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January, 2010:

The Spousal Benefit Option for Social Security Benefits

Jan 31st, 2010
by jblankenship.
2 comments

bride by cliff1066There is a provision in the Social Security system that many people don’t know much about – the spousal benefit.  This benefit is applicable when one spouse has had little or no working history, such as a stay at home mom or dad, and the other spouse has had a working career that has provided enough quarters of earnings to make him or her eligible for Social Security retirement benefits.

Note – to simplify the explanations, from this point forward we’ll refer to the lower-earning spouse as “spouse” and the higher-earning spouse as “worker”.

This benefit option allows the spouse to choose a potentially greater benefit than the one based on his or her own earnings record – equal to ½ of the benefit of the worker.  Specifically, if the spouse has earnings that represent a PIA (Primary Insurance Amount) that is less than ½ of the worker’s PIA, a spousal benefit amount is added to the spouse’s benefit to increase the amount of the benefit to ½ of the worker’s PIA.

So, if the spouse has a PIA of $1,100 and the worker has a PIA of $2,450, an amount would be added to the spouse’s benefit to increase the PIA to $1,225, ½ of the worker’s PIA.  The ½ benefit is provided if the spouse has filed for benefits at FRA (Full Retirement Age).  If filing for the spousal benefit at age 62, the spousal benefit will be equal to 35% of the worker’s PIA.  At any age after 62 but before FRA, the amount will be pro-rated.

Qualifications

There are several qualifications and factoids that you need to understand about the spousal benefit:

  • the spouse and the worker must have been married for at least 12 months (continuously) immediately prior to applying for benefits.
  • the spouse must be age 62 or older.
  • the worker must be eligible for benefits, meaning that the worker must file for benefits with Social Security.  The worker does not have to be actually collecting benefits, he or she could be utilizing the “file and suspend” option.
  • the spousal benefit does not include any credits that the worker may be eligible for upon delaying receipt of benefits, as the spousal benefit is based upon the worker’s PIA, not the actual benefit the worker may receive.
  • there is no increase in spousal benefit by delaying application after FRA of the spouse.
  • if the spouse has reached FRA and would like to delay receiving his or her own retirement benefit, the full spousal benefit will be available to the spouse until he or she files for his or her own benefit.
  • if the spouse continues to work while receiving benefits, the same earnings limits apply to the spousal benefits as would apply to primary worker benefits.
Photo by cliff1066™

Where to Get Your Annual Credit Report

Jan 29th, 2010
by jblankenship.
5 comments

credit card theft by Don HankinsAs a smart consumer, you have likely heard that it’s a good idea to get your credit report every year from all three services: Experian, Equifax, and TransUnion.  You’ve probably also seen the ever-present “Free Credit Report” commercials on the television (unless you TiVo everything and skip past the commercials!) – so you may be wondering:  is that the place to go to get the credit reports?

While the service in the commercials will likely provide you with the reports you need, since that service is a “for profit” venture, you’re also likely to get more than you bargained for along with your reports.  There are a lot of add-ons that can mysteriously show up, like hidden fees, credit score monitoring, identity theft protection, etc., all of dubious benefit.

The Real Answer

The ONLY authorized source for requesting your credit reports from all three agencies FOR FREE, with no strings attached, is at www.AnnualCreditReport.com.  This source was set up jointly by the three credit reporting agencies in response to the Fair Credit Reporting Act.

Via this service, which can also be contacted by phone at 877-322-8228, or by mail (see the website for the form and address), you are allowed to request your credit report from each agency once every 12 months at no cost.

I have found that the mail option, while decidedly low-tech, is the most pain-free option.  Navigating the online system can get a bit frustrating, especially if you’ve changed addresses somewhat frequently within the previous ten years, since mailing address is one of the important identifying factors.  Unless the system has greatly improved of late, it can cause you some grief.  I have to admit that it has been a few years since I tried to utilize the online order option, though.

The Report

The report you receive will be very detailed regarding your credit history, payment history, and any actions taken with regard to your credit.  It is important to review this information to ensure that it is accurate – if any errors are located, you need to work out resolving those errors with the credit agency and the creditor in question.

