sell to their friends and family. The same principle works today: accounts that offer nothing in interest on your deposit will still offer a cash signup bonus to attract your business. The deposit requirements, however, can be substantial: as high as $50,000 in the case of Citi's current $700 bonus. But if you're playing with the house's money, that's a higher interest rate than you're likely to earn on any other safe investment. Similarly, you might consider funding certificates of deposit with rewards-earning credit cards and then using low-interest loans to pay off your credit balances before any interest is owed.
5. Get cash discounts. I grew up hearing stories, which I choose to believe are true, but have no evidence of whatsoever, that when my father needed a new car, he would walk in the dealership with a briefcase full of cash and make the dealer an offer he couldn't refuse. In the consumer world I don't think there are very many "cash discounts" still available, but in business-to-business interactions I imagine there are still companies willing to accept less, perhaps much less, if you're willing to pay in cash up front. The reason most businesses aren't able to do so is they rely on the lag time between their purchases and sales to finance their operations! But if a low-interest loan allows you to settle immediately in cash, you may find vendors as flexible as my dad (allegedly) did.

Conclusion

Hopefully the above examples illustrate why I call this "institutional arbitrage." If Discover could deposit $50,000 with Citi and earn $700 in interest, they surely would. But Citi doesn't offer $700 signup bonuses to other banks — it only offers them to consumers, so the consumer becomes the intermediating institution. The consumer can take out a consumer loan from one bank, make a consumer deposit in another bank, and earn a return that the lender would not earn and the depository would not offer on their own. Hence, institutional arbitrage.Become a Patron!

"Use it or lose it" is the most important feature of retirement accounts

Become a Patron!I consider it an inevitable misfortune that conversations about investing begin and end with "what should I invest in?" An unsophisticated questioner might mean "what stocks do you think will go up?" while a sophisticated one means "what should my allocation be to low-cost stock and bond ETF's?" but both questions skip over the much more important question: how much are you saving?

Pre-tax savings are cheap

You can pay a financial advisor to game out different tax regimes and withdrawal scenarios, but there's nothing complicated about calculating your tax savings when you make traditional 401(k) and IRA contributions: every dollar you save reduces your taxes by your marginal federal and state income tax rate, and this is true in every marginal income tax bracket.In the 10% income tax bracket, putting $6,000 into a traditional IRA saves you $600 to do with as you please. You can then save the $600, if you like, but you don't have to: you can use it to pay down credit card debt, pay rent, buy a Nintendo Switch, whatever you please!When I talk to people about their 401(k) or 403(b) contributions, they often balk when I say they need to set their contribution to $1,625 per month in order to maximize their annual contribution. How are they going to get by with $1,625 less per month in salary? They're going to get by because a $1,625 contribution doesn't cost them anything close to that much. In the 22% federal income tax bracket and with a 10% state income tax, it barely costs them $1100.And, to return to the point, this is true regardless of what they invest in.

There is no such thing as a catch-up contribution

I detest imprecision in speech, which is why I call the Retirement Savings Contribution Credit the RSCC and not the Saver's Credit and why I call the Earned Income Credit the EIC and not the EITC. The way I see it, imprecision in speech usually reflects imprecision in thought.One of the most offensive such imprecisions is the conceit of the "catch-up contribution." In 2020, people over the age of 50 enrolled in either employer-sponsored or individual 401(k) plans can contribute an additional $6,500 per year in employee contributions, for a total of up to $26,000, and an additional $1,000 to IRA's for a total of up to $7,000. If able, they should certainly do so.This bonus pre-tax savings capacity for over-50's is referred to universally as a "catch-up contribution," on the premise that those who failed to save enough earlier in life should be given a chance to make up their missed savings opportunities.But this is absurd, since the amount of the "catch-up" contribution has no relationship to the amount by which a saver has "fallen behind." For those wealthy enough to save the maximum amount in pre-tax accounts throughout their working life, it's a windfall, while those who struggled to save anything at all are unlikely to find an extra $7,500 per year in income to defer in their last few years before retirement.

Use it or lose it

Personal finance gurus love to talk about giving your investments as much time as possible to compound, with their smoothly rising charts that inevitably look silly in the midst of capitalism's periodic crises.Forget all that for a moment: the reason to contribute as much as possible each year to retirement accounts is that once that year's contribution deadline has passed, you have permanently lost the ability to shield that year's contribution from taxes.

If you don't know what to invest in, save anyway

In recent years there has been a half-hearted movement to channel savers into simplified, lower-cost investing vehicles. I don't hold this movement in very high esteem, but it has certainly had some successes: allowing auto-enrollment into 401(k) plans, allowing automatic increases in contributions, and allowing automatic allocation into so-called "target retirement date" mutual funds.But fortunately, it doesn't matter very much. In constant-dollar terms (i.e., removing annual inflation adjustments), someone saving $19,500 per year between age 22 and 50, and $26,000 per year between age 50 and 67, will have accumulated $988,000 in savings even if their savings do not earn any interest at all.

Conclusion: hitch the savings horse before the investment cart

At the end of the day, investing for high-income, white-collar professionals is pretty boring: the only question is, how rich do you want to be when you die? If you want to be really rich, you can take on a riskier investment portfolio, and if you're content with being only somewhat rich, you can happily dial back your risk. The stakes are essentially non-existent.My point is that even poor, low-income people like me, with no advice whatsoever, and taking no risk whatsoever, can also die rich, not by maximizing their investment performance, but by maximizing their savings performance. Invested entirely in cash (not an allocation I would recommend!), a pre-tax saver will still see their 401(k) and IRA balances steadily rise over the course of their working life, while happily taking advantage of both an annual tax deduction and, for low-income savers, the RSCC.Become a Patron!

The Danger Is Still Present In Your Time

Become a Patron!The other day I saw an amazing tweet by someone who had turned the famous "long-time nuclear waste warning message" into an iconic "Live Laugh Love"-style etched board:Every line is funny and poignant in its own way, but the one that keeps coming back to me is, "the danger is still present in your time," because this is the most important warning while also being the warning it's hardest to actually believe.After all, the world is full of sacred, forbidden spaces. But today, they are typically sacred and forbidden to "someone else." The chief rabbinate of Israel teaches that it's forbidden for Jews to walk on the Temple Mount in case they accidentally set foot in the Holy of Holies. But access is permitted to Muslim and gentile visitors.So how do you convey to future generations that you are not expressing superstition, or paranoia, or religious fervor, but conveying a concrete, material, ongoing fact about the world? How can you convince people the danger is still present in their time?

The Danger Is Still Present In Your Time

A lot of people are paid a lot better than me to think and write about risk. The importance of taking risk, the danger of taking risk, the rewards of taking risk, an unfathomable amount of digital ink has been spilled on all these topics.But I'm not certain any of it has done a lick of good. If you tell me you want to invest in a conservative 60/40 stock/bond portfolio, I can tell you that means the value of your portfolio will drop by 48% at least once in your lifetime, and by 30-40% at least two or three times. That simply describes one 80% fall in the stock market and two or three 50-66% falls in the stock market, assuming that the bond portion of your portfolio maintains its value during those downturns (no sure thing, of course!).But just because I know that it will happen doesn't mean I know when it will happen. And the fact is, it might happen the day after you make your investment. It might happen the very day you make your investment! Imagine that: you deposit $1,000 in your account at 9 am and at noon it's worth $520. The fact that it was carefully invested precisely according to the risk you thought you could tolerate at 8:59 am is awfully cold comfort.

Risk tolerance is real

I don't mean to come across as overly pessimistic: risk tolerance is real. I have an extremely high risk tolerance and I've taken advantage of the present market excitement to very gradually shift out of my rapidly appreciating put strategy ETF into newly-cheap stock market mutual funds, and if the market falls further I'll buy even more. That's because I'm basically indifferent to the value of my portfolio, since I don't have any intention of drawing on it for another 25-35 years.When the next, inevitable crisis of capitalism comes in 8 or 12 years, I hope I'll face it with the same good humor, but I'm not sure I will. My retirement accounts will be worth two or three times as much, so the same 50% drawdown will hurt three times more. A $10,000 drop caused by COVID-19 doesn't seem like much, but a $30,000 drop caused by COVID-20 will surely sting. That's a year of college tuition, a new furnace, a kitchen renovation, or whatever else it is people ten years older than me spend their money on.

Conclusion

Nobody is intolerant of upside risk: an investment with a 90% chance of returning 6% per year and 10% chance of returning 100% per year is a no brainer, despite its extreme unpredictability. The only risk tolerance that matters is the tolerance for risk you demonstrate when markets eventually turn against you.What everyone needs to, but no one does, understand is that "eventually" might be a lot sooner than you think: the danger is still present in your time.Become a Patron!

Three approaches to cutting federal bonds out of untaxed accounts

Become a Patron!Last month I wrote about the curious fact that mutual funds designed to be held in retirement accounts, where their distributions are generally untaxed year-to-year, nonetheless hold federal bonds that are exempt from state income taxation. I suggested that it should be possible to optimize your retirement account holdings by replacing those federal bonds with taxable corporate bonds.Once I get an idea in my head it's hard for me to let go of it until I follow it to its end, so I decided to see if there was an easy way to make the swap.

How to think about your federal bond holdings

As I wrote in the previous post, if you own virtually any target retirement date or target risk fund, or a total bond market index fund, you probably own a lot of federal bonds simply because they constitute such a large share of the US bond market: about 43% of Vanguard's Total Bond Market Index Fund, for instance, is in federal bonds, and about 35% of its income is attributable to federal sources.What this means is that when you own the Total Bond Market Index Fund, either as a separate mutual fund or ETF or in a packaged target retirement date fund, you're saying you are willing to accept the interest rate the fund pays, given the volatility of the fund and the safety of the fund.When you hold the fund in a tax-advantaged account, however, you are also "paying," in the form of a lower interest rate, for a benefit the fund offers all shareholders, but which you are not using: the exemption from state income taxes of the federal portion of the fund's income stream.Logically, there are three ways you can "cash out" the value of the state income tax exemption you're not using. For these examples, I'll be using the following funds in case you want to check my math or strike your own balance:

• VTBIX to represent the total bond market;
• VCSH to represent short-term corporate bonds;
• VCIT to represent intermediate-term corporate bonds;
• VCLT to represent long-term corporate bonds;
• and VGSH to represent short-term federal bonds.

Option 1: match yield, minimize duration

"Duration" is a term of art that refers to the sensitivity of the price of a bond (or bond mutual fund) to changes in interest rates. A short-term bond has a lower duration because changes in interest rates don't have a big impact on its price: since the bond will mature soon, you can reinvest the principle at the new interest rate frequently. A long-term bond has a higher duration since you have to wait a long time to take advantage of higher interest rates, while if interest rates fall you can happily collect your legacy coupons for years to come.All else being equal, for any given yield, you should prefer your bonds to have a lower duration, thereby reducing their price volatility. As of the time I ran my calculations, you can match the 1.95% SEC yield of VTBIX with a combination of 73% VCSH and 27% VCIT. While offering the same SEC yield, by excluding the long-term bonds present in the total market fund, this corporate bond portfolio has a much shorter duration: 3.57 compared to 6.26.In this option, you're exchanging the unused state income tax exemption for a much lower level of price volatility.

Option 2: match duration, maximize yield

Since we specified at the outset that when you own VTBIX you're implicitly accepting the exposure to changes in interest rates embedded in that fund, another option is to try to match that interest rate exposure while exchanging the state tax exemption for higher-paying corporate bonds.In principle you could achieve this in almost unlimited ways, but I found a simple equilibrium in a corporate bond portfolio of 12% VCSH, 82% VCIT, and 6% VCLT. This portfolio has a duration of 6.24 (still slightly lower than VTBIX) and an SEC yield of 2.31%, about 18% higher than VTBIX.

