I was honored to speak alongside some industry heavyweights at AAII’s 2021 virtual conference. My topic was Using Income Annuities in Retirement. Here is a link to my (hour long!) presentation: https://lnkd.in/ehxXxScQ
Note: For those who are interested, I provided a link to the conference in the YouTube video description.
Readers interested in this topic may also want to read my other articles on annuities and income:
I spent some time on Google, but could not ascertain the origins of the term fixed income. Presumably, it was just a simple description given to investments where all of the related cash flows were dictated per contractual obligation. For example, this could be something as simple as a government bond that pays fixed coupons and returns the principal at maturity. However, the term fixed income has now come to describe pretty much any investment obligated to pay a pre-specified stream of cash flows – some of which are more complex (e.g., mortgage-backed securities).
Brushing some details under the rug (e.g., some bonds can be called), fixed income investments effectively allow investors to purchase future cash flows with a high degree of certainty.[1] However, it is important to note this degree of certainty only applies when the investments are held to maturity.
If an investment is sold before it matures, the sales proceeds will naturally be at the mercy of the market. Other investors will take into account the remainder of the cash flows to be paid and discount them via relevant interest rates. Thus, in the case where fixed income investments are not held to maturity, much of the certainty can be lost.
Without doubt, the high turnover of many bond funds can naturally destroy this essence of fixed income. Moreover, advocates of total return investing also seem to disregard the inherent stability of contractual cash flows as they put portfolio income right back into the market even when the ultimate goal is income.
This article attempts to restore this sanctity of fixed income. In particular, I advocate for the design and utilization of fixed cash flows in the context of asset-liability management (ALM) – thereby mitigating, if not avoiding, market volatility. While relevant to other investment mandates (e.g., private foundations with cash flow liabilities), I discuss this notion in the context of retirement income.
I use bond ladders and income annuities to highlight some potential benefits of this approach. In addition to potential cost and tax savings, the math behind this approach (i.e., time value of money) is much simpler than many of the statistical models used for portfolio management. Accordingly, I believe this approach can facilitate greater understanding and peace of mind for many investors. Retirement income is one natural application for this strategy. However, it can also be helpful in estate planning for blended families and other situations where one wishes to manage multiple beneficiaries’ claims to income and principal.
Note: Readers interested in this topic may also like to read an earlier article I wrote (Destroying Stable Income Streams) that focuses on a similar topic, but primarily in the context of dividends.
| Figure 1: 10-year bond cash flows vs IEF price[2]
Source: Aaron Brask Capital |
Figure 2: Dividend cash flows vs market price (VIG)
|
|---|
| Note: This article focuses on the context of retirement income, but it is worth noting the ideas are also relevant to other investment applications where one is tasked with addressing liabilities in the form of future outgoing cash flows (e.g., pensions, endowments, private foundations, etc.). |
|---|
When it comes to investment strategies for retirement (and almost any other application), most individual and professional practitioners have adopted an approach based on total return investing and modern portfolio theory (MPT). So the natural income from the portfolio (e.g., dividends and interest) is typically reinvested and income required for spending is chiseled off from the portfolio as needed.
Portfolio volatility presents a risk as it can jeopardize one’s financial security in retirement by increasing the probability of running out of money (i.e., potentially less money to chisel from). For example, retirees may still need to withdraw from their portfolios during market declines and this would result in forced selling at depressed prices. Of course, conservative financial planning should allow for such situations and be able to withstand such scenarios.
This typically results in constructing a diversified portfolio that will offer an attractive balance of growth potential and risk. If we confine ourselves to a world with just stocks and bonds (for the sake of simplicity), then the idea would be for stocks to generate sufficient long term growth to help combat inflation or generate real returns[3] while bonds might be regarded as a diversifying asset. As long as the bond allocation keeps up with inflation and tends to zig when stocks zag, many investors are content to maintain significant bond allocations in order to balance risk in their portfolios.
| Side note: Why do bonds typically exhibit lower returns and less volatility than stocks?
On the one hand, stocks are effectively perpetual securities and their dividends are not guaranteed. On the other hand, bonds ultimately mature and offer contractually guaranteed cash flows. Put simply, bonds offer more certainty than stocks. Thus, it is unsurprising stock prices tend to be more volatile than bond prices and investors label bonds as the safer investment. Investment theory indicates higher returns are the reward for higher risk – assuming that risk is systemic and cannot be diversified away. In the US, this has certainly been the case historically with stocks handily outperforming bonds over the long run. So conventional wisdom holds that stocks should have higher expected returns than bonds over longer periods since they are more volatile. This risk-based argument is presented from the investor’s perspective. What is less discussed is the flipside: the issuer perspective. That is, what about the perspective of the corporate or government issuers of securities? Let us take a corporation seeking to raise capital as an example. From their vantage point, issuing equity can be attractive in the sense that it does not impose any contractual payments (dividends, if any, can be skipped). However, if they issue a bond, then they will be obligated to make interest payments and repay the principal at maturity. In this light, issuing equity imposes less financial constraint and may be viewed as a favorable option. Accordingly, they may be encouraged to issue equity rather than bonds. In turn, this could tip the scales of supply in demand in such a way to make stocks cheaper and more conducive to higher returns. |
The bottom line is that market risk is critical in the context of retirement planning. So the lower volatility and low to negative correlations with stocks can make bonds useful in maintaining a diversified portfolio. However, viewing bonds only through the lens of market prices ignores the inherent stability they can provide in terms of generating specific cash flows with little to no uncertainty[4] (i.e., the same attribute that likely makes them less volatile).
Let us take a step back and look at the bigger picture. Consider a retiree who wants to ensure their portfolio will provide adequate income as long as they may live. A portion of this income will likely come from their fixed income allocation. So they purchase bonds or bond funds, but only to observe them as squiggly lines on charts that may later be converted to cash. In other words, they purchase future streams of cash that could be used for retirement spending, but ignore those stable cash flows, reinvest them, and end up at the mercy of the market when they want to extract those funds down the road.
Figure 3: Roundabout way to create future cash flows
 |
|---|
Source: Aaron Brask Capital
This seems a rather roundabout way of using bonds when the ultimate goal is income. Bonds and, more generally, fixed income investments already generate specific cash flows that are independent market risk when held to maturity. In my view, this is the real sanctity of fixed income investing. However, this notion seems to have been lost with many of the contemporary investment strategies that do not specifically align assets with liabilities comprised of future outgoing cash flows.
While the term fixed income is still widely used to describe various investments, it has lost the essence of its literal meaning. Hence this article and my goal to restore this sanctity of fixed income. The following sections discuss two specific tools investors can use to generate fixed cash flows and manage relevant risks: bond ladders and income annuities. While I touch on some of the potential cost and tax savings, I believe the greatest benefit is simplicity. In my experience working with many investors over the years, I find a greater understanding of one’s financial plan often facilitates the most peace of mind – regardless of the potential monetary benefits.
A bond ladder is basically a series of bonds spaced out over a specified time period (e.g., five, 10, or 20 years) and held to maturity. As time passes, each bond’s time to maturity decreases. In particular, the proceeds from each maturing bond are used to purchase a longer term bond to restore the original length of the ladder.
Figure 4: N-year bond ladder illustration
  |
Source: Aaron Brask Capital
For example, let us consider a 10-year bond ladder comprised of 10 bonds – one for each year. After one year passes, the first one-year bond matures and the 10-year bond is now a nine-year bond. So the proceeds from the maturing bond are used to purchase another 10-year bond and we are back to a 10-year bond ladder again.
I may have brushed some of the details under the rug (e.g., callable bonds and defaults), but this describes the general approach. The process is simple and eliminates unnecessary turnover from any jockeying around. There are basically two moving parts: how long of a time period to use and how far to space bond maturities within the ladder. So let us consider what to consider when deciding how to structure a bond ladder.
I find the main decision is how long to structure a ladder. Several factors are relevant here. In an environment with a typical upward sloping yield curve, longer ladders will naturally increase the yield. At the same time, this will also likely increase the volatility of the ladder’s market value and vulnerability to inflation. While many people consider volatility synonymous with risk, this could actually improve a ladder’s ability to diversify other positions (e.g., allocations to stocks).
Shorter bond ladders basically exhibit the opposite attributes. They generally have lower yields, are less volatile, and less susceptible to inflation. Indeed, as each year passes, shorter ladders would reinvest a larger proportion of their total capital (1 out of N bonds) and more quickly benefit from the presumably higher rates.
Figure 5: Bond ladder attributes
We could take this example to the extreme by considering a bond ladder with zero length. That is, the capital would simply be invested at overnight rates (like a savings account). On the one hand, it would not earn any term premium.[5] On the other hand, it could instantly benefit from any higher rates due to inflation. This train of thought could be useful for retirees where inflation is a critical risk.Source: Aaron Brask Capital
Of course, one could use different types of bond funds (long- vs short-term) to manage the above risks. However, I find the simplicity and passive nature of bond ladders attractive – especially when focusing on the income profile and its relationship with inflation. In my experience, both active and passive bond funds tend to have excessively high turnover. This jockeying around from one bond to another does not necessarily lead to any reliable benefits, but can impose additional fees and trigger sporadic capital gains.
Another application for bond ladders is one in which the actual bond principal is used for consumption. For example, consider a couple with one child entering college now and another starting four years down the road. In this case, they may wish to set aside funds to cover tuitions for the next, say, eight years. In this case, it is not just the bond income that is relevant as the principal will be spent as well. One might even use certificates of deposit (CDs) that accrue or fixed annuities,[6] but do not pay any interest.
Retirees may also set up bond ladders with the intention of spending the principal as bonds and CDs mature. The obvious challenge in this scenario is not knowing how long to they will live. If they build a bond ladder out to their (actuarial) life expectancy, then they may live longer than average and have no more bonds maturing to fund their retirement. One solution is to plan for a reasonably long lifespan. However, this requires one of two things:
On an individual basis, each retiree may effectively be forced to plan for the ‘worst-case’ scenario – living longer. For the lucky few that live like cockroaches, they will be happy they planned conservatively. For the majority who live shorter, average, or slightly above average lifespans, this conservative approach will result in their retirements being overfunded (only known in hindsight). Accordingly, this approach results in significant overfunding at the aggregate level – a natural byproduct of each individual’s desire to avoid running out of money. The income annuity products in the next section directly address this issue.
Simply put, an income annuity is a product offered by insurance companies whereby they allow individuals (or couples) to purchase income that is guaranteed to last as long as they live (e.g., throughout retirement). The amount of income relative to the purchase price is determined by a combination of actuarial (i.e., life expectancy) and market factors (i.e., interest rates). As of my writing, for example, a 70 year old male can purchase $1,443 in guaranteed monthly income for the rest of his life for $250,000. On an annual basis, this represents a payout of approximately 7%.[7]
| Side note: Annuities are bad, aren’t they?