You will not, as a rule, receive your credit score when you make this request for your credit report.  The credit score is a separate mathematical ranking of your credit, and this can be purchased from the agencies for a small fee (typically less than $20) when you make your request for the credit report.  If you’re concerned about your score and have not had reason to receive your score in another fashion (such as getting a mortgage), it might make sense to do so, but it’s not a requirement by any means.

Timing of Your Request

Since you have three agencies to work with and 12 months between reports, you have a decision to make:  should you request all three at the same time, or intersperse them throughout the year?

I suppose it really comes down to your situation – if you have a potential credit problem to resolve, I’d suggest getting all three at once, then you can compare them side-by-side as you work out any problems or inconsistencies.

On the other hand if you’re just in a maintenance mode, that is, you don’t anticipate any issues with the report, you might want to set up a schedule and request a report from a different agency every four months.  This way you can constantly monitor your credit to ensure that nothing funky is going on.

Just make sure that you use www.AnnualCreditReport.com, rather than the other, more publicized options.  You’ll be glad you did.

Photo by Don Hankins

Roth Conversion Timing Where After-Tax Contributions Are Involved

Jan 27th, 2010
by jblankenship.
2 comments

time reloaded by lrargerichYet another point that you need to keep in mind as you plan your Roth IRA conversion strategy is the timing of the activities.  This is especially true when you have after-tax contributions to your IRAs in addition to the growth on those contributions and the typical deductible contributions.  As you’ll see below, in some circumstances it can make a big difference in how much tax you’ll have to pay…

Timing Examples

Example 1. You have an IRA worth $100,000, of which $50,000 is after-tax contributions, $20,000 is deductible contributions, and $30,000 is growth on your contributions.  This is the only IRA that you own (which is a key fact, since the IRS considers all IRAs in a lump when determining the taxability of distributions).

Have decided that you’d like to convert $40,000 to a Roth IRA.  When you do so, half of the amount converted ($20,000) will be taxable and the other half non-taxed, since you have after-tax contributions amounting to $50,000 of the total account value of $100,000.

Simple enough, right?  Okay, let’s complicate it…

Example 2. Same circumstances as in Example 1, except that you also have a 401(k) plan worth $100,000, all deductible contributions – and you’ve just retired.  You decide at your retirement that you’d like to rollover the 401(k) to an IRA – you never liked the restrictive investment options available in that old 401(k) plan anyhow.

As in the first example, you want to convert $40,000 to a Roth IRA this year.  (Here comes the timing part)

IF you convert the $40,000 to your IRA BEFORE you rollover the 401(k), you will only be taxed on $20,000 of the conversion, just like example 1.

HOWEVER (and there’s always a however in life, don’t ya know) – if you rollover the 401(k) first and then convert the $40,000 to Roth, you will be taxed on $30,000 of the conversion.  This is because, now that you’ve rolled over the 401(k) plan, you have IRAs worth $200,000, of which only 25%, or $50,000 is after-tax contributions… therefore, only 25% of the conversion distribution is tax-free, and the remaining 75%, or $30,000, is taxable.

So – there you have it.  Timing is very important indeed…

Photo by lrargerich

Calculating the Social Security Retirement Benefit

Jan 25th, 2010
by jblankenship.
2 comments

social security lips by Aric RileyThere are three factors that go into determining the Social Security retirement benefit amount – your PIA (Primary Insurance Amount), your FRA (Full Retirement Age), and the age you are when you start receiving benefits.  We talked about the PIA here; then we talked about the FRA here.  Having these two numbers, we need to consider if you are applying for early benefits, and therefore a reduced amount, or if you’re delaying receipt of benefits to increase the payment amount.

Applying Early for Reduced Benefit Amount

When you apply early (before your FRA), a formula goes into effect to determine how much your benefit will be reduced.  First, determine how many months there are between your FRA and the age at which you’ll start receiving benefits.  The PIA will be reduced by a percentage based upon the number of months you come up with.  The first 36 months are multiplied by 5/9 of 1%, and any months beyond 36 are multiplied by 5/12 of 1%.

