I’m an employee and have already maxed out a 401K ($17.5K), a back-door Roth IRA ($5.5K), and an HSA ($3250).  I’d like to save more for retirement.  What are my other options?

A.

The amount of “space” in available retirement accounts rarely lines up exactly with what an investor would like to save for retirement.  Some people have far more space available than money they can actually save while others don’t have enough.  There are so many different options, there’s no reason one has to stop saving for retirement if they wish to save more in any given year.  Let’s consider each of them one by one.

Spousal Retirement Accounts

If you’re married, you can save money in your spouse’s retirement accounts.  Remember that money is fungible and a dollar doesn’t care if it was made by you or your husband.  There’s no reason you can’t take all your savings from your income and have most or all of your spouse’s paycheck go into his 401K.  If you have a stay-at-home spouse, or one with very little earnings, you can do a backdoor Roth IRA for your spouse with your own income, creating another $5500 in retirement “space” each year.  Being married also allows you to put $6450 into a Stealth IRA (i.e. HSA) instead of just $3250.

Paying Down Debt

Many of us, especially in our thirties, carry around a large amount of debt, some of which may be at a relatively high interest rate.  If you have maxed out your retirement accounts and have debt at 6-7% or even more, it’s a no-brainer to use your additional income to pay that down.  It’s the equivalent of purchasing an investment with a guaranteed 6-7% return.  Even paying down a 3-4% mortgage may be an attractive option for additional savings for some people.

Lobby Employer For Additional Retirement Accounts

Self-employed physicians can use a Solo 401K or SEP-IRA with a $51K limit.  Many partnerships have 401K/Profit-sharing plans in place with the same limit.  These physicians may also have a defined benefit plan allowing them to save another $10-50K.  While an employed doctor can’t just walk out and open these types of accounts on her own, she can lobby her employer to add them to the mix.  You may find your employer is more than willing to change the retirement options available, but just doesn’t happen to understand his options and how important this is to his employees.

Catch-Up Contributions

Once you hit age 50, you can actually contribute more to your retirement accounts.  The 401K employee contribution limit goes up from $17.5K to $23K.  Profit-sharing plans go from $51K to $56.5K.  Your personal and spousal Backdoor Roth IRA contribution limits also go up from $5.5K to $6.5K and even the Stealth IRA limit goes up by $1000 to $4250 (single) or $7450 (married).  If you have a 403B and a 457 as many academic docs do, the limit for each of them goes up from $17.5K to $23K, providing another $11K in retirement savings space.

Annuities

While I’m generally not a big fan of annuities due to their additional costs and the fact that they turn income that would be taxed at a lower capital gains tax rate into income taxed at your higher regular rate, there are situations when they can make sense, especially if costs are very low, the asset classes invested in are particularly tax-inefficient like bonds, REITS, or high-turnover stock funds, and if you hold it for a very long time.  They may also provide some additional, state-specific, asset protection benefits.  However, in exchange for some tax benefits and possibly some asset protection benefits, you give up many of the unique benefits and flexibility of investing in a taxable account.

Cash-Value Life Insurance

I’m also not a big fan of cash-value life insurance, whether it be whole life, universal life, or variable universal life.  It is often marketed to high-income people as an additional retirement account and has been discussed on the blog ad nauseum.  Returns tend to be low and you must hold the policy for the rest of your life to get any kind of reasonable return.  Withdrawals must be taken as “loans” from the policy, on which you must pay interest until your death (or pay back the loan.)  You must also be insurable at a reasonable rate, so it really isn’t an option for those with relatively poor health or dangerous hobbies.  A life insurance policy may provide you some estate planning and asset protection benefits depending on your individual situation and state of residence.  Some people may also highly value the permanent death benefit a cash-value life insurance policy is designed for.  There are a few steps you can take to make a life insurance policy work out a little better as an investment, but as a general rule, the lack of flexibility and low returns make these an inferior option.  You certainly shouldn’t be buying one if you haven’t maxed out all of more traditional retirement accounts.

Real Estate Investing

Investing in real estate allows you to take advantage of relatively safe leverage (when compared to buying stocks on margin) and many significant tax advantages such as depreciation, the ability to write off travel to the location of the property, 1031 exchanges, and the step-up in basis at death.  Downsides include huge transaction costs and the fact that, in many ways, real estate investing is a second job, something most physicians don’t need.  Certainly, many physicians and other investors have had great success with real estate investing.

Accounts For Your Kids

Some doctors prefer putting extra money toward 529 accounts for their children or into their children’s UGMA accounts.  While this does have the benefit of lowering your tax bill, it really isn’t a great place for your retirement savings due to restrictions on these accounts.  Money taken out of a 529 and not spent on education is taxed at your regular marginal rate with an additional 20% penalty.  Money put into a UGMA account can only be spent for the child’s benefit.  Besides, when the child turns 18-21, he can blow the money on dope and strippers and there’s nothing you can do about it.

Taxable Investing Account

The much-maligned taxable investing account isn’t nearly as bad as most physicians, and certainly most annuity and life insurance salesmen, think.  Sure, it is exposed to your creditors, but the truth is that few of us will ever have to deal with a judgment that isn’t covered by our malpractice or umbrella policies.  Retirement accounts, annuities, and life insurance aren’t really protected from the judgment most commonly faced by doctors, a divorce settlement, anyway.  It is also taxed as it grows, unlike many of the other accounts listed above.  However, it has many advantages that the other accounts do not.  First, it is immensely flexible.  You can invest in pretty much anything and you don’t have to deal with age 59 1/2 related restrictions.  Second, you can get a step-up in basis at death, passing money to your heirs income tax-free.  Third, you can get significant tax benefits during your life by donating shares to charity or tax-loss-harvesting.  Fourth, you can minimize taxable income by choosing tax-efficient investments such as total market stock index funds and municipal bonds.  If not completely tax-free or at least deferred, income will generally only be taxed at the lower capital gains and dividend rates rather than your regular marginal tax rate.

As you can see, there are lots of options for retirement investing even after you’ve filled your retirement accounts.  As with most things in life, knowledge and creativity are rewarded financially.

What do you think? Which types of accounts do you use for your retirement savings?

Larry Keller

[Editor's Note:  This is a guest post from Lawrence B. Keller, CFP®, CLU®, ChFC®, RHU®, LUTCF.  We have no financial relationship.]

Since my last disability insurance update, Berkshire has increased their Issue & Participation (I&P) Limits and introduced their broader ProVider Plus product offering (which includes the ProVider Plus Limited) in California.  MetLife has also introduced their Income Guard policy in the majority of states.

Berkshire

Berkshire increased the monthly benefit available to First and Second Year Residents from $4,000 to $5,000.  Additionally, the maximum issue limit for physicians and dentists has increased from $16,000 to $17,000 month.  The maximum participation limit with other individual disability insurance has also increased from $20,000 to $25,000 month (with the exception of the State of California).