Annuities have rightfully earned a negative stigma from the agents pushing more expensive products with higher commissions. While I have written extensively on the drawbacks of variable annuities (e.g., excessive fees and potential tax issues), I find income annuities to be a very efficient tool for retirement planning. Unlike their complicated variable cousins, income annuities are very simple. This simplicity makes it easier for insurance companies to manage their risk. In theory, this should help to reduce their costs. Moreover, simplicity also makes it much easier for investors and independent agents (like myself) to compare apples with apples, shop around, and get the best rate. This comparison shopping imposes additional gravity on income annuity prices from competition. In my experience, income annuities have become more competitively priced in recent years and this makes them an attractive option for many retirees. I built my own calculator to assess the implied costs embedded in income annuities for my clients, but online calculators are also available for those who know what they are doing (one example here). David Blanchett (Morningstar Investment Management), Michael S. Finke (The American College), and Branislav Nikolic (York University – Department of Mathematics and Statistics) published a recent article that corroborates my experience. Indeed, when normalizing for interest rates, they find the trend for income annuity prices was lower over the seven-year period ending in August 2020. In another article, Blanchett and Finke found that the rates offered by some multi-year guaranteed annuities (MYGAs) were more attractive than those with CDs, government/treasury bonds, and corporate bonds. |
Figure 6: Example income annuity illustration
As I highlighted in the previous section, individual investors generally cannot afford to run the risk of assuming they will only live to their actuarial life expectancy. Accordingly, they often play it safe by allocating enough money to fund retirement for a period that is significantly longer than their true life expectancy. So this results in overfunding at the aggregate level. This is where insurance companies can be helpful.Source: Aaron Brask Capital
Unlike market volatility, actuarial risks such as lifespans are very predictable when averaged across large groups of people. By pooling risks across many annuity customers, insurance companies can effectively net out the longevity risks and price guaranteed lifetime income based on the average life expectancy. For individuals who would otherwise have to plan well beyond their life expectancy to be safe, pooling risk via an income annuity could allow them to free up capital or purchase a higher level of income per year.
For example, consider a 65 year old man with a life expectancy of 18 years (i.e., expected to live to 83 years old) deciding between a bond ladder and an annuity. Assuming the same level of annual cash flows, constructing a bond ladder out to age 90 would cost significantly more than an annuity based off of a life expectancy of 83. Indeed, the bond ladder would require funding 25 years (90 – 65) of cash flows whereas the annuity price would only reflect the average of 18 years. Ignoring the time value of money, the bond ladder would require approximately 39% (25÷18-1) more capital for the same level of cash flows.
Figure 7 below illustrates the expected mortality rates for 65 year old males and females. As one might expect, very few people are expected to die early on, most will likely live to right around their actuarial life expectancy, and increasingly fewer will be expected to live each year further out. With a large enough group of income annuity purchasers, the shapes of these curves would directly reflect the actual outgoing cash flows. So an insurance company could purchase fixed income investments to provide for that cash flows.[8]
While insurance companies are in business to earn a profit, any additional expense (above and beyond the actuarial fair price) paid by income annuity purchases would likely be significantly less than what it would cost for them to secure their own income through age 90, 100, or beyond – whatever age required to ensure the likelihood of running out of money was de minimis. The market jargon used to describe this averaging phenomenon is mortality credits. That is, income annuity clients who live longer effectively receive credits from those who live shorter lifespans.
Figure 7: Distribution of mortality rates
 |
|---|
Source: Social Security Administration (2017 period life table)
Mortality credits alone can make income annuities an attractive tool for many retirees. However, I also like to present income annuities from another perspective. Given the current market environment where both interest rates and dividend yields are so low, most retirees will not be able to live off the natural income from their portfolios (i.e., dividends and interest). Accordingly, they will have to dip into principal to fund their retirement.
Once one acknowledges principal will be sold over the course of their retirement, they have a choice. One the one hand, they can wait and chisel as needed down the road. Of course, this leaves future income at the mercy of the market. Moreover, each time one chisels away from their portfolio, it will naturally reduce the dividend and/or interest income paid out in subsequent years. With less income, the shortfall could increase and require chiseling away even more principal. This can be a slippery slope.
On the other hand, one way to mitigate this risk could be to allocate a portion of one’s fixed income investments to a bond ladder or income annuity. Rather than being at the mercy of the bond market when chiseling off money for spending, an income annuity effectively allows one to pre-chisel income in advance – effectively eliminating the market risk for this stream of income.
In addition to fees (discussed in the shaded side note box above), another concern that periodically comes up is what would happen if one purchased an income annuity, but only ended up living a short period. If one paid a significant sum upfront for an income annuity, but only received a few payments in return, it would undoubtedly be negative economic outcome (and personal tragedy). However, most insurance companies will guarantee a 100% return of premium in exchange for reduction in payout. This is effectively a money-back guarantee – something most conservative bond funds cannot even offer. Given the low interest rate environment we are currently in, I find this option provides additional peace of mind – especially where children or other legacy concerns are present.
One approach many people choose is to allocate just enough to an income annuity to cover their basic necessities. More generally, I like to integrate income annuities into a broader plan for retirement income that complements the use of other assets and sources of income while tending to the potential risks that could jeopardize retirement security (inflation, healthcare needs, etc.). In addition to being able to provide guaranteed income, options like the cash refund feature described above, the ability to structure income via joint and survivor payouts for couples, and other features can make income annuities a versatile tool for retirement planning. This versatility can be especially useful for minimizing tax impact with retirement. I do not elaborate on the taxes here, but I wrote another article on precisely that topic: Optimizing Tax Benefits with Annuities.
Without doubt, the topic of annuities is often polarizing and many of the stigmas attached to them are for good reason. Having worked with individuals and families over the last decade, I have seen the good, the bad, and the ugly sides – including, but not limited to misleading sales pitches, excessively high commissions, tax inefficiencies, and poor performance. In other words, the standard of care under which annuity and insurance products are sold appears to fall short of the fiduciary standard.
I like to think my approach is different. While I uphold a fiduciary standard in all of my dealings with clients, I believe my PhD in mathematical finance, actuarial background, and Wall Street experience advising insurance companies make my perspectives on planning, investments, annuities, and life insurance truly unique. Moreover, I offer my clients multiple options: hourly/fixed-fee financial planning services, traditional fee-based portfolio management services, and income annuities (which are not necessarily mutually exclusive). By highlighting the risks, costs, and performance of each approach, I view my role as educating, guiding, and executing where applicable.
Put simply, I find there can be immense value in pre-chiseling income upfront via bond and CD ladders or income annuities. By combining this guaranteed income with other sources of income (social security, dividends, etc.), I can often structure portfolios in such a way to generate sufficient income naturally. I may be shooting myself in the foot to some degree, but I find this type of upfront planning can mitigate, if not eliminate, the need for ongoing portfolio management. As a result, this can significantly reduce both costs and taxes in many cases – thus allowing clients to spend more or leave larger legacies to their heirs.
Notwithstanding these benefits, I find the biggest benefit of this strategy is its simplicity. This building blocks approach to income is very intuitive and I find clients just get it. While this article focused on retirement income, this approach can also be used with trust planning for blended families and other situations where delineating income and principal is helpful.
I believe the true sanctity of fixed income lies in the ability to purchase specific cash flows in the future with precision and certainty. However, I believe this has become a lost art and the phrase fixed income has lost its literal meaning.
The primary benefit of fixed income assets is now seemingly derived from market prices being less volatile than or less correlated to other asset classes. Indeed, many market practitioners focus on modern portfolio theory and total return investing where all portfolio income, regardless of how robust or certain it may be, is indistinguishable from capital appreciation.
This article highlighted how we could restore the sanctity of fixed income via examples with bond ladders and income annuities. In particular, I highlighted the context of retirement income. Regardless of whether one is already retired or not, the focus of saving and investing ultimately becomes generating adequate income during retirement[9]. In this context, I believe that purchasing future cash flows with certainty can be immensely helpful.
For many, this approach may not meaningfully alter their allocations or economic exposures. If retirees were to look inside bond funds they own, then many might find the cash flows of the bonds they already own create a ladder of future cash flows they could use for retirement income planning. However, bond funds have notoriously high turnover and many of those bonds will not be held to maturity. As a result, many of those cash flows will be sold before they end up in the hands of investors who could use them.
Other articles that may be of interest:
Disclaimer
| DISCLAIMER: This article discusses topics at the nexus of investments, annuities, and taxes. This article does not provide and should not be construed as providing tax advice. In order to assess tax benefits specific to annuities, we assume they are held in taxable (non-qualified) accounts unless otherwise specified. |
| OVERVIEW
Annuities are popular tools for retirement income planning. While stigmas exist around some annuity products (for good reason), recent research shows how fixed annuities can add value in the context of retirement income. In addition to being able to guarantee income for life, tax benefits are often advertised as a key advantage of using annuities. This article discusses the mechanics of tax deferral in annuity products[1]. We first consider variable and indexed annuities and how the value stemming from their tax deferral can be diluted or even negated due to the growth eventually being taxed as income rather than capital gains. For fixed annuities, this is less a concern as bond interest is already taxed as income. So we explore ways to maximize their tax deferral benefits. We explain the concept of the exclusion ratio and how it relates to the taxation of fixed annuities. We then provide multiple examples and intuition that lead to a novel approach for optimizing tax-efficiency. By exploiting the manner in which the exclusion ratio is applied, we find our approach allows us to reduce taxes by as much as 12% relative to standard fixed income investments for investors with a marginal tax rate of 25%. |
| Figure 1: Tax deferral vs growth taxed as income
Source: Aaron Brask Capital |
Figure 2: Optimizing tax deferral with DIA start date
Source: Aaron Brask Capital |
Annuities have become a popular tool for retirement income planning. Cynically speaking, we would say commissions have always been a motivating factor for agents to push annuity products – especially the most expensive products. However, that is not to say all annuities are bad. Indeed, some can offer useful benefits. Our research and that from other practitioners and academics highlight many of the advantages fixed annuities can provide to investors and retirees, in particular.
We believe the primary benefit of annuities is their ability to guarantee income throughout one’s lifetime. This is an undeniably attractive feature (and compelling sales pitch) that can only be achieved via annuities[2]. Our concern naturally lies on the cost side of the equation. Indeed, our research and experience indicate the fees associated with more complicated annuity products typically outweigh (or at least dilute) the benefits of guaranteed lifelong income. For example, variable annuities are often saddled with expensive (and in our view, unnecessary) bells and whistles that make them prohibitively expensive.
Of course, insurance companies are in business to profit. So fixed annuities embed costs too. However, we have observed them becoming increasingly competitively priced and suspect this is due to three key factors:
Our research and experience corroborate the findings from the increasing body of academic and practitioner literature showing that income annuities can add significant value in the context of retirement. On balance, we find these types of annuities to be an extremely useful and cost-efficient planning tool for many retirees. So we are not surprised to see these products becoming increasingly popular.
