In early 2022, the U.S. Federal Reserve began raising the federal funds rate in an effort to reduce inflation. According to TradingEconomics.com, this effective rate grew from near 0% to over 5% in the past seven quarters, reaching a 22-year high. In this post, we examine ETF returns during this period of rate increases.
Stock and Bonds ETFs
The chart below shows the last seven quarters of ETF total returns, which includes price appreciation and short-term capital gains. This time frame corresponds to the increase in the federal funds rate. Investors saw positive returns in only two ETFs during this period of increasing rates.
Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate. Source: ETFreplay.com
Stock ETF returns during this period were mixed. As shown in black, the iShares S&P 500 Value ETF (ticker: IVE) was the best-performing stock ETF. During this time, the iShares Core S&P 500 ETF (ticker: IVV) in green and the iShares S&P 500 Growth ETF (ticker: IVW) in red lost 7% and 17%, respectively. Clearly, investors preferred value over growth during this period. Investors may have had concerns about the increasing cost of financing a firm’s growth opportunities. Alternatively, investors may have preferred dividend-producing firms commonly found with value stocks.
Intermediate and short-term Bond ETFs returns and increasing federal funds rate
The iShares Core U.S. Aggregate Bond ETF (ticker: AGG) also had a negative return during this period, consistent with how rising bond yields generally reduce bond prices. However, for short-term treasury bond ETFs like the iShares Short Treasury Bond ETF (ticker: SHV), investors saw a slow and steady climb. As we’ve written before, the increasing federal funds rate contributed to this growth. And, this short-term bond fund also has tax-efficient benefits when compared to money market funds and short-term certificates of deposit.
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In our posts from March and April, we discussed several aspects of Roth conversions. We showed that, if tax rates are higher in the future, Roth conversions can have a positive payoff. For tax-deferred assets, like pre-tax assets in a 401(k) or IRA, a retiree may pass some of these assets to an heir. The heir’s income tax rate determines the after-tax value of inheriting tax-deferred assets. This week’s post highlights the most recent software update made to our Optimal Retirement Income Calculator, which now includes Roth conversions and optimal withdrawals simultaneously!
How to model Roth conversions with Optimal Withdrawals
Roth conversions reduce tax-deferred assets by “converting” those assets in any year to a Roth account. Individuals performing a Roth conversion owe income taxes on the amount converted. But, the converted amount increases the individual’s Roth account assets, which a retiree can often access tax-free in retirement. One goal of generating tax-efficient retirement income is for optimal withdrawals to avoid large “spikes” in ordinary income. Our Optimal Retirement Income Calculator does this automatically and considers the tax rate of the heir under three distinct scenarios.
A retiree has insufficient funds to satisfy retirement income
Excess retirement funds and the importance of your heir(s) tax rate
In scenarios 1 and 2, the top and middle portion of the image above, our calculator already finds the lowest marginal tax rate to efficiently distribute tax-deferred assets. Consequently, our Optimal Retirement Income Calculator already provides a withdrawal strategy to utilize your tax-deferred assets efficiently. So, no additional tax-alpha is possible with a Roth conversion. However, this is not the case in scenario 3 or the lower right portion of the image above.
When a retiree’s assets are far beyond what is needed to support their retirement income needs, many of their assets will eventually be passed to an heir. In this case, our Optimal Retirement Income Calculator previously left a significant amount of tax-deferred assets to an heir. With our latest software update, a new Roth Conversion Analysis includes converting tax-deferred assets to a Roth account “using up” the retiree’s tax brackets that are less or equal to those of the heir. For example, if your heir has an expected income tax rate of 25%, scenario 3 would perform a Roth conversion up to the 24% tax bracket. Doing so typically adds about 0.10% tax alpha. We encourage you to use our Optimal Retirement Income Calculator to evaluate possible situations for you or your clients. You can easily see if a Roth conversion with optimal withdrawals provides an additional benefit.
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In our post from last week, we highlighted the potential benefit of converting tax-deferred assets to a Roth IRA. We showed that the amount of tax alpha, or the amount of additional return realized from converting, depended on current versus future tax rates. However, we simplified how a retiree may fund the tax liability by using retirement assets. In this post, we show the additional tax alpha when funding Roth conversions without using tax-deferred assets.