Option 3: match Treasuries, optimize something else

At this point you might be scratching your head and saying this whole experiment has gone too far. We started with a minor observation about an unused tax benefit, and now we're cutting Treasury securities out of our retirement portfolio entirely? And you're exactly right: remember that Treasuries have not one, but two advantages. The income they generate is generally exempt from state income taxes and they're completely safe (if held to maturity).While the corporate bond ETF's I've been using to illustrate these options only hold investment-grade securities, anyone who lived through 2008 knows that the term "investment-grade" can conceal just as much as it reveals. That being the case, you might simply chop your bond holdings into two categories: the federal bonds you hold because they're ultra-secure and the corporate bonds you hold to optimize some other value, like yield, duration, or credit.As mentioned, VTBIX holds about 43% of its value in federal securities. If that's the level of Treasury security you want in your domestic bond portfolio, you can simply allocate 43% of your domestic bond portfolio to a short-term bond ETF like VGSH. With that out of the way, you can set about optimizing your corporate bonds for some other value. Portfolio Visualizer has a nice, free tool that lets you optimize a portfolio for things like Sharpe ratio or risk parity (note: I have nothing to do with Portfolio Visualizer and don't vouch for any of their tools or results).

Conclusion

As a general rule, bonds are helpful to have even in the most aggressive investment portfolio, not because they're expected to contribute to total return, but because their imperfect correlation with stocks means they periodically present opportunities to rebalance into higher-expected-return assets. Treasury bonds offer the additional advantage of a federal guarantee of their value (if held to maturity) and exemption from state income taxes.In tax-advantaged accounts, you may well value the imperfect correlation of investment-grade bonds with stocks, and you may well value the federal backing of Treasury securities, but you should not value the state income tax exemption at all: you're not paying state taxes on the income either way. That means there should be some margin at which you're willing to shift away from the default allocation to federal bonds, either in order to reduce your risk even more, to collect additional yield from investment-grade corporate bonds, or to optimize your portfolio across both risk and yield.Become a Patron!

Don't pay for tax benefits you're not using

Become a Patron!I had a very interesting conversation today that got me thinking about a tax issue I had never given serious thought to before, and which I think is probably totally unknown to most investors, but that affects virtually all of them: the exclusion of US federal interest payments from state income tax liability. Upon just a moment's reflection, I realized that a vast swathe of US investors are making a simple and (relatively) easily avoidable error.

Asset allocation, asset location, and asset selection

In order to optimize your long-term rate of return, you typically have to take into account three factors:

• Asset allocation, or risk tolerance. This could be as simple as a 60% allocation to stocks and a 40% allocation to bonds, or as complicated as a carefully weighted average of every region and asset class in the world, rebalanced daily. There's no one right asset allocation for everybody but, in general, the more you depend on your assets for ongoing income, the less volatility you should be willing to tolerate in their value, and the more you plan on leaving to your children or grandchildren the less you should care about their day-to-day value and the more you should focus on the long-term potential for appreciation.
• Asset location. Some assets are more tax-efficient than others: if you own mutual funds that are constantly spinning off capital gains, the taxes you pay each year represent a drag on your overall returns. Those funds are best held in accounts where capital gains are shielded from annual taxation. Likewise, shares in companies like Berkshire Hathaway that refuse to pay dividends and instead reinvest their profits internally are a better fit for taxable accounts, since owning them generates little or no tax liability.
• Asset selection. Once you've settled on your asset allocation, and set up your IRA, 401(k), and 529 plan contributions, you still have to implement the allocation by choosing the securities you want to invest in. The simplest example is municipal bonds. Based on your marginal state and federal tax rates, you may find that buying municipal bonds issued in your state of residence gives you a higher after-tax yield on your portfolio's bond allocation than buying taxable bonds, even if the coupon payments on those bonds are in fact lower; after all, keeping 100% of $4.50 leaves you with more income than keeping 80% of $5. But that advantage is lost when you hold municipal bonds in a qualified account: if you get to keep 100% of your coupon payments regardless, just buy the higher-yielding security.

Most federal interest payments are exempt from state income taxes

Just as most municipal bond interest payments are exempt from federal income taxes, a reciprocal rule applies to federal interest payments: while federal income taxes are due on bond payments, state income taxes are typically not. Claiming this exemption involves looking up the share of your calendar year income attributable to federal securities and excluding it from your taxable income on your state return. You can find Vanguard's 2019 guidance here, for example:

• One share of the Vanguard Inflation-Protected Securities Fund paid out 29.2 cents in dividends in 2019, and Vanguard avers that 99.19% of that payout was due to income from US government obligations. That share of the otherwise-taxable income is likely exempt from state taxes.

Target retirement date funds are a bad tax fit for retirement accounts

If you know anything about target retirement date or target risk funds, then the problem is likely coming into view, but I want to dig into it. Take, for example, Vanguard's Lifestrategy Growth Fund. It holds:

• 48.3% Vanguard Total Stock Market Index Fund Investor Shares
• 31.4% Vanguard Total International Stock Index Fund Investor Shares
• 14.2% Vanguard Total Bond Market II Index Fund Investor Shares
• and 6.1% Vanguard Total International Bond Index Fund Investor Shares

A perfectly reasonable asset allocation for someone with a long-term investment horizon. The problem is that it also owns an embedded tax asset: 5.76% of the fund's income in 2019 was attributable to income on federal securities, and could be excluded from state income taxes if it were held in a taxable account. That's because, like most total bond market funds, the Vanguard version is weighted heavily towards US bonds, comprising as they do a majority of domestic bonds.As bad as that is, the situation becomes even more dire in target retirement date accounts: 24.68% of the income from the Vanguard Target Retirement 2015 Fund is attributed to federal sources!Just like municipal bonds pay lower coupons to reflect their lower tax liability to high-income taxpayers, the federal bonds embedded in target-risk funds are able to pay lower coupons due to the embedded tax asset of exemption from state and local income taxes.

Whatever your risk tolerance, don't pay for tax benefits you're not getting

The nice thing about target risk and target retirement date funds is they're calibrated to your risk tolerance and/or age, and that's not something you should sacrifice easily. Whether your risk tolerance indicates an 80/20 or a 40/60 stock/bond asset allocation, that's what you should invest in; I'm not here to judge.But when it comes to asset selection in your tax-exempt accounts, you shouldn't be sacrificing interest payments for the sake of a tax exclusion that doesn't apply to you.On the contrary, you should be able to mechanically achieve higher and/or more stable returns by swapping your federal bond allocation for higher-yielding, taxable corporate bonds and cash or cash-like securities like CD's within your tax-exempt accounts.Become a Patron!

The (weird) optionality of Series EE savings bonds

Become a Patron!There's a cliche at least as old as I am, that while ATM's were expected to reduce the demand for bank tellers, banks actually increased the number of tellers they employed, for the counter-intuitive reason that a bank branch was much easier to administer once simple deposits and withdrawals were handled by machines. Instead of wiping out the retail branch, they instead exploded, with one or two human tellers handling all the business that endless brass windows used to be required for.I mentioned this to my partner today in the context of seeing a teller redeem a US savings bond, something that I guessed any given bank employee was only asked to do once or twice a year; even with a computer's assistance, I remarked, it must be a struggle to remember training they use so infrequently.Then, to my amazement, my partner replied: "US savings bonds? I think I've got some of them around here somewhere."The documents she dug up were so strange and so old even the Treasury Department only reluctantly acknowledges their validity. But I couldn't help but investigate what on Earth these faded documents were for.

Some unique features of Series EE savings bonds

So-called "Series EE" savings bonds have three strange features:

• their value is guaranteed to double within a specified time frame (currently 20 years);
• the owner may choose to report the taxable interest on the bonds upon redemption;
• and the interest may be excluded from federal income taxes if the entire value of the bond is used for certain higher education expenses.

Like most federal debt instruments, the interest on the bonds is entirely excluded from state income taxes.My partner's bonds, in some cases dating back to 1993, were purchased at half of face value, while Series EE bonds today are purchased at face value, but let's set aside that technical nuance for now. I'm more interested in the question, what role could Series EE bonds play in an investment allocation?

A binary interest rate

If you hold a $50 Series EE savings bond for 20 years, it is guaranteed to be redeemable for $100, with the $50 in interest taxable at the federal level but exempted from state and local taxes, which my trusty financial calculator tells me works out to a 3.53% annual interest rate.If you hold the bond for any period of time less than 20 years, it will earn interest at a preposterously low interest rate (0.10% as of this writing, and for many years prior).

Annual interest rate resets

Series EE savings bonds can be cashed in, with accrued interest, after 1 year (with a 3-month interest penalty), or 5 years (with no interest penalty). That means every year you have the opportunity to recalculate whether you are better off holding onto the bond and getting closer to your 20-year 3.53% payout, or resetting the 20-year holding period at higher prevailing rates.These breakeven points are trivial to calculate (these values aren't quite right because for simplicity I'm rounding 0.10% APY down to 0%):

• after one year, if interest rates shoot up from 0.10% to 3.72%, make the exchange;
• after 5 years, they must reach 4.73%;
• 10 years in, they must be 7.18% per year;
• and with 5 years left to go, you'll need to earn 14.87%.

Another way of expressing this is that the closer your bonds get to maturity, the higher the interest rate you should think of them as earning: 3.53% may not be impressive 20 years out, but a 100% interest rate one year out should convince you to hang onto them almost no matter what, when their value jumps from $50.96 to $100.

Series EE bonds could be risk-free complements to 529 plans

Besides a nominal allocation to high-yield corporate debt, I own essentially no bonds, for the simple reason that I'm not smart enough to pick individual bonds, and investment-grade mutual funds don't pay enough interest to merit my attention. I prefer instead to put my "stable" savings into high-yield accounts like the ones I discussed last week.In tax-advantaged accounts like 529 college savings plans, where investments compound tax free and can be withdrawn tax and penalty free for eligible expenses, owning "safe" low-yield bonds makes even less sense. But 529 plans designated for actual education expenses pose a conundrum: what if your stock holdings happen to drop in value the very year you need them?Series EE bonds offer one kind of solution: making a bond allocation to Series EE bonds gives half the tax protection of a 529 account (state, but not federal, income tax exclusion). If the stock investments in your 529 account are shooting out the lights, you can make withdrawals tax and penalty free when your beneficiary enrolls.On the other hand, if your beneficiary happens to enter college during a stock market slowdown, cash out the Series EE bonds and let the stocks in your 529 plan ride. Subject to income limits, potentially all the interest on your bonds could be exempt from both state and federal taxes.

Just a few more complications

This is a modestly interesting idea, and I'm glad I looked into it, but there are a few major problems with actually pursuing this as a college financing strategy.First, the required holding period for Series EE bonds in order to trigger the special interest rate is 20 years. Since most Americans enter college between 17 and 19, you'd have to start planning awfully early, like, zygote-early, in order to make a Series EE investment part of your college financing plan.Second, purchases of Series EE bonds are limited to $10,000 per Social Security number, per year. In light of the above, you'd need to load up on bonds to the maximum immediately if you wanted to be sure to meet the requirements for both the full interest rate and, potentially, the federal income tax exemption.

Conclusion

When I visited the Jefferson County Museum in Charles Town, West Virginia, there was a lovely exhibit on the financing of World War II, with carefully preserved books of "War Stamps" and posters exhorting those on the home front to buy War Bonds. But I've never read a good account of exactly how these confusing documents worked.Series EE savings bonds seem to be somewhat similar to those War Stamps: purchased by relatives, forgotten by recipients, stuffed in drawers and safe deposit boxes, and offering random windfalls when discovered years or decades later.Become a Patron!

Direct indexing and shareholder democracy

Become a Patron!The late Paul Volcker is famously said to have quipped that he hadn’t seen a worthwhile financial innovation since the ATM, which makes him slightly more cynical than even I am. In fact, I think we're on the brink of a real revolution in shareholder democracy.