This article focuses primarily on the tax deferral benefits annuities can provide and is broken down into two sections. The first section discusses how tax deferral benefits are affected by the way annuity earnings are taxed upon distribution (i.e., as income). This is a known issue, but worth repeating. The second section highlights what we believe to be a new and useful strategy to create and maximize expected tax deferral benefits with fixed annuities in taxable accounts.
| Note: To be clear, this article focuses on tax benefits; it does not delve into the absolute costs of annuity products – generally a more important consideration (i.e., do not let the tax tail wag the dog). For example, fixed annuities do not come with price tags outlining their fees. Instead, they embed their costs in their payouts. So it is important to assess their payouts in the context of current interest rates offered by relevant bond investments. Given the technical nature of these calculations (e.g., actuarial/mortality/life tables), we provide both tax and cost analyses to clients interested in annuity (or life insurance) products. |
One of the benefits of annuity products is tax-deferral. That is, growth is not taxed until it is distributed outside the annuity[3]. This tax deferral is often a major selling point, but there is a downside; the growth or earnings is eventually taxed as income. This can be quite punitive as income tax rates are generally significantly higher than capital gains rates.
Figure : 2020 Income and Capital Gains Marginal Tax Rates[4]
|
Source: IRS
Figure 3 highlights the marginal income and capital gains tax rates for a variety of income levels. The difference between the two becomes greater for higher earners and this can make the tax aspects of annuities less attractive. Let us consider the simple example of $100 invested in a non-dividend-paying stock held by a couple in the highest tax bracket to illustrate the impact. If the stock grew by 10% per year over 10 years, then withdrawing those funds would leave $227.50 in a taxable brokerage account after capital gains taxes. If the same investment was held within an annuity and withdrawn after 10 years, they would end up with just $200.41 due to the gains being taxed at the higher rate (as income).
Of course, the above example was contrived to illustrate a point. In most situations, one will hold stocks and stock funds that pay dividends, bonds with taxable interest, and their portfolios will be rebalanced. All of these factors create tax drag when held in a taxable brokerage account, but not within an annuity. The point is that there are two potentially offsetting tax factors at play: the tax deferral during the growth phase and the ultimate tax rate applied to the growth.
Even if we can estimate the impact from the latter factor, there is no simple formula to estimate the impact of tax deferral as the factors we mentioned (dividends, interest, and rebalancing) can be different each year and their impact depends on the investors’ financial and tax situation. Notwithstanding, we used historical simulations to estimate these benefits for various types of portfolios and investors. These results are presented in two articles we published entitled Quantifying the Value of Retirement Accounts and Illustrating the Value of Retirement Accounts. Using the results from these articles, one can estimate the tradeoffs between these two tax factors.
Figure : Balancing Tax Factors
 |
Source: Aaron Brask Capital
There are other factors related to tax that can make annuities less attractive. For example, annuities do not receive a step-up in basis. So their embedded gains will also carry the corresponding tax liability which will eventually be taxed as income as distributions are taken by the beneficiaries.
On balance, we believe the tradeoffs between the tax-related issues highlighted above make annuities inefficient vehicles for most stock allocations[5]. We find the cost of taxing their growth as income (versus capital gains) is simply too high in most situations. However, the tradeoff for bonds is different since their interest and appreciation[6] is already taxed as income. In particular, the tax deferral provided by annuities is still helpful, but taxing their growth as income is not necessarily punitive as it would be taxed that way already without the annuity. The next section discusses how they are taxed and presents a novel approach for optimizing the tax deferral benefits for fixed annuities.
| Note: This section discusses fixed annuities. That is, we focus on annuities whereby one exchanges a lump sum of money for a stream of cash flows that may start immediately or at a later date and may or may not last throughout one’s lifetime. To be clear, our discussion does not include index annuities (a.k.a. fixed index annuities). While index annuities are often grouped together with fixed annuities, they are tied to the performance of one or more underlying indices (e.g., S&P 500) rather than fixed payouts or interest rates. |
This section is broken down into four sections. The first describes three types of fixed annuity products we consider for our analyses. The second section discusses how annuity taxation differs from standard investments in taxable accounts. In particular, it explains the concept of the exclusion ratio and how it can provide tax deferral benefits with annuities. The third section provides examples of how various annuity strategies can be used to exploit the exclusion ratio mechanics and improve one’s after-tax outcomes. The fourth section delves deeper into these strategies to optimize the results based on where DIA cash flows start.
We consider three primary fixed annuity products to assess tax efficiency versus using standard interest-bearing investments in taxable accounts. The first product is called a single premium immediate annuity (SPIA). This involves paying an upfront lump sum of money in exchange for cash flows that will start immediately (typically with 12 months) and continue until the annuitant passes. The second product, a deferred income annuity (DIA), is similar to a SPIA in that it is funded with an upfront lump sum, but its cash flows are deferred and start at a later date (typically after at least 12 months).
For SPIA and DIA products, we assume they embed a feature known as a cash refund. This will insure these annuities always return at least as much premium as was invested. We find this is a desirable option in practice, but it also makes the annuities more comparable to cash allocation strategies since they would both leave cash balances if the annuitant passed before their expected lifespan.
The third product is a multi-year guarantee annuity or MYGA (a.k.a. a fixed rate annuity since the rate of interest is fixed upfront). In effect, a MYGA can be used to purchase a future cash flow at a discount. This is similar to a zero-coupon bond or certificate of deposit (CD) whereby you select a desired maturity, invest your money, and then that money grows until its maturity according to the embedded interest rate. However, the MYGA also provides tax deferral.
We also analyzed fixed period annuities. Like SPIAs and DIAs, one pays for a fixed period annuity upfront and receives a stream of income. However, the income is limited to a pre-specified period and is not guaranteed throughout one’s life like SPIAs and DIAs. We use a fixed period annuity in an example below to illustrate annuity tax deferral benefits, but we did not include their results in the main analysis further below because they were only marginally different than the other products we considered.
In order to understand the tax benefits annuities can provide, we make some simplifying assumptions:
Now let us consider an investor who would like to allocate enough cash[7] to provide after-tax proceeds of $10,000 per year for 10 years. Given that each dollar invested will earn 2.25% after tax (3% gross return net of 25% tax), netting $10,000 N years later requires an initial amount of capital equal to $10,000 ÷ (1 + 2.25%)N. In our case, the total capital required to fund 10 years of $10,000 spending works out to $88,662.
In year one, there will be $2660 (3% x $88,662) of interest on our cash portfolio, $665 (25%) taxes will be paid on that interest, and the investor will withdraw $10,000. This (and every) withdrawal is larger than the after-tax interest. So a portion of each withdrawal will come from the principal and naturally deplete the capital over time (by construction, it will go to zero after 10 years). As a result of the reduced principal, the amount of taxable interest will be highest early on and decrease each year.
Figure : Tax profile illustrations
| Taxable cash allocation (front-loaded taxation)
|
Fixed period annuity (level taxation)
|
Source: Aaron Brask Capital
Fixed annuities offer an advantage relative to this front-loaded taxation. The IRS[8] effectively allows for level taxation of income annuities via a calculation based on the exclusion ratio. The exclusion ratio is calculated and provided as part of an annuity contract in order to determine how much of each distribution will be excluded from taxation. It is intuitively calculated as the amount of the original investment divided by the total expected payout[9] (original investment + return).
Figure 5 above illustrates the tax profiles for a cash allocation designed to generate the same after-tax $10,000 per year versus a fixed period annuity paying the same cash flows over a 10-year period. The benefit of the level taxation an annuity can provide is that it translates into lower taxes in the beginning (relative to the front-loaded taxation of interest-bearing cash) – thus allowing for more tax-deferred compounding. The benefit of this extra tax deferral is minimal in this example (i.e., the fixed period annuity tax deferral only saved $106), but the next section investigates strategies to make the benefits more significant.
Now that we have explained the concept of the exclusion ratio and how it works, we look at ways to use it to our advantage. The context for this discussion will be a 65-year-old female retiree who would like to generate $10,000 of after-tax income per year for the rest of her life.
We naturally cannot predict how long she will live. So it is impossible for us to know how much cash one would need to allocate and compare to annuity strategies with lifelong income. However, this turns out to be irrelevant for this analysis since the exclusion ratio and its tax deferral benefits only apply throughout one’s actuarially expected lifespan.
| Note: Annuity income becomes 100% taxable if one lives beyond their expected lifespan because all principal has been returned by then. That is, further income is 100% return and thus 100% taxable. However, taxation becomes an ancillary issue as the primary benefit of an income annuity at this point stems from the fact there is any income at all to be taxed (i.e., the cash allocation strategy would be depleted). |
Accordingly, one’s expected lifespan is the only period we need to consider and we can thus determine the specific amounts required to construct our baseline cash allocation strategy for comparison. We use an expected lifespan of 20 years for our hypothetical 65-year-old female retiree[10]. As a base case, the cash allocation strategy requires $159,637 to generate $10,000 per year for spending (i.e., after tax).
In order to compare the results from different strategies, we utilize a methodology similar to that used by Joe Tomlinson (actuary and retirement researcher) in this article. That is, we calculate the internal rate of return (IRR) of each strategy on an after-tax basis. To be clear, we generate the same $10,000 after-tax income per year and assume the same pre-tax rate of return. So the difference in initial investment required for each approach will be a direct result of its tax deferral benefits and be reflected in its post-tax IRRs (i.e., higher IRRs indicate more deferral and tax efficiency).
Figure : Comparing after-tax IRRs
| After-tax IRR | Effective tax rate | Effective tax cut[11] | |
| Cash allocation | 2.25% | 25.0% | 0% |
| SPIA | 2.30% | 23.5% | -6% |
| Cash allocation + DIA | 2.33% | 22.5% | -10% |
| MYGA ladder + DIA | 2.34% | 22.1% | -12% |
Source: Aaron Brask Capital
We also use the after-tax IRR to calculate and compare the effective tax rates[12] of these strategies. For reference, cash allocations involve no tax deferral. So their effective tax rate and after-tax IRR will always be precisely 25% and 2.25% (3% return net of 25% income tax), respectively.
We now consider three alternative approaches using fixed annuities. The first approach we consider is the simple SPIA. The benefit of its level taxation results in an after-tax IRR of 2.30%. This is a slight improvement over the 2.25% after-tax return of the cash strategy and reduces the effective tax rate from 25% to 23.5%.
The next two approaches break the 20-year period into two 10-year periods. While both use a DIA for the latter period, we provide income for the first 10 years in two different ways: via a cash allocation and a ladder of individual MYGAs. Recall from our description above that MYGAs are annuities that allow one to invest a sum of money with a pre-specified interest rate over a particular multi-year period of time – similar to CDs or zero-coupon bonds.
Each approach is taxed differently and thus yields different after-tax results. We present these results next to those for the cash allocation strategy and SPIA in Figure 6 above. Just as the SPIA’s level taxation improved the tax deferral benefits versus the cash allocation, introducing the DIA further improved the results by completely deferring taxes for the first 10 years and then leveling the accrued taxes over the latter 10-year period.
It is worth noting the cash allocation for the first 10 years suffered from the same tax front-loading issue, but was only relevant to just over half of the overall investment with the balance being invested in the DIA. This front-loading tax issue was addressed by using the ladder of MYGAs. In fact, the annuity ladder actually back-loads the taxation[13] and creates an even more favorable result than level taxation would have.
Figure : Tax profile illustrations
Fixed period annuity (level taxation) |
MYGA ladder (back-loaded taxation) |
Source: Aaron Brask Capital
Using the DIA with a cash allocation for the first 10 years increased the after-tax IRR from 2.30% for the SPIA to 2.33% with the DIA and reduced the effective tax rate by another full percent[14] to just 22.5%. Replacing the cash allocation with the MYGA ladder further increased the after-tax IRR to 2.34% and reduced the effective tax rate to 22.1%.
