Positioning a Portfolio in Early Retirement

Logan and Sydney epitomize the new face of retirement.

Both age 69, they're extremely active and live in a sunny part of the country where they can enjoy biking and hiking year-round. Sydney continues to teach Spanish at the local community college and also conducts private tutoring. Logan retired from his career as a scientist a few years ago, but he stays busy by playing in a jazz band, doing community service, and monitoring their portfolio. Their daughter and her family—including Logan and Sydney's two grandchildren—live nearby.

Thanks to income from Sydney's job and a modest level of spending, the couple haven't begun drawing any funds from their $2 million nest egg. "We have saved more and spent less over the years," Logan wrote, adding that a recent purchase of a high-priced bottle of sake is his idea of splurge. "That was money well spent," he said with a smile.

Yet, even as the couple is highly content with their life right now, a big change is looming: Sydney would like to retire within the next few years. Her retirement, as well as their plans to begin collecting Social Security late next year and required minimum distributions from their IRAs beginning two years after that, prompted the couple to seek a second opinion on their portfolio's positioning.

Logan has been an avid investor throughout his adult life and has always made room in his portfolio for individual stock holdings. But the recent market volatility has been unnerving. "I am risk-tolerant, but I am feeling increasingly worried lately," Logan said. "I am reconsidering our asset allocation and working to clearly focus our retirement financial goals."

The couple obviously wants to ensure that they won't run out of funds during their retirements, and their portfolio is set up to support their transition to being fully retired. But they would also like to create a plan that enables them to leave money for their daughter and her family.

In addition, they're hoping to streamline their portfolio a bit, and Logan worries that their cash position is too high. "Since we have saved more over the years, I think I have a strong bias to protect those savings from market downturns and black-swan events," he explained. But he's conscious of the opportunity costs of holding too much cash, especially in a higher-inflation environment.

The Before Portfolio

Logan and Sydney's portfolio includes about 65% in stocks, 20% in bonds, and 15% in cash. It's well dispersed across the Morningstar Style Box, largely because the bulk of equity assets are parked in broadly diversified index funds (and balanced funds that own them). The portfolio's costs are ultralow for that same reason; the average weighted expense ratio is just 0.07% versus 0.68% for a hypothetical portfolio of funds with average costs.

The portfolio's lack of direct foreign-stock exposure stands out, though: While non-U.S. stocks account for more than 40% of the world's equity market capitalization, just 1% of the equity assets in Logan and Sydney's portfolio are parked outside the United States.

The largest pool of assets, accounting for about three fourths of their total portfolio, is Logan's IRA, which is populated with several topnotch Vanguard funds. Most of the IRA is in index funds and exchange-traded funds, but the portfolio also includes a position in Vanguard Wellington VWENX, a standout active fund. Logan has also included a position in Vanguard Consumer Discretionary ETF VCR and a smaller stake in Vanguard Energy ETF VDE. The former position gives the portfolio nearly double the weighting of the S&P 500 in the consumer cyclical sector.

Logan's Roth IRA and taxable account, meanwhile, are where he has indulged his passion for picking stocks, mainly blue chips. He focuses on dividends and aims to buy good-quality companies after they've experienced a price downturn. He also holds a healthy dose of cash in those accounts.

Sydney's IRA and taxable accounts are more utilitarian in their positioning. She owns index funds and ETFs, and her largest position in both accounts is Vanguard Balanced Index VBIAX.

Source: Morningstar.

The After Portfolio

Portfolio spending is a starting point in assessing the appropriateness of an in-retirement asset allocation; annual withdrawals can be used to help determine how much to hold in cash and bonds. But Logan and Sydney haven't yet begun pulling from their portfolio, and they anticipate that Social Security will cover most of their living expenses once benefits commence. As a result, their need for safe assets will be limited to any lumpy outlays that might crop up over the next few years (home repairs, new cars, travel, and so on) as well as whatever they might need to provide peace of mind with their equity holdings.