Mutual funds and direct ownership are competitors

Vanguard has offered low-cost, commission-free, passively-managed mutual funds my entire adult lifetime, which makes it easy for people of my generation and younger to dismiss the seriousness of the problem Jack Bogle solved. After all, stockbrokers and mutual funds long predated Vanguard, so a savvy investor always had the option of either opening a brokerage account with a local provider and buying an appropriately diversified basket of stocks and bonds, or selecting an appropriately diversified mutual fund from one of the many available firms.The obstacle was cost: with commissions as high as $75 per trade, buying and selling a single stock, let alone a basket of stocks, was enormously expensive: you could spend almost $2,000 in commissions when buying just 25 stocks. Once you owned shares, of course, the ongoing cost to hold them was negligible.Mutual funds offered a different tradeoff. By paying a single up-front commission, you could buy into a basket of "expertly-managed" stocks that would be rebalanced at the manager's discretion. Of course, expert management isn't cheap, so you'd also pay an ongoing fee to keep the lights on at headquarters and return profits to the fund company's shareholders.We don't normally talk about it this way, but these models are in competition: stockbrokers offer wealthy investors and institutions the ability to save on their ongoing holding costs by charging large up-front commissions, while mutuals funds appeal to middle-class investors willing to pay higher ongoing costs in exchange for a smaller up-front investment.In the context of this competition, Bogle's solution was elegant: fire the company's shareholders (by making Vanguard's mutual funds the owners of the company itself), fire the experts (by offering passively-managed, market-capitalization-weighted funds), and pass the savings on to the shareholders in his mutual funds.Bogle won the first round, and Vanguard's investors have benefited enormously. But today, we're seeing the early stages of the stockbrokers' revenge.

Fee-free trading was a breakthrough; direct indexing of fractional shares will be a revolution

I've written plenty of times about Robinhood, the fee-free trading app. It's had some growing pains, both regulatory and technical but it has always fulfilled its essential promise: commission-free buying and selling of stocks and ETF's.As a company, Robinhood is as hopeless as Uber, incinerating millions of dollars in Saudi oil profits with signup bonuses and operating expenses that their revenue can't even begin to cover, praying to be acquired by a real company before the next crash.But as an idea, Robinhood was a brilliant strike back against Bogle's triumph: if trading is commission-free, and holding shares is free, then what advantage does a mutual fund have over ownership of the fund's underlying shares? Ownership of shares gives investors the right to vote at shareholder meetings, and it allows precision tax-loss harvesting, while even Vanguard ETF ownership only allows you to vote your shares of the mutual fund, not the underlying companies, and by blending together the performance of its constituents limits the availability of tax-loss harvesting.Robinhood offered one solution to one problem, but it's not enough, for the simple reason that it does not, and in my opinion cannot, offer fractional shares. That makes direct ownership of even a tiny, unrepresentative index like the Dow Jones Industrial Average absurdly expensive: the purchase of a single share of each DJI constituent would cost $4257.52. A market-cap weighted purchase of the average would be many times more expensive, if you can dredge up from grade school how to calculate lowest-common-denominators.

Fee-free trading of fractional shares will make mutual funds obsolete

I'm making this claim in the strongest way possible not because I think it is anywhere close to happening, but because I think it is inevitable.The earliest, easiest adoption will come in market-cap-weighted funds: when a Google or Excel spreadsheet can sit on top of your brokerage account and sell losers while replacing them with the shares of similar companies at no cost, why would anyone own a mutual fund or even an ETF that blends together the tax liability of capital appreciation with the tax benefit of price declines?Active managers and funds will feel the pressure a bit later, but they'll feel it eventually. Why pay an ongoing management fee when you can subscribe to a newsletter or website that sends a .csv file individualized for your brokerage and your tax lots?

Shareholder democracy matters and mutual funds aren't helping

It's a cliche that three companies (Blackrock, Vanguard, and Charles Schwab/TD Ameritrade) control a vast swathe of publicly traded shares through their mutual funds, and it's fashionable to point out they cast their votes as shareholders in ways their investors may resent, or even despise. Vanguard has gone so far as to hold its shareholder meetings not in populous, accessible Philadelphia, but in a satellite office in Arizona, to make sure as few people as possible show up and complain about how it deploys its influence over global capitalism.I don't think that mutual fund companies vote their shares with any kind of corrupt intent; on the contrary, I believe they vote them based on their belief about what is going to produce the greatest financial return for the shareholders of their mutual funds.But that's not how people vote, and if in 20, 30, or 50 years direct indexing has allowed investors to reassert humane control over the companies they own, it will ultimately come to be viewed as an enormous economic and ethical revolution.Become a Patron!

The SECURE Act is headed into law; small employers get a few handouts

Become a Patron!I've written extensively about the hilariously-named SECURE Act, which sailed through the House but was frozen in the Senate while Ted Cruz extorted his colleagues to allow wealthy Texans to make tax- and penalty-free withdrawals from their 529 accounts for "homeschooling" expenses. Contrary to some early reporting, that provision does not seem to have made it into the final bill, although the $10,000 student loan double dip did (the changes to 529 plans start on page 642).Since the retirement provisions have been widely covered (and here ridiculed), today I want to focus on a couple features of the bill which are relevant to small employers.

Existing retirement plan startup cost credit

To understand the changes made by the SECURE Act, you need to be familiar with the status quo, particularly section 45E(b) of the Internal Revenue Code. The section provides for a credit of 50% of an employer's "qualified startup costs," up to $500, for each of the first three years of an employer's qualified retirement plan. An employer is disqualified from the credit if they had a qualified retirement plan in any of the 3 tax years preceding the establishment of the new plan.In other words, even if you wanted to hack the current credit, it would mean opening and closing qualified retirement plans every 3 years, for a maximum benefit of $1,500 every 6 years. Obviously, no one should do this, and as far as I know, no one does; the juice isn't worth the squeeze.But the biggest obstacle to claiming the current credit is the definition of qualified startup costs: "any ordinary and necessary expenses of an eligible employer which are paid or incurred in connection with— (i)the establishment or administration of an eligible employer plan, or (ii)the retirement-related education of employees with respect to such plan."I'm not a tax lawyer, and I'm especially not your tax lawyer, but I interpret this as saying that the credit can only be claimed against the actual administrative costs of starting and running the plan for the first 3 years. In other words, it can't be claimed against costs incurred by the employer making contributions to the plan.The difference is important, since starting a 401(k) plan just isn't that expensive, and administering one on an ongoing basis is essentially free (once you exclude the employer's contributions to the plan).I'm not saying it's impossible to qualify for the credit. If you have to hire an outside firm to set up your plan documents, you'll have to pay them, and the credit helps offset that. In theory if your record-keeping is good enough you could probably even claim the credit against the wages paid to an existing employee for setting up a qualifying plan. But since the credit is worth just $500 per year for a maximum of 3 years, we're left with this kind of silly corner case.

Expanded retirement plan startup cost credit

The SECURE Act does not change the definition of qualified startup costs, nor does it remove the 3-years-every-6-years time limitation. What it does do is increase the maximum credit from $500 per year to $5,000 per year (technically the greater of $500 or $250 per employee, with a maximum of $5,000 if you have 20 employees). A $15,000 tax credit might get your attention where a $1,500 credit didn't.It's still hard to spend $30,000 setting up and administering a retirement plan (since the credit is still capped at 50% of startup and administrative costs), but it's not impossible. In particular, I think it's very likely that we will see new financial instruments that charge a certain portion of the ongoing costs of administering a plan to the employer, rather than the employee, in the first 3 years, as an "ordinary and necessary expense."This is completely speculative, but once you consider the possibility, the possibilities are endless. Consider an annuity provider that charges the individual employee accounts of a 20-employee company an average of $3,000 per year for ten years. Under the SECURE Act, they could charge the employer $10,000 per year for three years, while waiving their fees on individual accounts for ten; the insurance company accelerates its payment schedule, and the federal government foots half the bill!Of course, there's no need to take my word for it; once the SECURE Act is signed into law I expect we'll see such products aggressively marketed everywhere.

Credit for auto-enrollment

What isn't speculative is section 105 of the SECURE Act, which offers employers a credit of $500 per year for establishing an auto-enrollment provision, including in existing plans. Business and finance reporters are extremely lazy so you're sure to see this misreported, but the text of the law is crystal clear and blissfully short:Here the eligible period is not determined by the establishment of the retirement plan; it's determined by the establishment of the eligible automatic contribution arrangement. In other words, virtually all small employers, whether or not they have existing retirement plans, should be eligible for this credit if they start an auto-enrollment option any time after January 1, 2020.While the credit doesn't scale up by number of employees as the startup cost credit does, that makes it more valuable for even-smaller employers, almost none of whom include auto-enrollment in their retirement plans.Become a Patron!

Strategies to pay for an early retirement

Become a Patron!Last month I got to spend some time with a relation who recently left a high-powered tech job, and who asked for some advice about financing a more or less indefinite period of unemployment. I am strongly opposed to mixing money and family, but I eventually relented and offered some ideas in general terms about how I would advise someone who came to me in his situation. I thought it might be useful to write up those ideas in case they're useful to anyone else in his situation.

Get your finances in order

Over the course of a 15 or 20 year career, workers accumulate an enormous quantity of financial junk. Multiple 401(k) and 403(b) plans, stock options and grants, individual stocks, term and whole life insurance policies, etc. Even if you tend each garden carefully, it can be hard to figure out what you really own: is a Fidelity target retirement date fund really equivalent to a Vanguard fund with the same target date? Is a Betterment "aggressive" portfolio the same as a FutureAdvisor "growth" portfolio?An underrated advantage of an early retirement or break in your working life is that it's an opportunity to get all that junk sorted out at minimal or no cost, for the simple reason that long-term capital gains are untaxed if your taxable income (after deductions) is below $39,375 for single filers and $78,750 for married joint filers. In low-income years you should be "harvesting" as many gains as possible in taxable accounts, and unlike with capital losses, there's no wash sale rule with respect to gains. In low-income years, you can realize taxable gains, pay a 0% long-term capital gains rate on them, and then buy identical securities with a new, higher cost basis.In addition to resetting your taxable basis, you should also consolidate your old retirement accounts in traditional and Roth IRA accounts with your preferred custodian. This is a good idea in general, but a break from the workforce is as good a time as any to finally get around to doing it.

How likely are you to return to work, and when?

This is the single most important question when contemplating early retirement, but unfortunately one of the most difficult to answer accurately. The two easiest answers are "I'm certain I will return to work in 1 year," and "I'm certain I'll never return to work," but few people are able to give either. On the one hand, in one year unemployment could be 15% and no one will be hiring 40-year-olds with unexplainable gaps in their resume. On the other hand, 3 months into a supposedly "permanent" retirement you might have already landscaped the lawn, oiled all the hinges, replaced your floor, repainted your living room and be pulling your hair out from boredom.Nonetheless, while it may only be an educated guess, guess you must, since whether or not you return to work is the main input into the most important question: how much risk can you expose your savings to? Unlike some people in the FIRE community, my attitude towards risk is simple: if you do not plan to return to work, you cannot risk any money you need for retirement, while if you are certain to return to work, then you can expose a relatively large amount of your assets to risky investments.You may have noticed a semantic trick I played: I'm not interested in your total assets, I'm interested in the assets you need for retirement.Take the case of a 40-year-old with $1 million in liquid, taxable assets, in a brokerage account for example, who never intends to return to work. They can spend $2,778 per month for the next 30 years, before claiming their maximum Social Security old age benefit at age 70, the very day they exhaust their brokerage account balance. But what if, upon studious reflection, they determine that they only need $1,500 per month to live? In that case, while keeping $540,000 in safe assets, they're free to invest $460,000 in risky assets, knowing that even complete disaster will leave them enough money to meet their needs.It doesn't matter what they call that $460,000, whether it's their "legacy" or "play" money or "gambling" money, what's important is that you can't risk money you need to survive.Hopefully this makes clear the importance of the return-to-work question: if you're certain to return to work in a year, then your "sabbatical" shouldn't have a substantial impact your asset allocation at all: set aside 12 or 18 months worth of cash, CD's, or Treasury bills, and leave the rest invested in an age- and risk-appropriate long-term portfolio. 5 years out of the workforce requires a higher allocation to safe assets, both for the longer timeframe and to take into account the likelihood of lower earning as your experience and skills age. To account for 10 years of early retirement you should count on a significantly lower income, if you do ultimately return to work.

