Indexology^® Blog

Conventional wisdom tells us to maximize our contributions to a 401(k) account and to grow the balance as much as possible for retirement.

However, we may not have considered the decumulation side of retirement income.  If one waits till reaching the age of 70 ½, when the 401(k) balance is larger, he/she may face a large annual tax bill waiting, as the law requires withdrawals of a certain minimum amount from the balance.  The withdrawals are treated as ordinary income and as a result may end up in a higher marginal income tax bracket.

There are two age-related rules governing the withdrawals from one’s 401(k) plan and the traditional Investment Retirement Account (IRA).  The first one is the rule of 59 ½, which stipulates that, generally, for participants under the age of 59 ½, they must pay a 10% additional tax on the distribution from the account.  After reaching the age of 59 ½, participants can receive distributions without having to pay the 10% additional tax.

The second age-related rule is the rule of required minimum distributions (RMDs).  Individuals are required to begin lifetime RMDs from their IRAs no later than April 1 of the year after they reach the age of 70 ½.  This is in contrast with RMDs from employer-sponsored plans, which, in most cases, may be postponed until after the employee retires or reaches age 70 ½, whichever happens last.  One may have to pay a 50% excise tax on the amount not distributed as required.

Thus, there is an 11-year window during which withdrawals from such retirement savings accounts can be made, but are not required.  Against that background, an optimal strategy may be to smooth out one’s retirement income from all sources in such a way that the marginal income tax rate is at the lowest possible level.  In the event that one wants to delay receiving social security benefits until age 70 (in order to max out the social security benefits), tapping into a 401(k) or IRA to provide interim stopgap income could be considered.

RMD is based on life expectancy, and at 70 it is 3.65%.[1]  For the full table and all the details related to RMD, please consult IRS Publication 590-B.[2]

In 2014, the U.S. Treasury and the IRS amended the RMD regulations in such a way that the part of the account balance that is subject to the RMD can be allowed to purchase a qualifying longevity annuity contract (QLAC) , as documented on page 10 of our paper “Rethinking Longevity Risk: A Framework to Address the Tail End.”  Thus, by purchasing a QLAC which begins to pay the amount contracted no later than at age 85, one can defer the tax burden on one’s retirement assets for up to 15 years and have a guaranteed lifetime income starting at or before age 85.

[1] For an RMD calculator, see http://www.kiplinger.com/tool/retirement/T032-S000-minimum-ira-distribution-calculator-what-is-my-min/index.php

[2] See https://www.irs.gov/pub/irs-pdf/p590b.pdf

Current valuations of U.S. stocks inevitably lead to debate over their prospects for future returns, earnings sustainability, and whether we are in the midst of a stock market bubble.  Some measures indicate the market is richly valued by historical standards, but no one knows what the future holds.  However, one thing is clear—the potential value of rebalancing defined contribution retirement accounts.  As discussed in a recent PlanSponsor article by John Manganaro,[1] record 401(k) balances and equity performance could be skewing retirement accounts to higher equities allocations.  Plan participants can take advantage of automatic rebalancing if their plans offer it, or rebalance themselves if they have not done so recently.  Of course, rebalancing may result in transaction costs, so it should be assessed in light of the costs and benefits.

Retirement accounts that have not been rebalanced in a significant period of time would probably be good candidates for review.  For example, if never rebalanced, a portfolio that allocated 70% to the S&P 500 and 30% to the S&P U.S. Aggregate Bond Index as of June 2012 would have over 80% of its weight in stocks as of the end of June 2017.

Suppose your target allocation in 2012 was 70% stocks and 30% bonds.  Your account would be overweight in equities by over 10% if your target were still 70%.  But if you are approaching retirement, perhaps your new target is a lower stock allocation, such as 60%.  That would mean your account is more than 20% overweight in stocks.  That could represent a lot of unintended risk if you don’t take the time to rebalance.