In California, rates have increased across the board.  When combined with the new Mental and/or Substance-Related Disorders Limitation Discount (10%), sex-distinct level rates will generally be 4.25% higher.

A new occupational classification for all dentists and dental specialists (3D) has been created. As a result, rates for males will generally be 4.25% higher and female rates (especially for those female dentists under age 40) will be substantially higher (compared to the current 3M rates).

Perhaps, one the biggest changes is for those insureds that elect a graded (annually increasing) premium structure in order to minimize their initial premium outlay.  The initial graded premium rate has increased substantially.  So, for those looking to purchase a policy with a graded premium structure, the lower the initial premium rate, the better!

Rates have also been increased for all ProVider Plus products in the State of Arizona.  There is still time to lock into the “old” rates in both Arizona and Florida.  Applications submitted on or before May 24, 2013 will receive the “old” rates.  Beginning May 25, only the new rates will be available.

MetLife

Medical and Dental Specialty Language Introduced

Metlife will consider the material and substantial duties they were performing, including those of a professionally recognized specialty in medicine or dentistry immediately prior to the start of their disability to be the material and substantial duties of their regular occupation.

Tail-End Waiver of Premium

If premiums are being waived and benefits have been payable for 12 months or more, MetLife will continue to waive any premiums due during the first 90 days after disability ends.

Residual Disability and Residual Disability with Recovery Benefit Riders

MetLife now offers three Residual Disability Riders (Basic Residual, Residual with Recovery and Enhanced Residual with Recovery).  All of them provide benefits if disability causes a loss of earnings of 15% or more (reduced from 20% under the Omni Advantage) compared to the insured’s pre-disability income. The addition of a recovery benefit extends the period that benefits are payable under the rider to include a period after total or residual disability where the insured has returned to work on a full time basis, performing all of the material and substantial duties of the his/her regular occupation, but continues to have an income loss due to the condition that caused the disability. Under the Omni Advantage, recovery benefits, if elected, were limited to a maximum of 24 or 36 months.  The Enhanced Residual with Recovery Rider also modifies the time or duties requirement within the definition of residual disability.  Finally, the riders that include recovery benefits also state that, during the first 12 months in which residual disability benefits are paid, the minimum monthly benefit for residual disability will be 50 percent of the monthly benefit for total disability.

Mental Disorder and/or Substance Use Disorder Mandated for Certain Specialists

Under the current Omni Advantage policy, disabilities due to a mental disorder or a substance use disorder are payable for the entire benefit period.  However, with Income Guard, those in occupational classes 5D (the new occupational class for Dentists) and 4M (Orthopedic Surgeons, OB/GYNs, Psychiatrists, Anesthesiologists, Emergency Physicians, Interventional Radiologists, Interventional Cardiologists) will be issued policies that include a mandatory rider which limits the maximum benefit period for disabilities caused by mental and/or substance use disorders (MDSUD) to 24 months over the life of the policy, unless the insured is confined to a hospital, when the “specialty your occupation” language is included.   A 10% premium reduction will apply with the inclusion of this MDSUD Rider.  However, it will only apply to certain elements of the premium and not the entire premium. As a result, there is a huge incentive for Anesthesiologists and Emergency Physicians to purchase the “old” (Omni Advantage) policy while it is still available as the only other company that combines a true “Own-Occupation” definition of total disability with full coverage for mental and nervous conditions (for those specialties) is Standard Insurance Company. Unfortunately, in most states (with the exception of California, Florida and Vermont), Standard places Anesthesiologists in their 2P occupational classification (unless they are Pain Management Physicians) and, as a result, are subject to a 25% surcharge compared to all other medical specialties. Once the Omni Advantage is no longer an option, Standard will be a more viable alternative for Emergency Medicine Physicians (compared to Anesthesiologists), due to the more favorable occupational classification (3P) that they are assigned.

Limited Benefit Period While Outside the United States

Currently, under the Omni Advantage, claims are paid outside the United States with no limitation.  Under the Income Guard, while an insured is outside the United States, its possessions and Canada, benefits will be paid for a maximum of 24 months for all periods of disability combined during the insured’s lifetime.  This means that after the July 31st deadline (for those states in which Income Guard is already approved), in most cases, MassMutual will be the only company providing an insured the ability to receive benefits outside of the United States with no restrictions.  

Introduction of the 3% Compound Cost Of Living Adjustment (COLA) Rider

This Cost of Living Adjustment (COLA) rider increases the monthly benefit payable for disability by 3% of the monthly benefit payable from the previous year.

Introduction of the COBRA Reimbursement Rider

This rider reimburses the insured for COBRA premiums paid while the insured is disabled, not to exceed the monthly maximum (Up to $2,000 per month for a maximum 15 months per disability).  The only other company that offers a similar policy provision is Ameritas, which has it built into their contract at no additional cost.

For states in which MetLife Income Guard is currently approved on May 6, 2013 (currently all but California, Colorado, Connecticut, Florida, Louisiana, Maryland, Massachusetts, Minnesota, Missouri, North Carolina, Ohio, Rhode Island, South Carolina, Vermont, and Virginia,) the last day an Omni Advantage application will be accepted is July 31, 2013.  Finally, remember that policy provisions are subject to state availability.  Also note that the descriptions above are intended as brief summaries of actual policy provisions and you should refer to a specimen policy for complete policy terms and provisions.

In the market for disability insurance?  Recently bought some?  Which policy did you buy?  Comment below!

Eligibility Criteria

1. You can’t be behind on your mortgage and have to have made 12 months of on-time payments.
2. The mortgage must have been sold to Fannie Mae or Freddie Mac before May 31, 2009.
3. Your loan to value MUST be greater than 80%.  There is no maximum for fixed mortgages, but if you want an ARM the maximum is 105%.
4. You have to be able to reasonably afford the new mortgage (if you’re making payments on time on your current mortgage, this shouldn’t be an issue.)
5. You can only refinance through HARP once.
6. You must live in the home (no investment properties) [Update- Looks like you can do investment properties- see comments section].

Why Refinance?

The point of HARP is to make your payments smaller.  This is done by giving you a lower interest rate and a longer term.  For example, if you are 5 years into a 30 year 6% mortgage, you may be able to lower the rate to 4% and extend the loan term back out to 30 years.  On a $200K loan, this would lower your principal and interest payments from $1289 a month to $955 a month.  You don’t have to extend the term though, you could refinance into a 15 year mortgage.  If you could get a 15 year at 3.5% on that same $200K loan, your payments would be $1430 a month, but you’d have the loan paid off 10 years sooner.  HARP does NOT allow you to take any cash out, although most people using the program don’t have any cash to take out anyway since they’re underwater.  You’ll still need to pay the closing costs on the loan, but you may be able to opt to take a higher interest rate to make it a “no-cost” loan or add the closing costs onto the loan balance to make it a “no-cash” loan.