Funding Roth Conversions Using Assets in a Taxable Account
The additional tax-alpha from using taxable account assets arises due to these assets no longer generating taxable interest and dividends owed each year. Instead, a retiree could use these assets to pay for funding Roth conversions. Consequently, the benefit of funding Roth conversions with taxable account assets grows over time. But, two additional complexities arise. The return on the underlying asset is the first. The ultimate intended use of the taxable account assets is the second complexity. Markets dictate the first complexity, but not the second.
So, we may not know how the stock and bond market will perform in the future. But, a retiree may know whether they will use taxable assets to supplement their retirement income needs. If taxable assets are used to supplement retirement income and/or for funding Roth conversions, then there will likely be a long-term capital gain that would reduce the tax alpha. Otherwise, taxable assets may pass to an heir with a step-up in cost basis, thereby eliminating the capital gain tax owed by the retiree.
Case Study Results from Over 20 Years
To help quantify the additional tax alpha, we revisited the analysis in the Roth (2020) article for a 20-year period. We added the two complexities mentioned above, that the tax alpha will depend on market returns and if the taxable account assets received the step-up in cost basis. The left panel below shows the tax alpha without the step-up included. The right panel shows tax alpha when the step-up occurs.
No step-up in cost basisStep-up in cost basis
Key Insights from funding Roth conversions
The results above indicate the importance of the step-up in cost basis on the tax efficiency of funding Roth conversions. The horizontal axis represents the fraction of the cost basis of the taxable account assets used. So, using current interest, dividends or available cash from a taxable account implies a cost basis equal to 1, and highly appreciated assets would have a value approaching 0.
From the left pane, the tax alpha ranges from 0.10% to 0.30% per year over twenty years. Lower (higher) tax alpha occurs when markets underperform (overperform) their historical average returns.
When the heir realizes the tax-efficient step-up in cost basis, the tax alpha is up to 0.10% per year over twenty years. Also, the breakeven for this additional tax alpha occurs at approximately 0.70, implying that a highly appreciated asset intended for an heir should not be used for funding Roth conversions.
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The stock and bond markets are off to a great start for 2023. This news is especially notable after a difficult 2022 for stock-based ETF investors. Including dividends and interest, the iShares Core S&P 500 ETF is up 6.3%, and the iShares Core Total US Bond ETF is up 3.3%. While a strong start can be helpful against losses later in the year, what may be more relevant is that we are now in the third year of a presidential cycle. In this article, we discuss this unusually strong relationship.
Data since 1933
According to a researcher at Charles Schwab using data from 1933 to 2015, the S&P 500 had average returns in the first, 2nd, 3rd, and 4th years of a presidential cycle of 6.7%, 5.8%, 16.3%, and 6.7%, respectively. So, in the third year of the presidential cycle, there was nearly a 10% increase in average returns. We revisited this data to include the end of the Obama administration, as well as the four years of the Trump administration and the first two years of the Biden administration. The results appear in the table below, which indicates that, even with the impact of the global coronavirus pandemic, the relationship still holds.
Presidential Year
Average Return (%)
Sample Size
1
6.7
24
2
3.3
24
3
13.5
23
4
7.5
23
Average Returns of the S&P 500 from 1928 to 2022. Data Source: www.macrotrends.net
Clearly, we find that correlation is at play here, although the sample size is not very large. But, what could be the cause of this outperformance?
Possible Causes
A 2013 study at the University of Chicago attributed the effect of the 3rd year of a presidential cycle to increased future uncertainty of what a change of administration may cause. Others have argued that in the third year, the current administration has some momentum to start seeing the impact of their policies being implemented. But, it is always important to note that correlation is not causation, and there are likely many other factors at play that are producing this unusual market behavior. By the end of this year, we will see if the 3rd year of the Biden administration continues this outperformance.
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Happy 2023! Now is an excellent time to review changes to individual income tax brackets due to inflation. Here, we highlight the relationship between inflation and income taxes. To see details of all the 60 tax provisions changed for 2023, the Internal Revenue Service (IRS) published this document.