Many of the challenges in achieving investing success come down to discipline.  Avoiding overreactions when markets soar or dive, diligently saving, being aware of costs, diversifying within and across asset classes, and sticking to a reasonable investment policy that includes periodic rebalancing will go a long way toward reaching success.  With automatic rebalancing and the prevalence of target date funds in 401(k) plans, many plan participants can automate these steps.  But for those who do not or cannot, it is wise to monitor investment allocations and rebalance when actual allocations differ substantially from one’s investment policy.

[1] http://www.plansponsor.com/Record-Balances-May-Skew-DC-Accounts-Towards-Equity/

What does it mean when we talk about dividends?  When a company pays dividends, it shows that it is generating enough flow and profits, and that it seeks to generate an additional flow to its shareholders.

In May 2016, S&P DJI published a research paper entitled “Exploring Liquidity and Dividends in Peru.”[1]  This report identified that Peruvian companies have historically paid dividends: “Over the 10-year period ending Dec. 31, 2015, an average of approximately 70% of the companies in the Peruvian equity market distributed cash dividends annually.”

One way to find out about the possible impact of dividend payments on a portfolio’s performance is through the indices.  The performance of an index is calculated using the price movement of its components (price return), and the addition of dividends (total return).  The components and their weights are the same but the results are different.  In the case of the S&P/BVL Peru Select Index, for example, its YTD performance in Peruvian nuevos soles showed a return of 4.67%, while if we take the same index and incorporate the dividend payments, we see a return of 6.74% YTD (as of July 8, 2017).

On the other hand, there are indices that are created in order to identify companies that pay dividends consistently over a period of time.  In Peru, for example, the Lima Stock Exchange (BVL) and S&P DJI recently launched the S&P/BVL Peru Dividend Index on May 25, 2017.  The construction of this index started with the S&P/BVL Peru Select Index universe, but it only includes those companies that made dividend payments consistently over the past 12 months as of the rebalancing date, and the weighting of the components was by its dividend rate.[2]  The performance of the indices differs; for example, the S&P/BVL Peru Dividend Index registered a total YTD return performance of 17.44%, while the S&P/BVL Peru Select Index was 6.74% (as of July 8, 2017 in nuevos soles terms).

These results, wherein the performance of the dividend index is higher than the broad or benchmark index, are consistent across all markets.  Since 1956, dividends have accounted for about one-third of the S&P 500^® total return.  As a final thought, “dividend indices have historically offered attractive yields and total returns, allowing market participants to participate in up markets while potentially achieving protection in down markets.”[3]

[1]   Exploring Liquidity and Dividends in Peru

[2]   The dividend rate is calculated based on the dividend paid per share during the preceding twelve months, divided by its price at the rebalancing date

[3]   Selecting a Dividend Index? Three Factors Worth Considering.

The S&P GSCI Energy Total Return gained 8.1% in July, the most for a July in 13 years, led by petroleum that was up 9.2%.  Finally the fundamentals may be showing the oil market is starting to rebalance with the rest of the commodities.   The S&P GSCI Total Return had its best month this year, gaining 4.6%. lessening its year-to-date loss to -6.1%, while the Dow Jones Commodity Index gained 3.5% for a year-to-date loss of -2.1%.

Three of five sectors were positive that included both industrial metals and precious metals along with best performer, energy.  Also two-thirds or 16 of 24 commodities were positive for the month, the most since Sep. 2016, led by unleaded gasoline that was up 12.4%, its best month since Apr. 2015 and hottest July since 2005.  Other top performers were heating oil, gasoil and coffee, with total returns up 12.2%, 11.8% and 10.9%, respectively.  The biggest losing single was the S&P GSCI Kansas Wheat with a total return of -10.3% for July, its worst month in 2 years since July 2015.