Who’s Paying For This?

You may be asking yourself why banks are willing to give you a lower rate when they’ve got you locked into a high rate you can’t refinance.  The reason why is that the bank makes money every time you refinance.  Some are estimating that banks will have more than $12 billion in revenue from HARP loans this year.  Remember that the bank doesn’t hold your mortgage, investors do.  So when you refinance your loan, the bank pays off the old, high-interest loan (the investor’s bond is called), and then sells off the new loan to the same investor at a lower rate.  Just as the Fed’s low short-term interest rates punish savers to help borrowers, so the Federal HARP punishes investors and rewards borrowers.

What should I watch out for?

Basically, this refinance is just like any other.  You don’t have to go to your current lender (a change from the original HARP).  You have to pay closing costs.  You should shop around to get the best rates, lowest fees, and best terms.  You still have to go through underwriting.  You may or may not have to pay for an appraisal.  Many banks have been accused of charging higher rates or more fees for HARP refinances than for non-HARP refinances.  What did you expect?  Would you loan to someone that is underwater at the same price as someone that isn’t?  Of course not.  But that doesn’t mean you still can’t shop around and compare.  Competition lowers prices.  Remember also that refinancing isn’t always a good idea, especially if you’re selling soon.  You might not have time to recoup the closing costs with savings on interest.

In short, if you’re stuck in a high interest rate mortgage because you’re underwater or close to it, take a close look at HARP and shop around for a HARP refinance.

I am trying to get some information regarding retirement withdrawal for myself and my parents.  My parents are still working.  They have a 401K and my dad will also have a pension. My wife and I are also saving for retirement in a 401k and a profit sharing plan, although we’re a long way from retirement.  I would appreciate it if you could explain how it works in the withdrawal phase of retirement.  For example, I understand they have to withdraw a certain percentage starting at age 70 1/2.   They’ve been do-it-yourselfers, but perhaps they should now hire a financial planner in the withdrawal phase.  What do you think?

A.

That’s a lot of questions in a very short space.  Let’s see if we can address them all one at a time.  Retirees have traditionally had a “3-legged stool” including a pension, personal savings (401K), and Social Security.  It sounds like your parents will have all three legs in their retirement.

401K rollovers

Upon separating from an employer, you can transfer your 401K money into an IRA.  In some states, IRAs have less asset protection than 401Ks, but for most of us our liability goes down quite a bit after we quit working.  As a general rule, an IRA has lower expenses and better investment options than a 401K, although there are certain situations where this might not be true (for example if your 401K has access to TSP funds or DFA funds.)

4% Rule

I’ve written before about the 4% rule, which is an estimate of how much money a retiree can take out of his portfolio each year and have a decent chance it will last for 30 years or so.  So if your parents have a $500,000 401K, then they can take out $20,000 a year in retirement, increasing that amount each year with inflation.

SPIAs

Many retirees, especially those without a pension, elect to purchase a Single Premium Immediate Annuity (SPIA) in their late 60s or early 70s.  In exchange for a lump sum, a SPIA guarantees an annual payment until death, so you’ll never run out of money.  Although somewhat rare, you can also buy inflation-indexed SPIAs.  Although there won’t be anything left for heirs, SPIAs combine the “never run out of money” guarantee AND allow for a safe withdrawal rate of greater than 4%, which can be pretty useful, especially in the early years.  Immediateannuities.com tells me that a SPIA bought on a 70 year old male pays at a rate of 7.8%, so if you spent $100,000 on one, it would pay you $649 a month for the rest of your life.  There are many other types of annuities, and one type that is becoming more popular is being called “longevity insurance.”  You basically buy it in your 60s and if you’re still alive at 85, it starts paying you at a really good rate because it has had a long time to compound and many of those who buy the policies will be dead before 85.  Wikipedia’s example suggests that spending $20,000 at age 60 would pay you $11,000 a year starting at age 85.

Required Minimum Distributions

Beginning in the year in which you turn 70 1/2, the IRS requires you to start taking required minimum distributions (RMDs) from your tax-deferred accounts such as 401Ks and IRAs.  You’re required to take out 3.6% in the year you turn 70 1/2, and that amount goes up each year so that at age 90 you have to take out 8.8% per year.  The penalty for not doing this is huge, so don’t mess it up.  Some people prefer taking money out of their tax-deferred accounts before age 70 1/2 in order to reduce the size of their later RMDs, especially to do Roth IRA conversions prior to initiating Social Security payments.

Withdrawal Different From RMDs

Just because you have to take the money out of your tax-deferred accounts, doesn’t mean you have to spend it.  You can still continue to invest it for yourself or your heirs, you just have to do it in a taxable account (or do a Roth conversion.)  Most people, of course, need the income from their RMDs to live on.  You can’t take it with you so you might as well spend it!  The IRS RMD chart is remarkably similar to the 4% rule anyway.

Advisors

I’ve been accused before of being “anti-advisor.”  I’m very much a do-it-yourself when it comes to my own finances, and I see no reason why someone who can handle their own finances for decades in the accumulation phase needs to suddenly hire help when he shifts into the withdrawal phase.  But I’m not really anti-advisor.  I’m just against paying too much for bad advice.  I don’t have a problem with someone paying a reasonable fee for good advice.  This also isn’t an “either-or” choice.  Many advisors will work with you to draw up a financial plan, or even work for you on an hourly rate for as much time as you need.  If you wish to hire someone to manage your assets in addition to doing financial planning, that is generally paid for with a fee that is a percentage of assets under management (1% of the portfolio per year tends to be the going rate, although there are many firms who will do it for as little as 0.15% per year).  Flat fee options do exist as well.  Expect fees of $1000-5000 per year for quality asset management.

Plan for when you become incompetent

3 Legs Of The Retirement Stool- Social Security, Pension, and Savings

In summary, your parents should plan on living their retirement using the 3 legs of the retirement stool – Social Security, their pension, and their savings, some of which may be annuitized to provide additional income and some of which may be held in reserve for emergencies or to pass on to heirs.  You and your spouse need to realize that Social Security will probably start later for you and pay less than it will for your parents, but is unlikely to disappear completely.  You are also unlikely to have a pension.  You’ll need to make up for the losses of these two “legs” by strengthening your savings “leg”, and using it to buy your own pension (i.e. SPIA) at an appropriate age.

What do you think?  How do you plan to manage the withdrawal phase?  Comment below!

M. Wayne Patton

[Editor's Note:  This is a guest post from Wayne Patton, an "asset protection" attorney.  We have no financial relationship at this time.]

At its core, asset protection is nothing more than risk management. Unlike liability or malpractice insurance, asset protection is active planning that covers all sorts of liabilities from professional to personal, and if done properly, it will also allow you complete control over the investments inside your plan along with the option to remove your assets from the plan without any sort of penalty. For that reason alone, asset protection planning is far superior to whole life insurance.