Given that, Logan and Sydney's majority equity stake seems reasonable in light of their risk tolerance and modest withdrawal rate. But I agree with Logan's assessment that their cash position is on the high side, particularly given their modest spending and the higher inflation rates today. My After Portfolio reduces cash to about 6%.

In lieu of some of the cash in their IRAs, the After Portfolio also includes larger stakes in bonds, both nominal and Treasury Inflation-Protected Securities. While the outlook for bonds isn't great in the face of additional interest-rate increases, the couple don't have a near-term need for their assets; they're holding safer assets mainly as ballast for their equity exposure. With high-quality bonds, they're apt to lose less on an inflation-adjusted basis than they will with cash. Because RMDs will commence before long, the IRAs will likely be the best source for any withdrawals they need to make; hence, they're the best receptacle for their safe assets. Plus, bonds create a tax drag in their taxable accounts, and Logan's Roth is best positioned with a heavy stock emphasis because it will tend to be the longest-term asset.

As much as I like the simplicity of the all-in-one Vanguard Balanced Index, I prefer discrete stock/bond holdings to help facilitate withdrawal needs. Thus, I cut that fund—the largest position in both of their IRAs—and supplanted it with stock- and bond-specific holdings. I also added foreign stocks to both of their accounts to improve diversification as well as the portfolio's return potential in light of lower valuations overseas. I cut the sector-specific and market-cap-specific ETFs.

I focused on streamlining with their other accounts. I concentrated Logan's individual equity holdings in his taxable account, focusing on those with Morningstar Ratings of 4 stars or above. Of course, Logan can reposition based on his own stock-picking criteria as well as any tax implications of selling his existing positions from those accounts. I like the idea of using single diversified funds in their smaller accounts—Vanguard LifeStrategy Growth VASGX in Logan's Roth IRA and Vanguard Tax-Managed Balanced VTMFX in Sydney's taxable account.

If Logan and Sydney will likely reinvest their distributions once RMDs start, they can take advantage of in-kind distributions from their IRAs at that point, investing the assets they pull from their traditional IRAs into their taxable accounts or even their Roth IRAs if Sydney continues to earn some income after age 72. (Earned income is a requirement to make an IRA contribution.) Of course, they'll still have to pay taxes on the RMDs, but in-kind distributions will enable them to maintain the same portfolio exposures.

This is also an excellent life stage for Logan and Sydney to get some tax advice. Given their low level of taxable income currently, they could explore whether converting a portion of their traditional IRA assets might make sense in the pre-RMD, pre-Social Security years. Converting a portion of their IRAs would reduce the amounts that are subject to RMDs, of course, and could help lower their susceptibility to the "tax torpedo." And if they're able to remain in the 0% tax bracket, they could also consider tax-gain harvesting in appreciated positions within their taxable accounts. Selling and rebuying the securities they'd like to hang on to would reset their cost basis to today's higher levels and lessen the capital gains due when they eventually sell. Those taxable accounts are also great holdings to earmark for their daughter and her family.

Given their portfolio withdrawals haven't yet commenced and that Social Security will cover most of their ongoing expenses, there's little risk that the couple will outlive their assets. The only major risk to their plan is if either or both of them were to experience a significant long-term-care need. That worry is allayed, however, by the fact that home prices have escalated sharply in their geographic region, and they have built about $1 million in home equity in their house. A home sale or reverse mortgage would enable them to tap that asset in such an event.

Logan notes that the couple has about $160,000 left on their mortgage, due to be paid off in 2026. The couple could explore deploying some of their cash to pay down the mortgage even more aggressively; the "return" on their investment would be higher than what they're earning on their cash today.

Source: Morningstar.

Note: Names and other potentially identifying details in the makeovers have been changed to protect the investors’ privacy. Makeovers are not intended to be individualized investment advice, but rather to be illustrations of possible portfolio strategies that investors should consider in the full context of their own financial situations.

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This article originally published on April 29, 2022.

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