Given Brent and WTI crude oil together have just over 40% weight in the S&P GSCI, they contributed heavily, 3.4%, to the 4.6% gain in July.  Although according to the International Energy Agency (IEA,) OPEC compliance fell to just 78% in June, they are hoping to improve compliance by capping Nigerian production.  However, the cuts may be already be impacting the market as about 1 million barrels per day have been removed in addition to further cuts from non-OPEC countries.  Also, a key factor in the oil price rebound is U.S. production may be starting to slow as companies reach drilling capacity and fear the risk of another drop in oil prices.  This may happen just as Saudi Arabia cuts oil exports to the U.S., potentially accelerating the inventory reduction.

One possibly bullish sign is the S&P GSCI Enhanced Crude Oil signaled it is time to hold the near contract rather than the later dated one.  Today the enhanced index will start its five day rolling period to roll out of the Dec. 2018 contract and into the Oct. 2017 contract.  This is the first time the index will hold the near contract since Nov 2014.  The rule in the methodology that determines the contract says, “it will hold the near contract if the contango is not more than 0.50%.”

In July, the roll return, as measured by the excess return less the spot return, was -0.45% for crude oil.  The negative roll return still reflects contango, a losing condition where near contracts are cheaper than later dated ones, mainly resulting from excess inventories with high storage costs. While the contango is still present, it is the least since Dec 2014, when the crude oil roll return measured -0.23%.  The S&P GSCI Crude Oil Spot Return year-to date through July was -6.6%, but the total rolling loss (year-to-date through July) subtracted an additional 5.6% from index positions in the most liquid nearby contracts, dropping the S&P GSCI Crude Oil Excess Return to -12.2% in 2017.   This is far less than the negative impact in the first seven months of 2015 and 2016 when the roll costs were -12.7% and -20.8%.

Equal-weighted indices typically outperform their cap-weighted counterparts (although 2017 so far has proven to be an exception to the general rule).  This means that portfolio managers can usually create a performance tailwind by equal weighting rather than cap weighting their holdings.

But do they?  One way to assess this question is by using the Herfindahl-Hirschman Index (HHI).  The HHI is a measure of market concentration, often used in industrial organization studies, that has the great virtue of being easy to compute: simply sum the squares of the market share of each firm competing in a market.  Possible HHI values range from 0 to 10,000.  This measure can be applied to portfolios by summing the squares of each holding’s percentage weights.  For example, the HHI value of a single-stock portfolio is 10,000 (the maximum possible); the HHI value of a 100-stock, equal-weighted portfolio is 100.

We applied the HHI to a handful of mutual fund portfolios in order to assess where their portfolio construction methodologies lay on the spectrum between cap and equal weight.  This is a simple exercise: compute each fund’s actual HHI value, and then compute comparative HHI values by assuming that the fund’s holdings were cap weighted or equal weighted.

We sampled funds with holdings that ranged from less than 70 names (Dodge & Cox) to those with more than 1,000 (Parametric Emerging Markets).  With one exception, the funds’ portfolio weights in our sample were much closer to equal than to cap weighting.

For funds to come close to cap weighting, they must maintain substantial portfolio weights in large-cap names.  For example, if Dodge & Cox’s Microsoft holding were cap weighted, it would amount to 12% of the fund (instead of its actual 3%).  Fidelity Magellan would hold 10% in Apple to be cap weighted, but only holds half that at 5%.  T. Rowe Price should also hold 10% in Apple, but strays even further, with only a 1% portfolio weight.  Parametric Emerging Markets needs a 4.9% weight in Samsung to maintain a cap weight, but only holds 0.7%.  Even Growth Fund of America, which is the closest to cap weighting, has only a 1% weight in Apple (where cap weighting requires a 6% weight).  The fund makes up for it by overweighting other large cap names—for instance, it has a 7% weight in Amazon Inc., while cap weighting only requires a 3% weight.

This is an admittedly small sample, but it confirms our intuition that most active portfolios are closer to equal than cap weighted.  This means that their performance, relative to standard cap-weighted benchmarks, could be even worse than you think.