Separate Ownership From Control

The legal basis for asset protection planning is the age-old concept of separating legal ownership from beneficial use and control of assets. Most physicians and almost all entrepreneurs take advantage of this legal separation every day without consciously thinking about it. Any time you direct the actions of an LLC, S Corporation, or a limited partnership, you are managing assets, employees, and liabilities that don’t belong to you personally. That’s true even though you personally benefit from the profits and capital gains appreciation of the underlying business entity. From this example, let’s set out Rule #1 of Asset Protection Planning:

It is legally permissible to separate legal ownership from beneficial use and control.

For purposes of protecting your wealth, there is no tool better suited to take advantage of Rule # 1 for the protection of personal wealth than a Portable Asset Protection Trust, which very effectively removes individuals from legal title while allowing them to retain exclusive control and use of the assets. The reason this protects the assets is that if you don’t technically, legally own an asset, that asset cannot be taken from you, even if you have the right to use and benefit from the asset.

Different Place, Different Laws

Before we dive too deeply into specifics, let’s first identify Rule #2 of Asset Protection Planning:

You have the legal right to determine the choice of law that governs a trust.

Rule # 2 is what allows so many promoters to legally tout and create offshore trusts for their clients. To be sure, there are many benefits to being offshore. It is certainly an ironclad form of asset protection available for non-exempt assets (i.e. assets outside of a 401(k) or homestead exemption, for example).

Offshore trusts work like this: Assets are titled in the name of an offshore trust of which you are a beneficiary (and which you control). If you are personally sued and have a judgment entered against you, the assets in the offshore trust are off limits. Sure, an aggressive attorney or even the court might send letters to the offshore trust company demanding payment from trust assets, but those letters will be put in an offshore wastebasket!

Is It Legal?

When I describe this to potential clients, the first question asked is “How can that be legal?” Well, reference Rule #2 of Asset Protection Planning above. You have the legal right to choose the jurisdiction that governs a trust. If the jurisdiction you choose happens to have a law in place that says it will ignore judgments of U.S. courts, that rule will be respected.

At this stage of the game, a lot of people ask if they can be held in contempt of court if an offshore trust doesn’t pony up on a judgment. Courts certainly have gone to this extent in the past, but in the majority of cases, the answer is “No.” I’ve never had a client held or even threatened with contempt. In the reported cases where contempt has been used as a remedy, the timing of trust creation or funding has been questionable to say the least (i.e. trusts were created or funded after a claim or lawsuit was filed). All of my clients also benefit from other customized tools I’ve developed that are intended to reduce the likelihood of contempt to a minuscule risk.

Don’t Go Offshore Just Yet…

What most proponents of offshore trusts won’t tell you is that maintaining an offshore trust is extremely expensive. It requires an annual accounting to the I.R.S., which usually costs between $3,000 and $5,000, and it requires that you have an offshore trustee on retainer (about $3,500). That’s obviously significant.  In order to curb those costs, I put many of my clients into Portable Offshore Trusts. The benefits of this type of trust are that it’s initially a U.S. based trust, it is ignored for tax purposes, and it can be moved offshore without consequence if a threat to assets ever arises. While it’s generally not okay to create or fund a trust when there’s legal trouble on the horizon, there is nothing wrong with moving an existing trust offshore to take advantage of favorable international laws in the face of potential litigation, so long as the trust is properly structured on day one.

Benefits of a Family LLC

While every situation is different, in many cases asset protection plans have two components. The first is a Family Limited Liability Company or Family LLC. The Family LLC usually holds “safe assets” directly. Safe assets consist of cash, stocks, bonds, precious metals–pretty much anything that can’t generate a liability. “Risky assets” (e.g. rental real estate, airplanes, etc.) are best compartmentalized into sub-LLCs (i.e. an LLC that is owned by the Family LLC).

The Family LLC is wholly owned by a Portable Offshore Trust. This structure gives you the most privacy available under the law, and it gives you the option to legally upstream your assets into the Portable Offshore Trust and into a foreign jurisdiction without any hiccups if you’re ever threatened with a lawsuit.

Insurance Can Encourage Lawsuits

I’m a fan of insurance. Buy a reasonable amount for general personal liability and as required by law. That said, insurance is not an adequate substitute for asset protection planning. Insurance actually encourages litigation! Asset protection discourages (or even dissuades litigation) and certainly provides an incentive for quick and reasonable settlements.   I have talked to many malpractice defense and plaintiffs attorneys about this issue, and one thing is clear: Physicians without insurance do not typically get sued! So going bare has its benefits, especially if you have asset protection planning.

If you have more questions about asset protection planning, feel free to give me a call at (850) 803-1166. Please mention that you found me via The White Coat Investor.  Finally, here’s a quick video that basically sums up this article with a quick comparison to bear bags used while camping.

What do you think?  Have you “gone offshore?”  Do you have enough non-exempt assets to make this worthwhile?  Have you formed a family LLC?  Comment below!

Pre-pay the Mortgage When Your Risk Is Higher Than The Bank’s Risk

When you first take out a mortgage, especially a 0% down mortgage, the bank is the one taking most of the risk.  All you’re risking is your down payment (if any) and your credit score.  The bank could be left holding the bag if you become unable to make your payments or choose not to make them in the event of the house declining in value.  As time goes on, the bank takes on less and less risk.  For example, when you only owe $100K on a $500K home, the bank only has $100K at risk, and if you default, stands to make $400K on the deal.  Meanwhile, a foreclosure costs you $400K and only saves you $100K.  Why put $400K of home equity at risk for a relatively small benefit of carrying a $100K mortgage?

Mortgage Interest Deduction Becomes Less Valuable

One of the reasons many high-income professionals buy a home is so their monthly payment can become partially deductible.  As long as you itemize, mortgage interest and property taxes may be deductible on your taxes (although the Pease law reinstated in 2013 limits the deduction for those with an AGI greater than $250K ($300K married)).  However, as you pay down the mortgage, more and more of each payment goes toward principle.  This decreases the interest you have to pay, but also decreases the interest you get to deduct.  At a certain point, it may not be worth it to you.  In fact, it may even be possible that without a big mortgage interest payment that your itemized deductions are close to or less than the standard deduction, effectively raising your after-tax mortgage interest rate.  If you end up cutting back and decreasing your income (or retire completely), putting yourself into a lower marginal tax bracket, that interest deduction also becomes less valuable.   $10K of mortgage interest at a 40% marginal rate is worth $4K.  At 25%, it’s only worth $2500.

Paying Off The Mortgage Is Like Disability Insurance

One of my partners considers paying off his mortgage the equivalent of buying a disability insurance policy that would produce the same amount of income.  For example, to cover a mortgage payment of $3K a month with disability insurance would cost $1000-1500 per year in disability insurance premiums.  This is similar to raising the interest rate on your mortgage.