How inflation and income taxes are related
As we discussed in our post from last month, the Consumer Price Index (CPI) continues its downward trend. Unfortunately, the CPI of 7.1% for November is still above the long-term norm of 2-3%. However, there is some good news for U.S. income taxpayers in 2023. The IRS adjusts income tax brackets for inflation, so income and capital gains tax brackets in 2023 have increased by about 7%. The images below show these new brackets for income, capital gains, and the standard deduction.
So, income tax brackets recently changed in a significant way. Our optimal retirement income calculator now provides an updated forecast for after-tax retirement income using the 2023 tax brackets. Forecasts based on the Common Rule withdrawal strategy remain free for 2023. In addition, you can expedite your calculations by registering a free profile. For individuals or financial planners wishing to use our award-winning tool to see the details that led to their individualized tax alpha, please consider subscribing before the price goes up.
On Saturday, January 14th from 10-11 am Pacific Time (1-2 pm Eastern Time), we will be conducting a live demonstration of our retirement income and retirement savings calculators, fielding your questions, and discussing new features planned for 2023. Please use the link below to join us at this time. If you wish, please contact us prior to this demonstration with any questions you may have or use cases you wish to see.
In 2022, many long-term trends in asset correlation appear to be changing. In this post, we discuss the longer-term trends in several popular asset class correlations and highlight recent changes that continued from the first half of the year.
Short-Term Correlations and Long-Term Trends
The stock and bond markets continued their downward slide this month. The iShares Core S&P 500 losses for 2022 reached 24%. In addition, the bond markets continue their losses for the year, with the iShares Core U.S. Aggregate Bond Market ETF down about 15%. This latter result is quite surprising, given the long-term correlation between the stock and bond market is 5%, but has recently grown to over 40%. Thus, the stock and bond market returns are more similar than they were in the past, so provide fewer diversification benefits. The chart below shows this upward trend in the correlation between the stock and bond markets in blue. The horizontal dotted line shows the long-term correlation from returns dating back to February 2004.
90-Day Asset Correlation of Total Returns against the S&P 500 Index
Asset Correlation Among Other Sources
The chart above also highlights the diminished effect of other sources on a portfolio’s diversification. For example, international equities are often sought for their diversification benefit. However, the long-term correlation of 88%, which also appears in this figures legend, hasn’t changed much this year. Bitcoin’s long-term correlation is 21%, but this correlation has steadily grown to over 60% this year. The one asset that has performed well this year is a direct investment in the U.S. Dollar ETF, ticker UUP. Long-term, the dollar has an insignificant correlation to the S&P 500. However, in 2022, the dollar’s correlation to the S&P 500 has grown significantly negative, as interest rate rises have increased demand for U.S. dollars. The chart below shows the total return of the five ETFs discussed here.
2022 Total Returns for ETFs associated with the S&P 500, Bonds, International, Bitcoin, and U.S. Dollars.
Given the economic pressures creating these effects on the markets, the remainder of 2022 may continue to surprise investors. In particular, asset classes that formerly had low correlations to the stock market may continue to diverge from their long-term values.
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During our webinar earlier this year, we highlighted one of the retirement income challenges called “The Widow’s Penalty”. This situation occurs when the surviving spouse is filing taxes as a single, instead of married filing jointly. In this post, we elaborate on the effect of this penalty on a fictitious couple we call John and Jane and show that tax-efficient retirement income can help mitigate its effect.
Case Study for John and Jane and the widow’s penalty
The bulleted list here summarizes John and Jane’s situation at the start of their retirement.
John is 65 and has a life expectancy of 80. Jane is 62 and has a life expectancy of 82.
Their after-tax retirement income needs are $150,000 per year, reduced to $140,000 per year for the surviving spouse. (Today’s dollars)
Both have RMDs starting at age 72.
Their heir’s marginal income tax rate is 25%.
John and Jane both have retirement assets tax-deferred ($800k, $100k) and tax-exempt accounts ($400k, $50k). John owns a taxable account valued at $1M with a cost basis of $300k in stocks and $272k in bonds.