So, if your FRA is age 66, and you intend to begin receiving benefits in the month that you are age 62 and 6 months, your PIA would be reduced by 20% for the first 36 months (36 * 5/9% = 20%) plus an additional 2½% for the remaining 6 months (6 * 5/12% = 2½%) for a total of 22½%.  The maximum amount that the PIA can be reduced is 25% for folks with FRA of age 66, ranging up to 30% for those with FRA of age 67.

When you come up with this reduction factor, it is then applied to your PIA, and the result is your anticipated benefit amount.  You can see in the table below how waiting a few months or years can make a big difference to the benefit amount.  And this change can have a huge impact on your lifetime benefits – because once you start receiving your benefit, it won’t change other than with the annual COLA increases – unless you continue to work while receiving benefits, which could increase your PIA.  The other way to increase your benefit is to take the “do over” – described here.

Delaying Receipt of Benefits to Increase the Amount

If you are delaying your retirement beyond FRA, you’ll increase the amount of benefit that you are eligible to receive.  Depending upon your year of birth, this amount will be between 7% and 8% per year that you delay receiving benefits – which can be an increase of as much as 32½% if you delay until age 70 and you were born in 1941 – when your FRA is 65 years and 8 months, and the increase amount is 7½% per year at that age.  See the table below for the increase amounts per year based upon birth year:

Birth Year FRA Delay Credit Minimum
(age 62)		 Maximum
(age 70)
1940 65 & 6 mos 7% 77½% 131½%
1941 65 & 8 mos 7½% 76?% 132½%
1942 65 & 10 mos 7½% 75 5/6% 131¼%
1943-1954 66 8% 75% 132%
1955 66 & 2 mos 8% 74 1/6% 130?%
1956 66 & 4 mos 8% 73?% 129?%
1957 66 & 6 mos 8% 72½% 128%
1958 66 & 8 mos 8% 71?% 126?%
1959 66 & 10 mos 8% 70 5/6% 125?%
1960 & later 67 8% 70% 124%

So you can see the impact of delaying receipt of retirement benefits – it can amount to more than 50% of the PIA, when you consider early benefits versus late benefits.  Of course, by taking benefits later, you’re foregoing receipt of some monthly benefit payments; given this, early in the game you’d be ahead in terms of total benefit received.  This tends to go away as the break-even point is reached in your mid-70′s to early-80′s in most cases, which we’ll review in a later article.

Photo by Aric Riley

Things to Consider as You Set Up a SOSEPP

Jan 23rd, 2010
by jblankenship.
2 comments

water bottle caps by Incase DesignsSo, you’ve decided that you’d like to begin taking distributions from your IRA funds – and you’re under age 59½, so you need to structure your distributions as a Series of Substantially Equal Periodic Payments (SOSEPP).  (For more background information on the SOSEPP, see this article.) It is important to do this right, because once you set up the plan, you’re pretty much stuck with it.

Steps to Set Up a SOSEPP

The first step in setting up a SOSEPP is to figure out just how much you’ll need to take each year.  In the best of all circumstances, your SOSEPP plan will take small enough payments that it will not exhaust your IRA funds… Working with a financial advisor or an actuary, you can figure out how much money is required to support the SOSEPP payments that you require.

Once an amount is determined, a new IRA can be opened and the money required rolled over into that account.  Other IRAs and 401(k) accounts will then hold the remainder of your funds – which provides your savings for future needs, once the SOSEPP is no longer in effect, or a “safety valve” for you to use in the event that you need additional funds at some point.  Of course, taking an additional amount from one of these other accounts would require payment of the 10% penalty (unless one of the other exceptions applies) – but this is much better than taking too much from your SOSEPP IRA and busting the plan, which carries some heavy penalties.

Keep in mind, especially if you’re setting up your SOSEPP early in your life, it will be possible to set up another SOSEPP from a different account should the need arise.  You would just have two series’ going on at the same time, with different variables impacting each series.

