In The Vanguard
®
Autumn 2016
Vanguard’s chairman emeritus remains
a powerful advocate for everyday investors
John J. Brennan heads the boards of several notable organizations,
reflecting his interests in philanthropy, business, education, and
investor rights. He’s still fiercely devoted to Vanguard and its
client-focused, value-oriented fundamental principles.
John J. Brennan
In this issue
pages 4–5
Jonathan Clements
suggests path to a
good financial life
The noted author’s latest
book says that the goal with
money is having enough to
lead the life we want.
pages 2–3
Since retiring as CEO in 2008 and chairman
in 2009, Mr. Brennan is as busy and committed to investors as ever. Along with his roles
as Vanguard chairman emeritus and senior
advisor, he serves as chairman of the boards
of trustees of Vanguard Charitable and the
University of Notre Dame and as lead
independent director of General Electric.
On August 15, Mr. Brennan also became
chairman of the Financial Industry Regulatory
Authority (FINRA) Board of Governors, where
he had been lead governor since 2011.
He spoke with In The Vanguard about
his new position with FINRA, the financial
markets, and his enduring allegiance to
the everyday investor.
For people who aren’t familiar with FINRA,
can you talk a little bit about what it does?
Mr. Brennan: FINRA’s an interesting
organization. Unlike most other regulators,
it is privately funded—by members, securities
firms, and fees on transactions in the markets.
It oversees most of the cross-market
surveillance of behaviors as well. FINRA has a
very succinct mission: investor protection and
market integrity. It has a strong, institutional
commitment to investors that is also core
to Vanguard.
Importantly, FINRA plays a crucial role for
Vanguard’s clients because it oversees the
markets and retail-oriented sales practices.
That’s, of course, also vitally important for
the broader investing public. FINRA does
a very good job protecting investors and
ensuring that markets are liquid and fair.
What are your duties with FINRA?
Mr. Brennan: As lead governor and now
chair, I’ve been working with the CEO and
the board to ensure that the governance
of FINRA is as strong as it can be. One of
the most enjoyable parts of my role is to
continue working closely with our new
CEO, Robert Cook, who brings great
talent, passion, and experience to
this role.
See Q&A WITH JOHN J. BRENNAN on page 7
Connect with Vanguard® > vanguard.com
Nothing seems to rise faster
than the cost of a college
education. You can take steps
to make it more affordable.
page 6
Some foreign central banks
have set negative interest
rates. What do those mean
for U.S. bond investors?
page 8
A look at historical returns
of large-capitalization funds
shows the edge that the lower
costs of indexing can offer.
Managing your wealth
How can you ease college expenses? Here are some tips
As any parent will tell you, nothing seems to rise
faster than the cost of a college education. Over
the past 30 years, colleges have raised tuition
and fees by an annual average of 3%–4% above
the rate of inflation, according to the College
Board.
Charu Gross
The average cost of tuition and fees at a public
university for the 2015–16 school year was
$9,410 for an in-state student and $23,898 for
an out-of-state student, a yearly College Board
survey found. The figure for a private nonprofit
university was much higher—$32,405.
Be aware of tax implications when tapping
various account types. For instance, you can
withdraw tax-free from tax-advantaged accounts,
such as a Roth IRA, provided the money is used
for qualified higher education expenses. But
spending from tax-deferred accounts, such as
a 401(k) plan or a traditional IRA, can increase
your taxable income.
There’s good news, though: You can take steps
to make college more affordable.
And be sure you aren’t undermining other
important goals.
Use tax benefits to offset college costs
Jonathan Kahler
student in a given tax year. Keep in mind that
529 accounts may also offer a state tax benefit.
Determine which benefit is most advantageous
and plan your spending accordingly.
In a perfect world, families could save enough
in a tax-advantaged account such as a 529 plan
to cover the full cost of college. But for most,
that goal is unrealistic. For 2015–2016, the
average family paid $14,540, including money
from parent and student income, savings, and
loans. That represents 61% of the total cost of
tuition, room and board, and other expenses,
according to education lender Sallie Mae. The
remainder came from financial aid, including
scholarships and grants.
One way that families can maximize their college
funds is through tax savings from a tax-efficient
spending plan.
Because 529 plan assets already provide a tax
benefit, dollars spent from that account won’t
let you take advantage of benefits such as the
American Opportunity Tax Credit. The AOTC
provides a $2,500 credit on $4,000 of qualified
spending. For federal tax purposes, you can use
only one education credit or deduction per
“Be careful not to shortchange your retirement
by dipping into your savings to pay tuition bills,”
said Charu Gross, head of Vanguard’s Education
Savings Group. “You may ease your short-term
financial obligations, but these actions can have
long-term financial impact. As the saying goes,
you can borrow for your child’s education, but
you can’t borrow for your retirement.”