In summary, the above strategies were able to increase the after-tax IRRs by just under nine basis points (0.09%). While this figure may sound small, it is amplified to the extent it applies to all of the compounding for all of the cash flows from year one to year 20. Another way to look at it is to consider the absolute amount of taxes paid on the investments. In this context, the benefit of the annuity tax deferral was able to reduce overall taxes paid by as much as 12%.
Now that we have observed how the exclusion ratio and corresponding tax deferral benefits differ for various approaches, we explore a simple strategy to try and maximize those benefits. In our previous examples, we split the 20-year period into two equal halves and seemed sensible. However, this 10-10 split was still arbitrary. Following along with our hypothetical 65-year-old female retiree, we assume the same 20-year period as before, but we alter the point at which we start the DIA cash flows and see how it impacts the results.
We first look at the approach using the cash allocation with a DIA. The following two charts show how changing the DIA starting year impacts the after-tax IRR and effective tax rate. It is worth nothing that starting the DIA in year one is equivalent to the SPIA approach and starting it after year 20 is equivalent to the cash allocation approach (no annuity). The dark blue lines in Figure 8 represent this approach and indicate the IRR is maximized (and the effective tax rates is minimized) when the DIA is started in year nine. So the 10-year DIA start we used before turns out to be near optimal when combining it with a cash allocation.
Figure : IRR and effective tax rate for varying DIA starting dates
IRR |
Effective tax rate |
Source: Aaron Brask Capital
We repeated the same analysis for the approach with a MYGA ladder and DIA. Those results are represented by the light blue line in Figure 8 above. In this case, the IRR increased and the effective tax rate decreased in a monotonic fashion from years one to 20. This is a direct result of the favorable (back-loaded) taxation the MYGA ladder offers. As the charts indicate, the marginal benefit of starting the DIA later is significant in the early years, but diminishes through time. As a result, it may be sensible to start the DIA around 10-year mark as there is minimal benefit beyond that point (e.g., to ease the administrative burden involved with filling out 20+ annuity applications). Alternatively, one could utilize a fixed period annuity instead of the MYGA ladder. This achieves much of the tax deferral benefit via its level taxation, but only requires a single application.
This article focused on tax-related aspects of annuities, but we do not advocate letting the tax tail wag the dog. There are, of course, many other important factors one should consider. Indeed, we find the fees and embedded costs associated with many products make them prohibitively expensive – regardless of their tax-efficiency or other benefits. Liquidity constraints and surrender penalties should also be considered.
Our research and experience indicate fixed annuity products can be both cost- and tax-efficient tools for retirement income planning. The embedded costs of fixed annuities are specific to each policy (age, gender, current market rates, etc.) and should be considered on an individual basis. However, the rules governing their taxation do not change and that is why this article focused on strategies to maximize their tax efficiency.
Below we list what we believe are the primary points made by this article. We also highlight several other non-tax-related points we did not discuss, but are also worth considering in the context of annuities.
Primary points made in this article
|
Additional points unrelated to taxes
|
| OVERVIEW
Building on the concepts presented in our Dividends Are Different article, here we present data and observations highlighting how dividends can protect investors from inflation and market volatility. While this content is relevant to other applications, we focus on it within the context of retirement income. When designing portfolios to provide for retirement, conventional wisdom holds that allocations to stocks generally facilitate growth that helps hedge against inflation. We agree with this notion, but try to make it more concrete by highlighting the fundamental and market-based mechanics behind this relationship. We then look at empirical data to investigate how inflation relates to market prices, earnings, and dividends. We measure results over 25-year time periods – fairly typical horizons for retirement planning. Our findings reveal impressively strong relationships between fundamental performance and inflation, but an unsurprisingly weaker linkage between market returns and inflation. Relative to chiseling away from a portfolio, we believe dividends provide a more direct tool to combat inflation as they avoid the layer of noise imposed by often-volatile market prices. This can be especially important when inflation surfaces as asset prices may react negatively – thereby requiring higher withdrawals when asset prices are depressed. This situation can impose permanent damage on retirement security and is why retirement researchers identify inflation as such a critical risk. |
Source: Robert J. Shiller market data, Aaron Brask Capital
OutlineThis article is organized in three primary sections followed by our concluding remarks. The first section highlights theory and mechanics that relate inflation to stocks price movements. The second section quantifies these notions and presents our empirical findings. The third section discusses the potential roles dividends can play in the context of addressing and managing market risk. |
When it comes to investing for retirement, conventional wisdom holds that allocations to stocks generally facilitate growth that helps hedge against inflation. The following highlights what we believe are the key fundamental and market-based mechanics that drive this relationship.
At the root level, shares of stock represent profit-seeking enterprises and these businesses require capital to acquire resources (e.g., PP&E[1], raw materials, and labor), alter or assemble them, and turn them into something they can sell to their customers. This capital naturally demands a return. Thus, as inflation increases input costs, maintaining the required return on this capital will increase the absolute level of profit. Put simply, profits should rise with inflation under these assumptions.
Of course, economic forces do not follow a set schedule or formula. Innovation and competition involve much trial and error. Moreover, companies ultimately rely on humans to make decisions. On an individual basis, this introduces some subjectivity into their fundamentals. However, the level of entropy is increased as they interact and create feedback loops. The bottom line is that the inflation-profit model described above will naturally involve significant noise.
Notwithstanding this randomness, as long as survival instincts, profit motives, and competition exist, the above logic regarding returns on capital will apply and help explain why profits, and thus stock prices, should be positively correlated with inflation over the longer term.
| “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
– Benjamin Graham (Warren Buffett’s mentor) |
While the relationship between inflation and profits is already noisy, market-based forces make the relationship between inflation and stock prices more tenuous. We firmly believe prices follow fundamental performance over the long term. However, investor sentiment can influence prices over shorter periods. This notion is particularly relevant in the context of inflation. Historically, we have witness periods where investors reacted negatively to significant bouts of inflation and we suspect that is due to them assuming (implicitly or explicitly) a higher interest rate is warranted for discounting future cash flows. However, this reaction ignores the phenomenon we highlighted above and will illustrate below with historical data – i.e., that inflation appears to give rise to increasing profits over the longer term.
| “Inflation is truly the great enemy of the retiree.”
– William Bengen[2] |
In the context of retirement, inflation can require one to withdraw more money to maintain the same standard of living. Moreover, the threat is magnified to the extent that a sustained uptick in inflation can increase prices for the remainder of one’s retirement. Even worse, negative market reactions during inflationary periods can add further risk to this situation. On the one hand, inflation may force an increase to the dollar amount of portfolio withdrawals. On the other hand, each dollar of withdrawal may require selling more shares or bonds in an environment where their prices are depressed. This is why academics and practitioners view inflation as such a significant threat to retirement security.
The goal of this section is to illustrate the historical relationship inflation has had with corporate fundamentals (i.e., earnings and dividends) and stock prices. We use Robert J. Shiller’s online data for S&P 500™ prices, earnings, and dividends. We start out by investigating these relationships over 25-year time periods as we believe this can help us address some of the noise highlighted above and identify longer term trends. Moreover, 25 years is a reasonable period to consider in the context is retirement planning.
Figure 1 on the front page shows how stock prices, earnings, and dividends were correlated with inflation over 25-year periods. It shows impressively strong relationships between fundamental performance and inflation, but an unsurprisingly weaker linkage between market returns and inflation. S&P 500 returns were 58% correlated with inflation while earnings and dividends exhibited correlations of 64% and 83%, respectively.
Figure 2: Standard deviation of growth rates (25-year periods)
 |
Source: Robert J. Shiller market data, Aaron Brask Capital
We also calculated how volatile these quantities were by measuring the standard deviation of their growth rates.[3] Figure 2 above shows these results. CPI exhibited the least volatility with a standard deviation of 4.6%. We suspect this primarily due to the slow-moving forces of supply and demand, but hedonic adjustments to CPI figures[4] and central bank mandates for price stability may also be factors. The standard deviations for dividends, earnings, and S&P 500 prices were all higher at 10.7%, 27.5% and 17.9%, respectively.
Interestingly, earnings showed the highest volatility. We believe this is due to the apples-oranges nature of the comparison. For example, each earnings figure represents the profits of the underlying companies reported over a particular period. However, market prices represent an average of expected earnings over many different periods. Moreover, earnings figures can be arbitrarily small over some periods (no negative readings in the data we used). Thus, percentage-based growth figures calculated from lower levels may accelerate rapidly. It is also worth noting that dividend volatility might also be lower due to the discretion CEOs and CFOs have in declaring dividends. Indeed, they have the ability to dig into retained earnings and pursue what they expect will be sustainable dividend policies despite fluctuations in their earnings.
Even if they exhibited the highest correlations with CPI or the lowest level of volatility, earnings are not accessible, except to the extent they are paid out as dividends. That is, only share prices and dividends represent tangible, liquid money investors can use for spending. As such, earnings are effectively irrelevant in the context of retirement where one requires liquidity.
Figure 3: Dividend and inflation growth over rolling 25-year periods (annualized)
 |
 |
Source: Robert J. Shiller market data, Aaron Brask Capital
Figure 3 above provides two visualizations of the 25-year growth rates for S&P 500 dividends and the consumer price index (CPI). The first chart on the left shows how the 25-year growth rates for dividends and CPI evolving through time. While they broadly followed each other, the most recent data show inflation trending lower while dividend growth rates have sustained their near-peak levels. The second chart shows the same data in scatter chart. We believe this chart reveals at least one key point. In periods where CPI grew the most (data points to the right), dividends also grew at a significant rate. This would have been particularly important to those relying on dividends for retirement income since the growth in dividends would have been there when it was needed most.
The above calculations utilized growth rates from 122 overlapping 25-year windows spanning the 1872-2019 period. In particular, each growth rate depended only upon its starting and ending value. Thus, even if the dividend/inflation correlation of 25-year windows was high, the intra-period trajectories of these quantities could be divergent. Figure 4 in the left panel below illustrates a hypothetical example of a period whereby the end result was the same for two quantities, but the trajectories were very different.
In order to assess the relationship between dividends and inflation at a higher resolution (i.e., within the 25-year periods), we made similar observations over smaller periods. Figure 5 shows the correlations calculated for rolling time periods ranging from five to 25 years. To be clear, the 25-years correlations in Figure 5 are the same as those presented in Figure 1. As expected, correlations increase with longer time periods. We attribute this to the noise we highlighted while discussing the theoretical underpinnings of this relationship (e.g., companies might temporarily absorb price increases before passing them on to their customers). Dividends show the highest correlations regardless of the time period chosen. Moreover, while not shown here, correlations between CPI and dividends fell to 34% for one-year time periods but increased to 95% with 50-year periods. On balance, we believe this indicates a strong relationship between dividends and inflation.
| Figure 4 : Same result via two different trajectories
Source: Aaron Brask Capital |
Figure : CPI correlations for different size periods
Source: Robert J. Shiller market data, Aaron Brask Capital |
To summarize, we highlight a few key points related to inflation:
In the previous sections, we shared our conceptual model and data indicating how inflation relates to corporate fundamentals and stock prices. This section highlights two roles dividends can play in mitigating risks related to market volatility.