It’s Like Life Insurance Too

If you owe $400K on your mortgage, you probably need to have an extra $400K in life insurance to protect your family in the event of your death.  A 40 year old healthy male buying 30 year level term insurance would pay at least $500 a year for a $400K policy.  Let’s say you have 15 years left on a 5% mortgage and owe $400K on it.  Your payments are $3059, of which $1497 is principal and $1562 is interest.  If you also add in the cost of disability insurance ($1500 per year) and life insurance ($500 per year) that’s the same as increasing your interest rate from 5% to 5.53%.

Skeptics would argue that if you invest that money instead of paying down the mortgage then you should have that $400K (or possibly more) on the side in an investing account.  That may or may not be true.  First, you need the discipline to actually invest that money instead of spending it.  Second, you actually need to earn a return equivalent to or better than your after-tax mortgage interest rate.  Third, you have to pay investment expenses and taxes in order to liquidate the investment.  Paying down the mortgage is a guaranteed return equivalent to your after-tax interest rate plus the costs of the disability insurance and life insurance equivalent to that amount.  That guarantee is worth something.

Paying Off Your Mortgage Allows For A Smaller Nest Egg

Paying off your mortgage early is even more attractive while in or near retirement.  If a retiree can count on spending ~4% of his nest egg each year, then a $3000/month mortgage payment requires a nest egg of $900K, just to pay the mortgage!  Far better to use $400K to pay off the mortgage, and then use the remaining $500K to produce an income of $20K per year.  It’s easy to see that carrying a mortgage into retirement isn’t particularly wise, no matter how you feel about it during your working years.

Asset Protection Considerations

Asset protection laws are state-specific.  Most states protect your 401K and IRAs from creditors.  No states protect a taxable investing account.  Some states protect a significant amount of your home equity from creditors.  In Texas, where up to $1M of home equity is protected, there is an additional benefit to paying down your mortgage and “hiding your money in your house.”  In Virginia, where only $5K of home equity is protected, that might not be the best plan.

Behavior Vs Math

As you can see, there is more to the pre-pay mortgage decision than just weighing a psychological benefit of being debt-free with the ability to invest using low-interest, non-callable margin debt like a mortgage.  It’s an individual decision, but recognize that it is likely that there is a certain point in the term of your mortgage and in your life when it probably makes sense for you to pre-pay your mortgage, especially when the alternative is investing in a taxable account.

My Recommendations

I recommend you have your mortgage paid off by the time you wish to cut back on your workload or retire.  People with debt of any kind aren’t really ready for retirement in my opinion.  One of my financial goals is to be able to cut back on my clinical workload by age 50, so I plan to have my mortgage paid off by then.  Rather than just amortizing it over the next 12-13 years, at some point I imagine I’ll just pay off the last $20K, $50K, or even $100K very rapidly to reduce my risk and improve my cash flow.  In general, I think using money that would otherwise be invested in a taxable account to pay down student loan or mortgage debt is a fine move, but I would hesitate to give up significant tax breaks to reduce low-interest debt.  In other words, max out your 401K, Stealth IRA and Backdoor Roth IRAs before paying down your mortgage.

What do you think?  How do you plan to pay your mortgage off?  Comment below!

I want to buy a house in residency.  I know that in general you think most residents shouldn’t buy a house.  What if I keep it as an investment property after I move?

A.

If you want to buy a house as an investment, you need to evaluate it as an investment BEFORE buying it.  There are two great reasons to keep a house you used to live in as an investment property.  First, you already own it.  That means you get to save on transaction costs.  I conservatively estimate transaction costs at about 5% of the value of the home to buy it and 10% to sell it.  If you don’t have to pay one (or both) of those, it automatically makes an investment a little better.  Second, you get a better interest rate (and often terms) on an owner-occupied property than you do on an investment property.  But no lender expects you to get a new loan just because you move out and convert your residence to an investment property.  The extra interest you don’t pay is now investment profit.

Calculating A Cap Rate

A real estate investor should be familiar with a few basic terms, such as capitalization (cap) rate.  The cap rate is the amount of cash on cash return you would get from your property if you owned the whole thing free and clear.  It is the net operating income (NOI) of the property divided by the value of the property.  If a property gives you an income of $15K per year and is worth $200K it has a cap rate of 7.5%.  That’s pretty good.  So for every thousand dollars you invested in the property, you’re getting $75 a year in cash as your investment return.  This ignores other sources of real estate return, such as amortization of the loan, depreciation of the building (tax benefit), and appreciation (or in recent years, depreciation) of the property. The 55% Rule The easiest way to calculate the cap rate is to use the 55% rule.  Several studies have shown that a good estimate of your net operating income is about 55% of the gross rents.  45% of the gross rents go to property taxes, insurance, maintenance, repairs, HOA fees, vacancies etc.  It is much easier to use the 55% rule than to try to estimate all the expenses every time you consider a property.  So if the gross rent on your $200K property is $20K per year, then your NOI is $11K, and your cap rate is 5.5%. Levered Cash On Cash Return

Many professional investors prefer to use the levered cash on cash return to evaluate a property, rather than the cap rate.  This takes into account the size of your downpayment as well as the rate and terms of the mortgage on the property.  For example, if you have a $200K property, you put 25% ($50K) down, your NOI is $11K, and you get a 3% 30 year mortgage with P&I payments of $10,204 per year, then you can calculate your levered cash on cash return.  You take your NOI and subtract the costs of the mortgage.  That means you’ll clear $796 per year.  On your $50K investment, that’s a levered cash on cash return of 1.6%.  Doesn’t sound so good does it?  Yes, part of that payment goes to principal ($4203 that first year), which would increase your total levered return to about 10% a year, and you get some of that rent tax free thanks to depreciation, and the property might even appreciate (which is awesome when you’re highly leveraged, but remember that leverage works in both directions), but your cash on cash return is still pretty pathetic.

You can compare your cash on cash return to similarly risky investments.  For example, if I expected 9% a year out of a risky, but completely unleveraged, stock mutual fund, then I would want something like 12-20% out of an investment property to compensate me for the risks of leverage, lack of diversification, illiquidity, and hassle factor.  (It only takes me 5 minutes on the computer to buy a mutual fund.)  I certainly wouldn’t be interested in an investment property with a levered cash on cash return of 1.6%.  I recently evaluated an investment opportunity with a levered cash on cash return of 6.6%.  (Cap rate was 5.9%.)  That’s better, but I certainly didn’t feel like I was missing out on a huge opportunity when I gave it a pass.

People Don’t Buy Homes As Investments

The problem is that people really don’t buy homes as investments.  Most buyers don’t even find out what a similar house in the neighborhood would rent for.  They buy homes as a luxury consumption item.  In order to have a place to call their own, they are willing to essentially overpay for a house.  That’s okay, you can’t take your money with you when you go, but a consumption buyer utilizes a different mindset than an investor when evaluating a property.  Typically when you buy a home, you take a look at what similar homes have sold for.  So does your appraiser and your realtor.  Nobody considers whether it would be a good deal as an investment property, because it rarely is.

