Portfolio Makeover Profile
Investors: Ed and Joanne | Ages: 68 and 60
Assets: $1,817,597 | Key Financial Goals: Funding Retirement, Including a Lot of Travel
With $1.8 million in their retirement kitty, Ed and Joanne wouldn't seem to have a lot to worry about when it comes to funding this next phase of their lives. Ed, 68, hopes to retire fully from his career in the financial-services industry by year-end, while Joanne, 60, is aiming to retire from her position in education administration two years from now. Social Security payments, along with a small pension for Ed, will cover most of the couple's daily living expenses in retirement. But even as they're looking forward to sharing retirement, the couple is concerned about shouldering Joanne's health-care costs from the time she leaves her employer (and its health-care plan) until she's eligible for Medicare in 2018.
An even bigger issue for this couple, Ed writes, is "balancing the maximization of life (travel) with the fear of outliving our funds." Ed notes that travel is "our only real extravagance," writing, "We have maintained what we think is a very controlled standard of living over the years, considering our income and net worth. The big-ticket items for a lot of Americans--housing and automobiles--have had reduced significance to us. Thus, travel is a major financial goal for the remainder of our lives, as long as our health allows."
But Ed acknowledges that crossing some of the far-flung destinations off their bucket list won't come cheaply. How can he and Joanne craft a retirement plan that will enable them to take maximum advantage of those years when they're both healthy and able to travel while also ensuring that their retirement assets can last 25 years or more? This couple's age gap, while not large, is another complicating factor. Thus, they would like a second opinion on their planned in-retirement withdrawal rate, as well as the makeup of their portfolio.
The Before Portfolio
Given how long Ed and Joanne have been investing and the fact that they have multiple accounts--taxable holdings, IRAs, 401(k)s, and 403(b)s--their portfolio is quite streamlined and features just 18 holdings. Most of their assets reside within the confines of tax-sheltered vehicles, meaning their withdrawals from those accounts will be fully taxable.
Their total long-term portfolio features a fairly aggressive asset mix: 61% in equities, one third of which is in foreign stocks, and 38% in bonds. Their aggregate Morningstar Style Box exposure tilts toward growth stocks, with 45% of their total exposure landing in the right-hand side of the style box. (For comparison's sake, 33% of the global market capitalization lands in growth stocks.) Their sector exposure is fairly evenly distributed, with the exception of a slight overweighting in health-care stocks and a bias against energy stocks relative to the S&P 500.
Ed's IRA constitutes the couple's largest pool of assets by far, at nearly $1 million. His IRA features some of Morningstar analysts' favorite funds, including Vanguard Primecap (VPMCX), Dodge & Cox Income (DODIX), and Sequoia (SEQUX). The couple's sole individual stock position is a quasi-mutual fund in and of itself,
Berkshire Hathaway (BRK.B). They have only a small holding in Berkshire currently, having trimmed it back in 2012. "Oh yeah, that was a great decision," quipped Ed. "We sold at $85 and it's now selling at $112." Ed also has a 401(k), which is invested in DFA Global Equity (DGERX), a world-stock fund that emphasizes small- and mid-cap names.
Joanne has a few separate pools of assets: her 403(b), invested in PIMCO Total Return (PTRAX) (the largest holding in her name); her IRA, invested in Vanguard Total Bond Market Index (VBTLX); and her pension assets, invested in a low-cost S&P 500 index tracker.
The couple's taxable assets consist of three long-held stock funds: a sizable position in Columbia Acorn (ACRNX), Mutual Shares (MUTHX), and Primecap Odyssey Aggressive Growth (POAGX). They also have a small position in Vanguard Short-Term Federal (VSGBX).
The After Portfolio
Given that retirement is so close at hand, a sensible starting point for this couple is to sketch out their anticipated income needs on a year-by-year basis, then subtract their certain sources of income such as Social Security. They can then test the sustainability of their planned withdrawal rate.