Their asset allocation is 60%/40% stock/bonds in all accounts, and they increase bond allocation by 1% each year.
John and Jane have annual pension income starting at age 65 of $18,500 each, and social security income starting at age 67 of $11,000 each.
As we showed in our previous post, if Jane is the surviving spouse, she can realize an additional 0.55% of investment return by drawing down from a mix of taxable, tax-deferred, and tax-exempt accounts. But, can this benefit still be realized if Jane lives longer?
Tax efficiency for a longer-living surviving spouse
In the example above, Jane lived for five years as a widow so needed to file her taxes as a single. Re-running our retirement income calculator and increasing Jane’s retirement horizon yields the following results.
Widow’s penalty and opportunity for tax-efficient retirement income
So, these results show that Jane can still increase the inheritance for her heirs if she lives up to 15 years as a widow. If she lives 25 years as a widow, she will exhaust all of her savings but will be able to increase her portfolio longevity by 3.5 years. Either of these situations is possible by not following the common rule for retirement account drawdowns but instead using optimal account drawdown decisions.
Want to see how the widow’s penalty may affect your retirement plan? We invite you to try out our calculator to see how your heir’s inheritance or your portfolio longevity may improve!
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It has been a very difficult year for cryptocurrency investors. Here, we will discuss the recent trend of cryptocurrency returns. Also, we will highlight the current cost of cryptocurrency mining, and share some thoughts on the future of this asset.
Cryptocurrency returns in 2022
Year-to-date returns of Bitcoin, Ethereum, and the first ETF that tracks bitcoin futures (ticker: BITO) appear below. Like the stock and bond markets, all three of these assets lost value in 2022. Also, in our previous post on the risks of cryptocurrencies, the volatility of all of these cryptocurrency assets was significantly higher than the long-term historical norm of 15-20% for the S&P 500.
Like oil, natural gas, and precious metals, there is a cost to “mine” bitcoin. Economic theory for commodities suggests that, when demand is constant, rising prices should increase production, since even less efficient miners can operate profitably. However, as prices drop, less efficient producers will exit, and less production of a commodity will occur, thereby stabilizing prices. That may be occurring now, as the price to mine one bitcoin is in the $20,000 to $34,000 range. As of July 31, 2022, the price of one bitcoin was within this range, with a value of $23,819.
Bitcoin production cost. Source: TradingView
The Future of Cryptocurrency
The future of cryptocurrency remains uncertain. However, few expect these new innovations in decentralized finance to go away. Instead, we may see longer-term price stabilization, as the investment in mining produces enough cryptocurrency to satisfy demand. Such price stabilization may not entice investors seeking outsize returns but could help cryptocurrency gain wider acceptance if its volatility can also be reduced.
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With the 1st half of 2022 now behind us, we devote this post to a mid-year review of ETFs in a variety of stock sectors. We also highlight some recent research on sectors that have historically held up well during periods of high inflation, and the benefit of time horizon when investing in stocks. We hope you find this mid-year review helpful!
Record-breaking 1st half of 2022
According to this MarketWatch article, the S&P 500 recorded its steepest 1st-half year loss in over 50 years. But, remember that the S&P 500 is a broad-based index consisting of many different companies across a variety of industries. In fact, there are 11 sectors in the S&P 500, which in order of size (and an ETF to represent them) are:
Information Technology (XLK)
Health Care (XLV)
Financials (XLF)
Consumer Discretionary (XLY)
Communication Services (XTL)
Industrials (XLI)
Consumer Staples (XLP)
Energy (XLE)
Utilities (XLU)
Real Estate (IYR)
Materials (XLB)
Mid-year review of best and worst performing sector ETFs
The chart below sorts the total return for the 11 ETFs identified above for 2022. As can be seen here, the biggest gains were among the energy sector (XLE) and the worst in consumer discretionary (XLY). Over this same period, the S&P 500 total return, measured by the iShares Core S&P 500 ETF (ticker: IVV) was -19.2%. Also, note that the energy sector was the only ETF here that saw a positive return, which is not surprising given the war in Ukraine and its impact on supply in the energy sector.