Health insurance

While healthcare costs can pose a serious financial hardship for workers, in retirement the situation is much simpler: if you live in a Medicaid expansion state, you can enroll in Medicaid, which has no premiums or deductibles, and nominal co-payments for prescription drugs. There's no open enrollment period, so you can enroll as soon as your employer-sponsored insurance coverage ends.If you live in a non-expansion state, you'll need to claim the maximum advance premium tax credit and cost-sharing reductions by entering an income into your state's health insurance marketplace that's right around 140% of the federal poverty line, and selecting an eligible Silver plan. You may end up paying a few dollars a month in premiums — in non-expansion Wisconsin my monthly premium was $0.83, so I just paid the $12 once a year in advance to make sure my policy wasn't canceled in case I forgot. When you file your taxes you'll be asked to calculate how much of your advance premium credit you have to repay, which will be $0 or close to it, as long as you're sure to keep your income low enough.And once you turn 65, of course, you're eligible to enroll in Medicare. While Medicare is worse insurance than Medicaid (coming as it does with premiums, co-payments, and deductibles), it does give you access to a somewhat wider range of providers, which is increasingly valuable as you age, depending on your health status.One quick note here: many people have heard of the "Medicaid asset test," which requires people enrolled in Medicare to spend down certain assets before they become "dual eligible" and begin to receive much more generous Medicaid coverage. This asset test does not apply to non-Medicare enrollees living in Medicaid expansion states. Thanks, Obama.

The incredible advantage of working at least a little bit in pretirement

Finally, I want to point out an important advantage to bringing in at least a little bit of income in retirement, or "pretirement" as my relation calls it. Consider the same 40-year-old above, with $1 million in liquid assets and $1,500 in monthly expenses, who therefore needs $540,000 in safe assets and can invest $460,000 in risky assets — an overall asset allocation of 46/54.Earning $500 per month (33 hours at $15 per hour, or roughly 8 hours per week), reduces the cash need over the next 30 years to just $360,000, leaving $640,000 to invest in risky assets — a much risker overall asset allocation of 64/36, with a consequently higher expected final value.A few hours of work per week, whether it's as a high-powered consultant, or a low-powered Walmart greeter, relieves an enormous amount of pressure on your assets.

A few notes on timing

I mentioned above the advantages of harvesting tax-free capital gains in low-income years, but I want to point out a few other opportunities that arise once you've stopped working.Once you've rolled over your workplace-sponsored retirement balances to IRA's, you're able to convert your traditional IRA balances into Roth IRA balances. This is a taxable, but penalty-free, event, so you can convert up to the amount of your standard deduction every year (or your remaining standard deduction after accounting for earned income) tax-free (and substantially more than that at today's favorable income tax rates). Those Roth balances can then be withdrawn tax-free any time after age 59 1/2, and aren't subject to required minimum distributions.Finally, it's worth considering how and whether to make withdrawals from retirement accounts in general. An example of a "simple" strategy would be to draw down taxable assets before age 59 1/2, take distributions from qualified retirement accounts until age 70, then rely on your Social Security old age benefit and any remaining required minimum distributions from then on. More sophisticated strategies do exist, however: your assets may last longer, or accommodate higher spending (two ways of saying the same thing) if you're able to meet your spending needs with your untaxed long-term capital gains in lieu of retirement assets prior to age 70, giving the latter more time to internally compound tax-free. Retirement assets are also granted much more protection in bankruptcy, a kind of built-in insurance policy against sudden financial misfortune.These strategies can be quite complex, and I would not attempt to implement one without consulting a fee-only financial advisor, i.e. one who is not paid to sell you their firm's flavor of the week.Become a Patron!

What the media can't get right about retirement, and why

Become a Patron!A long-time reader passed along an article from the World Economic Forum's blog (yes, for some reason the World Economic Forum has a blog) titled "To retire at 65, American millennials need to save almost half their paycheck." While the article is absolute drivel, it's a good starting point to understand some things the business and financial press gets consistently wrong about savings.

The article itself makes no sense

The extremely thin premise of the article is easily dispatched with: relatively high stock market prices today suggest that future returns will be relatively low. That means projecting today's return on savings forward means today's workers will have to fund a relatively large portion of their retirement spending out of savings and a relatively small portion of their retirement spending out of dividends and price appreciation.I will make a simple observation about this thesis: retirement savings are accumulated over time, not with lump-sum contributions. The idea that "high prices today predict low returns tomorrow" only applies to this year's contributions. Next year's contributions will earn returns based on next year's prices, and contributions made 10 years from now will earn returns based on prices 10 years from now. In other words, assuming steady or rising contributions, today's prices tell you nothing about the lifetime savings rate required to achieve a given level of income replacement in retirement.To give a simple example, the 30-year Treasury bond rate reached a high of about 14.8% in 1981. Since $1 invested at 14.8% for 30 years yields $62.84, using the World Economic Forum's logic, a 35-year-old in 1981 could have invested just 0.8% of their salary each year in order to replace 50% of their pre-retirement income, since 30 years later, that 0.8% would have swollen to 50%.The problem is that 10 years later, the 30-year Treasury rate had fallen to below 8%, and the same 0.8% salary savings would replace just 8% of their salary 30 years later. The World Economic Forum is making the primitive mistake of projecting this year's expected returns forward to all future years.With the Social Security full retirement age already raised to 67 for my generation, even the oldest millennials have 25 or more earning years ahead of them; of course it's possible today's high stock market prices will continue for the next 25 years, but let's just say I have my doubts. And if we do have 2, 3, or 4 crises, recessions, or depressions between now and then, there will be plenty of opportunities to buy assets with expected returns just as high as they are low today.

The financial press doesn't get it: no one saves anything

In some ways it's unfortunate that we use the same verb in two radically different, almost opposite meanings: to "save," and to "save up for." To "save up for" is the most common and natural thing in the world, and virtually everybody does it. Whether you're saving up for Christmas presents, a new console game, a down payment on a house, or an anniversary dinner, the idea is the same: you set money aside every week or month, for a known or unknown period, and then you spend it, and it's gone. This is not fundamentally different from buying something on credit, it's just cheaper: with credit you get the object of your desire up front, then pay for it over time, while with savings you pay for it over time, then get it at the end.But "to save," let alone "to invest," means something totally different. It means setting money aside, for an indefinite period of time and for no definite purpose. This behavior is vanishingly rare because upon a moment's reflection, it makes almost no sense.First, setting money aside today comes with an obvious cost: that money could be spent instead. It's one thing to save up $300 for a new gaming console; it's another thing entirely to have saved $300 and then, instead of buying a new gaming console, keep saving instead!Second, the indefinite period creates obvious risks. I'm not talking about investment risks, since even most people who do save don't invest their savings. I just mean the risks of doing anything over time. Maybe you'll die before you ever spend any of your savings — you can't take it with you. Maybe you'll get divorced and "lose" half your savings to your former spouse. Maybe word will get around that you have savings and your friends and relatives will come around asking for a "loan."To put it as simply as possible, if saving were easy, the government wouldn't have to go to outlandish lengths to encourage people to do it. And despite those outlandish efforts, the only people who save are still the same people who would do it anyway: high-income professionals. Don't get me wrong, they're happy to take the government handouts, but the handouts are pure gravy.

The fantasy of the retirement "number"

Let's turn back to the underlying premise of the World Economic Forum post: the goal of retirement saving is to replace a certain percentage of your pre-retirement income by setting aside money during your working years. If you can project forward both your earnings trajectory and your investment returns (whether on a year-by-year basis or using the "starting year" fallacy described above), then you can determine the total balance you need to have in your accounts on the day you stop collecting a paycheck.But who could this model possibly describe with any degree of accuracy? The majority of people start collecting Social Security old age benefits on the day they become eligible, and have no savings or an amount that is simply inconsequential to their long-time retirement spending needs. Using the 4% rule, someone who has managed to accumulate the fantastic sum of $100,000 at retirement can only safely withdraw $333 per month to supplement their Social Security benefits, and if the money is kept in a risk-free account, the safe withdrawal rate must by definition be even lower.On the other hand, savvy high-income professionals pour vast sums into their pre-tax retirement accounts, 529 accounts, Roth accounts, HSA's, after-tax 401(k) accounts, and these sums accumulate so quickly they dwarf any conceivable financial needs in retirement.What the "retirement number" presupposes is that there's some group of people in-between, who can afford to save more than nothing, but less than the absolute maxima allowed in tax-advantaged accounts. And this group no doubt exists: there are a lot of numbers between $0, the amount saved by most people, and $19,000, the amount contributed by high-income professionals to their 401(k) plans in 2019, so in a country of 350 million souls there are certainly people contributing $1,000 and people contributing $18,000.Unfortunately, the first $1,000 you save does nothing for your retirement security (you'll still rely on Social Security old age benefits), and the last $1,000 you save does nothing for your retirement security (you'll retire wealthy no matter what).

Finance journalism is an ideological project

What all the above should make clear is that the relentless focus on this sliver of the population, the "in-betweeners," is not about personal finance, it is about ideology. Tax-advantaged investment accounts obviously provide the overwhelming majority of their tax benefits to the people who can afford to contribute the most money to them, and no benefit at all to people who can't afford to contribute anything.If retirement income security, or affordable higher education, were really public policy goals, then the money currently spend shielding the investments of the wealthy from taxation would go a lot further in boosts to Social Security benefits and public subsidies for higher education.But if you can create a mile-wide, inch-thick class of people who have contributed "something" to an IRA, 401(k), 403(b), or 529 plan, then you suddenly have tens of millions of people mobilized to protect those programs for the wealthy despite the trivial benefits they receive from them, and the ideological basis for cutting Social Security benefits and public higher education funding even further: anyone without sufficient retirement income should have raised their retirement contributions faster; anyone who can't afford to send their kids to college should have opened that 529 plan earlier.After all, the financial press was there all along telling you to, so you have no one but yourself to blame.Become a Patron!

What to watch for as the Senate panics over the SECURE Act

Become a Patron!My readers know that the SECURE Act, passed unanimously out of its House committee and overwhelmingly on the floor of the House, was conjured into existence by the insurance industry in order to increase the distribution of expensive, opaque annuity products in 401(k) retirement plans. It incidentally also includes a few other provisions designed to reduce the taxes paid by the extremely wealthy, like the SECURE backdoor into 529 assets. Throughout 2019 the Act has been held up in the Senate by Ted Cruz, who wants to open the backdoor even further by allowing tax-free distributions from 529 accounts for "homeschooling" expenses.The SECURE Act is back in the news since, with impeachment looming, the Senate's legislative calendar is looking increasingly time-constrained, and the insurance industry's senators are panicking to make sure their masters get what they paid for.Since some version of the Act will likely be folded into end-of-year budget negotiations, here's what to watch for as that process plays out.

What won't change: annuities and RMD's

The core of the SECURE Act, and its companion measure in the Senate, has always been to increase the distribution of annuities in employer-provided 401(k) plans by shielding employers from liability when those plans are unable to make their promised payments. The sop to individual savers to "balance out" that giveaway is an increase in the age, from 70 1/2 to 72, at which minimum distributions are required from pre-tax individual retirement accounts and 401(k)'s.Those two giveaways are the reason the Act exists, and are unlikely to change substantially since they've already been frozen in carbonite by their respective lobbyists.

The 529 backdoor

The House version of the SECURE Act includes the SECURE backdoor into 529 assets, allowing account owners to double dip into their account balance, once by taking a tax-free distribution for higher education expenses covered by a student loan, and then a second tax-free distribution of up to $10,000 in order to repay that loan.The Senate version did not contain that provision, so it remains to be seen whether the final measure will include the backdoor, and if so, whether the House's $10,000 limit will be kept, raised, or lowered.

The "homeschooling" loophole

In the smash-and-grab tax act of 2017, a private schooling loophole was added to 529 plans, allowing for up to $10,000 in tax-free distributions for certain private primary and secondary education expenses. Ted Cruz wants to blow that loophole wide open by allowing for the same tax-free distributions for "homeschooling" expenses, and has blocked passage of the Act in the Senate until he gets his way.Upon even a moment's reflection, this is simply open-ended permission for the wealthy to shield their investments from capital gains taxation. After all, education takes place throughout the year. Who is to say that tennis lessons aren't a form of homeschooled "physical education?" Who is to say that a laptop isn't necessary for homeschooled "computer science?" Who's to say that a month in France isn't a "foreign language" field trip?So far the Senate has had the good sense not to bend on this point, but in the flurry of year-end negotiations, Cruz may end up getting his way.