Obtaining financial aid
A college education is one of the most
expensive investments you’ll ever make.
Fortunately, the vast majority of students
receive some form of financial aid, and
70% of aid recipients get it in the form of
grants and scholarships, which don’t need
to be repaid.
It’s important to understand how saving and
spending decisions can affect the availability
and amount of aid your child receives. For
example, distributions from a 529 account
owned by a grandparent are considered
student income and may lower aid eligibility.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure
a profit or protect against a loss.
For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description,
which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully
before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or
the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments
in such state’s qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for
some 529 plans.
2
In The Vanguard > Autumn 2016
Likewise, 529 assets in a dependent student’s
account are considered parental assets, which
can also affect eligibility.
Identify the income sources and assets that
most affect eligibility, and create a spending
strategy that maximizes your child’s chances
of obtaining aid. Consider spending any
savings that your child has accumulated
early on in college.
Spend strategically from your 529
You can make the most of a 529 plan by spending
strategically. Understand which college expenses
can be paid for with your 529 savings.
Start by inventorying your expenses and
resources. Include any expected contributions
from grandparents or other relatives. Consider
delaying spending from tax-advantaged accounts
such as your 529 plan until the student’s later
years of college.
“One area where families often get tripped up
is spending from a 529 owned by a grandparent
or other relative,” said Jonathan Kahler, an
analyst in Vanguard Investment Strategy Group.
“When expenses are paid from those accounts,
it’s counted as student income. Financial aid is
based on the applicant’s tax returns from the
prior two years, so if you hold off on spending
from those accounts until the student’s final
two years of college, it will no longer affect
aid eligibility.”
For a closer look at what to
consider when financing
college costs, see Tackling
the Tuition Bill: Managing
Higher Education Expenses,
available at vanguard.com/
tacklingtuition.
At the same time, spreading out spending from
your 529 can allow for continued tax-deferred
growth, which can reduce the amount you need
to borrow or to pay out of pocket. Continued
contributions to your 529 during your child’s
college years can also help, especially in states
that offer a tax benefit on them. If you have
more than one college-bound child, you can
transfer unused money to another beneficiary
to avoid taxes and penalties on earnings.
Although the cost of college can be intimidating,
creating a tax-efficient spending plan can help
ease your burden. ■
Review your tax situation before year-end for possible savings
Most people wait until tax-filing season to
assess their tax situation, but it’s far better
to do so before the end of the year. That way,
you’ll have time to make adjustments to save
on your 2016 taxes. Here are three steps you
can take:
Look at the big picture. Map out a financial
strategy through the end of 2016 and consider
the tax implications. Were you planning to defer
income until 2017, for example, or make a large
charitable contribution by year-end? You may
conclude that it’s more tax-efficient to delay
some plans until 2017 or move up some of
next year’s plans to this year.
Make sure your withholdings are on target.
Figure out what you’ve already paid in 2016 in
federal and state taxes. Have you underpaid?
Overpaid? The goal at year-end is to be as
close as possible to what you actually owe,
so you can avoid paying penalties or receiving
oversized refunds.
Be aware of recent changes. The only constant
in tax law is change. But it’s difficult to anticipate
how IRS rules and rates may change or when,
or how a particular revision may affect a specific
taxpayer in a given year. Monitoring what has
changed and how that may affect the amount
you owe can help you be tax-efficient. ■
Notes: The information provided here is for educational purposes only and is not intended to be construed as legal
or tax advice. We recommend that you consult a tax or financial advisor about your individual situation. It is possible
that tax-managed funds will not meet their objective of being tax-efficient.
Connect with Vanguard > vanguard.com
3
Managing your wealth
Author offers his recipe for a ‘happy, successful financial life’
Jonathan Clements
Money has always been necessary to survive
and thrive, but an outsized supply isn’t
guaranteed to satisfy. In his new book, How
to Think About Money, Jonathan Clements
explores the field of behavioral finance and
draws some enlightening conclusions based
on his 31-year career as a personal finance
journalist, most notably with The Wall Street
Journal. Mr. Clements recently spoke with
In The Vanguard by email about his book and
its message that investors are best served
by having a healthy, less stressful relationship
with money.
Your book’s title seems ambitious. How did you
select this topic, and what was your motivation
for writing the book?