An Example

There’s a home in my city that is listed for rent for $2100 per month.  Zillow.com estimates it is worth $391K.  Applying the 55% rule, the NOI is $13860 and the cap rate is 3.5%.  Investors typically consider a cap rate of 6-8% to be adequate compensation for their investment, and a double digit cap rate to be a real score.  3.5% does not impress them I assure you.  Even if you put down 20% and scored great financing at 3.5% for 30 years, your levered cash on cash return is actually negative (NOI = $13,860, mortgage cost=$17,007, downpayment = $78,200, so levered cash on cash return is a NEGATIVE 4%.)

The problem is exacerbated for a typical resident.  Most residents don’t put 20-25% down, acquiring a “doctor loan” instead that only requires 5% down.  Imagine the house above that costs $391K and has a NOI of $13,860.  If you only put 5% ($19,550) down (and are thus paying 4% instead of 3.5%), then your annual mortgage costs are now are $21,481.  Your cash flow is now a negative $7629.  Considering you only put $19,550 down, that’s a levered cash on cash return of NEGATIVE 39%.  Even if you don’t mind the negative cash flow situation (feeding this beast $636 per month, of which $552 goes toward principal) you’re still banking on uncertain appreciation to get any kind of significant return on this investment.

A Personal Example

If I calculated out the cap rate for the home I live in, it would be about 5.0%.  I have a very low interest rate (2.75%) but also a 15 year mortgage, so despite having a relatively favorable loan to value ratio, I would be cash flow negative (and thus have a negative levered cash on cash return) if I turned my house into a rental tomorrow.  This is unfortunately the most likely case for most of us, especially a resident who only put 5% down on a property and then lived in it for 3 years.   That’s okay, I bought the house as a consumption/luxury item, and I’m not trying to fool myself that it would be a great investment if I moved out.  If you, however, have decided that you’re buying an investment, and not a consumption item, then I suggest you run the numbers beforehand to determine if it is a wise investment.  You should also have a plan to deal with the almost inevitable negative cash flow situation.

Josh Mettle and Family

The advice I give my resident physician clients is: don’t get discouraged and don’t give up.  Instead, I advise them to be aware of the challenges that they will face this year when trying to buy a home, and arming them with tools to overcome what can seem like insurmountable odds.  I’m passionate about home ownership and feel strongly most residents will have a good equity position in three to five years and they will be better off buying a home than renting.  Many of my clients agree, but just don’t know how to pull it off.

Here are a few of the challenges you can expect as a resident entering the home buying market and potential solutions you can employ to help you:

It’s A Seller’s Market

This is particularly challenging for relocating residents because of their small window of opportunity to find a home and an even smaller window of opportunity to close.  Most of my clients are trying to do their house hunting on one to two weekend trips to their new home city. With increasing competition for homes, especially in the $200 to $300k range, it’s become challenging to find a home in the right area that fits their family’s needs.

There are two solutions to this challenge that I offer to my clients.  First and foremost, you need to be working with the right kind of Realtor.  Just what is the right kind of Realtor?  Look for someone who is SERVICE oriented, who is not too BUSY to devote 100% attention to you when you come into town to preview properties. Look for a professional who cares as much for a job well done as they do for the money. Seek out referrals and speak to several Realtors to get a feel for them. Rule out anyone who feels pushy or salesy. You should sense they care when you speak to them and tell them your challenges with finding a home from a distant location.

You must be able to close on your loan quickly once you find a home.  It’s highly advantageous to find a loan that will allow you to close as early as possible before your employment contract begins and that allows you to push your payment out as far as possible after you close.  In past years you could find a home and write an offer in March and not close until June.  Now sellers are in control, so you need to be able to close quickly. That may be 60 days before you are scheduled to start your new employment contract. These loans do exist; make sure you are working with a physician mortgage specialist who will allow you to close based on your employment contract or offer letter.

Student Loans

Most mortgage loan officers and underwriters will not know what do with your student loans and how to calculate your payment.  I liken a resident’s student loan situation to being in “no man’s land”.  Student loans are currently deferred, but in most cases for less than 12 months.  They can’t be deferred again before you’ll need to buy a home and you don’t want to roll into Income Based Repayment (IBR) until after your 6 month stay of payments after graduation.

Be aware that the vast majority of lenders will tell you no, you don’t qualify for a mortgage, but there are those that will tell you yes.  You need to search them out.  Start by searching online for physician home loans and the state you are moving to.  (For example, physician home loans Oregon.)  [You can also check out the Doctor Mortgage Loan page here on the blog -ed]  Look for lenders who have have physician testimonials available and physician references you can call.

Another suggestion is to call your contact person at the residency program you are about to enter.  Explain your situation and ask if they know of a professional lender who specializes in helping physicians.

There are lenders who have solutions; you just need to find them.  Don’t make the mistake of working with a family member who does loans on the side or even your realtor’s referral if they don’t specialize in servicing relocating residents with student loan debt.

Limited or No Down Payment

Surviving college and medical school is challenging enough; saving a big down payment for your home at the same time is nearly impossible.

There are some areas and states that still have 100% financing options available, but most physician loan programs and areas will require 3-5% down payment.  Depending on your situation, make sure the loan program you are qualifying for can accept a gift from family, or be sure to have the money for down payment in your account 90 days prior to when you expect to close.  Underwriting will want to see a 60 day history of those funds and underwriting should occur 30 days prior to closing, so the funds must be in your account 90 days before closing.

If you have found a physician home loan specialist, they should have this low down payment product and be able to guide you through the documentation process.

I’m Sorry… Underwriting Declined Your Loan

This is not what you want to hear as you are driving a U-Haul from Cleveland to Arizona…  unfortunately, I get more calls from residents who are declined at the last minute than any other physician or client type (yes, I have received calls from clients in the moving truck).

Why does this happen?  Residents have more “moving pieces” to their loan file than do most clients.  They may or may not have any income or tax return history; they want to close before they have their first pay-stubs to document income; their student loans show zero payment but are about to come out of deferral; money for down payment is magically showing up in their bank accounts, etc., etc., etc.  At the end of the day, there is more complexity to a resident physician’s loan application than there is to almost any other type of client situation.

This may result in mental lapses from loan officers who have not thought it all the way through and way too many last minute declines by underwriters.

The solution is to get ALL of your documentation to the lender and ask for an underwriter to review and issue a credit approval as early as possible in your home buying process.  If you are working with a physician mortgage specialist, they should be gathering all of this data early and having it underwritten anyway.  If the mortgage specialist does not ask for all income, down payment and student loan info up front, there is a problem brewing.  Don’t be afraid to ask your lender about their pre-underwriting process and what lengths to which they go to ensure your loan is truly pre-approved and you won’t get surprised at the last minute by underwriting.