Ed and Joanne are anticipating baseline expenses of $76,000, an amount that realistically takes into account both their necessary expenses (food, Joanne's car payment) and those in the category of "nice to have," such as dining out. In addition, their "feed the travel bug" line item amounts to $40,000 a year.
The good news is that based on their anticipated Social Security strategy, with Ed starting at age 70 (to ensure the maximum allowable benefit and the largest possible survivor benefit for Joanne) and Joanne starting Social Security shortly after she retires, this couple will have $61,000 in inflation-adjusted income from Social Security per year. Ed's pension will supply another $11,000 in annual income per year. That means their portfolio will only need to supply $4,000 in additional income to meet their living baseline expenses. When their desired travel costs are added in, that tab rises to $44,000.
To help address the sustainability of their desired portfolio withdrawal rate, I started by giving their withdrawals a haircut to account for taxes. I assumed an ordinary income tax rate of 25% for the withdrawals from tax-sheltered accounts, and 15% (the long-term capital gains rate) for withdrawals from the taxable account. Even then, their planned withdrawals--at 2.8% of their starting balance--easily pass the sniff test for sustainability.
The next step is to determine which accounts they'll tap for income on a year-to-year basis, with an eye toward keeping the income tax burden down. Although there's no one-size-fits-all sequence of withdrawals, the sequence discussed in this article will make sense in many situations. In this couple's case, optimizing withdrawals will soon become a moot point, as Ed's required minimum distributions from his IRA and 401(k)s, which kick in when he turns age 70 1/2, will supply much of the income for their living expenses during their retirement. (Ed and Joanne might consider converting part of their tax-sheltered assets to Roth, especially in the years after Ed has retired and before he begins taking Social Security. An accountant versed in planning issues should be able to coach them on the tax ramifications of doing so, both the pros and cons.)
To help tee up the money for RMDs, I think it makes sense for this couple to begin positioning Ed's IRA and 401(k) more conservatively than is the case now. Using a version of the moderate bucket strategy I laid out in this article, for example, he could think about holding a combined one to two year's worth of cash in his IRA and 401(k) (bucket 1). The next segment of both IRA and 401(k) accounts can be positioned to, together, provide living expenses for the next eight or nine years of retirement (bucket 2). I stairstepped this piece of the portfolio by risk level, ranging from quite conservative ( T. Rowe Price Short-Term Bond (PRWBX) ) to the most aggressive ( Loomis Sayles Bond (LSBRX)). The remaining assets in Ed's IRA can be held in stocks (bucket 3). I didn't make substantial changes to the actual holdings, because they were uniformly excellent.
Those adjustments should help reduce the risk level in their total portfolio, which, after a multiyear rally in stocks, is looking a bit equity-heavy given the couple's time horizon. At the same time, bonds aren't looking especially attractive, either, so Ed and Joanne might consider derisking immediately by moving the bond money into cash, as discussed in this article. They could then gradually build up their bond stakes as interest rates trend up and the outlook for the asset class improves.
In contrast with Ed's tax-sheltered assets, Joanne's IRA and 403(b) won't need to be tapped for RMDs for another decade, so it's arguably too conservative for that time horizon. Ed says that Joanne is more risk-averse than he is, but if she sees the logic behind a higher equity weighting, she'll be convinced that holding more stocks makes sense. A high-quality equity fund such as Vanguard Dividend Growth (VDIGX) can supplant Vanguard Total Bond Market Index in her IRA; she can also bump up her equity holdings in her 403(b).
Within the taxable portion of the portfolio, positions in Columbia Acorn and Primecap Odyssey Aggressive Growth are giving the portfolio a heavy skew toward mid-growth stocks, so I scaled those positions back in favor of a core tax-managed fund that focuses on a diversified basket of mega-caps. (Of course, Ed and Joanne will want to carefully consider capital gains issues before selling out of these long-held positions.) Their portfolio still tilts toward the growth side of the style box, but much of that exposure comes via valuation-sensitive core funds like Sequoia and Jensen Quality Growth (JENSX). I also moved some of their taxable equity assets into a short-intermediate-term municipal-bond fund to provide additional liquidity.
Data as of May 22.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.