Mr. Clements: Intelligent money management
is fairly straightforward: We settle on our goals,
take on debt cautiously, save diligently, hold
down investment costs, manage taxes, diversify
broadly, and buy insurance against life’s major
financial risks. Yet, despite the relative simplicity,
many folks make major financial mistakes, they
worry constantly about money, and they don’t
get all that much happiness from the dollars they
spend. That raises an obvious question: What
does it take to have a happy, successful financial
life? I’ve thought about this question a lot over
the past three decades—and How to Think
About Money is the result.
Do people treat money in a more complicated
way than necessary? If so, why?
Mr. Clements: We all like to think we’re rational
when handling money, but there’s ample
evidence that suggests otherwise. We struggle
to save enough. We become unnerved when
the stock market goes down. We think we
4
In The Vanguard > Autumn 2016
can outperform the market averages. We buy
possessions not just for their utility, but also
because of how they make us feel and what
statement they make about us to the rest
of the world. This maelstrom of greed and
fear leads us to spend too much, earn
lackluster investment results, and end up
with an unnecessarily messy financial life.
Part of the blame lies with the hardwired
instincts we inherited from our hunter-gatherer
ancestors. Our nomadic ancestors were focused
on surviving until tomorrow. We, on the other
hand, have to focus on saving for a retirement
that might be 40 years away. Not surprisingly,
this isn’t something that comes naturally to us.
Part of the blame, however, also lies with
financial firms. Wall Street feeds the fantasy that
investors can beat the market, because efforts
to beat the market are highly profitable—for Wall
Street. You can charge a lot more for an actively
managed fund than for an index fund.
You express some skepticism about Wall Street,
yet you make a compelling case for investing in
the stock market. Why should we continue to
have faith in the U.S. and global economies?
Mr. Clements: As long as the global economy
keeps growing, stocks should be a decent
long-run investment. But make no mistake:
Returns over the coming years will likely be
lower than historical averages, partly because
the U.S. economy will almost certainly grow
more slowly and partly because valuations
are richer.
Over the past 50 calendar years, we’ve had
annual inflation-adjusted economic growth of
2.9%, with half coming from rising productivity
and half from increasing the number of workers.
But with the workforce projected to grow at just
0.5% a year, well below the 1.5% average over
the past 50 years, it’s more reasonable to expect
2% average annual economic growth. That, in
turn, might mean 2% annual growth in corporate
earnings. Meanwhile, dividend yields today are
closer to 2%, versus the almost 3% they were
50 years ago. Add that 2% dividend yield to the
2% expected growth in corporate earnings, and
you might be looking at long-run stock returns
that are perhaps 4 percentage points a year
above inflation. That’s far below the historical
average of 7 percentage points.
How are people better served by thinking about
money as a tool, rather than as a trophy?
Mr. Clements: As I argue in my book, managing
money shouldn’t be about proving how clever
we are, beating the market, or becoming the
richest family in town. Instead, it’s about putting
aside money today so we can spend it tomorrow
on important goals like purchasing a house,
putting kids through college, and retiring in
comfort. These specific goals fall within a larger,
overriding objective: We want to have enough
money to lead the life that we want.
Each of us gets just one shot at making life’s
financial journey—and we shouldn’t do anything
that could potentially derail that journey. When
the issue is framed that way, it becomes much
clearer how we should handle our money. We
should eschew unnecessary risk and instead
pursue strategies that have a high likelihood
of success. That means diversifying broadly,
minimizing investment costs and taxes, and
purchasing insurance against major financial
threats.
You write that income doesn’t appear to affect
happiness after it reaches roughly $75,000.
How was that figure computed?
Mr. Clements: The $75,000 comes from a
study by academics Daniel Kahneman and
Angus Deaton and was based on Gallup
Organization survey data. What’s shocking
is how low it is. A key implication is that if
we want a happier financial life, we shouldn’t
focus on earning more. Instead, we should
think hard about how best to use the money
we already have. Think about all the dollars
you’ve spent in 2016, especially discretionary
spending on items like dinners out, travel, and
possessions you wanted but didn’t really need.
Which of these expenditures brought you the
greatest pleasure—and which purchases made
little or no difference to your happiness?
How can saving and investing lead to freedom
and happiness?
