An Aggressive Tax-Efficient Portfolio for Retirees

I've written articles featuring several tax-efficient model portfolios over the years, which in turn have sparked many useful comments from readers.

Several of you noted that you'd like to see a greater focus on income production, while others quibbled with my recommendation of tax-managed funds for the portfolios' equity components. (More on this in a moment.) Others of you noted that you're looking to your portfolios for greater return potential than my conservative and moderate portfolios, each of which devoted less than 50% to stocks, could provide.

My aggressive tax-efficient model portfolio is for those of you who seek to be (or have time to be) more aggressive. It's appropriate for retirees and pre-retirees with time horizons (estimated life expectancies) of 25 years or more or for those who can look to other sources of income, such as a pension or part-time work, during their retirement years. Capital appreciation is the key goal here, but the portfolio also pays attention to limiting big market downdrafts.

As with the other two portfolios, this one is built with an emphasis on total return rather than current income for a couple of key reasons. Given low yields, it's currently a tall order to generate a meaningful income stream strictly from the income a portfolio's holdings kick off; to do so, you've got to either have an awful lot of wealth or be willing to take on a lot of risk. Second, I generally favor total-return approaches for taxable portfolios because the total-return strategy allows investors greater control over when (and whether) they receive taxable income.

An Aggressive Tax-Efficient Retirement Portfolio

Holding                                                                                    Allocation % Vanguard Tax-Managed Capital Appreciation                                  35 Vanguard Tax-Managed Small Cap (VTMSX)                                                 5 Vanguard Tax-Managed International (VTMGX)                                           15 Fidelity Short-Intermediate Muni Income (FSTFX)                                          8 Fidelity Intermediate Muni Income (FLTMX)                                                35 Vanguard Tax-Exempt Money Market VMSXX                                                2 Total                                                                                                    100

 
Asset Allocation
This portfolio, like the previous portfolios, uses Morningstar's Lifetime Allocation Indexes to guide its asset allocation. In keeping with the moderate allocations for a 59-year-old, it holds a bit less than 60% in equities and the rest in safer securities such as bonds and cash.

Retirees with greater appetites for risk (and importantly, a safe stream of income from other sources) can think about nudging the equity weighting higher; the aggressive summary allocations on the Lifetime Allocation Indexes document can help guide you into the right ballpark.

It's also worth noting that even though this portfolio includes a cash allocation (Vanguard's muni money market fund), it's there strictly to improve the portfolio's risk/reward characteristics. Your own spending needs will help you arrive at how much to hold in cash; one to two years' worth of living expenses is a good rule of thumb.

Stock Holdings
As with the other two portfolios, the aggressive portfolio gets its equity exposure from tax-managed mutual funds. I based that decision on two factors: one, the tax-managed funds' strong past tax-efficiency statistics versus those of exchange-traded funds and traditional index funds, and two, tax-managed funds' abilities to adjust their strategies to suit the current tax climate. (Note that  Vanguard Tax-Managed International (VTMGX) imposes a 2% redemption fee for shares held fewer than two months.)

Bond Holdings
To flesh out the portfolio's fixed-income holdings, I used the same municipal-bond funds here that appeared in the conservative and moderate portfolios: actively managed muni funds from Fidelity, which our analysts like for their sensible management and reasonable costs. Vanguard's muni lineup serves as a low-cost, low-maintenance alternative.

Although potentially higher tax rates will tip the scales in favor of municipal bonds for many investors' taxable portfolios, don't automatically assume that you must hold munis in your taxable account. The tax-equivalent yield function in Morningstar's Bond Calculator can help you quantify whether you're better off, on an aftertax basis, holding munis or taxable bonds.

As with the previous two portfolios, this one forgoes inflation-protected bond exposure, even though the indexes I used as a blueprint call for it. That's because Treasury Inflation-Protected Bonds are a poor choice for taxable investors. And though I-bonds are more tax-friendly, purchasers are limited to $10,000 a year. That's not an impediment for smaller investors, but larger investors will have to get their inflation protection through Treasury Inflation-Protected Securities and should do so within the confines of an IRA.

A version of this article appeared March 16, 2011.

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