Changes to "stretch" IRA's

For technical reasons, it's much easier to pass legislation that does not have a budgetary cost than legislation which does, so in addition to its handouts to the very wealthy, the House version of the SECURE Act also included a measure to increase revenue: drastically shortening the period over which withdrawals from inherited IRA's and 401(k) accounts must be taken.Under current law, required distributions from an inherited IRA can be calculated based on the heir's life expectancy, rather than the original account owner's. This allows an heir to both reduce required distributions and strategically time distributions for low-tax years. Under the SECURE Act, all inherited IRA's must be completely distributed within 10 years.This is an extremely important change in the world of tax planning, but obviously not of much interest to the overwhelming majority of people: most people do not inherit anything; most people who do inherit something don't inherit IRA's; and most people who inherit IRA's just withdraw the money immediately, they don't strategically time withdrawals for the next 60, 70, or 80 years.If the SECURE student loan backdoor limit is raised, or the "homeschooling" loophole is added, the budgetary cost of the Act will soar. That may mean the stretch IRA period will be shortened further: a 7-year window raises less money than a 10-year window, since it mechanically reduces the opportunities for strategic withdrawals.It's also possible the necessary revenue will be raised elsewhere in the final bill, or the procedural point of order will be simply be waived.

Conclusion

The SECURE Act is a bad law that should not be passed: the benefits go overwhelmingly to the wealthy in the form of tax savings, and the costs, particularly the ability of annuity marketers to target employers for inclusion in 401(k) plans, will be borne exclusively by the working and middle classes.But since it likely will be passed in some form, eventually, now you know what to watch for.Become a Patron!

Are there 529 plans so bad they aren't worth their state's income tax benefits?

Become a Patron!A lot of financial planning and advice can start to seem pretty routine over time: maximize contributions to tax-advantaged savings vehicles, invest in a basket of diversified, low-cost assets, and periodically (but not too often!) rebalance.I'm always interested in identifying places where that kind of routine advice breaks down, and the other day, I got to thinking: many states allow certain state income tax deductions for 529 college savings plan contributions, but only when contributions are made to plans sponsored by the state where you take the deduction. Since the fees and expenses of 529 plans can vary considerably, I wondered if there are states where the costs of using the in-state plan instead of a cheaper alternative exceed the value of the state income tax benefits.

Deductions, credits, and rates

To investigate this question, I had to isolate several different dimensions:

• Does a state offer a tax deduction or a tax credit? Four of the 35 states offering state income tax benefits offer a tax credit for contributions: Indiana, Utah, Vermont, and Minnesota. The rest allow for contributions to be deducted from state income instead.
• What are the limits on the state tax benefit? Colorado, New Mexico, and West Virginia allow taxpayers to completely eliminate their state income tax liability through 529 contributions. The remaining states place a cap on the amount that can be deducted.
• What are the state income tax rates? A deduction is more valuable in a state with high income tax rates than in a state with low ones. I used the lowest and highest non-zero income tax brackets for each state to identify the range of potential values of a state income tax deduction.
• Does the state only allow deductions for in-state plan contributions? Seven states allow income tax deductions for contributions to out-of-state plans: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
• And finally, what is the cheapest appropriate investment option in each plan? For this comparison, I selected the lowest-cost broad US equity option in each plan, which was typically a US large cap, S&P 500, or total stock market fund.

Whether or not you're interested in my particular research question, you might find the resulting spreadsheet useful on its own, and you can find it here.

Reminder: state tax benefits are worth less to federal itemizers

Before I go on, I want to remind folks who choose to itemize their federal deductions that state tax credits and deductions are worth less to them, since reducing their state income taxes mechanically reduces their state and local tax deduction and increases their federal income taxes.Take, for example, a South Carolina resident in the 7% state income tax bracket who owed exactly $10,000 in state income tax and no other state or local taxes in 2018. If they chose to itemize their federal deductions, for example due to a large deductible charitable contribution in 2018, then the $10,000 is also deductible from their taxable federal income.Since South Carolina allows 529 plan contributions to be deducted against an unlimited amount of state income, the taxpayer can save $10,000 in state taxes by contributing a bit over $100,000 to a South Carolina 529 plan. But this will reduce their state and local tax deduction by the same $10,000, increasing their federal income tax liability by up to $3,700.Such corner cases cover only a tiny number of taxpayers, but it's something to be aware of in case you happen to be one of them.

First impressions

Taking a look at the spreadsheet, the first thing that should jump out at you is that these plans are all over the place. Investment costs start as low as 0.035% (for Rhode Island residents to invest the "U.S. Stock Portfolio"), and run as high as 0.65% (for Mississippi's "U.S. Large-Cap Stock Index Fund Option"). Note that these are the lowest-cost equity investment options in each plan — fees for other investment options can run much, much higher than this.The second noteworthy observation is that some of these supposed tax benefits are trifling. Rhode Island will give a married couple with over $145,600 in taxable income a deduction worth a little less than $60 for contributing $1,000 to their in-state plan. For a low-income single filer, the deduction is worth less than $20. What exactly is the point supposed to be?At the high end, the state tax benefits can be considerable. In addition to the states with unlimited deductions I mentioned above, high-income married taxpayers in Alabama, Connecticut, Idaho, Illinois, Indiana, Iowa, Mississippi, Nebraska, New York, Oklahoma, and Vermont can all save $500 or more by making contributions to in-state plans. Single filers have it tougher, but can still save more $500 or more in Mississippi and Oklahoma state income taxes.

If you're just maximizing state tax benefits, don't diversify!

This is a corollary of what I wrote above: since I chose the lowest-cost equity option in each plan as my benchmark, if you don't use that option, you will likely end up paying more in fees. For your primary 529 account, you should have an appropriately diversified portfolio that scales back risk as your beneficiary nears enrollment. For your tax-scam 529 account, just put however much money you need to maximize the state tax benefits into the cheapest equity fund and forget about it.If you're lucky enough that your primary account is also your tax-scam account (Utah, I'm looking at you), then feel free to disregard this warning.

It's almost always worthwhile for non-zero rate payers to maximize their in-state tax benefits

Remember the original question we started with: are there states where the cheapest investment option is so expensive it outweighs the state income tax benefits?And the answer, to a first approximation, is no. What I was looking for is a state with a very low income tax benefit, like Rhode Island, and very high investment costs, like Mississippi or North Dakota. But those states mostly don't exist: for taxpayers with any state income tax liability at all, making the maximum deductible contribution to the cheapest in-state 529 investment option will almost always create a greater reduction in state income taxes than the increased expenses compared to the cheapest 529 plans available.There are two exceptions: in states with fixed account maintenance fees in addition to investment costs, low balances may incur much higher proportional expenses, in the same way that fixed fees on origination can increase a loan's APR far above the stated interest rate.The second exception is folks without state income tax liability. If you aren't taking advantage of your state's tax benefits for in-state plan contributions, don't feel compelled to make in-state plan contributions: find the cheapest plan with the best investment options and use that instead.Become a Patron!

The Fidelity "dead accounts" study is fake, not wrong

Become a Patron!I've noticed an interesting phenomenon, which I call "common knowledge about common knowledge" (doesn't exactly roll off the tongue, I know). It's when some piece of conventional wisdom becomes so banal that someone decides to refute it, and then the refutation becomes as widely known as the original factoid, if not more so.To give an easy example, "everyone knows" that vitamin C strengthens your immune system. But "everyone" also "knows" that's ridiculous folk wisdom based on a single poorly conducted study in the early 20th century.The problem is this can cause people to overcorrect, and end up saying "actually vitamin C has no health effects."Except vitamin C really is essential to human health!

There's no Fidelity "dead accounts" study

An ancient piece of financial lore holds that one day, the beancounters at Fidelity decided to study the performance of every account at the firm in order to identify what characteristics were shared by the accounts yielding the highest returns. Small stocks, big stocks, domestic stocks, foreign stocks, frequent trading, infrequent trading, they looked at everything.After months of crunching the data, the beancounters made a shocking discovery: there was one account type that consistently outperformed all the others. The accounts of dead people! It turned out that people who did no trading in their accounts whatsoever had higher long-term returns than any other strategy.Now, if you think about this for even a moment, you'll realize it doesn't make any sense. How many accounts could Fidelity possibly have in the names of dead people (another version sometimes includes "people who had moved and forgotten about their accounts")? If Fidelity could easily identify dead accountholders, why hadn't they notified the appropriate authorities already?Today, people gleefully debunk the apocryphal Fidelity study.

The Fidelity study is fake, not wrong

Whenever I see a reaction like this building, whether it's "actually vitamin C doesn't make you healthy" or "actually a dead person's account would not achieve better returns than an actively managed account," I like to take a second to ask, what if the conventional wisdom was right all along?To find out, I used Morningstar's portfolio tool to check the performance of two portfolios: a simple 60/40 portfolio using the Vanguard 500 (VFINX) and Vanguard Total Bond Market (VBMFX), and a Boglehead 3-fund portfolio substituting a 12% allocation to Vanguard Total International Stock (VGTSX). The 2-fund portfolio performance goes back to 1986, and the 3-fund portfolio to 1996. In both cases, I selected reinvested dividends and capital gains.For each portfolio, I checked its annual return (and the final value of an initial investment of $100,000) with a monthly, quarterly, semiannual, and annual rebalance, and with no rebalance at all.For the 2-fund portfolio dating back to 1986, the average annualized returns (and final value) for each rebalance selection were:

• Monthly: 8.73% ($1,526,134)
• Quarterly: 8.79% (1,553,836)
• Semiannual: 8.71% ($1,517,894)
• Annual: 8.73% ($1,526,244)
• No rebalance: 9.02% ($1,665,050)

Here are the same values for the 3-fund portfolio since 1996 (the pattern is similar for the 2-fund portfolio over the same period):

• Monthly: 7.06% ($486,314)
• Quarterly: 7.16% ($496,945)
• Semiannual: 7.28% ($510,056)
• Annual: 7.32% ($514,528)
• No Rebalance: 7.07% ($487,180)

Conclusion

I like this data precisely because it lends itself to multiple interpretations. Looking at the two-fund portfolio since 1986, you'd conclude no rebalancing at all yields the highest returns — the fake Fidelity was right all along, the best investor is a dead investor!On the other hand, the three-fund data since 1996 suggests annual rebalancing yields the highest returns — having a pulse matters after all.If you're reading this, I'll go ahead and assume you have a pulse, so allow me to split the difference: if you're invested in a simple 2-fund, 3-fund, or 4-fund portfolio, you're almost certainly rebalancing too often. If you're rebalancing monthly, consider switching to quarterly. If you're rebalancing quarterly, consider switching to semiannually (perhaps on the equinoctes?). And if you're rebalancing semiannually, consider switching to annually. If you're rebalancing annually, your blood is already ice cold and you don't need my advice.The logic is simple: when you rebalance a portfolio, you're by definition selling your winners and buying your losers. But the tendency of assets, especially over short periods, is for winners to keep winning and losers to keep losing, meaning frequent rebalances move you out of assets that are performing well and into assets that are performing poorly.There are good reasons to do that, for example if you are targeting a particular balance in lower-performing, more stable assets, in anticipation of a near-term expense. One of the benefits of diversification is that it tends to increase your risk-adjusted return. But while risk-adjusted returns are an important metric when designing a portfolio, you can't eat them. For that, you need the ordinary kind.Become a Patron!

What do the wealthy need from their financial advisors?

Become a Patron!I've had two conversations lately that got me thinking about a question which, for obvious reasons, doesn't come up in most people's lives: what do you do after you've exhausted all the obvious financial planning tools?

Financial planning isn't complicated, it's just hard

Most people have been trained to think about financial advice in terms of investment decisions, so when they say "give me some financial advice," what they usually mean is, "give me a stock tip." If the stock goes up, they think you're a financial genius, and if the stock goes down, they think you're a con man.That's why I always try to tell people, I have no idea what the stock, bond, commodity, real estate, or any other market is going to do over any time horizon. Not just over 6 months, but even over 30 years, the performance of individual investments is something I have no insight into.That makes asset allocation inherently unsatisfying work, as important as it is. At the end of a 30-year period, a well-diversified portfolio will have some holdings that have increased in value by much more than others, which may have even fallen in value over the previous 30 years. What is the point of diversification if it means you end up holding crap that weighs down your overall return? Why not just buy winners?Financial planning for most people can be boiled down to three inputs, in order:

1. savings rate
2. asset location
3. asset allocation

This is an inconvenient for some people because it doesn't feel like saving is something your financial advisor is doing. But if you raise your IRA contributions by 9.091%, from $5,500 (the 2018 contribution limit) to $6,000 (the 2019 limit) I can guarantee your contributions will be 9% higher. Holding your savings rate fixed, I can make at best an educated guess about the effects of asset location (predicting future tax rates) or asset allocation (predicting future market performance).The flip side of this is that by far the most important thing anyone can do to get their financial house in order feels to most people completely impossible. You earn $80,000 a year? Not anymore. Now you're contributing $19,000 to your 401(k) and $6,000 to an IRA and you make $55,000. Thinking about having a kid? Congratulations, now I need you to save even more.In other words, one of a financial advisor's most important jobs is to make you feel much poorer than your friends, family, and colleagues.