Mr. Clements: I believe there are three things
money can do for us. First, having some savings,
coupled with a reasonable grasp of financial
basics, can lead us to worry less about money—
and that’s a huge benefit. Second, we can use
our money to create special times with friends
and family, which research suggests will deliver
a big boost to happiness. Third, money can allow
us to spend our days doing what we love. We
talk about retirement as though it’s the great
financial prize. But in truth, most of us get a lot
of satisfaction from work—as long as it’s work
we’re passionate about. If we’re smart about
managing money, we can achieve true financial
freedom. In my book, that means spending our
days focused on activities that we think are
interesting and important. ■
Note: Opinions expressed by Mr. Clements are not necessarily those of Vanguard.
Connect with Vanguard > vanguard.com
5
Investing your money
Are negative interest rates a negative for bond investors?
The idea of bonds with negative interest rates
can be difficult to grasp. But that’s been the
reality lately in some markets outside the United
States. Instead of getting paid to lend money to
bond issuers, lenders are essentially paying
borrowers for the privilege of making the loan.
Greg Davis
How did this happen?
Some central banks, notably those in Europe
and Japan, have enacted negative short-term
rates, charging banks for depositing money. The
central banks are trying to stimulate economic
growth by making it so cheap to borrow money
that consumers and businesses will be prodded
to spend and invest more.
And with prevailing interest rates so low, bond
buyers have bid up prices so high that the yields
of some bonds have dropped below 0% in the
open market in more than 20 nations, including
Japan, Germany, and Switzerland. (Bond prices
and yields move in opposite directions.)
The impact on investors
Although negative rates have rarely appeared
in the U.S. bond market (except for Treasury
Inflation-Protected Securities), the downward
pressure on yields worldwide has affected it.
U.S. bond fund yields have fallen, and net
asset values have risen sharply.
Bond fund investors may enjoy seeing their
principal balances grow, but the shrinking yields
are tempting some income-oriented investors
to shift their money into riskier higher-yielding
bonds or dividend-paying stocks.
As a result, those investors may be exposing
themselves to more volatility than they’re
prepared to handle.
What about people who hold international bonds
to better diversify their portfolios?
Even though yields for many foreign bonds
have sunk below 0% in their native currencies,
it still makes sense for investors to hold
international bonds, said Greg Davis, global
head of Vanguard’s Fixed Income Group.
Traditional currency hedging changes the
equation for U.S. investors when foreign
bond returns are converted into U.S. dollars.
“Through currency hedging, the yields of
international bonds look more like domestic
yields for U.S. investors,” Mr. Davis said.
“With hedging, the ‘currency-adjusted’ yield
on international bonds for U.S. investors has
been positive, because U.S. yields have
remained positive.”
What should investors do?
Many investors worry that bond prices have
nowhere to go but down. Even if that happens,
Mr. Davis said, long-term investors can ultimately
benefit by reinvesting dividends into higheryielding bonds, resulting in higher total returns.
Nonetheless, he said, “the days of above-average
annual returns from bonds are probably over.
We’re likely to remain in a low-yield, low-return
environment for a while.”
It’s important to remember the primary role of
bonds in a long-term portfolio, Mr. Davis said.
“The best reason for investors to hold bonds
is not just for their regular income, but also
for their role in cushioning a portfolio from
the volatility of the stock market,” he said.
“They’re a powerful diversifier. They’ve
proven their worth over and over again.” ■
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of
rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal
in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the
price of that bond to decline. Investments in stocks or bonds issued by non-U.S. companies are subject to
risks including country/regional risk and currency risk.
Currency hedging is the chance that currency hedging transactions may not perfectly offset a security’s
foreign currency exposures and may eliminate any chance for a security to benefit from favorable
fluctuations in relevant currency exchange rates.
6
In The Vanguard > Autumn 2016
Putting investors first
Q&A WITH JOHN J. BRENNAN, from page 1 >
Serving on the FINRA board is a great way
to continue supporting one of the reasons
Vanguard is so special––commitment to the
client’s well-being. Like Vanguard, FINRA is,
in its bones, committed to the well-being of
everyday investors. It’s very gratifying work
from my standpoint because you come back
to its effect on tens of millions of people.
That’s what FINRA is about.
What are your views on the recovery of the
financial markets and the economy? What about
the challenges regulators face in maintaining
liquid and fair markets?
Mr. Brennan: The recovery from the bottom
of the recession in 2009 is remarkable in many
ways. You could look at it and say, as some
people do, that it’s artificial because interest
rates are low. Or you can look at it and say
it’s a normal recovery, because ours is the
most resilient economy in the world. I choose
to think it’s a probably a combination. Investors
who stayed the course have been served very
well, as have those whose portfolios remain
balanced.
Looking ahead, what are the greatest challenges
facing investors?