The first context focuses on using dividends as a source of income versus having to chisel away at a portfolio’s principal and thus being at the mercy of the market. Dividends depend on underlying operating performance of the company but are not at the mercy of fickle investors’ buying and selling. So this can reduce one’s dependence on market performance (see our Dividends Are Different article).
| Note: Our next article will revisit this notion of mitigating dependence on market performance as it can apply to fixed income allocations as well. |
The second context focuses on reducing rather than avoiding market volatility. Indeed, we believe dividends can be used to identify companies with higher quality fundamentals and less market volatility. However, not all dividend strategies are the same. There are two primary types of dividends strategies and they are effectively polar opposite in nature. Given the proliferation of indices, ETFs, and dividend-related products, it is easy to get confused. So we describe these two dividend strategies in the shaded boxes below.
High dividend yield strategiesMany dividend-based products and strategies target stocks that are paying high dividend yields. These are usually stocks that pay dividends, but have run into troubles – thereby sending their share price lower and making their dividend yield higher. Investors generally take notice of successful companies that consistently increase their earnings and dividends. This can keep their prices elevated and make their dividend yields lower. Accordingly, we find high dividend yield strategies often result in portfolios comprised of lower quality companies. Rising dividend strategiesThe second type of dividend strategy we highlight targets stocks that have consistently paid and raised dividends for an extended period. While these companies may have lower dividend yields, the quality of the underlying companies is typically much higher – as evidenced by their ability to pay and increase dividends. Accordingly, this approach is very different than pursuing higher dividend yields. |
For our purpose of investigating how dividend strategies can impact market performance, we focus on the latter dividend strategy. Our hypothesis is that companies that have consistently paid and raised their dividends are, on average, higher quality and exhibit lower market volatility. For this purpose, we consider the Vanguard Dividend Appreciation ETF (ticker: VIG). As the name indicates, this fund invests in companies that have records of growing their dividends. Moreover, it has a live track record going back to April 2006. So we can observe performance over at least one complete market cycle.
Of course, this is just one fund. So the evidence may appear anecdotal in nature. However, our research reflects similar trends whereby portfolios of higher quality companies tend to exhibit lower market volatility and reduced drawdowns – regardless of whether they pay dividends or not. We first present quantitative evidence indicating companies with histories of increasing dividends are high quality in nature. This is an obvious and unsurprising finding to us, but some prominent practitioners and academics maintain that dividend policies provide little, if any, useful information for investing purposes.
We used www.PortfolioVisualizer.com to examine our assertion regarding the quality of these types of companies and calculate key performance figures for returns, volatility, and drawdown.[5] Figure 6 below shows the tabular results from running the Fama-French five-factor regression for VIG. In layman’s terms, this model compares the historical performance of VIG to the performance of various factors portfolios (i.e., portfolios built to emphasize stocks with those specific factors) to statistically determine what flavors of stocks are in VIG. Technical details aside, the model indicates a significant and almost certain exposure to quality stocks as we suspected (profitability loading of +0.21 and p-value of 0.0%).
Figure 6 : Fama-French factor attribution for Vanguard Dividend Appreciation ETF (ticker: VIG)
Source: www.PortfolioVisualizer.com
We believe the above results show how dividends can be used to identify higher quality companies. We now investigate how this is related to their market performance. We are particularly interested in how these types of stocks held up during turbulent periods. Figure 7 below shows the additional output from PortfolioVisualizer. Since its inception in 2006, VIG 8.92% on an annualized basis and this was almost identical SPY (an S&P 500 ETF) which returned 8.65%. However, the volatility and drawdown of VIG were both significantly lower than for SPY. The standard deviations of their returns were 12.75% for VIG and 14.52% for SPY and their drawdowns were -41% and -51%, respectively. This drawdown data is anecdotal since it only represents one particular event. So we investigated the data for the benchmark index VIG targets (NASDAQ US Dividend Achievers) and found similar results. While these results were actually stronger, it is worth noting that they were based on an index back-test rather than a live track record.
Figure 7: Vanguard Dividend Appreciation ETF (ticker: VIG) factor attribution
Source: www.PortfolioVisualizer.com
While some refuse to accept any role for dividends in portfolio construction or management, our intuition and historical data lead us to believe such views are dogmatic. We believe dividends possess important attributes with regard to inflation and market volatility that allow them to play a unique and critical role, especially in the context of retirement income planning.
This article first presented our theoretical model for how inflation relates to both corporate fundamentals and share prices. We then shared empirical results showing how dividend growth has been more strongly correlated with inflation than stock market returns or earnings growth. We also discussed and presented data describing how dividends could be used to bypass and possibly reduce stock market volatility.
We believe the empirical results regarding inflation corroborate the ideas behind our economic model as well as the notions we discussed in our previous article, Dividends Are Different. In particular, dividends are fundamental in nature and represent an economic phenomenon that is distinct from market prices and share buybacks.
At this point, refusing to acknowledge these unique attributes of dividends is effectively alleging the correlations we calculated were just a coincidence or manipulated by corporate managements. Given that these trends occurred over multiple time periods, we think the possibility of coincidence is de minimis. Moreover, that would be quite a conspiracy. Executives of companies from all sectors and across many time periods would have had to collaborated so that their dividend policies would aggregate in just such a way to conform to inflation trends over multi-decade periods.
We do not subscribe to any such conspiracies. We believe the dividend-inflation trends we highlighted represent a visible hand of capitalism at work as required returns on capital effectively push inflation through the economy’s profit mechanism. Since dividends are taken out of profits and paid to directly to investors, they are not subject to the sentiment of often-fickle investors. This is especially important since investors can react negatively to inflation and send market prices lower at a time when liabilities may be rising. As such, we believe they provide a better source of income for investors who have liabilities that will likely grow with inflation.
We believe retirees, in particular, can leverage the benefits of dividends we highlighted in this article to combat the deleterious effects of inflation and market volatility. Indeed, our next article will outline an innovative approach to retirement income that leverages these notions and can yield significant advantages over standard withdrawal methods in the contexts of costs, risk, performance, taxes, and transparency.
| OVERVIEW
There has been abundant discussion regarding the utility of dividends. Many investment models rely on factors or other strategies in their attempt to increase returns or reduce volatility. These approaches generally focus on total returns and brush dividends under the rug. Some go further and argue specifically against dividends – occasionally likening dividend advocates to sacred cow worshippers. The low dividend yields and strong capital appreciation we have observed in recent years has probably diminished the reputation of dividends as well. On balance, we find the art and science of dividends has largely been forsaken. This is a pro-dividend article. While we acknowledge some issues with dividends (e.g., inefficiencies in how they return capital to shareholders), we find many investors and practitioners do not fully understand or appreciate some of the key attributes that can make dividends useful – especially in the context of retirement income. This article discusses some pros and cons of dividends. We also weigh in on previously-discussed issues and share what we believe are some new perspectives. Some of claims we revisit/challenge are:
As the title suggests, the primary goal of this article is to explain what makes dividends different. We believe it is important to acknowledge the intrinsic fundamental nature of dividends. In particular, this creates a unique value proposition in that dividends can provide investors with a growing stream of income that is largely independent of market volatility. On balance, we believe dividends are a powerful financial planning tool many retirement models seem to neglect. Please stay tuned for our future article(s) were we will present a retirement income strategy that leverages some of the benefits discussed in this article. |
Figure 1: Achieving the same result via different actions
 |
 |
Source: Aaron Brask Capital
We first explain what a dividend is and highlight its fundamental (as opposed to market-based) nature – a critical notion that resonates throughout the rest of the article. We then discuss two key issues regarding how dividends may be an inefficient means of returning capital to shareholders. The following two sections challenge popular claims regarding dividends and how they are related to market returns and buybacks. The penultimate section (before our concluding remarks) discusses the relevance of calculating performance via total returns versus internal rates of return in different contexts and shares related empirical observations.
Figure 2: Executive summary
Source: Aaron Brask Capital
A dividend is a direct cash[1] payment from a company to its shareholders. Of course, if you hold stocks and/or stock funds at a broker or custodian (e.g., Charles Schwab), then they will simply facilitate that payment by transferring the funds from the issuer to your account. In many cases, they will take your dividend and reinvest it by purchasing more shares of the stock via an automated DRIP (dividend reinvestment plan). A key point here is that dividends are paid directly from the operating business to shareholders. So they depend on the fundamental performance of the business and effectively bypass stock market volatility[2].
Figure 3: Dividends bypass market volatility
Source: Aaron Brask Capital
Of course, economic cycles and stock markets are related. For example, market collapses often occur around the same time as recessions. During these periods, the overall market’s fundamental performance (e.g., earnings) can slow or turn negative and result in dividends cuts. Based on these observations, some may be tempted to equate dividend risk and market volatility. However, this logic is not sound.
If we control for cyclical versus non-cyclical businesses (without a look-ahead bias), then the linkages between fundamentals, market prices, and dividends becomes more clear. For example, our data shows that dividends of non-cyclical businesses were significantly more robust than those from cyclical businesses during the last recession (i.e., the credit crisis) and other turbulent periods. While markets may have thrown out the babies (share prices of non-cyclical business) with the bath water (share prices of cyclical businesses), the underlying fundamentals were real drivers of dividend performance. We will revisit this notion and provide more data in our next article.
Another way to recognize the fundamental versus market–based nature of dividends is to consider a private company paying a consistent stream of dividends to its shareholders. Based on the operating performance of the business and management’s decisions, those dividends are 100% fundamental in nature. There isn’t even a market price to consider since it is a private company. Now let us consider what happens if this company went public with an IPO[3] but continued its policy of paying dividends. The company’s shares would trade on an exchange, but such trading would not alter the fundamental nature of the dividend cash flows.
Note: Recognizing this fundamental versus market-based nature of dividends is important as many of the arguments we put forth in the rest of this article rely on it.
Before we address some common misconceptions regarding dividends, we first acknowledge two related disadvantages. Both of these factors highlight potential inefficiency in how dividends return capital to shareholders.
The first and most straightforward issue relates to taxes. The crux of the disadvantage is that dividends are typically taxed in their entirety. Even if we use the same tax rate (i.e., long-term capital gains rates for qualified dividends), only the capital gain component of stock sold (i.e., not the cost basis) is taxed – not the entire dollar amount of stock sold. In this sense, dividends impose additional tax friction relative to selling one’s holdings and this imposes a real cost.
Assuming a hypothetical (qualified) dividend yield of 2% and long-term capital gains tax rate of 20%, dividends would impose approximately 40 basis points (20% x 2%) of tax drag. If the stock were flat or down, then there would be no capital gains tax for selling shares to create a synthetic[4] dividend. Only holdings with extremely low cost basis (i.e., the position is mostly capital gain) would trigger a similar magnitude of taxes upon selling.