Mid-year review of returns from 11 sector-ETFs in the S&P 500 Index
Where will stocks go from here and what to do about it?
Given the current high inflation rates, Derek Horstmeyer at George Mason University recently showed the following “inflation fighters” in his June 5th Wall Street Journal Article.
Best performing sectors during periods of high inflation. Source: Derek Horstmeyer
Of course, the most prudent course of action may be to simply do nothing based on this mid-year review. Given longer investment horizons, the stock market is less likely to suffer losses. Based on Bank of America research, the chart below supports this fact.
In our last post, we introduced a new calculator to help you forecast your retirement savings. Part of this introduction showed you how the uncertainty in the markets may affect your savings forecast. So here, we summarize the differences between the two simulation options available in our new retirement savings calculator: bootstrapping and geometric Brownian motion.
Simulation of asset prices helps manage savings risks. (The vertical axis is price. The horizontal axis is time.)
Why use simulation?
Simulation, or often termed “Monte Carlo” simulation, is a scientific method to model future uncertainty using a random number generator. In the case of our savings calculator, it models the uncertainty of annual stock and bond returns. By running many simulation trials, each trial can represent one of many possible outcomes for investment returns over your planning horizon. Then, you can see what risk you may be taking in assuming a more pessimistic or optimistic account balance at retirement. For example, using default inputs to our model, a retiree can expect their future tax-deferred account balance to be likely more than $629,047, but likely not more than $1,073,058. (These values are based on default 25th and 75th percentiles. Our calculator allows these levels to be adjusted.)
Simulation provides a range of possible account values and the risk associated with achieving them.
Bootstrapping
The two most common approaches to simulation are bootstrapping and geometric Brownian motion. Bootstrapping uses historical returns of stocks and bonds, and randomly samples from them for each trial to develop simulated returns. For our model, we reconstructed annual returns for an S&P 500 ETF and aggregate bond ETF from 1989 to 2021. We used the same methodology described by DiLellio (2018). Retirees benefit from using bootstrapping since it preserves the historical distribution of stock and bond returns, as well as the correlation of their returns. In particular, extreme market shocks, like the financial crisis of 2008-2009, the dot-com bubble burst of 2001, and the Covid-19 pandemic of 2020 are all included when simulation uses bootstrapping.
One approach to simulating future returns is termed bootstrapping, where we simulate returns by random selection from a set of historical returns. In our calculator, we use annual returns from an S&P 500 and aggregate bond index ETF from 1989 to 2021. This approach has the benefit that it accurately represents the past, including the large market corrections in the financial crisis of 2008-2009, the dot-com bubble bursting in 2001, and the global pandemic in 2020. You can read more about this simulation approach in this peer-reviewed research in DiLellio (2018).
Geometric Brownian Motion
However, what if the future isn’t entirely represented by the past? In this case, we can use the geometric Brownian motion (GBM) stochastic process to simulate future stock and bond prices. Why? Using a GBM permits you to dictate return behavior using a normal distribution of asset returns. This simulation approach gives the retiree complete control over future returns. And, the retiree can select volatility and correlations of stock and bond returns. Lastly, GBM is the foundation for the famous Black-Scholes Option pricing formula. Unfortunately, GBM does not capture extreme events well. The image below from DiLellio (2018) shows how the normal distribution does a fair job, but not a perfect one, of fitting stock and bond returns.
Daily return distribution of stock (top pane) and bond market (bottom pane) indices. Two normal distributions are also shown, with volatility estimates using historical returns from 1989 to 2017. Reducing the volatility appears to provide a slightly improved fit near the center of the distribution, but worsens the fit in the distribution tails. Source: DiLellio (2018) Risk and reward of fractionally leveraged ETFs in a stock/bond portfolio, 27 Financial Services Review.
So, which simulation approach is better?
The short answer is “it depends”. Like any mathematical model, they both have their own strengths and limitations. Fortunately, you can use either of these models to develop your savings plan. In fact, we hope you consider using both, to best understand the risk of achieving your savings goals!
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