In other cases, you may just want to take the greatest possible payment that you can from your collective plans, which can be easily determined when the span of the plan is understood, given your age and the amount in the IRAs.

Several choices are necessary to set up the plan:

  • Choose one of the three permitted methods – RMD, amortization, or annuitization
  • Choose a life expectancy table – single, joint, or uniform life expectancy
  • Choose an interest rate (if using amortization or annuitization)
  • Decide whether to use annual recalculation (if using amortization or annuitization)
  • Choose the account balance valuation date
  • Determine the “period” for your payments.  These can be monthly, quarterly or annually, but must at least be annual, and must be at the same regular interval each “period” once set up.

All of these details must be attended to when setting up the plan, and careful attention should be paid when making these decisions.  If you set up such a plan early in your life (say at age 50 or earlier) you will have to live with your choices for a considerable amount of time.  Understand what each choice means and can mean in the future as you make these decisions.

For more information on the SOSEPP – including all of the methods, the life expectancy tables, and all of the other details, see the IRA Owner’s Manual.

Photo by Incase Designs

First Time Homebuyers: No (eFile) Soup For You!

Jan 21st, 2010
by jblankenship.
2 comments

soup_naziIf you’re planning to take advantage of the First-Time Homebuyer’s tax credit or the more recently announced “long-time homeowner new purchaser” credit – you will not be eligible to eFile your tax return when you claim the credit.  To find out more about these credits, see the article at this link.

In a move to reduce fraudulent claims, the IRS recently decided that in order to claim this credit, proof of the purchase of the new home must be attached to the return with form 5405 and the entire return must be paper-filed.

This will likely add at least a week to the processing time, and likely much more as the filing season progresses.  So if you’re claiming this credit, keep in mind that your turnaround for your refund will be extended specifically because of this credit.  I’m sure it will be worth the wait!

Social Security Bend Points Explained

Jan 19th, 2010
by jblankenship.
2 comments

i love deep blue by JennyHuangOkay, you’ve probably already guessed that this has nothing to do with deep-sea diving, but I’m pretty sure I would have disappointed my seven loyal fans readers (okay, it’s really more like two or three – Hi, Mom!) if I hadn’t made the pun.  Bend points are the portions of your average income (Average Indexed Monthly Earnings – AIME) in specific dollar amounts that are indexed each year, based upon an obscure table called the Average Wage Index (AWI) Series.  They’re called bend points because they represent points on a graph of your AIME graphed by inclusion in calculating the PIA.

If you’re interested in how Bend Points are used, you can see the article on Primary Insurance Amount, or PIA.  Here, however, we’ll go over how Bend Points are calculated each year.  To understand this calculation, you need to go back to 1979, the year of the Three Mile Island disaster, the introduction of the compact disc and the Iranian hostage crisis.  According to the AWI Series, in 1979 the Social Security Administration placed the AWI figure for 1977 at $9,779.44 – AWI figures are always two years in arrears, so for example, the AWI figure used to determine the 2010 bend points is from 2008.

With the AWI figure for 1977, it was determined that the first bend point for 1979 would be set at $180, and the second bend point at $1,085.  I’m not sure how these first figures were calculated – it’s safe to assume that they are part of an indexing formula set forth quite a while ago.  At any rate, now that we know these two numbers, we can jump back to 2008’s AWI Series figure, which is $41,334.97.  It all becomes a matter of a formula now:

Current year’s AWI Series divided by 1977’s AWI figure, times the bend points for 1979 equals your current year bend points

So here is the math for 2010’s bend points:

$41,334.97 / $9779.44 = 4.2267

4.2267 * $180 = $760.81, which is rounded up to $761 – the first bend point

4.2267 * $1,085 = $4,585.96, rounded to $4,586 – the second bend point

And that’s all there is to it.  Hope this helps you understand the bend points a little better.

Photo by JennyHuang

Social Security’s PIA – What is this?

Jan 19th, 2010
by jblankenship.
8 comments

peoria il by kla4067If you’ve ever looked at the information about Social Security retirement benefits, you’ve likely come across a figure called the Primary Insurance Amount, or PIA.  So just what is PIA? I mean, besides the airport designation for the General Wayne A. Downing Peoria (IL) International Airport?