The other issue we highlight relates to valuation. Consider an investor who reinvests dividends in a company. The dividend represents a direct transfer of book value[5] from the balance sheet to the shareholder on a dollar for dollar basis (i.e., each dollar of dividend reduces the book value by one dollar[6]). However, when reinvesting the dividend, this investor will likely repurchase book value at a premium (i.e., the price to book ratio is typically greater than one). This is effectively buying high and selling low (albeit in the opposite order). Warren Buffett touched on this topic and shared an illustrative example in his 2012 annual letter. There are multiple assumptions and nuances embedded his analysis,[7] but the conclusion is straightforward: returning capital via dividends can negatively impact investors.
Conventional wisdom amongst many academics and practitioners is that dividends are the same as capital appreciation for all intents and purposes.[8] They assume one should be indifferent to receiving dividends versus selling shares to generate the same level of income. We disagree. The following two subsections highlight and refute what we believe are the two most popular pieces of evidence (academic research and the ex-dividend phenomenon) used to argue for dividends’ equivalence to capital appreciation.
Perhaps the most popular research articles commonly referenced in this context is a 1961 paper entitled Dividend Policy, Growth, and the Valuation of Shares by Merton H. Miller and Franco Modigliani (M&M). The article starts out by assuming “… an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty.” We find each of these assumptions rather unrealistic. So we are naturally skeptical of any conclusions based on all three. Notwithstanding, we will try to highlight where we believe their logic does not gel with the real world.
First, let us consider Buffett’s 2012 annual letter highlighted above where he unambiguously argues dividend policy does matter for investors. Taking Buffett’s words for gospel, we might be tempted to stop there. However, it is more informative to reconcile these two theories and get to the heart of the matter. We break this challenge down into two scenarios: one where the dividend is spent and the other where it is reinvested.
In the case where a dividend is kept or spent (i.e., not reinvested), this income comes directly from the company and is thus fundamental in nature – not impacted by the daily noise in the market. However, if one were to create a synthetic dividend via selling stock, the price of the stock would matter. For example, any market noise on that day (e.g., a Trump tweet) could change the price and hence the number of shares one would need to sell, but would not alter a dividend payment. The essence of risk is different (fundamental vs market-based) and we believe this differentiates real dividends from synthetically generated dividends and capital appreciation, both of which are clearly impacted by market noise.
The potentially more interesting case to consider is when a dividend is reinvested. The discussion and calculation of stock returns[9] in the M&M paper indicates there is an embedded assumption the money would not be spent but remain (re)invested. A fair question to ask is: What if the market prices were different that day? Then the investor would purchase either more or fewer shares with that dividend. Moreover, they would still generally end up owning less book value than if the dividend were not paid. This is due to the transition of each dollar of dividends from the balance sheet to the shareholder. As highlighted above, the market typically values each dollar on the balance sheet at a premium (i.e., the price to book value is usually greater than one). However, once it is passed on to shareholders, it is just a dollar. So when each dollar of dividend is reinvested, it purchases less than one dollar of book value.
The net result is the shareholder owning less book value. If that dollar were left on the balance sheet and put to productive use within the company (even if the marginal rate of ROA or ROE was slightly lower), it would still be valued at a premium. So the payment of a dividend (versus no dividend) clearly has an impact on what shareholders own and thus pokes a hole in the M&M paper’s conclusions.
| Concept: Dividend duality
In our view, dividends represent a unique phenomenon in that they straddle (pierce) the veil between corporate fundamentals and markets prices.[10] The M&M paper ignores this subtle but interesting dichotomy. We are by no means saying this was an intentional omission; it is simply a byproduct of their framework that does not look below the surface of market prices to consider fundamental performance or valuation. Instead, their starting point was efficient markets. So their assumptions did not allow for the possibility of such an inconsistency (i.e., dollars inside the company may be valued more than dollars outside). Of course, it is not surprising there is some discrepancy on the matter since M&M’s assumptions regarding market efficiency are at odds with Buffett’s take on markets and picking stocks. Indeed, one might say our view on fundamentals and markets represents a bottom-up perspective. We believe there are fundamentals and that prices generally follow them over the long run. However, the M&M paper takes a top-down perspective. They effectively assume the market is right and reverse engineer conclusions from there. We suspect this fundamental versus market duality of dividends is not compatible with many of the market models and assumptions used in academia and practice. In their white paper entitled The Dividend Disconnect, Samuel M. Hartzmark and David H. Solomon (H&S) identify and discuss behavioral patterns related to dividends that many investors exhibit. Their paper starts with a quote (from James MacKintosh of the Wall Street Journal) that glorifies dividends as being the rightful “arbiter of stock-market value.” Then they highlight the irrelevance of dividends (versus, say, synthetic dividends or capital appreciation) based on the M&M paper. This concept provides the basis for their analysis whereby they make interesting observations regarding investors’ behaviors around dividends that are seemingly irrational given the assumption of dividend irrelevance. They even go as far as to put forth the notion of the free dividend fallacy whereby some investors may view dividends as being free and not impacting the corresponding stock prices. We find ourselves somewhere in the middle. On one hand, we do not believe dividends are free or that they are the ultimate rightful “arbiter of stock-market value.” On the other hand, we do not find them irrelevant either. Given our healthy respect for dividends and their fundamental/market duality, we find the observations from the H&S paper unsurprising. We suspect many of their conclusions are the result of widely varying utility functions digesting this duality differently. For example, savers in the accumulation phase and retirees focused on income may perceive and value dividends very differently. It may simply be the case that dividend-paying stocks should be analyzed in a different manner than companies that do not pay dividends. Accordingly, many existing market models may need refinement to better accommodate this concept of dividend duality. |
| Geek’s note
Here we mathematically interpret and reconcile the assumptions behind the M&M paper and those described in Buffett’s 2012 annual letter. First their respective formulas for stock returns: ρMM (t)=(p(t+1)+d(t))/p(t) -1 Miller/Modigliani: where ρ represents the return over period t, is the price at time t, and is the dividend paid at time t. ρWB (t)=(p(t)×(1+ROE)-(MTB-1)×d(t))/p(t) -1 Warren Buffett: where is the assumed return on equity and is the assumed market to book ratio (a.k.a. price to book). The first formula is a taken directly from the M&M paper with minor algebraic manipulation. The second formula is our translation of Buffett’s framework from the 2012 annual letter. The real world of fundamentals and markets naturally do not conform to either of these rigid models, but we believe the formulas can help us illustrate a couple points. First, the numerator of the fraction describing Buffett’s return grows book value by the ROE, but then subtracts a second term. That second term effectively represents a penalty for dividends. On the balance sheet, those dollars of equity are valued at a premium (MTB), but they are regular dollars when passed shareholders. Note: In the absence of dividends, the return on the stock is the same as the ROE in his framework – an observation we find sensible. Second, the M&M formula for return involves no fundamental factors. In fact, the returns are exogenously defined so that they are equal for all stocks. So the formula does not represent a function whereby independent variables are combined to calculate a dependent variable (as is the case with the formula based on Buffett’s framework). Instead, the variables on the right side of the equal sign are effectively there to conform to the return on the left side. This effectively highlights the mathematical distinction between the top-down M&M model and Buffett’s bottom-up framework. |
The ex-dividend phenomenon (EDP) describes the pattern whereby stock prices tend to decline by the amount of their dividends once they trade ex-dividend. There is much research supporting this hypothesis and our findings corroborate it as well. However, there are many who cite the EDP as empirical evidence or conclusive proof of the equivalence between dividends and market prices. This is where we disagree. To be sure, we would not be convinced even if ex-dividend price declines perfectly reflected the dividend amounts in every instance.
According to Buffett’s example and our concept of dividend duality, it may be the case that some value is destroyed at the instant when cash for dividends leaves the balance sheet and goes to shareholders. I have not seen or heard of any such models, but it is possible markets decompose stock values into their future reinvested earnings and their dividend stream. These models could even discount the price to reflect the value destruction highlighted above. So dividends would effectively accrue,[11] but they would be valued separately from other book value on the balance sheet.
Under these contrived market model assumptions, dividend duality would no longer be a concern as the balance sheet cash earmarked for dividends would be accounted for separately and could thus make a more seamless transition from the balance sheet to the shareholder – thereby making this efficient market framework perfectly compatible with the EDP.
We simply do not believe markets systematically value stocks this way. Markets are made up of many investors with different utility functions[12] and much market volatility is just noise. In fact, daily stock price volatility is on a similar order of magnitude as ex-dividend adjustments.[13] So we find it presumptuous, if not naïve, to assume markets operate this way when stock price volatility can mask the real mechanics of fundamentals and valuations.
The discussion above does not disprove the logic whereby some use the EDP as evidence that dividends and capital appreciation (or synthetic dividends) are equivalent. It merely pokes holes in one theory (our contrived market model) that would be sufficient to equate the two. To call this equivalence further into question, we highlight another theory that could explain the EDP, but still allows for the possibility of dividends being different.
Let us now consider the derivatives market. Unlike cash markets where the activity of buyers and sellers sets prices, most derivatives are priced by arbitrage. That is, their prices do not necessarily reflect traders’ expectations of how those derivatives will perform. Instead, their prices are determined by how much it costs to hedge the derivative risk.
A forward or future contract might serve as a good example. Think of a hypothetical stock XYZ with a current price of $100. The price of a future whereby the stock would be delivered one year from today has nothing to do with futures traders’ expectations for this stock. Instead, they think of the cost of delivering that stock to their counterparty with as little risk as possible. In this case, they borrow $100 at, say, 5% and purchase the stock. They plan to sit on it for a year and then deliver it to the other party. Knowing they will have to repay $105[14] to their creditor, they set the price of the future contract accordingly. Any other price (higher or lower) would leave an arbitrage opportunity on the table.
The key point here is that the derivative price is set by arbitrage assumptions – not market expectations. This introduces another duality; one could have a view on the price of a derivative that differs from the arbitrage price. For a futures contract, this discrepancy is less interesting since a view on the futures contract would effectively just be a view on the underlying. However, it can get more interesting with options or more complex derivative products. For example, Berkshire Hathaway sold some derivatives (basically insurance or put options on equity indices) where the arbitrage-determined prices were higher than their expectations.
The EDP may simply reflect arbitrage. If stocks did not adjust by the amount of the dividend, then there might be an arbitrage. Strictly speaking, the EDP would fall into the category of statistical arbitrage since prices could move overnight based on other factors – noise or real news. Even so, arbitrage theory represents a very plausible (likely in our view) explanation for the EDP.
As Figure 1 indicates (see this link for a more humorous example of confusing cause and correlation), it is not always obvious what the true driver of a particular result is when observing an event. In this case, the ex-dividend price drop clearly reflects the amount of the dividend to some extent. However, we believe it is a mistake to interpret this observation with too much precision. Given the nuances of dividend duality, magnitude of market noise, and the existence of arbitrage as an alternative explanation for the EDP, we find it presumptuous to conclude that dividends and synthetic dividends are equivalent.
Let us first state that we agree that dividends are equivalent to buybacks when the dividends are reinvested. In this case, one ends up owning the same amount of book value as they would have had there been no dividend. Of course, taxes and the price one reinvests at[15] may alter things to some degree. However, the key element here is that both scenarios involve the purchase of book value at the same premium. This was not the case when we compared a reinvested dividend to a non-dividend payer.[16]
In the case where dividends are not reinvested in the same stock, dividends are not equivalent to buybacks. This follows from the distinction we made earlier regarding how income is generated. In the case dividends, investors receive a direct stream of cash flows directly from the companies, which makes any market volatility or noise irrelevant. In the case of buybacks, one will be at the mercy of the market when they go to sell shares to create their synthetic dividend. This market dependence makes buybacks intrinsically different than dividends.
