Creating a Portfolio That Will Weather the Storms
A couple seeks guidance on their retirement portfolio's longevity and asset allocation.
Investing Specialists
"What I hope to get out of the portfolio makeover is that by reallocating my holdings, we will have a better chance of weathering any storms that come our way."
Herb stated the above comment in his email request for a portfolio makeover. A 72-year-old retired product manager for an industrial firm, he and his wife Connie, a 66-year-old accountant, hold a portfolio with nearly 70% of its assets in stocks and the rest in cash and bonds. That's an aggressive asset mix that, at first blush, appears to leave them vulnerable to periodic market downdrafts.
In addition to soliciting an opinion on their current asset allocation, Herb is also seeking assurance that their portfolio, with roughly $1.4 million in total assets, can support their desired lifestyle in retirement while also allowing for regular travel as well as an inheritance for their daughter.
The Before Portfolio
Herb and Connie have clearly taken care in selecting the investments for their traditional IRAs, Roth IRAs, and taxable accounts. Composed almost entirely of ultra-low-cost Vanguard funds, their holdings include exposure across the style and geographic spectrum and include both index holdings as well as topnotch actively managed funds. Their overall portfolio has a substantially greater emphasis on small- and mid-cap names than the broad market does, however, in part because of repeat appearances from Vanguard Explorer (VEXRX) in a number of the couple's accounts.
Herb's traditional IRA is the pair's largest asset pool; its largest holdings include Vanguard Explorer as well as Vanguard Total Bond Market Index (VBTLX) and
Vanguard High-Yield Corporate (VWEAX). The pair's stock-heavy taxable account is the next-largest pool of assets; in addition to an individual stock portfolio with an emphasis on the financials sector, the account's largest holdings are Vanguard Total Stock Market (VTSAX) and Vanguard Windsor II (VWNAX). Furthermore, Herb and Connie each have Roth IRAs; Connie also has a traditional IRA and a 401(k) with her employer.
Herb reports that he and his wife spent $72,000 last year, $30,000 of which was supplied by a combination of Social Security and the remaining coming from Connie's salary and portfolio withdrawals. When Connie retires within the next few years, Herb estimates that their portfolio withdrawals will increase somewhat.
The After Portfolio
Given their current asset level of $1.4 million, Herb and Connie's prospects for not outliving their nest egg look bright, even after Connie's retirement. At $42,000 a year, their withdrawal rate is currently just 3%, comfortably within the zone that planners deem to be safe. Herb notes that he and Connie would like to travel more in the years ahead, and their assets could support a higher withdrawal rate if they so desired. In fact, they could take up to $54,000 per year while still staying below a 4% withdrawal rate, which would allow them to pay for a few big trips or several small ones a year.
However, I think the couple could make some adjustments to their portfolio to better suit their situation. At 15% of assets, their cash position seems too high given that their near-term cash needs are modest. At today's ultralow interest rates, holding more than two to three years' worth of living expenses carries too high an opportunity cost. At the same time, their bond stake, at less than 20% of total assets, is too light. Moving a lot of money into the bond market all at once subjects their portfolio to the threat of rising interest rates, so I think it makes sense for them to plan to enlarge their bond stake gradually during the next few years. Bond holdings such as Vanguard Total Bond Market Index and Vanguard Short-Term Investment Grade (VFSTX) are worthy linchpins, but I've also added a stake in Vanguard Inflation-Protected Securities (VAIPX) for explicit inflation protection. The bond and cash components of the portfolio should be largely in the couple's IRAs and taxable accounts, which will be first in line for liquidation; Herb's required minimum distributions account for much of the couple's cash needs, while taxable accounts can supply the rest. Their Roth IRAs should be last in line for withdrawals, so equity-heavy positioning makes sense for those accounts.
Holding Market Value ($) Weight (%) Star Rating 401(k): DFA Emerging Markets Core Equity (DFCEX) 2,500 0.18
I also took some steps to reduce the volatility in Herb's and Connie's equity portfolio. For starters, their aggregate equity holdings skew heavily toward small and mid-caps relative to broad market indexes; scaling back some of that exposure in favor of large-cap wide-moat offerings such as Vanguard Wellington (VWENX) is a good starting point. Their foreign-stock position is also light relative to Morningstar's Lifetime Allocation Indexes; I enlarged the position while also keeping quality high and not going overboard with emerging markets. Vanguard International Growth (VWILX) is my go-to holding here (despite having "Growth" in its name, it's a well-balanced core holding), though Vanguard Total International Stock Market Index (VTIAX) would be a worthy substitute. Both of these funds have substantial exposure to emerging markets; thus, I excised the dedicated emerging-markets holdings.
Finally, although long-term care insurance is likely to be prohibitively expensive for 72-year-old Herb, I think it makes sense to price out the coverage for Connie, particularly given that an extended stay in a long-term care facility could take a huge bite out of the assets they'd like to leave for their daughter. That protection will supply additional peace of mind. In addition, I'd recommend that Connie and Herb check with a financial or tax advisor to discuss converting a portion of the pair's traditional IRA and Connie's 401(k) assets to Roth. Although doing so will increase their tax burden and could also increase their tax bracket, the benefit is that their daughter wouldn't owe income tax on any Roth assets she inherits from them.
Data as of May 11.
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Webinar: Make Over Your Portfolio for Retirement
Friday, May 18 | 12 p.m. Central Time
Morningstar director of personal finance Christine Benz will tell you how to ready your own portfolio for retirement. Christine will discuss how to assess your in-retirement income needs and test the viability of your planned withdrawal rate. She'll also discuss how to segment your portfolio and arrive at an appropriate asset allocation based on your expected income needs. Finally, Christine will share tips for streamlining your in-retirement portfolio so that it requires little in the way of ongoing maintenance. Premium Members: Check back soon for the webinar replay link. Not a Premium Member? Take a free 14-day Premium trial today.
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