You can do it.  Home prices are still attractive in many areas of the country and with rates still below 4%, buying in many areas will be the same or less than rent.  Good luck!

What do you think?  Did you get a “physician mortgage?”  What problems did you run into with it?  Did you buy a home as a resident?  Were you happy you did so?  Comment below!

There is a very strange phenomenon I’ve noticed amongst 4th year medical students.  They have this seemingly overwhelming desire to buy a house.  I’m not sure if its the delayed gratification thing rearing its ugly head, or if it is some unwritten rule that once you own a house “you’ve made it.”  While everyone’s situation is different, and rules of thumb aren’t necessarily helpful, most residents probably shouldn’t buy a house.  I should have bought one, but only because I did a residency in Arizona during the housing bubble and would have sold just before it burst.  Some of my classmates doubled their money in 3 years.  That’s obviously not a situation that is going to be replicated any time soon.  The new interns who were buying houses when we were selling ours obviously took a shellacking when the bubble burst.  Here are 10 reasons why new interns should curb their housing fever.

1) You don’t have a down payment.

There are five benefits to using a down payment.  First, you protect yourself from swings in housing prices.   It costs approximately 10% of the value of a house to sell a house (6% commission, 1-2% to fix it up and 2-3% due to the house sitting empty for a couple of months.)  If you put 20% down, the value of the house can drop 10% or so before you’re underwater.  Many people are stuck living in or renting out their homes because they literally cannot afford to sell it.  You don’t want to be in that situation.  Second, the more money you put down, the more loan options and better interest rates you are offered.  There are a few lenders out there who do “Doctors Loans,” requiring little to no down payment, but just because someone is willing to lend you money without a down payment and without verifiable income (aside from a contract) doesn’t mean that loan is actually a good deal for you.  Third, a 20% down payment allows you to avoid private mortgage insurance, which doesn’t even help you. It is insurance your lender makes you buy to protect him.  Fourth, you may be able to avoid a higher rate “jumbo” loan by putting more money down.  Last, the more you put down, the smaller the principal and thus the smaller the mortgage payments, improving your future cash flow.

2) You don’t have any income

Traditionally, no one would loan you money until you had a steady job.  If you’re applying for a loan in April of your last year of med school, you’re unable to show any income.  If you were a lender, who would you offer a better deal to, someone with several months of steady income or someone who hasn’t made anything in years?  Again, this constrains your loan options and the fewer options you have, the more expensive your options will be.  “Doctors loans” are generally your only option, and depending on your state, you may only have one or two lenders to choose from.

3) You have tons of debt already

It is no longer uncommon for a graduating medical student to have $250K or more in relatively high interest student loans.  Residents usually already require a special government program like IBR to help lower their payments during residency.  It really isn’t a great time to be adding on even more debt, not to mention it is harder to get a loan with tons of debt hanging over your head, forcing you to choose between a handful of lenders willing to do “Doctors Loans.”

4) Residency is only 3-5 years long

Even realtors, the most diehard advocates for purchasing a home early and often, admit that it’s hard to break even on a home unless you’re in it for at least 3 years.  The main reason for this is transaction costs.  Expect to spend 5% of the value of a home when you buy it, and another 10% when you sell it.  This includes closing costs, the cost of fixing it up, furnishing it, realtor commissions, and a couple of months of the house sitting empty while you’re selling it.  In order to make up for those 15% in transaction costs, you’ll need to pay down the loan and the house will need to appreciate.  On a typical 30 year mortgage (4% fixed) bought with 0% down, you’ll pay down 5.5% of the mortgage in 3 years (9.5% in 5 years.)  That means you need the home to appreciate about 3% a year during residency just to break even.  If it doesn’t appreciate, or worse, goes down, you’re going to lose money.  Even if everything works out, and you spend 5 years in the home and it appreciates 3% a year, you’re looking a gain of only 9.5% of the value of the home.  That’s $14K on a $150K house and assumes that your monthly costs for principal, interest, taxes, insurance, and maintenance are equal to what the equivalent rent would be.  That’s hardly a huge sum of money worthy of all the risks and hassle you went through for 5 years.

5) You can rent a house

I always hear about how people are sick of living in an apartment and delaying gratification for their entire 20s.  People don’t seem to realize that you can usually rent a house that is just as nice as one you can buy.  Your choice isn’t between renting a tiny apartment and buying a big house.  Your choice is between renting the house you want to live in and buying the house you want to live in.

6) New home buyers underestimate the costs of ownership

Houses are expensive consumer items, not an investment. When the furnace or dishwasher breaks, you can’t just call the landlord to replace it.  Roofs, windows, flooring, carpet, and paint only last so long.  New buyers are also often surprised by the cost of property taxes and homeowners insurance, not to mention special hazard insurance like flood and earthquake insurance.   Don’t forget to add in the cost of furnishing the house also – drapes, rugs, and furniture.  It’s not a simple matter of comparing your rent payment to a mortgage payment.  Play around with the NYT Rent vs Buy calculator and you’ll quickly see what I mean.

7) You won’t want to live in that house as an attending

I counsel graduating residents to try to live like a resident for a while to get themselves set up on a solid financial footing, but the truth is that almost everyone upgrades their lifestyle at least a little upon residency graduation.  That 1400 square foot bungalow that seemed like a mansion compared to the 500 square foot apartment you had as a med student isn’t going to seem adequate when those attending-size paychecks start rolling in.  For most graduating residents, staying in your residency house isn’t even an option since you’re starting a job (or a fellowship) in another city.

8) Home maintenance costs either time or money

When you rent, much of your home maintenance will be taken care of by the landlord.  Fixing broken appliances, repairing leaky roofs or windows, cutting the lawn, or removing snow all costs either time or money, neither of which is abundant for a resident.  The less of this you have to worry about, the more time you can spend learning medicine and the more money you can use to stabilize your financial future.

9) Residents don’t get a tax break for owning a home

As an attending, I itemize my taxes and I’m in a high tax bracket.  I spent about $10K in mortgage interest and another $4K on property taxes last year, saving me something like $5K on my taxes.  Residents likely can’t afford a big enough house that the mortgage interest and property taxes are more than the standard deduction.  A resident likely only has a 15% marginal tax rate, decreasing the value of any deduction he would get.  Remember that part of the reason that people say you should own your home is for the tax benefits.  You don’t really get those as a resident.

10) Budgeting is easier as a renter

Living on a tight budget isn’t ever easy, but it is far easier to budget for a simple rent payment each month than it is to account for the myriad of variable expenses you’ll run into as a home owner.  As an attending, you replace an appliance out of your monthly earnings.  As a resident, you’d have to clean out your emergency fund to do the same thing.  You can also project your housing costs up front- exactly 36 months of rent for a 3 year residency as opposed to who knows how many repairs you’ll have to do and how many months it will take you to sell when you move on to your attending job.