So far, much of this article has focused on understanding dividends and how they are different than capital appreciation. We made the distinction between whether dividends would be reinvested or not to clarify some of our arguments. We now highlight what we believe to be a better way to account for dividends in the context of retirees and other situations where dividends are spent and not reinvested.
For example, those in the accumulation phase (i.e., savers) may be more likely to reinvest dividends whereas those in the decumulation phase (i.e., retirees) might not be. This raises an interesting question regarding market performance calculations. In particular, is the total return (TR) or internal rate of return (IRR) calculation more appropriate?
Perhaps we are ignorant of the literature on the topic and we did not try hard enough to find relevant material, but we did not come across a paper or article that accurately reflected our perspective on the relevance of TR versus IRR for different investment purposes (i.e., saving versus retirement income).[17] Given our view that dividends are different (than, say, capital appreciation), we are naturally cautious about calculations that mix the two together.
The total return calculation conflates the notions of dividends and capital appreciation. When dividends are reinvested, they effectively ride on the back of future capital appreciation. So if one uses TR metrics, the information regarding the contribution from dividends is lost. In other words, you can use capital appreciation and dividends to calculate TR, but you cannot back out capital appreciation or dividend information from TR data.
This is why we believe IRR metrics can be useful – especially in the context where investment income will be spent rather than reinvested. IRR allows one to easily disentangle dividends from capital appreciation. Indeed, you start with an initial investment in a stock (or other asset). Then for any given period, you will have a stream of dividends and the terminal value of the stock at the end. You can calculate the IRR of the capital appreciation alone and then you can calculate the IRR with the dividends.
One might argue you could make similar calculations with and without dividends via TR. However, the key distinction here is that TR calculations depend on the trajectory of the share price – not just the terminal value. The IRR is not impacted if prices go up then down, down then up, or monotonically inch toward their final destination.
To be sure, TR calculations are convenient to use and are stored in thousands of databases. Virtually all academics and practitioners utilize TR for measuring stock performance. We suspect the bifurcation of the investment services industry between security selection and asset allocation[18] reinforces this trend. Indeed, investment advisors typically sift through the universe of funds and other investments based on TRs (and other technical measures like volatility, correlations, etc.) and build portfolios and asset allocations accordingly. So they effectively ignore dividends and that suits their needs.
As the British statistician George E.P. Box wrote, “All models are wrong but some are useful.” It is fine if dividends do not play a role in everyone’s models. However, we like to acknowledge the fundamental nature of dividends and the potential utility they can provide, especially in the context of retirement income. So we finish this section with some comparisons of the IRR and TR calculations. The first scenario is hypothetical and assumes share prices and dividends grow at a rate of 5%. The second scenario is based on S&P 500 data index over the last century (1918-2018). We think of this second scenario as a real-world sanity check for the results in our hypothetical scenario.
In a world where share prices and dividends grow by precisely 5% each year, the TR and IRR over every period is 10%. This is simply by construction. What is interesting is the difference between the dividend contributions as measured by TR vs IRR. Let us consider a 30-year period (not atypical for a retirement time horizon). The TR excluding dividends is 5% – again by construction. So that means dividends contributed 5% or half of the TR. However, the dividend contribution when measured by IRR was 7.6%. So the capital appreciation contributed just 2.4% when measured by IRR. If we extended the time period to 100 years, then the dividends claim an even larger share of the contribution – 9.95% of the total 10% return – when measured by IRR.
Figure 4: Dividend contribution depends on context (hypothetical portfolio)
Source: Aaron Brask Capital (Robert Shiller’s online data)
Of course, the above scenario is contrived and the real world does not follow formulaic conventions. So let us look at the second scenario using real data. Over the last 30 years (1988-2018), the S&P 500 TR was approximately[19] 10.3% and dividends contributed 2.0% of this. During the same period, we calculated the IRR to be 11.1% with dividends contributing 5.9%.
Over the last 100 years (1918-2018), the S&P 500 TR was approximately 10.1% and dividends contributed 3.9% of this. During the same period, we calculated the IRR to be 10.0% with dividends contributing 9.8%.
Figure 5: Dividend contribution depends on context (S&P 500)
Source: Aaron Brask Capital (Robert Shiller’s online data)
Of course, much of what we see in these results is just the mathematics of the starting dividend yield and subsequent growth (both dividends and capital appreciation). However, it should be evident that the contribution of dividends is relative – to both the context of the investor and the time frame. This is an important consideration when you come across claims regarding the importance of dividends or how much they contribute to overall market returns. Moreover, this analysis highlights the utility of the IRR metric when one wishes to truly isolate contributions from dividend versus capital appreciation.
Why did we write this article? Some might say we just like to quibble over pointless semantics. That is certainly not the case here (though the author is guilty of this sometimes). We are preparing the groundwork for future articles where we will articulate what we believe is a new and innovative retirement income strategy. Dividends are an essential component of this approach, but we simply prefer not to dilute that discussion.
This article addresses some misconceptions and mischaracterizations related to dividends. Some of these are likely the result of what we dub dividend duality. Indeed, dividends’ unique ability to straddle and pierce the corporate veil represents an anomaly that many market models may not be able to properly digest.
We may have beaten this horse to death, but the primary point of this article is to show that dividends are different. In some ways, this is negative (e.g., taxes and loss of valuation premium). In other ways, this can be positive. Given that dividends are direct transfers of assets (typically cash) from companies to shareholders, they can provide growing streams of income that are largely independent of market volatility.
It is important to understand there are different perspectives at play here. There is the decision by each company to pay a dividend (and/or buyback stock) or not. As the CEO of Berkshire Hathaway, Warren Buffett clearly prefers not to pay dividends. We understand his reasoning and do not disagree with his logic.
As investors, however, we are selecting stocks. Some pay dividends and some do not. Even those who are most critical of dividends seem to agree it is not sensible to let the dividend tail wag the dog. That is, dividends may have their disadvantages, but they are not so bad as to avoid them altogether.
Many credible approaches to investing and retirement income (e.g., factor models) still invest in dividend-paying stocks. Some even have higher dividend yields[20] and thus suffer more from the disadvantages we highlighted earlier. So these investment managers are clearly not avoiding dividends payers. We suspect they simply do not want to constrain their opportunity set (i.e., the universe they draw from) as it could have unintended consequences and potentially detract from performance (e.g., bias toward growth stocks which could underperform or be more volatile).
As a parting summary to help avoid ambiguity, here we layout several items we are and are not claiming:
What we are claiming:
|
What we are not claiming:
|
Net unrealized appreciation (NUA) refers to an IRS provision regarding company stock inside a retirement plan. If you have come to this page to learn about NUA, then you are probably facing an important but potentially challenging decision. In particular, you may be investigating whether you should distribute some or all of these securities in-kind.
This approach may provide tax advantages. That is, the NUA will ultimately be taxed as a long-term capital gain rather than as ordinary income. However, it may also leave you with concentrated risk in your company’s stock.
Alternatively, you may have the option to roll these shares over into an IRA. This approach allows for diversification into other investments. However, these funds will ultimately be taxed as ordinary income upon distribution.
One must weigh the tax benefits against the investment (i.e., concentration risk) considerations. Only then can one sensibly decide what to do with shares of stock in your company’s retirement plan.
For those with significant company stock holdings, NUA is naturally a more critical decision worth taking the time to analyze. Moreover, this is a very nuanced decision. So it should not be taken lightly or based on rules of thumb. Indeed, there are many variables that go into this decision and they are different for everyone. Some of these include:
In the process of helping my clients with their NUA decisions, I looked for resources to help me make some relevant calculations and weigh various options. However, the online NUA tools I came across were inadequate for multiple reasons. In particular, their models embedded erroneous assumptions and overlooked significant details.
In some cases, they naively compared the total amount of taxes paid for the NUA versus an IRA rollover option. However, minimizing taxes paid is not the same as maximizing after-tax returns or wealth. For example, consider the IRA rollover option. Only looking at the taxes one pays completely ignores the benefits provided by IRA accounts. However, some of these benefits are significant and can extend beyond the original owner’s lifetime (i.e., via inherited IRAs). I provide a more technical accounting of the math behind the benefits of retirement accounts in my article Quantifying the Value of Retirement Accounts. Moreover, my follow-up article Illustrating the Value of Retirement Accounts provides more user-friendly examples.
Given these issues with existing tools, I decided to build my own model. My goal was to provide a more accurate and comprehensive analysis. You can find my free online NUA tool at www.NUAcalc.com. I made this tool for roll-up-your-sleeves DIY individuals and professional advisors dealing with NUA options. If that is you, then I hope it can help you make better decisions. If that is not you and you would like specific advice regarding NUA or other investment-related matters, please get in touch (details on my contact page).
Please note: I have not updated this tool after the passing of the 2017 Tax Cuts and Jobs Act (TCJA). However, you can customize the inputs to reflect the shortening of ‘stretch’ options.
You may also learn more about me and my firm here:
This article attempts to clear up some of the confusion around the assumptions, logic, and results discussed in my previous article on retirement accounts.
Continue reading
This article quantifies the immense value in not having to pay taxes on investment income and rebalancing (i.e., dividends, interest, and capital gains) within retirement accounts.
Continue reading
This article dispels any notion of a relationship between correlations and opportunities for active managers to perform despite the many comments that assume such a relationship exists.
Continue reading
| There has been much discussion of the small cap premium recently. Has its popularity cannibalized its utility? Are large firms preventing a level playing field? Will the small cap premium exist going forward?
This article does not address these concerns directly, but it does identify and analyze another potential issue that could diminish the utility of small cap exposures. In particular, I investigate how stock mispricing and misplacement could impact the performance of size-based indices. |
Figure 1: Security Misplacement
Source: Aaron Brask Capital
I first provide some relevant background information and then I define and discuss the issue of security misplacement. In particular, I highlight potential implications security misplacement has for the performance of portfolios and indices involving small cap (SC) exposures. I then present a simulation model to capture this misplacement phenomenon and quantify its impact.
While I appreciate the behavioral side of finance, I have also pitched a tent in the mispricing camp. I believe there is a certain level of chaos inherent in our markets. Indeed, there are many types of investors with different needs, emotions, models, etc. The inevitable flows from their competing perspectives create occasional if not constant mispricing in many securities. While it might be tempting to believe hedge funds and active market participants instantly jump on these opportunities and keep prices in line, in practice there are limits constraining their ability to do so (constraints on short-selling and a popular J.M. Keynes quote come to mind).
This is not to say one should not question why opportunities exist. Indeed, I have seen many hedge fund blowups due to a lack of sufficient scrutiny of what may have appeared to be obvious opportunities. I simply do not believe opportunities should be ignored if we have some reason to believe they are attractive and do not require more risk or transactional costs (even if we cannot specifically identify the root cause beyond the reasonable assumption that some opportunities are afforded by the general chaos inherent in our capital markets).