What financial advice do the wealthy need?

This is a question I want to pose as carefully as possible, since the wealthy want the same thing from their financial advisors as everyone else: a good stock tip. But obviously the wealthy need a good stock tip even less than everyone else: if you're earning more than a couple million dollars per year, you can keep your money in cash and you'll still die a millionaire.I think there are at least five important buckets financial planning can fall into for the very wealthy:

• Permission to spend. This is the flip side of financial advice for the working and middle classes. A financial advisor severely restricts the amount of spending money a middle class professional has available by directing as much of it as possible into tax-advantaged accounts. But someone who maxes out their contributions in January of each year may still be flying across the country in economy twice a week when they can easily afford business class. They may need permission from someone they trust to spend money on their own comfort.
• Permission to give. There's a cliche in financial planning circles to insist people "save every raise." In other words, if you can keep your living expenses flat, you can contribute more and more money to your retirement accounts each time you receive a promotion, raise, or cost-of-living adjustment to your salary. But this is obviously irrelevant to people who earn far more than any of those contribution limits, which is why I suggest "giving every raise." If your living expenses are already fully covered by your existing pay, then in a year where you earn a significant raise or bonus your quality of life won't be affected by giving it away.
• Permission to stop. When people luck into high-income fields there's an almost inevitable temptation to "run up the score" and earn as much as possible as long as the gravy train is running. But obviously there's no material reason to continue working once you've saved enough to satisfy your needs, and some people aren't able to give themselves permission to stop. That's another role a trusted advisor can perform.
• Permission to change. If "permission to stop" means retirement, "permission to change" means redirecting your time and energy towards other activities. Change is hard, in some ways harder than retirement: the very idea of a "serial entrepreneur" is based on the premise that someone who successfully gets rich once, increasing an initial investment 1,000- or 1,000,000-fold, has some ability to replicate that performance. But of course, after founding one successful social network, Mark Zuckerberg didn't found dozens of additional social networks, because he recognized he simply got lucky the first time. Instead, he incorporated another company to dispose of his wealth, which seems to keep him busy and happy.
• Estate planning. I put estate planning last on this list because it's what most people think of first when they think of financial planning for the wealthy. And obviously there are techniques you can use to reduce the tax and administrative burden on your heirs when you pass. But it doesn't take more than a glance at the techniques actually employed to evade estate taxation to wonder what, exactly, the point is supposed to be? I don't mean that wealthy people should feel a "patriotic duty" to pay estate taxes in order to "reduce the deficit" or any such nonsense. I simply mean that I find it absurd that the wealthiest people in the wealthiest nation in human history spend any time at all worrying that their heirs will have to pay taxes on their inheritance, let alone organize all their affairs around minimizing those taxes. It seems to me that what many wealthy people need to hear from their financial advisors is simply that "your heirs will be fine." That's not an easy thing to hear, but financial advisors aren't supposed to give easy advice; they're supposed to give true advice.

Conclusion

As I mentioned, this is an issue that has recently come up in a number of different contexts, and I plan to revisit it from multiple angles in the future. Hit the comments to let me know what you think: what financial advice do wealthy people need — with a special emphasis on the advice they need but don't want?Become a Patron!

Why I just changed my 529 asset allocation

Become a Patron!I've written before about what I consider the two best 529 college savings plans: the Nevada-sponsored Vanguard 529 plan and the Utah-sponsored my529 (formerly UESP). In general, most people making contributions in excess of their in-state tax deduction for 529 plan contributions (if any) should consider using one of those two plans, thanks to their broad range of low-cost, passively-indexed investment options.On July 11, I received an interesting e-mail from my529, where I keep my own 529 assets, which contained references to the following program changes:

• "Reduction of the Administrative Asset Fee for all investment options
• "Elimination of the Public Treasurers’ Investment Fund investment option
• "Increase in the Utah state income tax credit/deduction
• "Update of year-end deadlines
• "Reduction in some underlying operating expense ratios"

Obviously any reference to "reductions in fees" gets my attention, so I opened up the new Plan Description and dug into the details.

My529 introduced variable administrative asset fees

When I wrote in February, 2018, my529 charged a flat 0.20% administrative asset fee in addition to the expense ratios of your underlying investment options. As their e-mail states, that fee has fallen for all investment options, but it is also no longer constant: their pre-packaged investment options now charge between 0.10% ("Fixed Income") and 0.13% (all others), while customized investment options now charge 0.18%.To be clear: no one is paying more under the new fee regime. However, those who invested their my529 assets in pre-packaged options saw a bigger fee cut than those of us in customized investment options.

Consider simplifying your my529 asset allocation

Since I don't have any children yet, my 529 assets are invested for the very long term, i.e., entirely in stocks. When my529 charged a flat 0.20% asset allocation fee, I used the "customized static" option to allocate 65% of my account to the "Institutional Total Stock Market Index Fund" and 35% to the "Total International Stock Index Fund."Under the new variable fee regime, that asset allocation cost a total of 0.218%: a weighted 0.038% fund expense ratio and a flat 0.18% asset allocation fee.Meanwhile, the pre-packaged "Equity—30% International" investment option has a total cost of 0.156%: a weighted 0.026% fund expense ratio and a flat 0.13% asset allocation fee.I want to stress that these options are not exactly identical: the pre-packaged portfolio has a slightly smaller allocation to international stocks, and the international component is invested only in developed markets, while the Total International Stock Index Fund I had been using includes some exposure to emerging markets. Nonetheless, those differences struck me as minor enough to happily make the switch, on the basic premise that the fewer fees I pay, the more money I get to keep, no matter what the stock market does.

How do the new my529 fees stack up against Vanguard?

Of course, these changes weren't made in a vacuum: Vanguard has also been aggressively reducing the cost of their investment options. Vanguard uses a slightly different method to calculate expenses, but their "Vanguard Total Stock Market Index Portfolio" costs a total of 0.15% and their "Vanguard Total International Stock Index Portfolio" costs a total of 0.195%," which means (almost) replicating the my529 "Equity—30% International" allocation would have a weighted all-in cost of 0.1635%.

Conclusion

Most people don't have 529 college savings plans, and most people who have 529 college savings plans don't have more than a few hundred dollars in them. They were conceived, birthed, expanded, and are passionately defended by the wealthiest people in the country, those willing to do absolutely anything to minimize the taxes they pay on their investment income.If that describes you, make sure you're not overpaying for your investment allocation, and don't be afraid to switch between plans if lower-cost investment options become available (however, note that under some circumstances rolling 529 assets from one plan to another may require you to repay any in-state tax deduction you took for your contributions in prior years).Become a Patron!

The SECURE Act and the defects of the centrist mind

Become a Patron!I've written previously about the SECURE Act, the House version of a measure designed to encourage employers to allow employees to gamble their retirement savings on the long-term financial stability of private insurance companies. The measure has since cleared the House but is currently being held up in the Senate for now by Ted Cruz who is trying to turn the 529 loophole into a piggy bank for the wealthiest Americans. With this terrible measure one step closer to passage, I want to use it to illustrate a particular problem raised by the cult of moderate centrism.

401(k) plans have enough bad investment options without adding annuities

Like many pieces of the American welfare state, 401(k) plans became a retirement savings tools for private sector workers more or less by accident. Consequently, they are governed by a mishmash of rules and regulations of different vintages. For example, while the investment options within a 401(k) plan have to be administered exclusively for the benefit of the contributing employee, the design of the plan and selection of investment options does not — employers can and do receive kickbacks from 401(k) custodians for filling their plans with high-cost investment options, for instance. Employee lawsuits typically revolve around this distinction: is the kickback an employer receives based on employees' investment choices or based on plan design?Every 401(k) plan I've seen has included 10-15 high-cost, actively managed mutual funds alongside 2-4 low-cost index funds. That's not the exception: that's the rule. When deciding on an asset allocation within a 401(k), there's simply no alternative but to look up the ticker for each available investment option, record its benchmark and expense ratio, and try to cobble together an appropriate low-cost asset allocation from the options available. This is not terribly difficult for someone who knows what they're doing and has the time and patience to do it, but it's naturally overwhelming for the vast majority of people who have neither aptitude not interest in making these kinds of investment decisions.

Insurance companies want to add their annuities to your 401(k)

That brings us to the core policy goal of the SECURE Act: give employers a "safe harbor" from employee lawsuits when they include annuities offered by insurance companies that meet a rudimentary test of financial stability.You might observe this is a very counter-intuitive way to frame the policy change, and you would be right. The SECURE Act is supposed to improve employee retirement security by preventing employees from suing when their employers offer them crappy retirement investment options? Surely it would make more sense to improve employee retirement security by increasing their legal recourse against employers who do not offer them appropriate and appropriately-priced retirement investment options!But of course the circle is easy to square when you remember that annuities are sold, not bought. The issue is not that employers, let alone employees, are demanding access to annuities in their 401(k) plans. The issue, rather, is that insurance companies are clamoring to have their annuities included in 401(k) plans but are being stymied by the unwillingness of employers to take on the legal risk of vetting them. With that barrier removed through the "safe harbor," insurance companies will be free to offer the same kickbacks investment companies do today to sell their confusing, expensive annuity contracts to 401(k) participants.

Annuities don't eliminate risk, they transform and hide it

In theory I don't have anything against single-premium immediate annuities as a method of converting a lump sum into a predictable stream of income upon retirement (or any other time), but it's important to understand what is and is not happening when you do so.When you hold an FDIC-insured bank deposit, or a SIPC-insured security in a brokerage account, you are roughly speaking entitled to some stream of income (interest, dividends, capital gains distributions), plus the value of the underlying asset. Both components of the asset will generally fluctuate: the interest you earn on your bonds will change as you reinvest coupons over time; dividends will rise and fall along with the profitability and capital allocation decisions of the underlying companies; the asset's resale value will change along with the winds of capitalism. Even cash grows more or less valuable as inflation rises and falls.When you exchange those real assets for an annuity contract, you receive a different kind of asset in exchange: the promise of an insurance company to pay you a fixed or variable sum described in the contract over some time period. You've now converted the variable stream of income and variable asset value of your stocks and bonds into a fixed income stream.But there's no sense in which you have eliminated your risk by doing so. Instead, you've simply transformed the risk you're taking. Instead of being subject to the whims of inflation, interest rates, and the stock market, your income now depends on your insurance company being able to pay the promised stream of income over the promised time horizon.To be clear: I'm not an insurance company analyst and I don't have the tools to perform a comprehensive assessment of the creditworthiness of American insurance companies over the next 70+ years (a 40-year career followed by a 30-year retirement, for instance). Of course, your employer probably isn't either, and that's why they don't offer annuities in your 401(k) plan. If passed, what the SECURE Act will do is relieve employers of that responsibility, so you won't have any recourse if the annuity you select flounders and your contributions are lost or deeply discounted in your insurer's bankruptcy.

