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02 - The Perfect Portfolio*


Right off that bat, I have to add a disclaimer. There’s no such thing as a “perfect portfolio”, but it sounded really good as a title.

Moving on…...

One thing that you need to have organized before retirement is your investment portfolio. Whether your living expenses will be covered by a pension and Social Security, or your portfolio will be providing the bulk of this, it needs to be organized and aligned for the next 5-25 years.


Account consolidation

Throughout your career, collecting investments accounts can become a silent hobby. Where you once had an IRA at the start of your career, you can end up with employer retirement accounts, old employer retirement accounts that are hanging out there, other IRAs and taxable accounts by the end. If your spouse has gone through various job changes they can have this problem as well – multiplying the effect.

Before entering into retirement, the aim is to make things as simple as possible. One way is to consolidate accounts until you have the smallest amount allowed.

Tax-deferred retirement accounts can all be rolled in one Traditional IRA, multiple Roth IRAs can be rolled into one, and taxable accounts can be merged together – even if the holdings don’t change in the transition. I have seen clients go from a dozen accounts to three, just being deliberate in ensuring only one account existed for each type. This will also make investing easier as you won’t be checking accounts to ensure investments aren't duplicated, or which account would be best to take money from. As well as a simplified investing approach, you’ll cut down on the paperwork you receive – both monthly in terms of statements but also at tax-time when it comes to receiving 1099s.


Account Titling

When it comes to retirement accounts, they can only be held in the owner’s name.

But in looking at taxable accounts, there are multiple options in how to title the account. Single, Joint, Joint with Survivor, Joint in Common, Trust, etc.

One way to approach this is to look at how you manage your day-to-day finances. If you're married, does one person control the process and handle all the money decisions? If so, having separate accounts might make things easier. Or do you have a joint approach to handling the finances – joint credit card, bills in each of your names? If this is the case, then joint accounts will keep this approach intact.

But it should also be viewed from a legal standpoint as well. If your spouse has all of the accounts in their name, how will you access them if they are in an accident? What if you wanted to avoid probate when you pass – having an account in a Trust would be the only surefire way of doing this. Make sure that the titling of your accounts has been thought through. If you’re not sure, seek guidance from an estate planning attorney.


Asset “Allocation”

If you’ve been investing by yourself or with an advisor throughout your career, you’ve no doubt heard of the phrase “asset allocation”. This is the mix of your investments and how they are split between various “assets” – stocks, bonds, real estate, etc. An asset allocation is a broad split between these classes and is often determined by how much risk you are comfortable taking. If you are comfortable taking more risk, then you might be more comfortable with riskier investments which, although having the potential for higher returns, are more volatile.

For some people, they have an appropriate allocation as they near retirement. For example, this could be 60% stocks & 40% bonds. Others may be too aggressive (100% stocks), while others may be too conservative (100% cash). If the portfolio is too aggressive, then a dip in the market could cause a significant drop in the portfolio’s value which could impact the long-term viability of income in retirement. The same is true for a portfolio that’s too conservative – it won’t generate the returns needed to keep the portfolio growing while income is being taken out.

While there’s no overall “perfect portfolio” when it comes to asset allocation, there is a perfect one for you. By gauging your risk tolerance (most typically through a questionnaire), you can determine which portfolio is best suited for your risk profile and what’s needed to maintain your portfolio throughout retirement.


Asset “Location”

This is where Asset Allocation goes into overdrive. While it’s important to understand which allocation is appropriate for you, you can go a step further and make sure that the investments you choose go into the correct account. By doing this, you can saving money spent on income taxes and potentially increase your investment returns. Here are two examples:

  • If you own a real estate mutual fund, they are taxed differently than most mutual funds. Most mutual funds have distributions that can be taxed at capital gains rates, which can be from 0-20%. However, real estate mutual funds don’t share that treatment – all of their distributions are treated as ordinary income. This means if you hold real estate in a taxable account, you will be adding to your income each year, which can cause these distributions to be taxed as high as 39.6%.
  • Like real estate funds, bond funds also generate distributions that are taxed as ordinary income. While this can be mitigated by putting bonds in a tax-deferred account (of which all distributions are treated as income), it might not be possible from an allocation perspective if most of the portfolio is in taxable accounts. Another option is to use municipal bonds in taxable accounts, as these investments do not provide any taxable distributions.
  • Taxable accounts, as they are subject to taxation each year, should hold the most tax-efficient investments. From a tax perspective, this would be stocks, stock mutual funds and stock ETFs. Qualified distributions from a stock position is typically paid at capital gains rates, and any gain in a sale after a 12 month holding period is subject to long-term capital gains as well.


Income Strategy

That leaves us determining how to set up a portfolio to generate the desired amount of income.

The first thing to consider is expectations. You cannot expect a $500,000 to generate $100,000 of annual income for the rest of your life. Investment returns would not be able to keep up with withdrawals and the account would be depleted in a matter of years. As a rule of thumb, it should be expected for an account to handle a withdrawal of 4-5% each year, giving the portfolio a good chance of not running out during your lifetime. For a $500,000 account, this would be between $20,000-$25,000.

Next, you’ll need to understand what accounts you hold and what rules apply to them. For example, tax-deferred accounts will require you take out a certain amount from the account when you reach age 70.5 – whether you need the money or not. Roth and taxable accounts do not require you to take any money out at any point.

While there are many ways to generate retirement income, I like to use a “3-bucket approach”. The three buckets are:

  • Cash – money needed for income in the next 12-24 months.
  • Fixed Income / Bonds – money needed to refill those buckets, totaling 3-5 years of income
    • This way, the portfolio will always have 4-7 years of income to weather most market downturns.
  • Equities / Stock – used to grow the portfolio and, when needed, are sold to replenish the fixed income portfolio when it is sold to generate cash.

The approach to running this system is very systemized. Every quarter, you’d look at accounts and rebalance assets to their original target, and also keep the targeted years of income intact. When markets go up, you can sell some equities to fund the fixed income bucket. When markets are bad, you don’t sell anything. In prolonged periods of time, the equity portion is not sold, and the bond bucket goes into the 1-4 year range of income. Hopefully, with 12-24 months of cash, and 1-4 years of income, it should leave enough time for markets to rebound and equities to get back on track again.

While the theory is sound, in practice, it takes some discipline. You have to ignore what’s happening in the stock market (except for abnormal events which may change the funding levels), and just concentrate on keeping the buckets appropriately funded. It takes a diligent investor to stay focused on their own personal goals without making changes based on what the market is doing.

I have some clients who do this by themselves and I applaud them for it. Most of the times, my clients pay me to do this for them and take the worry and work off of their plate.


Your portfolio

So how does your portfolio stack up to what we’ve just said? Is it in line with everything, or does it need some work?

If you’re comfortable in changing things, use this piece as guidance in “righting the ship”. If not, why not give me a call, and we can see if I’d be the right advisor to adjust your situation for you.

Until next time…