A Young Couple Kicks Their Financial Plan Into High Gear
A stock-heavy mix makes sense, but too much company stock can spell trouble.
Investing Specialists
Chris and Stephanie have seen a lot of life changes--and achieved a lot of important goals--in the space of a few short years. Both 32 years old and married for the past eight years, they have earned master's degrees and recently landed jobs in their respective fields; Chris' job necessitated a move across the country, from the West Coast to the East. They're also proud parents of a baby boy, now 2.
With the major groundwork laid for the rest of their lives, Chris thinks it's a good time to do a temperature check on whether their investing plan is on track. He wrote, "While I wish we had started earlier, we have been aggressively saving and investing for the past five years." He and Stephanie would like help assessing their asset allocation, investment choices, and current savings plan, which involves socking money away for their son while also saving for their own retirements. Chris says he would also like to reduce their number of holdings before things get too far out of control. Although the couple's portfolio has fewer moving parts than some others, Chris would like a strategy for "treating my investments as one portfolio."
The Before Portfolio
The couple's nest egg is roughly $280,000, consisting of Chris' 401(k) assets, Roth IRAs, and pension assets from Stephanie's former employer, which she intends to roll over into an IRA. They have also begun funding a 529 plan for their son. Chris notes that he's been maxing out his 401(k) contribution each year, and they've also been making so-called backdoor Roth IRA contributions, too. Because their combined income is too high for them to make full contributions to Roth IRAs outright, they have been opening traditional IRAs and then immediately converting them to Roths. (For more details on this strategy, click here.)
Chris' 401(k) is the couple's largest pool of assets: At roughly $142,000, it consists of topnotch actively managed and ultra-low-cost index options; Chris also has a stake in shares of his company that amounts to about 19% of the couple's total assets. Chris' and Stephanie's Roth IRAs are with Fidelity. Chris' Roth consists of a single sector fund, Fidelity Select Software and Computer Services (FSCSX). Stephanie's main Roth holding is Fidelity Contrafund (FCNTX), but she also has smaller positions in Fidelity Small Cap Stock (FSLCX) and Fidelity Real Estate Income (FRIFX). Their overall asset allocation, not including Stephanie's pension assets, tilts heavily toward equities: According to Morningstar's Instant X-Ray tool, they have 82% of their assets in stocks and the remainder in bonds.
The After Portfolio
Chris rates his and Stephanie's risk tolerance as high. But even if it weren't, I think their equity-heavy asset mix makes a lot of sense given this couple's long time horizon until retirement. Chris has also made good use of the index and active options available to him in his 401(k) plan, employing index funds as core holdings and active funds in spots where active managers have a better shot at adding value, such as small and mid-caps. I also think that the pair's current nest egg and savings rate put them in a good position to achieve a comfortable retirement and college funding, especially if they're able to bump up their contributions as their salaries increase.
However, I think the couple can make some adjustments to put themselves on even firmer footing. Given that streamlining is a goal, Chris could employ an index-only approach with his 401(k). The one exception would be with his bond holdings. There, I would recommend sticking with
PIMCO Total Return (PTTRX) as his core fixed-income holding, because I think an active fund's ability to maneuver should be an advantage if fixed-income markets are rocky in the years ahead.
In addition, I think Chris' allocation to his company stock is too high. Given that so much of this couple's livelihood is already riding on his employer, I'd like to see them gradually scale back on the position during the next few years, to a target of 5% or 10% of their overall assets.
Holding Market Value ($) Weight (%) Star Rating 401(k): PIMCO Total Return (PTTRX) 20,000 7.0545,000 15.86
Moving over Stephanie's pension assets from her former employer into an IRA will give the couple even more assets to allocate. Given that simplification is a goal and Chris would like to limit the number of providers they deal with, Stephanie can roll her pension assets into broadly diversified index funds from Fidelity, including
Fidelity Spartan Total Market Index , Fidelity Spartan Global ex-US Index , and a small stake in Fidelity Total Bond (FTBFX). The bond fund is not an index tracker, but it is a superb core fixed-income holding with fairly low costs.
As they execute this maneuver, they should also consider moving the money to a Roth IRA rather than a traditional account. They'll need to have the cash on hand (separate from the pension money) to pay the taxes due at the time of the rollover into the Roth; if they need to invade the pension to pay the taxes due, they'll incur a penalty plus tax on the money they withdraw. Yet being able to take tax-free withdrawals in retirement will be an important advantage for this couple, particularly if their own tax bracket--and taxes in general--trend up by the time they've retired. Moreover, unless Stephanie rolls over her pension into a Roth, the pair will no longer be able to execute their backdoor Roth IRAs without triggering a tax bill, as outlined in this article.
Fidelity Contrafund is a fine anchor for Stephanie's Roth, but our analysts have more conviction in Fidelity Small Cap Discovery (FSCRX) than they do Fidelity Small Cap Stock. Small Cap Discovery's manager, Chuck Myers, was mentored by Joel Tillinghast, manager of Fidelity Low-Priced Stock (FLPSX), and uses a value-leaning approach to picking small-cap stocks. The fund, like many small-cap offerings, has the latitude to own REITs, so I think I dedicated real estate fund is unnecessary.
Although their portfolio could use the growth and technology-stock emphasis that Fidelity Select Software and Computer Services brings to the table, I think that fund is too focused to serve as a core holding for Chris' Roth, particularly if he continues to add to it. I'd reduce its prominence (or cut it altogether) and direct new contributions to a broadly diversified offering like Fidelity Spartan Total Market Index.
I'd also like to see this couple enlarge their cash holdings to cover emergency expenses or tide them through the unexpected loss of one of their jobs. Chris says he hates the idea of inflation eating away at their cash holdings, and correctly notes that he and Stephanie could withdraw their Roth contributions without penalties or taxes if they were in a true financial bind. Nonetheless, it would be a shame to have to raid long-term assets to cover near-term cash needs, so I'd suggest that they shoot for a minimum of three months' worth of living expenses in true cash, as well.
Finally, the couple can take one thing off their financial to-do list: changing 529 plans. Their former state offers a better 529 program than does their new state of residence, and their new home state offers state tax breaks on contributions to any 529 plan. Thus, they can continue contributing to their current plan rather than opening an account in their new home state while still earning a state tax break.
Data as of May 14.
 | | | | |
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.
Visit our Portfolio Makeover Week 2012 homepage for more makeover reports.