Social Security has always been the answer

Social Security's old age benefit is the only source of income security for the overwhelming majority of older Americans. It's important to understand exactly what this means. Social Security is not the only source of income for older Americans. About 27% of Americans continue to participate in the labor force (i.e. work or look for work) between the ages of 65 and 74. Others receive passive income from rental real estate, farm, mineral, and gas leases, etc.What distinguishes those sources of income from Social Security is that Social Security old age benefits are paid by the federal government and subject to annual cost of living adjustments, and they're guaranteed to continue for as long as you live. Employment income in old age lasts as long as you're employed, rental income fluctuates over time (just ask Detroit if you don't believe me), and commodity prices go through long cycles of rise and decline. Social Security isn't like that.That means the first place you should look to improve income security is the only source of income security most people have, and the obvious place to start is allowing people to make additional, voluntary Social Security contributions. Since the only input into the Social Security benefit calculation is the average wage-inflation adjusted income reported in each year of a worker's earnings record, a natural approach is to treat voluntary contributions as "increased income" for the year the contribution is made.For example, a worker earning $50,000 in 2019 would ordinarily pay $3,100 in OASDI (the Social Security component of FICA), matched by their employer. An additional, voluntarily payment of $6,200 (conveniently close to the 2019 IRA contribution limit) could raise their recorded OASDI income for that year to $100,000. Note that this would not double their Social Security old age benefit, since each year of earnings only contributes 1/35 to a worker's average earnings, and old age benefits increase at a graduated rate.

Centrists say personal responsibility when they mean risk

I'm all for "personal responsibility," defined properly. I simply don't know how a person can take personal responsibility for the trajectory of interest rates, or the performance of the S&P 500, or the rise and fall of US auto manufacturing, or the financial stability of America's insurance companies. If you believe an important problem facing America is the problem of retirement security, by all means let us allow workers to reduce their present consumption in exchange for higher income in retirement.But having decided to do so, why on earth would we then subject them to the cost, complexity, and vulnerability of private insurance companies?Because when a centrist talks about personal responsibility, what they really mean is risk. Personal responsibility for the decision of whether to go to college, and what to study, means the risk of poverty. Personal responsibility for an unplanned pregnancy means the risk of homelessness. Personal responsibility for filing your SNAP application on time means the risk of hunger. Personal responsibility for your income in retirement means the risk of being taken advantage of by unscrupulous employers and insurers.But there's no way to take personal responsibility for what happens to us under a system that mechanically produces pain and trauma. Our personal responsibility is to fix the system.Become a Patron!

Roth 401(k)'s are different, but they're not special

Become a Patron!The other day I got into a very frustrating argument with a popular anonymous Finance Twitter account about the epistemology of 401(k) savings vehicles. The frustration arose from a very specific phrase he used to describe one of the benefits of a Roth 401(k) over a traditional 401(k): "you’re able to contribute more with a Roth 401k." This is such a strange claim I asked him to clarify his argument, but he was never really able to do so.That being the case, I want to see if I can try to make the strong form of the argument that he wasn't able to make.

It's legal to save money in taxable accounts

While most financial planners will readily tell you that most people, under most circumstances, should maximize their workplace retirement savings contributions before investing in a taxable brokerage account, it's important to remember that it's perfectly legal to invest in taxable accounts at any time for any reason. Not only that, there are some advantages to doing so:

• Funds can be contributed in unlimited amounts, at any time, for any reason. For example, the S&P 500 hit its financial crisis low in March, 2009. If you were somehow aware of this fact at the time, making contributions through a workplace 401(k) would leave your hands somewhat tied: first of all, two months of payroll contributions had already been made for 2009, leaving you just 83% of your maximum $16,500 contribution left. Deferrals are limited to the amount of your paycheck, and sometimes to just a fraction of your paycheck, so it might take months to max out your contributions for the year, dramatically reducing the value of your clairvoyance.
• Dividends and capital gains are taxed at preferential rates, as low as 0%. Moreover, over time reinvesting dividends and capital gains allows you to establish a range of different cost bases for different lots, allowing you to right-size your capital gains depending on your tax rate year-to-year.
• Capital losses can be used to offset gains and ordinary income. A diversified taxable portfolio will experience gains and losses in different positions over time, giving taxable investors additional tools to manage their tax liability.
• Assets can be withdrawn at any time for any reason. There are no restrictions, no holding requirements, no caps, and no repayment requirements when withdrawing assets from a taxable account. It's your money from the day you deposit it to the day you withdraw it.

Of course, there are disadvantages as well, first and foremost among them that taxable investments are made with after-tax money. Thus, the price you pay for all the advantages of taxable investments is the income taxes owed on the invested amount in the year it's earned. To be consistent throughout, let's use the 22% marginal tax rate on single filers making between $51,475 and $96,200 in earned income per year. In order to make $19,000 in taxable investments, this investor must first pay $5,359 in federal income tax on $24,359 in earned income.Splitting it up in this way allows us to think about the $19,000 deposit as a "bundle" of two different assets: $19,000 in investible funds, plus the combination of rights and privileges the investor paid $5,359 for. This doesn't mean preferential taxation and ease of access are worth $5,359, rather, it means they cost $5,359.Knowing these facts allows us to perform all sorts of fancy calculations. For example, at a 0% discount rate (you value a dollar today exactly the same as a dollar in the future), it would take a little over 9 years for the benefits of maximal tax-loss harvesting ($3,000 in losses per year at a 22% income tax rate saves the taxpayer $660 per year) to recoup the amount paid for the right to tax-loss harvest. At a discount rate of 6%, it takes over 11 years to break even.It also allows us to adjust the value of our asset in the face of changing circumstances. Raising the maximum amount of deductible losses from $3,000 to $3,500 raises the value of the asset by reducing the amount of time needed to break even. Lowering or eliminating deductible losses reduces the value of the asset by extending the breakeven period.This sounds straightforward, because it is, but it's also a useful tool to use when thinking about the difference between traditional and Roth 401(k) contributions.

Traditional 401(k)'s combine a discounted investment asset and a tax liability

Traditional 401(k) contributions are made from payroll and removed from your taxable earned income before it's reported to the IRS. The same $24,359 in earned income as above can be split into a $19,000 traditional 401(k) deferral and, after paying federal income taxes at 22% on the remainder, a $4,180 taxable investment.It's essential to understand that your current-year cash flow situation is identical whether you make the traditional 401(k) deferral or whether you direct the income entirely into a taxable account: in both cases you earned $24,359 in income, in both cases you spent $0 on current-year consumption. The fact that in the first case you paid $1,179 in taxes while in the second you paid $5,359 in federal income taxes is entirely irrelevant to your current-year cash flow, which in each case is $24,359-in and $24,359-out.The difference is that in the second case you have created, alongside $23,180 in total investible assets, a new bundle of liabilities. Just as a taxable account represents "investments plus rights," a traditional 401(k) represents "investments plus duties."But this is a very peculiar liability. Most importantly, it is:

• the duty to pay taxes at your ordinary income tax rate, plus a 10% penalty, on withdrawals made before age 59 1/2.
• the duty to pay taxes at your ordinary income tax rate on withdrawals made between ages 59 1/2 and 70 1/2.
• the duty to make withdrawals (and pay ordinary income tax) starting at age 70 1/2.

Moreover, we know precisely what the federal government is willing to pay our investor for this liability: $4,180, the taxes foregone on his income when he made the traditional 401(k) deferral. The terms of this deal have some obvious advantages to the investor:

• playing with the house's money. Traditional 401(k) deferrals offer a kind of heads-I-win-tails-you-lose dynamic, since only 78 cents of each dollar in the account was contributed by the investor. This might allow the investor to take on more risk: if they hit a home run, there will be plenty left over to pay back their liability with, while if the account goes to zero, they get to walk away from their liability with no consequences.
• control over timing. While the $4,180 liability was created at a 22% marginal tax rate, it's paid back at the investor's marginal tax rate at the time of retirement. Planning on an early retirement and taking advantage of the Social Security magic trick might allow the investor to repay their liability at a 12% tax rate or below.
• pre-retirement rollovers and conversions. During a break in service it may be possible to move assets from traditional 401(k)'s into Roth IRA's, exchanging a liability for an asset at a deep discount, depending on your marginal tax rate.

Just as we can adjust the value of our taxable rights up and down as the tax code changes, we can adjust the value of our traditional 401(k) liability up and down. With the end of the "marriage penalty" and cuts in personal tax rates at least through 2028, tax brackets are historically wide and marginal tax rates are historically low. If those brackets narrow, or are tied to a slower measure of inflation, then the value of the traditional 401(k) liability might even grow faster than the value of the assets in the account. If you work longer or earn more money than expected, the value of the liability will likewise grow.Meanwhile, if you retire earlier than expected, your income is lower than expected or tax-exempt for whatever reason, tax rates are cut further, inflation adjustments are made even larger, or the required minimum distribution age is increased to 72 or higher, then the value of the liability on your books will fall.

Roth 401(k)'s are just another bundle of investments and rights

All of this brings me back to Jake's bizarre claim that Roth 401(k)'s allow you to "save more money." As should be clear at this point, nothing could be further from the truth. With $24,359 in earned income, you can:

1. invest $19,000 in a taxable account;
2. invest $19,000 in a traditional 401(k) account and $4,180 in a taxable account;
3. or invest $19,000 in a Roth 401(k) account.

In each case you have "saved" the same $24,359, in the concrete material sense that you earned the money but did not spend it. In the first case you pay $5,359 in federal income taxes for the right to preferential dividend and capital gains taxation and the ability to offset ordinary income with capital losses. In the second case you receive $4,180 in investible assets in exchange for a liability to pay your marginal ordinary income tax rate, plus penalties under certain circumstances, on any amount withdrawn from the account. And in the third case, you receive $19,000 in investible assets that can be withdrawn tax- and penalty-free in retirement.All of these assets and liabilities can be analyzed, assigned a value, and recorded on your personal ledger based on a sober analysis of present and future conditions. Moreover, the value can be adjusted over time as the future becomes clearer. It can be worth incurring liabilities to invest more money (traditional IRA's) if the investment will yield a higher return than the liability, and it can be worth paying for an asset up front (taxable and Roth investments) if you believe the value of the asset will appreciate at a faster rate than the consideration paid.And, of course, you can diversify your investments, assets, and liabilities across all three, and change that allocation over time, as public policy and your life circumstances change.That's the argument I hoped Jake was making in his initial tweet, but since he wasn't able to make it, I figured I would instead.Become a Patron!

Taking the inverted yield curve literally, not seriously

Become a Patron!Last month, a funny thing happened: the yield on a 10-year US Treasury obligation dropped below the yield on a 3-month Treasury obligation. This bizarre financial market event attracted a lot of attention, even in the mainstream press, because such "yield curve inversions" have historically been correlated with economic recessions. Given the length of the current economic expansion and the reckless mismanagement of the economy, many people leapt on the inversion of the yield curve to predict that our next recession is visible on the horizon.Gambling is fun, so if you want to gamble some money on the ability of the yield curve's shape to predict economic growth, you have my blessing, not that you need it. But due to my unfortunate literal tendency, I have a different take.

An inverted yield curve means you're not rewarded for patience

A US Treasury obligation's yield (bills, notes, and bonds) is traditionally decomposed into several pieces: the real interest rate, expected inflation, and what's often called a "duration," "maturity," or "term" premium. That last component reflects the fact that if you buy a long-term bond at a given interest rate and economy-wide interest rates rise, the price of your bond will fall so that its interest rate matches the economy-wide interest rate for comparable bonds. To compensate for those price fluctuations, long-term bonds should offer higher interest rates than short-term bills; otherwise people would only buy short-term debt, knowing they can always reinvest their principal at maturity at the prevailing interest rate.One reason an inverted yield curve is interpreted as a predictor of a recession is that it implies falling inflation or falling real interest rates, which most often occur during recessions when firms experience downward price pressure and the Federal Reserve cuts interest rates in order to stimulate the economy. If markets predict lower real interest rates or lower inflation, then they'll be unwilling to lock in today's nominal interest rates for longer periods, believing they'll be able to buy the same nominal return at a lower price in 3, 6, or 12 months.I do not know what is going to happen to interest rates, inflation, or economic growth, and have no opinion whatsoever on the ability of the yield curve's shape to predict those values. My view is much simpler: if you are not being paid to take on the risk of investing in long-term securities, don't take the risk of investing in long-term securities!