Just to be clear, my goal here is not to debate mispricing (it is just background for what follows). There is already much research on this topic and I believe the empirical evidence (e.g., from Alpha Architect and AQR) supports the notion that mispricing exists.
Figure 2: Mispricing versus Efficient Markets Illustration
Source: Aaron Brask Capital
So this leads me to the question ‘So what if mispricing exists?’ Even if we cannot necessarily pinpoint where it is (e.g., identifying specific stocks using bottom-up valuation analysis), understanding potential systematic implications of mispricing may allow investors to protect themselves from negative impacts. For example, let us consider Research Affiliates and their concept of fundamental indexation.
Their basic premise is that a stock portfolio based on market capitalization weighting (MCW) effectively over-weights overpriced stocks and under-weights underpriced stocks. Their solution was to use fundamental weights (i.e., quantities from financial statements instead of market prices). This approach severs the link between the market’s opinion (which could be wrong) on price from the stock weights and their research indicated significant improvement in historical performance using their fundamental weights.
| Note: Cliff Asness of AQR may have mocked the innovation claimed by fundamental indexation advocates (see these humorous slides), but I believe there is something special. Even if fundamental indexation is actually just one type of value investing (I would call it value-light), I believe it fulfills a need on behalf of investors who want market-proportioned portfolios without the mispricing biases. However, if relatively minor value-based adjustments are good, then a larger value-based adjustments might be even better (think QVAL for concentrated value exposure). |
This article highlights another potential negative implication related to stock mispricing. In particular, some stocks will be inadvertently misplaced in different size-based indices or portfolios. For example, consider the companies in a large-cap (LC) index. It is possible some of them are overpriced to the extent they could be placed in the corresponding mid-cap (MC) index if they were fairly valued. Thus, this could bias the LC index with richly valued firms and impose a drag on performance.
Going to the other end of the spectrum, the opposite could be true for small-cap (SC) indices. They might naturally catch some of the underpriced MC stocks and benefit from higher returns (at least over the long term). This raises an interesting question: Is it possible mispricing is partially responsible for the SC premium? This is the motivation for the simulation model and results I present in the next two sections.
| Note: Pure value (i.e., shopping in the valuation trash can) might represent the logical extreme of the mispricing phenomenon highlighted above and has historically provided investors with significantly higher returns than standard market portfolios. |
In order to highlight and quantify the impact of security mispricing on size-based exposures, I constructed a Monte-Carlo simulation with the following assumptions:
|
|
I have not specified the actual fundamentals or valuation metrics underlying the model. That would be a slippery slope as one could argue what levels of valuations are appropriate for firms with different growth rates, risks, etc. I have only modeled the existence of mispricing. Of course, the fundamentals of different firms grow at different rates. In fact, one might argue SC firms should grow at higher rates than LC. However, this do not take away from the overall results as my assumption is that mispricing exists regardless of how one accounts for these other details.
Most of the assumptions above are generic but there are two parameters I have chosen the level of volatility for mispricing (20%) and the period over which it is expected to revert (three years). There is nothing magical about these figures; I simply thought they were reasonable estimates. Moreover, the magnitude of turnover they generated in the simulations was on the same order of magnitude as historical levels of turnover realized in existing size-based indices[2]. This observation leads me to believe these assumptions are plausible. However, even if my volatility mispricing estimate of 20% was off, this would only impact the magnitude of the results – not the direction.
There are some interesting dynamics here. For example, more (less) mispricing increases (decreases) the amount of security misplacement and thus impacts performance more (less). This is fairly obvious in the LC (SC) portfolios where the impact is asymmetric and systematically negative (positive). However, it is also true within the MC portfolio. The (positive) impact of mispricing among larger stocks in this portfolio (where MC portfolio captures underpriced stocks from LC while migrating some overpriced stocks to LC) is naturally larger in magnitude than the negative impact of mispricing at the smaller end of the portfolio since the larger securities have larger weights. So the net impact of mispricing and misplacement is positive. Consequently, the net benefit is amplified (attenuated) with more (less) mispricing.
The model above assumes uniformity of mispricing across all sizes. In theory, there should be greater mispricing in SC stocks (e.g., less analyst coverage). This would balance out the impact asymmetry of mispricing on the larger versus smaller stocks – such as in the MC portfolio as discussed above. So I also ran simulations where mispricing was inversely scaled with size. Spoiler: Depending upon how I scale mispricing, the net impact on MC portfolio performance could be positive or negative.
It should be noted this framework does not include micro-caps which could impose the analogous drag around the lower breakpoint for SC portfolios (i.e., I did not allow for companies to fall out of or migrate up into the SC portfolio at the smaller end). However, we can still observe the net impact on the MC portfolio and draw some conclusions about the mispricing dynamics in the context of size-based portfolios. In particular, the impact for the LC portfolio will always be asymmetric and systematically impose a negative performance bias from mispricing and misplacement (regardless of whether mispricing is scaled or not).
| Note: I acknowledge this is not a perfect model. However, I believe it suffices in order to highlight and quantify (not necessarily precisely but at least reasonably) the potential impact of mispricing on size-based indices. As George Box (mathematician / statistician) is quoted saying, “All models are wrong but some are useful.” |
The simulation results are presented in the table below. It shows the results for the same lognormal distribution of mispricing (20% volatility) across all stocks – SC, MC, and LC (i.e., no scaling) and three scenarios for scaling mispricing inversely with size.
For reference, please note that returns would all be the same (assumed to be 10% here) in a perfectly efficient market simulation (i.e., no mispricing) by construction. Moreover, the total market portfolio in this simulation (all 300 stocks) averages 10% returns as well because the universe is static (i.e., no misplacement from outside the universe – such as micro-caps).
Figure 3: Impact of misplacement with and without scaling mispricing
| Large-cap | Mid-cap | Small-cap | Equal-weight | |
| No scaling | 9.8% | 10.8% | 12.5% | 11.3% |
| With scaling (10-30%) | 9.8% | 9.9% | 13.5% | 11.4% |
| With scaling (10-40%) | 9.8% | 9.4% | 15.0% | 12.1% |
| With scaling (20-40%) | 9.6% | 10.6% | 16.6% | 13.1% |
Source: Aaron Brask Capital
As expected (by construction), LC performance fell short of the 10% market average in all of the simulations. However, the underperformance was marginal at around 20-40bps. As discussed above, this is due to it absorbing some overpriced stocks from and losing underpriced to the MC portfolio. On the other hand, the equal-weight (EW) portfolio outperformed in all instances and its outperformance increased as the overall level of mispricing increased (from the top of the table to bottom).
| Note: At first, I thought the outperformance of the equal-weight over LC portfolios were too low. Indeed, Research Affiliates found that MCW imposed a performance drag of approximately 2%. However, I then realized I cannot compare the results directly to fundamental indexation because the simulation here only captures mispricing around the breakpoints – not across the entire portfolio. |
It is also worth noting the impact of scaling on the MC portfolio. Depending upon the scaling scenario, MC performance was either better or worse than the overall market. In cases where the relative scaling varied the most (from 10-30% or 3x and from 10-40% or 4x), the negative impact stemming from the lower breakpoint (absorbing overpriced from and losing underpriced to the SC portfolio) outweighed the benefit at the upper breakpoint with the LC portfolio. So the MC portfolio underperformed LC with the higher breadth of mispricing scaling but outperformed when scaling was less extreme.
The simulation was setup such that the SC portfolio did not suffer from these negatives issues associated with a lower breakpoint (i.e., assumed no micro-caps). So the significantly higher returns experienced by the SC portfolios should be taken with a grain of salt. In reality, the SC portfolio would have a lower breakpoint and it would impose a drag on performance. However, this does bring up another interesting consideration.
Given our assumption that mispricing is lognormally distributed (which I think is reasonable), there is another factor that will determine the amount of performance impact from misplacement. In particular, the distribution of market capitalizations for the firms in the universe will be a significant determinant for how much misplacement occurs around breakpoints. Indeed, if the sizes of the firms around breakpoints are tightly clustered, then mispricing will be more likely to create misplacement. If the sizes are more spread out, then mispricing will be less likely to help firms leapfrog across breakpoints.
This prompted me to investigate the distribution of (free-float adjusted) market capitalizations. The results I came up with are very interesting. I took the size of each company and divided it by the average size of the next 10 largest companies (then subtracted one). I then plotted the results across all companies in the iShares Total Market ETF. Interestingly, the shape was a smile. This indicates the largest and smallest firms were spread out (higher ratios) whereas many of the companies in the middle were closer together (on a percentage basis).
Figure 4: Dispersion of firm sizes across total market portfolio (free-float adjusted)
Source: Aaron Brask Capital
Curiosity got the best of me and I conducted the same analysis on the companies within the small, mid, and large iShares ETFs portfolios. This is where it gets more interesting. Each of these portfolios exhibited a similar smile-shaped output – again indicating the smallest and largest companies within each portfolio were more spread out. But wait! The distribution within the total market portfolio was not spread out except at the ends. So how could this be? If I were to tape these three distributions (for SC, MC, and LC) together, then I would have expected it to resemble the total market distribution as one big smile. However, that was not the case (there were three mini-smiles). It got me to thinking and I came up with two possible answers.
First, it is possible these mini-smiles are just the result of market volatility. Once an index rebalances, then the prices and hence market capitalizations will move around. This could cause more size disparity around the breakpoints.
The second idea that came to mind involves index rules. In particular, many index providers employ buffers around index breakpoints in order to mitigate unnecessary turnover. This could also keep some stocks from migrating across breakpoints and would also result in more size disparity near the breakpoints.
Figure 5: Dispersion of firm sizes across small, mid, and large portfolios (free-float adjusted)
| Large-cap
|
Mid-cap
|
Small-cap
|
Source: Aaron Brask Capital
My results were generated by a Monte-Carlo simulation and do not precisely capture all the dynamics (or real history) of our stock markets. However, I believe this is a fair market model for the purposes of illustrating the existence of mispricing impact.
Truth be told, the magnitude of my results were not as strong as I suspected before I conducted the analysis. In light of the minimal impact on the LC portfolio (20-40bps) and the variable impact on MC portfolios (teetering between positive and negative depending upon the scaling scenario), I am not convinced that mispricing and misplacement make up any significant portion of the SC premium. At the same time, I am pleased to have uncovered the interesting smile phenomenon around index breakpoints which warrants further consideration.
About Aaron Brask CapitalMany financial companies make the claim, but our firm is truly different – both in structure and spirit. We are structured as an independent, fee-only registered investment advisor. That means we do not promote any particular products and cannot receive commissions from third parties. In addition to holding us to a fiduciary standard, this structure further removes monetary conflicts of interests and aligns our interests with those of our clients. In terms of spirit, Aaron Brask Capital embodies the ethics, discipline, and expertise of its founder, Aaron Brask. In particular, his analytical background and experience working with some of the most affluent families around the globe have been critical in helping him formulate investment strategies that deliver performance and comfort to his clients. We continually strive to demonstrate our loyalty and value to our clients so they know their financial affairs are being handled with the care and expertise they deserve. |
Disclaimer
|
Source: Aaron Brask Capital
