Photo by anvesh baru
If you are surprised to see two “case study” posts from me in a row, your reaction is no more than my own.
For the last one it could be charged that I succumbed to flattery and bribery in taking it on. No case to be made for that here, as you’ll see.
This comment appeared on a post I wish they had read before investing.
From Mr. Pink…
My sister is 50 years old and recently became disabled.
Over the past 30 years, she has managed to save $618,000 by saving most of her salary.
She has never invested in the stock market. She believes the stock market is worse than gambling.
Because she is unable to work now, she became very concerned that she will outlive her money, so she met with three financial planners and took their advice and on 12/01/2021 invested $600k into the VFORX (Vanguard Target Retirement 2040 Fund).
Although this is a ‘Target Retirement” fund, because she is disabled and not working now, she had to invest it in a ‘taxable’ account. She wanted to invest the money little by little over the next few years AKA dollar cost averaging but was advised that she would benefit more by just doing a lump sum investment and have more time in the market with that large sum of money.
The financial planners told her that Vanguard has been around forever, they are very well respected in the industry, they created the index fund, and have very low fees.
They explained VFORX also invests in bonds, and told her bonds move in opposite directions as equities so even if the stocks go down, the bonds will go up.
Last I checked, the bonds within VFORX are also down 9.1%. My sister received $94,187 in capital gains taxes (yes you read that correct, NINETY FOUR THOUSAND ONE HUNDRED EIGHTY SEVEN DOLLARS.) The capital gains were roughly 40 times higher than the amount in 2020 for VFORX.
I believe there is a Class Action Law Suit filed against Vanguard because of this. You can read about it here.
I told my disabled sister who saved for 30 years to accumulate 618K only to get hit with a huge capital gains tax and to see it go down over 19% in 6 months, not to worry because…
The Market Always Goes Up.
Wow. There is a lot to unpack here. Broadly speaking, there are three issues:
- Was investing her $600,000 as a lump sum a bad idea?
- Was VFORX a poor fund choice?
- Was Vanguard a poor choice?
So, did Ms. Pink get bad advice from her three advisors? We’ll look at each of those questions in turn, but let’s start with a couple of caveats.
The first is, we don’t know exactly what she told them or what guidance she provided. We also don’t know if these were three advisors working together in the same firm or three distinct advisors who separately came up with the same advice.
Presumably, the advisors would have asked why she wanted to invest her money and she would have told them what Mr. Pink tells us:
“Because she is unable to work now, she became very concerned that she will outlive her money”
While the last six months have been tough on her portfolio, with that guidance, overall I’d say the advice was sound. But not entirely, as we’ll see.
Let’s take a closer look.
Was investing her $600,000 as a lump sum a bad idea?
With the benefit of hindsight, clearly Ms. Pink would have been better off had her advisors used the “Dollar Cost Average” (DCA) approach to slowly deploy her capital over time. Doing so, she would have accumulated her shares at lower prices than what she paid in December. But this assumes the prices after December would in fact be lower, something her advisors could not have known at the time.
So, what were the odds the price of her shares would be lower? Turns out, only ~25% of the time. The other ~75% of the time, stock prices rise.
Since the only time you benefit from using DCA over investing the lump sum is when share prices decline, you are making a bet with a 25% chance of winning.
Of course sometimes that 25% pays off, as it would have in this case. But back in December the advisors didn’t have the benefit of today’s hindsight. Back then going with the 75% chance lump sum investing offered looked to be the better choice. It was.
For more on this see: Why I don’t like Dollar Cost Averaging
Was VFORX a poor fund choice?
Again, with the benefit of hindsight, sure. It is down 15.5% as of July 21st as I am writing this post. That is slightly better than the market overall –the S&P 500 is down 17.5%.
VFORX is a “Target Retirement Fund” (TRF) and, while I am not wild about these I do think they are a good fit for some people. People like Ms. Pink for example.
They provide a mix of stock and bond funds that automatically become more conservative (i.e. more bonds) as they get closer to the retirement date. In this case, 2040. So Ms. Pink never has to worry about adjusting her asset allocation as time goes by.
TRFs make long-term investing just about as simple as it can possibly be, which for someone like Ms. Pink is an important consideration.