If you're not being paid to be patient, then get impatient

I mostly don't believe in investing in individual stocks and bonds (unless you're gambling which, as mentioned above, is extremely fun and 100% fine by me), but you can glance at a list of Vanguard mutual funds and get a decent sense of what kind of return you can expect over the ultra-short-, short-, medium-, and long-terms. As of April 9, 2019, these Vanguard funds earned the following SEC yields:

• Prime Money Market: 2.45%
• Short-Term Treasury: 2.33%
• Intermediate-Term Treasury: 2.32%
• Long-Term Treasury: 2.81%

These are the objective facts. The question is, given these facts, do you have any alternative investment opportunities that will yield more over the relevant timeframes? I think you probably do. My go-to resource for these things is DepositAccounts.com. They're owned by lendingtree, which is a loan origination affiliate company, but so far DepositAccounts doesn't seem to be corrupted, as long as you ignore their "sponsored" account suggestions.For short-term savings, you can take advantage of Consumers Credit Union, Orion FCU, and One America Bank, which have certain deposit and transaction requirements but earn between 3.5% and 5.09% APY.For intermediate-term savings, you have a range of options: Andrews FCU is offering 3.05% and 3.45% APY on 55-month and 84-month certificates, respectively; Sallie Mae, Freedom CU, and WebBank have competitive interest rates on other terms. These products allow you to lock in those higher rates even if rewards checking accounts radically drop their interest rates in the face of a new recession or interest rate environment.But for longer-term savings, you have a real problem. Investing in long-term securities exposes you to all the risk of rising interest rates, but pays you a negligible amount for the privilege.

How do you invest for the long term in a world without a term premium?

There are, I think, three ways to realize above-average long-term returns on your savings in a world where long-term savings don't yield above-average returns.

• Reduce your exposure to long-term debt. If an inverted yield curve is telling you that long-term debt is too expensive, then sell it while it's expensive. Whether you move to cash, equities, or anything else, when the market is screaming that your assets can fetch more than they're worth, take the market's word for it and walk away.
• Pay down debt. I have a somewhat different take on debt than many folks in the travel and finance hacking community, since I love negative-interest-rate loans, but it's indisputably true that if you have a mortgage or other long-term debt with an interest rate above what you can earn on debt with a comparable term structure, paying down the debt is likely the highest and best use of your savings. In other words, if you're paying 5% on a 30-year mortgage and the potential to earn 3% on a 30-year Treasury bond, you've got a pretty easy decision to make.
• Start a business. Remember, the reason the Federal Reserve has kept interest rates at such low levels for so long is for the simple reason that the Board of Governors wants your public sector investments to earn as little as possible, so that you will sell everything and start a business. That window is still open, as I've tried to explain in this post, but it's rapidly closing.

Conclusion

These are not predictions. I have no idea what it "means" that the yield curve is inverted, except that it means long-term debt is not offering a term premium over short-term debt. As far as I know, the yield curve might stay inverted for the next 500 years. But what I do know is that while the yield curve is inverted, long-term debt is at a rare disadvantage compared to short-term debt, accelerated debt repayment, and business investment. This isn't a theory or a coincidence: it's the definition of a situation where the Federal Reserve would strongly prefer you do literally anything else with your money than buy long-term government securities.So, take the hint!Become a Patron!

So you've decided to invest in real estate!

Become a Patron!Last week over at Travel is Free Drew wrote a very thoughtful post about his experience taking out long-term residential leases and then subletting them for short-term stays through a variety of platforms. The post has a lot of details on the various expenses and complications he encountered and is worth a close read if you're considering doing the same.He concludes that while this temporal arbitrage is a potentially profitable business, he wouldn't rent to arbitrage again, in the future planning to buy properties for short-term rentals instead. This ultimately led to a long, branching, fruitless Twitter argument about what kinds of risks this kind of strategy entails. At the instigation of reader calwatch, I'll make a few general observations about residential real estate in general and short-term rentals in particular.

Cash flow, basis, and return

One of the most dramatic claims Drew made on Twitter was that "the actual cash on cash return is near infinite." As ludicrous as it sounds, this is actually a fairly common claim made by real estate investors, which Drew spelled out more explicitly a few tweets later, when he said "if you buy at 80% value and refinance, then your $0 in. So all cash at that point is profit."The mechanics of what Drew is talking about here are simple enough to describe in a few words: if you buy a piece of residential real estate with a 20% down payment and an 80% mortgage, then you have 20% equity in your home. If you can then take out another loan (or refinance the existing loan) against your equity stake in the property, and you'll end up having purchased the property entirely with borrowed money.At that point you have a simple calculation: does the property produce more money than it costs, on an appropriate time scale, for example quarterly or annually? Many people make a big deal out of one real estate expense or another, but that's totally unnecessary for this calculation. Just add up all your costs: your mortgage payments, utilities, insurance, maintenance and repairs, lawyer fees, furniture, linen, dishes, housekeeping, landscaping, and everything else you can think of. Even add an additional safety buffer if you like. Then add up all the revenue the property produces. If your income is higher than your costs, you arrive at Drew's "near infinite" cash on cash return: you didn't put any of your own money into buying the property, so your return is on a basis of $0 (until your mortgage payments begin to rebuild your equity).Of course, eagle-eyed readers will have noticed the necessary corollary: if your revenue is less than your costs, then your rate of return is near-infinitely negative. You're pouring money into a hole without receiving anything of value in return, especially since traditional mortgages apply payments overwhelmingly to the loan's interest, rather than principal, for much of the loan's term.The rest of this post is not about disproving or challenging anything above, since everything above is true: if you are able to secure the necessary loans, you can achieve near-infinite positive or negative returns by purchasing real estate entirely with other people's money. Rather, I want to explain why nothing about this is "risk-free."

There's nothing special about real estate

One of the most common claims by real estate enthusiasts is that real estate is "different." Drew made this precise argument when he tweeted, "Real estate is the only investment I know of where you can benefit from appreciation (while claiming depreciation on taxes) without putting your own cash."But this is false. I've never added it up, but I probably have around $200,000 in unsecured credit available to me on my credit cards, and many of those lenders mail me checks every few weeks I can use to buy anything I want. It's true the interest rates are high, but they're not in the stratospheric, payday-loan territory. Instead, they typically top out around 30-35%. My guess is it would take me about 5 days to deposit that $200,000 into my checking account, transfer it to my Vanguard account, and then buy any mutual fund or ETF I pleased with it.And this would put me in precisely the same position as Drew's real estate investor:

• Exactly like the real estate investor, I would be making my purchase entirely with other people's money.
• Exactly like the real estate investor, I would have a near-infinite rate of return if the dividends and appreciation of my investments exceeded my cost of financing.
• Exactly like the real estate investor, if I had to sell investments to meet those financing expenses I would be able to deduct those losses against my ordinary income (the equivalent of Drew's "depreciation").

Now, you might rightly point out the difference is that my financing expenses are 30% and Drew's are 5%. That's all well and good, but as Churchill apocryphally told the society Lady, now we're just negotiating over the price. If you have an investment idea that you believe will generate more revenue than your cost of finance, you should consider pursuing it.Of course it's true real estate has some special treatment in the tax code. I've written about it before. But so does horse-breeding! The principle is the same in both cases: as long as you are calculating your total cash flow properly, i.e. including any tax benefits and penalties, then all you have to do is compare it to your equity to derive your return, whether it's on real estate, stocks, bonds, or horses.With that out of the way, let's turn to some idiosyncratic risks of investing in real estate, in particular for short-term rentals.

Regulatory risk

Regulatory risk is what I call changes in government regulations and the effect they have on your cash flow.This can happen when a community bans short-term rentals, passes new regulations, or begins enforcing its existing regulations. Importantly, this can easily affect your expenses, your revenue, the value of your property, or all three.If a community bans short-term rentals, you may still be able to rent out your property to long-term tenants, but at a lower rate. Keeping monthly expenses fixed at $1,000, moving from $6,000 in income to $800 in income is the difference between earning near-infinite profit and incurring near-infinite losses on your near-$0 equity.On the flip side, if a community passes new regulations or begins enforcing existing regulations, for example by forcing landlords to acquire hospitality licenses, pay for annual inspections, and pay hospitality taxes, then your expenses may overcome your revenue even if your revenue remains unchanged.And finally, in a real estate market where prices are driven by demand for short-term rentals, either of those changes can affect the value of your property, meaning your expenses can rise, your revenue can fall, and you can end up with a property worth less than you owe on it.

Regional risk

More than any other kind of investment, real estate is tied to the land, which creates regional risk: Drew's most profitable months were during Austin's South by Southwest festival, when demand for hotel rooms swamps the city's capacity and many people turn to expensive short-term rentals. Those profits can make up for less-profitable or even unprofitable months — as long as South by Southwest continues to drive visitors to Austin. But tastes change, fads come and go, and who knows if South by Southwest will still be a phenomenon in 5, 10, or 15 years? Relying on a few profitable months really means relying on things staying more or less the same — things you have no control over.

Secular risk

In the aftermath of the global financial crisis, Larry Summers re-popularized the idea of "secular stagnation," one version of which says that the stubborn slowness of the economic recovery was the result of long-term, economy-wide forces, not just bad short-term public policy. In other words, the best that the government could do was manage stagnation and decline, not spur accelerated catch-up growth. Larry Summers was wrong about that, but it's a useful framework to think about long-term, economy-wide changes.If Americans overall travel less, if more business is done through long-distance conference calls or virtual reality, if new technology makes it fast and cheap to build new structures, then the overall rental real estate landscape might be completely changed. Your revenue might dry up and your land and structure might become near-worthless, not because of anything you did or didn't do, but because of changes in the overall economy.

Platform risk

One fascinating element of Drew's post was the sheer number of different services he mentioned as part of his short-term rental empire: AirBnB, Homeaway, PayPal, Venmo, InstaCart, Favor, Walmart Delivery, Craigslist, TurnoverBnB, Your Porter, BeyondPricing, PriceLabs, plus a few I'm certain I missed.That's not to say he uses all these services: some of them were mentioned specifically because he tried and didn't like them. The point, rather, is that a big part of the short-term rental economy is powered by these third-party services, and the more dependent you become on them, the more vulnerable you are to platform risk: losing access to a service, either because you're (rightly or wrongly) accused of a violation, or because the service itself goes out of business.Since my expectation is that in the next downturn all the unprofitable service business platforms will go out of business, this exposes you to a kind of compound risk: just when occupancy rates are falling, you'll also lose access to your main booking channel.I'm particularly sensitive to platform risk because of my own personal experience with it, when the business PayPal account I used to collect monthly reader subscriptions was closed and I had to beg readers to create new subscriptions on my new subscription platform. Most of them migrated over, much to my surprise and pleasure, but it was still a harrowing couple months.Platform risk can be mitigated, of course: you can build your own booking channels, diversify into as many booking channels as possible, maintain multiple backup accounts, etc. But mitigating platform risk creates its own costs, and its own drag on your total cash flow.

Volatility risk

The risk that real estate investors least understand is price volatility, and no wonder: stock investors can see the price of their assets fluctuate second-by-second, which may even lead them to believe stocks are more volatile than they actually are (if you don't believe me, just turn on CNBC after the S&P 500 drops 0.5%). Meanwhile, real estate investors tend to anchor the value of their property on what they paid for it, and can only guess within broad ranges what it's worth on any given day.The other risks I mentioned revolve around factors that might permanently reduce your income, raise your costs, or lower the value of your property. Volatility risk is different: it's the risk that your property will be worth less, or worthless, at the moment when you happen to need the money.This is true whether or not you believe, as Drew does, that real estate "consistently goes up." Many people describe real estate as a kind of savings vehicle: you borrow money, and the payments on that loan slowly build up equity, which you then own and can "withdraw" through a sale or refinance. But while it may be a savings vehicle, real estate is not a savings account. A savings account has a known, federally-insured value. But even if you are certain the value of your real estate will increase over 5-year, 10-year, and 20-year time horizons, that tells you nothing about its value over any of the intermediate periods!

Conclusion

None of this is intended in any way to discourage people from investing in real estate. To me, it sound like a phenomenal amount of work, but as I always say, if you do what you love you'll never work a day in your life. I like writing, Drew likes buying and managing rental properties, it takes all kinds to make the world go 'round.But this post is intended to make it emphatically, entirely, and conclusively clear that real estate is not special, it is not risk-free and it is not even particularly low-risk, although many of the risks are unusually well-hidden. Like all investing, it can be done with your own money and it can be done with other people's money. It can be done well and it can be done poorly. It can be profitable and it can be loss-making.So if you do decide to invest in real estate, do yourself a favor and do it with both eyes wide open.Become a Patron!