Primary Insurance Amount

The Primary Insurance Amount (PIA) is the projected amount of Social Security retirement benefits that you will receive upon reaching Full Retirement Age – FRA, in Social Security Administration parlance.  (see this article for information about determining your FRA).

The PIA is one of the factors used in determining the actual amount of your retirement benefit – the other factor being the date (or rather your age) when you elect to begin receiving retirement benefits.

So, how is PIA calculated?

In true government style, this calculation can be pretty convoluted.  You start off with your Average Indexed Monthly Earnings (AIME – which we defined here).  Then, hold onto your hat, because it gets hairy from here:

  • the first $761 of your AIME is multiplied by 90%
  • the amount between $761 and $4,586 is multiplied by 32%
  • any amount in excess of $4,586 is multiplied by 15%

Note: these are the figures for 2010.  The figures used (referred to as “bend points”) are based upon the year when the retiree is first eligible to claim benefits – at age 62.

So let’s work through a couple of examples:

Our first retiree is age 62 in 2010, and is hoping to begin taking Social Security benefits immediately upon eligibility – to get what’s coming to her.  Her AIME has been calculated as $6,500.  Applying the formula, we get the following:

  • first bend point: $684.90 ($761 * 90%)
  • second bend point: $1,224 ($4,586 – $761 = $3,825 * 32%)
  • excess: $287.10 ($6,500 – $4,586 = $1,914 * 15%)
  • For a total PIA of: $2,196 ($684.90 + $1,224 + $287.10)

The second example retiree also is age 62 in 2010.  His AIME has been calculated as $4,000.  Applying the formula:

  • first bend point: $684.90
  • second bend point: $1,036.48 ($4,000 – $761 = $3,239 * 32%)
  • excess: $0
  • For a total PIA of: $1,721.30 ($684.90 + $1,036.48)

You should note that the PIA is always rounded down to the next multiple of $0.10 – otherwise in the second example the PIA would have been $1,721.38.

… And that’s just the start!

Once your PIA is calculated, it doesn’t just sit there like the boring number that it is.  Each year, your PIA will adjust, according to the annual Cost of Living Adjustment, as well as any additional (increased) earning years that may impact your AIME.  Plus, your PIA is only the basis of your Social Security retirement benefit calculation:  the age that you begin taking the payment of retirement benefits is taken into the equation as well, which you’ll see in the Retirement Benefit Calculation article.

Photo by kla4067

The Dreaded “Double Tax” on IRAs

Jan 17th, 2010
by jblankenship.
1 comment

double delight by audreyjm529Chances are, if you hold a significant amount of money in your IRA accounts, you may have been approached by a financial professional who tells you about the “double tax” that may be a part of your account’s future.  Here’s a brief explanation:  when the owner of an IRA dies, assuming that the size of the estate is greater than the exclusion amount (which is a dicey question in 2010’s “limbo” for estate taxes – see below for the 2010 and 2011 specific explanations), your estate will have to pay tax on any amount above the exclusion.  Presumably this includes your IRA account… and THEN, when your heirs begin taking their Required Minimum Distributions from the IRA account, they will have to pay ordinary income tax on the amounts that are distributed.  Hence the term double tax.

It’s a real situation that could happen – you should be aware of it, if you happen to be in that position… and you should also be wary of any financial professional who claims that you can avoid the double tax by taking your money out of the IRA.  Typically this pitch is designed to sell you an immediate annuity or some other form of annuity product.  The problem is, pulling the money out of the IRA does nothing to eliminate the double tax.

In fact, what this does is to accelerate the process and cause you to pay one part (the ordinary income tax) on the distribution up front.  Plus, this is usually pitched as a lump sum maneuver, which increases your taxable income and thereby increases the rate at which your distribution is taxed.  Clearly, if someone tells you that pulling all your money out of your IRA will avoid the double tax situation, you should walk away and don’t look back.