Here is my full take on TRFs
TRFs are what is know as a “fund of funds” — that is the fund holds other funds. This is what VFORX (Vanguard’s Target Retirement 2040 Fund) holds:
- 47% VSMPX (this is the institutional version of VTSAX – US stocks)
- 32% VGTSX (international stocks)
- 14% VTBIX (this is the institutional version of VBTLX – US bonds)
- 6% VTILX (international bonds)
What we have here is an allocation of ~80% stocks/20% bonds.
Now this is the same allocation I have with my stocks and bonds, and I consider it fairly aggressive. Too aggressive for Ms. Pink, based on what Mr. Pink has told us.
Staying with a TRF, others from Vanguard look like this:
- VTHRX (Vanguard’s Target Retirement 2030 Fund) is ~65% stocks/35% bonds.
- VTTVX (Vanguard’s Target Retirement 2025 Fund) is ~60% stocks/40% bonds.
- VTWNX (Vanguard’s Target Retirement 2020 Fund) is ~44% stocks/56% bonds.
I probably would have chosen VTTVX, because without the growth of at least 50% in stocks portfolios have a hard time lasting for decades. (See my 4% Rule post)
But all this will be splitting hairs for Mr. Pink. His complaint is that bonds have performed poorly unlike what the advisors said:
“They explained VFORX also invests in bonds, and told her bonds move in opposite directions as equities so even if the stocks go down, the bonds will go up.”
Of course, in this he is correct. But I would make a couple of observations, none of which are likely to make him feel better.
- Bonds going down in tandem with stocks is unusual and is a function of rising interest rates implemented in the face of inflation.
- Investing is inherently risky and doesn’t always go to plan.
- Bond funds will recover. They have the advantage of some bonds in the portfolio always reaching maturity freeing up the cash to buy the new, higher yielding bonds being now offered.
- The key, as with stocks, is to stay the course.
Was Vanguard a poor choice?
Looking at the link Mr. Pink provided, it really does look like Vanguard stepped in it on this one.
The article Mr. Pink links to gives an excellent explanation, but here is what happened in a nut shell.
Like most of their funds, Vanguard offers “Institutional” versions of their TRFs.
Institutional Funds are aimed at 401-K type plans and have very large initial investment requirements. In exchange, these funds also offer lower expense ratios (ERs).
Vanguard, attempting to make these cheaper funds available to smaller companies, dramatically lowered the threshold. As the article says…
“In December 2020, Vanguard lowered the plan-level minimum investment requirement for the Institutional Target Retirement Funds to $5 million from $100 million. Now, as long as an employer’s 401k plan had $5 million in assets across the entire plan (not just one person), they could now access the much cheaper Institutional version… a big savings for possibly thousands of small businesses.”
As well intentioned as this probably was, it triggered an unintended consequence: It worked too well.
Evidently massive amounts of money moved from TRFs like VFORX to their institutional twins which caused massive selling in the funds. And that caused massive capital gains then passed on to the fund shareholders.
For those holding these funds in an IRA or 401-K, this was a non-event. No taxes would be due.
But for those like Ms. Pink, who owned the fund in a taxable account, it was a rude and expensive surprise. A surprise compounded for Ms. Pink in that her advisors put her into the fund in December, right before capital gains for the year are distributed.
While her advisors couldn’t have known this uniquely massive capital gain distribution was coming, it is basic common sense to avoid buying a fund right before capital gains and dividends are paid out. Doing so simply returns some of your money to you with a tax due.
There is no telling how this lawsuit will play out, but perhaps Mr. Pink and his sister can take some consolation in the fact his math on this is wrong when he says:
“My sister received $94,187 in capital gains taxes…”
What she received was $94,187 in capital gains, which are then subject to tax.
From the article, the capital gain paid out on VFORX was 15.55%. That percentage x the 600k she has in the fund would = $93,300. Mr. Pink’s $94,187 is probably due to her having a bit more than 600k in the fund.
That $94,187 in capital gains would be subject to the capital gains tax at a rate determined by Ms. Pink’s tax bracket. The capital gains rates for 2021 (the year she booked the gain) look like this:
If you are single and your taxable income is…
…below $40,400, the capital gain rate is 0%
…between $40,401-$445,850, the capital gain rate is 15%
…over $445,851, the capital gain rate is 20%
If you are married and your taxable income is…
…below $80,800, the capital gain rate is 0%
…between $80,801-$501,600, the capital gain rate is 15%
…over $501,601, the capital gain rate is 20%
Based on what we know, my best guess is Ms. Pink will be in the 15% bracket. 15% x $94,187 = $14,128 tax due.