Now don’t get me wrong.  Sometimes buying a house can work out just fine.  You might be in a situation where you can’t find anything acceptable to rent.  Buying will work out better for a longer residency than a shorter one, and if your spouse works too then you may even see some tax benefits from it.  It also seems like a decent time to buy in general with very low interest rates and housing much cheaper than it has been for years.  But for these 10 reasons, the default option for a resident should be to rent, not buy.

Since bond yields are at all time lows, should I buy high-yielding dividend stocks instead?

A.

I have been seeing various versions of this question on internet forums, comments sections, and various other blogs more and more lately.  Larry Swedroe has spoken out against this investing “technique” and I’d like to add my voice to the mix.

Stocks Aren’t Bonds

The first mistake I see people make is confusing a stock and a bond.  Remember that when you own a stock you own part of a business.  If the business does well, you do well.  If the business does poorly, you do poorly.  A bond, however, is a loan, whether made to a business or a government.  So long as that business or government remains sufficiently solvent to actually pay the loan back, the only thing that really affects its value is interest rates.  If the bond yields 4%, you get 4%, no matter if the business has a great year or if it just has a mediocre year.  If the US wins a war or takes gold at the Olympics treasuries don’t somehow give you a higher return.  Treating a stock yield like a bond yield is a rookie mistake.

Stocks, even “blue-chip”, “diversified”, “strong” stocks with a “decades long history of increasing their dividends”, are still subject to the risks of stocks, primarily the risk that the company will not make much money or that the stock market in general will go down, taking this stock with it.  Take GE for instance.  Surely you’ll agree this company isn’t going anywhere any time soon.  How much value did GE lose in the recent bear market?  80%.  Exxon?  40%.  Apple?  59%.  Johnson and Johnson?  33%.  Frankly, it doesn’t matter if it is yielding 3-4% when you could lose 1/3 to 4/5 of it at any given moment due to stock risk.

But Bonds Are Risky Now!

Those who suggest you should be investing in high-yield stocks instead of bonds also carry an irrational fear of bonds.  While I agree that returns going forward for bonds are likely to be rather disappointing at these yields, the fact is that if you keep your quality high and duration short that you won’t be taking any significant losses in your principal by investing in bonds.  Vanguard’s Total Bond Market fund has a duration of about 5 years.  That means if interest rates go up 1% (not just the short term interest rates the Fed controls, but all interest rates) then you’ll lose 5% of principal.  So let’s imagine a circumstance where interest rates go up 3% in a single year.  What would you lose?  About 15% of your principal.  That pales in comparison to the 33-80% losses you may take in high-yield stocks.  And when bond values drop, you now own an investment with a yield that is 3% higher than it was previously, and you’ll actually make up your losses in 5 years, and after that come out ahead.

When bond values go down due to rising interest rates, their yield goes up in a very predictable way.  When stock values go down, yield does go up, but not in a predictable way.  The stock value went down because the company isn’t worth as much as it was, and dividends are often cut.  In the recent bear market, 1092 companies cut their dividends.  So not only are you losing principal, you’ll losing income too.  When businesses do well, those who own them do well, whether their profits come in the form of dividends or capital gains.  When they do poorly, watch out!

Dividend Stocks Are The Most Expensive They’ve Been in 4 Decades

I love reading the Bridgeway annual reports.  John Montgomery always has some interesting insights.  In the most recent one, he writes this:

As many investors see money market rates near zero, or wonder what to do with the proceeds from maturing bonds, they look desperately for some extra yield, even a moderate amount. One place they have turned is high yield dividend paying stocks. While these stocks do provide some potential reduction of inflation risk, benefits from diversification (if owned along with fixed income and other asset classes), and the benefit of current income, Bridgeway’s investment team recently asked the question, “How cheap or expensive are these stocks?” The graph below provides an eye opening answer: On the basis of one measure of valuation, “price to book value”, they are the most expensive, relative to other stocks, we have seen at any time in our data history going back to 1972. On this measure, the price of these stocks has already been bid up on a relative basis. For the first time in at least four decades, high yield large cap stocks are actually more expensive than the broader market. Buyer Beware.

It’s a little hard to read I know, but basically the top line (at least the top line until the last year or two) is the Price to Book Value of the overall market, and the bottom line is the Price to Book Value of “high-yield” stocks.  You can see that in general, the high-yield stocks are the equivalent of value stocks, with P/B that is around 0.5 lower than the overall market.  During the tech stock bubble, the P/B of high-yield stocks was only 2.5, while the overall market ballooned to 4.5 prior to the crash.  Now, in the last two years, the P/B of high-yield stocks is actually LOWER than that of the overall market.  If that isn’t a high-yield stock bubble, I don’t know what is.

High Dividend Not The Best Of The Value Strategies

Now don’t get me wrong.  I like value stock investing and tilt my portfolio to both small and value.  But when analyzing various value strategies, it appears that a high dividend strategy may be the worst.  Rick Ferri recently posted a chart from the Ken French Library:

Basically, there are four value strategies, high earnings/price ratio (E/P), high book to market (BtM), high cash flow to price (CF/P) and high dividends (Div$).  Last year, BtM was the best, followed by E/P, then CF/P.  Using a high dividend strategy was the worst of the value strategies.  Larry Swedroe discusses the long-term data (also from French’s website) using data from 1952 to 2009 and found this:

Remember that a Sharpe ratio measures risk-adjusted returns- the higher the better.  The highest Sharpe Ratio was the P/CF ratio.  The highest earnings came with the low P/E ratio strategy.  The price to dividend ratio not only had the lowest return, but it had the lowest risk-adjusted return.  Now, I’m not sure which of the value strategies will be the best going forward, but I don’t think betting on the dividend strategy is very wise given past results and current valuations.

But I Invest For Income!

I meet a lot of people who purport to be income investors and don’t care about capital gains.  However, income and gains are essentially interchangeable.  Not enough income?  Sell a few shares.  Too much income?  Buy a few more shares or another property.  There are some tax effects that make capital gains superior to dividends and rents, but for the most part, it’s the same thing.  That’s why you need to be a total return investor.  I once had an investor tout an investment to me showing “It has an 8% yield!”  He wasn’t quite as impressed with that once I pointed out to him that over the last few years the value of his principal had gone down about 5% a year.  Pay attention to the total return, not just the dividend yield.  Yes, gains tend to be more volatile than income, but far too many income investors don’t realize until it’s too late that dividends get cut, rents stagnate, and vacancies happen.  Income is no sure thing.  Not to mention that the value of the asset producing the income fluctuates whether they care about it right now or not.

The Answer

If your investment policy calls for you to hold bonds, then buy bonds.  Stocks with high dividends are NOT bond substitutes.  If people like John Montgomery, Rick Ferri, and Larry Swedroe (all of whom know far more about investing than I ever will) are warning against this strategy, it would behoove you to pay attention.

What do you think?  Agree?  Disagree?  Sound off below!