Instead, if this double tax is a concern for you – that is, if your estate is large enough to be impacted by this – it makes good sense to review the entire potential estate and consider planning out your distributions to your heirs.  A gifting plan, along with appropriate trust mechanisms, can possibly reduce your gross estate below the exclusion level.  This could have the effect of eliminating any double taxation issues in advance, and is truly the only way to possibly avoid the dreaded double tax.

2010-Specific Situation

As the law is presently in force, there is no estate tax for 2010.  Because of this, the double tax situation doesn’t apply.  At the death of an IRA owner, the IRA begins distributing to the heirs as required (see this article for more information), but no estate tax is owed on any part of the estate.  The “step-up” or basis carryover provisions do not apply to IRAs, other than the basis referring to any part of the IRA assets that were attributable to after-tax, non-deducted contributions or rollovers.

It’s possible that the law may be changed soon, and possibly changed retroactive to the first of the year, so stay tuned…

2011 and beyond

As the law is presently written, beginning in 2011 the estate tax exclusion is $1 million, and step-up of basis is back in force.  Again, if the funds are in an IRA, there is no step-up, although as noted before, basis of after-tax contributions and rollovers remains intact.

So if your estate has the opportunity to be greater than $1 million in value, any amounts above that exclusion amount will be subject to estate tax.  If those assets that are above the exclusion amount include your IRA, then your heirs will also have to pay ordinary income tax on the distributions – effectively paying tax again on the same money, the double tax.

As you can see, with the 2011 law, it doesn’t take long to have an estate that is possibly impacted by this double taxation situation, so it would likely make sense to review your overall estate plan and determine if there is a way to avoid the tax on some part of your estate.

Photo by audreyjm529

Bonds and Bond Funds

Jan 15th, 2010
by jblankenship.
No comments yet

james bond street by Dan ZenThere is a question that often comes up when discussing investment strategies, especially for an astute investor who has done some research on various kinds of investments.  Specifically the question often is: why would we choose a bond fund or a bond index fund versus purchasing a specific bond (or several bonds)?

Bonds in General

To answer the question, we have to start with a basic understanding of bonds in general.  A bond is a loan – either to a corporation, the US government (or a foreign government), a state, or a municipality, among others.  For this loan there are very specific terms, which include:  maturity of the bond (how long it exists), the coupon rate (what amount of income it provides), whether the bond is “callable” – meaning, if circumstances change and the issuer wants to pay off your bond early, is that allowed?

If you had a bond with a corporation that was worth $1,000, had a maturity of 30 years, and pays you $60 every year, your yield is 6% ($60 divided by $1,000).  Here’s where it starts to get complicated though:  when you purchased the bond, you likely didn’t purchase it for $1,000 – the purchase price is discounted due to the fact that you won’t get your money back for 30 years, so the price might have been something like $900.

If nothing changes, you will receive your annual $60 payment for the next 30 years, and then you’ll receive the $1,000 value of the bond.  However (and there’s always a however in life, right?), if you decided after 15 years that you wanted to get your money out of the bond, you would sell it on the secondary market – but not likely for $1,000, or even for the $900 that you paid.  If nothing else has changed (current rates are the same, credit risk of the corporation is the same, etc.) then this bond is likely worth somewhere between your purchase price and the redemption value of $1,000.

If other things have changed, this bond could be worth much more than the $1,000 or much less than the $900 that you paid.  Let’s say that interest rates had dropped off for new issues of similar bonds to 3%.  Obviously your locked-in 6% is worth much more to a new investor coming to the market, so your bond might bring $1,100.  Vice versa is true if rates had climbed – your bond could be worth less than you paid for it.  In either case, if you don’t sell the bond, at maturity it will still be worth $1,000, the face value.

Likewise, if the company that issued the bond was facing hard times and their creditworthiness was in question, the value of the bond would decrease to reflect this situation, and vice versa if things had improved for them.

Adding to this, if the bond happens to be callable (which most are), if a situation arose wherein the company could obtain loans at a more favorable rate after, say, 18 months of your purchase, they would pay you the value of the bond and end your loan with them.  This would leave you having to purchase another bond at the new, prevailing lower rates.