I continually worry that Vanguard clients—and
investors more broadly—are faced with too
many headlines, too much noise, and too much
focus on what happened to the stock market
today or yesterday. Investment firms have a
responsibility to provide investors with the
timely information and helpful perspectives
they need to plan for the future without
adding to the clamor.
One really important example of that is firms’
perspectives on long-term return expectations.
We’ve had a really good run in the markets.
Are prospective returns going to be that good?
What should investors expect from a balanced
portfolio? I think that is one of the real challenges
that investors face, since future returns are
unlikely to be what you see looking backward.
Are investment firms doing enough to educate
and advise people to increase their savings rates
and/or adjust their lifestyles, if that
proves to be the case? ■
That’s one of the messages we continually
have to get out as an industry—that investing is
a long-term endeavor, and it’s one that requires
patience and perspective. Obviously, Vanguard
is a champion of this mind-set.
It would be awful if people lost faith in the
markets, which was a risk as we went through
the financial crisis. I think regulators have done
a really fine job of adjusting their oversight of
markets for the current environment and for
the future, so I’m very positive that our
markets will remain fair and liquid.
Connect with Vanguard > vanguard.com
7
Investing your money
Indexing: When being ‘average’ is a lot better than average
Not only did Vanguard founder John C. Bogle
launch the first index mutual fund in 1976,
but he also was among the first to clearly
explain to the investing public the benefits
of what was then a novel, unproven strategy.
In 1977, in the first annual report for what was
later renamed Vanguard 500 Index Fund, he
wrote that an index fund “represents a tough
and demanding ‘par.’… And if there are some
professionals who can ‘beat par’ more often
than not—in investing or in golf—they do not
seem to be in the majority.”
With the 500 Index Fund having recently
marked its 40th anniversary, it’s worth taking
a moment to consider the impact that indexing
has had on investing.
below, out of 1,238 actively managed largecapitalization funds, a clear majority—65%—
trailed the 7.31% average annual return of the
Standard & Poor’s 500 Index over the decade
ended December 31, 2015. And 518 funds,
or about 42% of the total number, trailed by
more than 1 percentage point.
For information about Vanguard
funds, Vanguard Brokerage
Services®, or your account, call
us Monday through Friday from
8 a.m. to 10 p.m., Eastern time. For
general information and account
services: 800-662-7447 (Flagship
clients, 800-345-1344; Voyager
Select clients, 800-284-7245;
Asset Management Services
clients, 800-567-5163).
The data speak for themselves
The track record looks even more discouraging
for active funds when you consider that of the
35% of them that outperformed the index,
only 119—or about 10% in all—did so by more
than 1 percentage point. The 315 others also
took on risk to try to outperform the index
(and likely experienced greater volatility) but
surpassed it by less than 1 percentage point
in average annual return.
Cost is a key indexing advantage
Lower operating and transaction costs and
very low advisory fees can give index funds a
head start in performance over many actively
managed funds.
Mr. Bogle’s analogy has been borne out by
historical returns. As you can see in the chart
Indexing may have been a hard sell 40 years
ago, but it has won over many investors in
the decades since. Its share of U.S.-based
exchange-traded fund and mutual fund
assets stands at a little more than one-third,
representing about $3.5 trillion. ■
Over a decade, a majority of active large-cap funds lagged the S&P 500 Index
Based on average annual returns, 2006–2015
Number of funds
800
600
65% of funds underperformed
35% of funds outperformed
42%
400
200
S&P 500 Index
(+7.31%)
23%
25%
286
315
Comments?
Topics of interest?
Write to us at
[email protected].
518
0
By more than By less than
1 percentage 1 percentage
point
point
10%
119
By less than By more than
1 percentage 1 percentage
point
point
Notes: Data based on average annual returns of all 1,238 existing actively managed large-cap funds over the decade ended
December 31, 2015. Note that index funds seek to track the performance of a benchmark index but typically won’t “match”
the benchmark’s returns because of the costs of passive indexing.
P.O. Box 2600
Valley Forge, PA 19482-2600
Sources: Vanguard calculations, using data from Standard & Poor’s.
Past performance is not a guarantee of future results. The performance of an index is not an exact representation of any
particular investment, as you cannot invest directly in an index.
For more information about Vanguard funds and ETFs, visit vanguard.com or call 800-662-7447 to obtain
a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses,
and other important information about a fund are contained in the prospectus; read and consider it
carefully before investing.
© 2016 The Vanguard Group, Inc.
All rights reserved. Vanguard Marketing
Corporation, Distributor.
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