Still a pretty swift kick no doubt, but considerably less than the one Mr. Pink was expecting.
So, that’s my read on those three major issues:
Unlucky timing, but overall good advice with two exceptions — The allocation in VFORX is a bit aggressive in my judgement and buying it right before the capital gain distribution.
But there is another question that dwarfs the considerations above…
Should the advisors have put Ms. Pink in the market at all?
Probably not. At least not without preparing her for what to expect.
After all, Mr. Pink tells us his sister has been saving “most of her salary” for 30 years and that…
“She has never invested in the stock market. She believes the stock market is worse than gambling.”
He doesn’t tell us where she has been putting this money, but he does say that with her disability “…she became very concerned that she will outlive her money.”
This suggests she has been in low return investments like CDs or savings accounts. She probably has been watching the stock market provide handsome returns and had finally decided to reach for those herself.
Unfortunately, it also sounds as if she and Mr. Pink don’t really understand how the market works. He closes, after all, with a sarcastic…
“I told my disabled sister who saved for 30 years to accumulate 618K only to get hit with a huge capital gains tax and to see it go down over 19% in 6 months, not to worry because…
“The Market Always Goes Up.”
That last line being a shot at me as it is one I am famous for. See, I told you, unlike the last case study, I didn’t chose this one for the flattery and bribery.
Of course, it is possible that I am misreading the tone here and this close is not sarcastic at all but rather an astute observation.
But I doubt it.
Mr. Pink doesn’t ask for my advice, this is more about venting his frustrations. But for any of you who might be curious what it would be, here it is.
No question his sister got off to a very rough start, but the fund she is in is a reasonable choice and she should stay the course. If she wanted to get a bit more fancy, she could sell it, book the capital loss and buy one of the more conservative TRFs I mentioned above.
She could also do this if, as I fear, she has already sold out and locked in her losses.
But before she does anything, she should educate herself on this market stuff. And at the risk of being immodest, the Stock Series on this blog is the perfect place to start.
If she had done this before investing, she would have known that market drops like this recent one are perfectly normal, to be expected, and they don’t last forever.
Market crashes are to be expected.
They are the price we must pay for the long-term gains we seek.
What has happened these last six months is a perfectly normal part of the process. It has been mild as these things go, barely tipping into the -20% bear territory a couple of times. Much more gentle than the crash of 2008-9. It has happened before and it will happen again. And again. This is the nature of the beast and it is the topic covered in the very first post of the Stock Series:
There is a Major Market Crash Coming
Before investing, she should have also read this post:
Why You Should NOT be in the Stock Market
As someone who “…believes the stock market is worse than gambling” there is a pretty good chance she shouldn’t be.
At least, in reading that post, she would have heard me say…
“If you are going to follow The Simple Path to Wealth described on this blog and in my book, it is critical that when the market plunges you ignore it and stay the course. If you don’t, if your nerve fails and you sell in the panic all around you…
“The advice on this blog and in my book will leave you bleeding by the side of the road.”
I like that last line so much, I have used it routinely in interviews and in other posts like this one.
“If you panic and sell when the market drops, my advice here on the blog and in my book will leave you bleeding by the side of the road.”
What’s done is done. What matters now is what Ms. Pink chooses to do going forward.
Addendum: Free books!
If you have read this far, you deserve a reward!
That’s Doc G., who we all know now is really the soon-to-be-famous author Jordan Grumet, hanging out with me at Kibanda. That comes with a price.
With a small bit of arm twisting (I promise no Grumets were injured in the making…) I have managed to secure two print and one audible copies of his new book…
Taking Stock: A Hospice Doctor’s Advice on Financial Independence, Building Wealth, and Living a Regret-Free Life
…to give away!
They go to the first people to ask in the comments below. Be sure to specify which version you’d like.
If you aren’t lucky or quick enough to get it free*, it is well worth buying. Hit the link below.
*They have been taken — spoken for instantly!