Bond Funds

So, armed with the knowledge of individual bonds, we can now define a bond fund.  A bond fund is an investment vehicle that owns many bonds.  There are many types of bond funds, some defined by the maturity (or duration, a term related to maturity), some defined by creditworthiness of the bond issuers, and others defined by the governmental entity that issues the bonds.  We won’t get into specifically discussing all these types of funds at present, just suffice it to say that all of these types (and many more) exist.

Since a bond fund holds many bonds, the result that the bond fund receives is the aggregate of all of the bonds it is holding.  So, if the majority of the bonds in the fund are experiencing price increases (perhaps due to a market-wide decrease in rates for new bonds), then the price of the fund will increase.  If nothing changes, the yield for the fund (in dollar terms) will remain the same.

But bond mutual fund managers are constantly buying and selling their holdings.  One bond may show a hefty increase in value, prompting the manager to sell it for a gain, replacing it with a less-costly bond that achieves a similar yield.  Or maybe the manager is looking to the future and believes that a particular bond’s value could increase due to circumstances that will improve the creditworthiness of the issuer, and so the manager might purchase that bond.

All this buying and selling make the contents of a bond fund fluctuate quite a bit over time, but the manager always pays close attention to the price of shares in his fund – if not enough new money is flowing into the fund to maintain the present price level, the manager may take some moves with his holdings that have the effect of keeping his fund’s price stable or growing slightly.  If a major event occurred that the manager didn’t foresee, such as a dramatic market-wide increase in rates for new bonds, the price value of his fund could drop – or vice versa for a drop in rates for new bonds.

Bond managers are always managing their fund to maintain a stable price level and yield, but they can’t always make the right decisions.  Sometimes the value of a fund will drop off because the manager misinterpreted some signal on the forefront, or a major holding in the fund declines in creditworthiness.

bail bonds by harry by rioncmBond Index Funds

Bond index funds aren’t managed actively, but rather (like all index funds) they track a specific index, and as such hold bonds representative of that index.  When the index’s makeup changes (bonds are added or removed), the index automatically makes those changes.  This takes the decision-making process out of the fund, so a fund manager won’t make a mistake (or a big winner) decision that results in a dramatic drop-off in value (or a dramatic rise in value).

So, if you are holding a bond index that always invests in medium-term bonds (maturity of 5-7 years), the bonds in the index will be constantly changing as bonds mature and new bonds are added to the mix.  But in general you’ll experience much less volatility with the index fund, as you are taking that “forecasting” risk out of the picture.

An example of the “steadiness” or lack of volatility in a bond index can be seen with the Vanguard Total Bond Market Index (VBMFX).  Over the 23-plus years of this index fund’s existence, the price has fluctuated from a low of $8.92 (the only time this fund was ever below $9, in 1987) to a recent high of $10.43.  In general this fund fluctuates approximately 25 to 30 cents on either side of the $10 range, while providing a steady 5% to 6% yield annualized over the past 10 years.

Risks Associated with Bonds

Credit Risk. The issuing entity, whether it’s a corporation or a governmental entity, brings the risk that they could go bankrupt.  With governmental entities this is less common, but it still occurs… and actually going bankrupt isn’t the whole risk, either.  As the ratings agencies (Moody’s and Standard & Poors, primarily) review the issuing entity’s results and earnings forecasts, the rating of the bond can be changed.  As this changes, the value of the bond may decrease or increase, depending upon which way the rating changed.

Interest Rate Risk. I mentioned this earlier, but this is the situation where the bond you hold has a rate of, for example, 5%, and the rates on new bonds is higher, perhaps 6%.  This would cause the value of the bond you’re holding to drop.  This isn’t a problem if you plan to hold the bond to maturity, but if you need to cash it in early, you might lose money on the deal.  Of course, on the other end of the spectrum, if the rates on new bonds decreased to 4%, your bond would be worth more if you cashed it in.  But again, this situation would subject your bond to be called by the issuer, leaving you in a lurch with no bond.

Inflation Risk. This is similar to interest rate risk, except that this is where general economic growth might cause the value of your bond to decrease.  If inflation picked up to a point where your bond was only just keeping pace with inflation (such as a 4% bond and inflation at 4%), then of course new bonds being issued would have a higher rate, and as such your bond’s value would drop.  Again, not a problem if you’re holding the bond to maturity, but would be a problem if you needed to cash it in early.

Characteristics of Bonds, Bond Funds, and Bond Index Funds

The chart below describes the major characteristics of individual bonds, managed bond funds, and bond index funds.  Hopefully this will help you to understand the benefits of one type of bond investing versus the others for your individual situation.

Individual Bonds Managed Bond Fund Index Bond Fund
Maturity Definite.  Individual bonds have a specific maturity date when you will receive the face value of the bond. Indefinite.  The fund will indicate an average maturity of all bonds held in the fund, but there is no specific maturity date.The benefit is that your fund will always have the same average maturity, whereas a bond’s maturity is always declining.
Holdings Known – you should be able to list out your individual bond holdings at any time. Generally known but a specific list of bonds held at any point in time is not available. The index is generally available and the holdings can be listed.
Volatility May have significant fluctuation in price over the life of the bond, although value at maturity is always known. Generally less volatile than stocks but depending upon maturities and interest rate fluctuations, can have some volatility. Minimal volatility as compared to Managed Bond funds.
Liquidity Generally liquid (depends upon the bond) but may have to accept a much lower value than face value, or delay liquidation to maturity. Very liquid, with a ready market.
Income Regular, known quantity coupon payments are made on a semi-annual basis. Interest income may fluctuate with changes to the underlying portfolio. However, bond funds generally make interest payments on a monthly basis, rather than semiannually (as with individual bonds).
Diversification Must purchase many diversified bonds to achieve diversification. Diversification is achieved via the ownership of the fund, as well as by owning more than one fund with different classifications. (see Entry Point for additional information)
Entry Point Individual bonds are generally priced at $1,000, however, many brokerages have minimums for purchase of $10,000 or greater. Most funds have very low entry points, often between $1,000 and $3,000. Same as Managed Funds, although ETFs can lower the entry point even more.
Default Risk This will vary by the credit quality of the bond. Varies by credit quality of the class of bonds in the fund, but limited by diversification.
Interest Rate Risk Exists but declines as bond nears maturity. Exists and sensitivity to interest rates depends on portfolio of holdings.
Expenses Purchase and sale will involve sales charges that are typically hidden in the purchase/sale transaction; no maintenance or annual costs. Annual fees are present, and may have front-end or back-end sales charges. Annual fees are present but usually lower than Managed Funds. Sales charges are not typical.
Management An individual bond will not have an inherent professional manager. You may hire a professional manager to help you manage a portfolio of bonds. Active professional management. Passively managed.
Reinvestment No reinvestment of dividends. Reinvestment is usually a feature of these funds. Reinvestment is usually a feature of these funds. ETFs do not typically include a reinvestment feature.

a fan of savings by allyrose18The Bottom Line

So, we started this discussion to answer a question: why would you choose a bond fund or an index bond fund over investing in an individual bond? Hopefully discussion above has helped you to understand the benefits of one type of investment over another. The bottom line for me is – unless you have a pretty large sum of money to invest in bonds, in excess of a couple hundred thousand dollars, it costs an awful lot of time and money to build, diversify, and manage a portfolio of individual bonds. There is one important overriding factor that may cause some wary investors to choose individual bonds: the principal guarantee at maturity.

The convenience of mutual funds for their low entry point, instant diversification, reinvestment of dividends, and moderately stable value makes the choice pretty simple for most folks. Managing individual bonds is cumbersome, can be costly, and can cause liquidity problems (depending upon the term of the bonds).

Indexed bond funds reduce the volatility associated with managed bond funds, plus they generally have the lowest overall cost structure of all options out there (especially ETFs). It is for this reason that index bond funds are the overall best choice for most investors, and therefore index funds and ETFs are the bond investment option that I most often recommend.

Photo 1 by Dan Zen

Photo 2 by rioncm

Photo 3 by allyrose18
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