The Multitaskers: Saving for Retirement With an Eye on College
With a toddler, and another baby on the way, a single-earner couple aims to get the most bang for their investment dollars.
Investing Specialists
Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. This article originally appeared May 20.
Portfolio Makeover Profile
Investors: Steven and Abby | Ages: 39 and 39
Assets: $421,683 | Key Financial Goals: Funding Retirement, Paying for College
Steven, 39 years old, is accustomed to juggling multiple obligations. He puts in long hours at his IT position in the biotechnology industry, a job that entails frequent travel. And with their nearly two-year-old daughter, Marnie, up and walking and another baby on the way, he and his wife, Abby, don't have much downtime at home, either. Abby worked in educational administration during her 20s and 30s, but for the time being is enjoying life as a stay-at-home mom.
Steven is also the household financial manager, and like many people in his age range, he finds himself juggling two competing longer-term goals: investing for retirement and earmarking funds for the kids' college educations. He and Abby also have a few shorter-term goals: They'd like to make modest home renovations, and eventually they'll also need to replace one of their cars. Steven earns a healthy salary of $90,000; once household expenses are factored in, he and Abby are able to set aside about $15,000 per year for their long-term investments. Steven steers 8% of his salary to his 401(k) and earns a 3% match on his contributions. He and Abby also try to contribute to their Roth IRAs each year, using current-year earnings plus savings in their taxable brokerage account to hit the maximum allowable annual contribution for each of them. Steven is aiming to get a second opinion on the allocations of their retirement portfolio and would also like some guidance on streamlining the portfolio to keep it from becoming unwieldy.
Steven and Abby would also like to kick-start a college-savings program for their children but haven't yet taken the plunge. Their state boasts a respectable 529 college-savings plan with a decent state-tax break, but Steven is attracted to the flexibility that Coverdell Education Savings Accounts offer. Coverdell ESAs are akin to a Roth IRA for college savings: You contribute aftertax dollars, but withdrawals for qualified college expenses are tax-free. And unlike 529s, which confine investors to a preset list of investments and may carry extra layers of fees, you have more discretion over what to invest in within a Coverdell, and administrative costs are minimal. The big hitch is that Coverdell contributions are capped at $2,000 per beneficiary per year, and high-income earners may not be able to make a full contribution. (In 2013, married couples earning more than $220,000 and single filers earning more than $110,000 cannot contribute to a Coverdell.)
The Before Portfolio
Although Steven doesn't have a lot of time to dedicate to their investments, the couple's portfolio reflects his careful research and his growing belief that controlling investment costs is a big swing factor in investment success. The total portfolio has roughly 70% of assets in equities, about a third of which is in foreign stocks; nearly one fourth of its assets is in bonds; and the remainder is in cash. Mutual funds dominate the portfolio, split roughly equally between active and passive products.
The couple's portfolio consists of four main pools. The largest is their taxable brokerage account, which contains both their emergency fund--held in a low-cost Vanguard money market and municipal-bond funds--and equity holdings. On the stock side, their taxable brokerage account includes actively and passively managed mutual funds, as well as small stakes in Berkshire Hathaway (BRK.B) and Leucadia National (LUK), sometimes called "baby Berkshire" owing to its diversified basket of companies.
The next-largest share of the total portfolio is Steven's 401(k), which also includes a combination of active and passive vehicles. His 401(k) portfolio features some of Morningstar analysts' favorite actively managed funds, including the go-anywhere
PIMCO All Asset (PAAIX), Oakmark International (OAKIX), and Vanguard Dividend Growth (VDIGX).
Steven's Roth IRA consists exclusively of low-cost Vanguard index funds, a reflection of a growing conviction, based on his research, that "it is hard for an active manager to beat the market net of expenses." (Steven does think active managers have a chance to beat their benchmarks in certain areas, however, such as international.)
Abby's Roth IRA is the smallest pool of assets and is invested in a single low-cost target-date fund, Vanguard Target Retirement 2045 (VTIVX). She also has a small 403(b) with her former employer. In addition, Abby plans to return to work when the children reach elementary school age, and she has a strong motivation to do so. Should she log 20 years of service with her school district--and she already has 17 years under her belt--she'll be eligible for a partial pension, and she'll receive a full pension if she logs 30 years with the district. That pension, along with Steven's Social Security, will provide a valuable income floor for this couple in retirement.
Holding Market Value ($) Weight (%) Star Rating Taxable: Vanguard Prime Money Market 19,904 4.72 N/A Taxable: Vanguard Ltd Trm TE (VMLTX) 20,898 4.96
The After Portfolio
This couple's asset allocation, at 70% equity and the remainder in cash and bonds, looks a little too mild at first blush. But excluding their cash holdings and the short-term muni fund they use as their emergency reserves, their long-term asset allocation is roughly 80% equity/20% bonds--in the right ballpark given their 25-year time horizon for those funds.
Steven expressed an interest in streamlining, and the portfolio provides opportunities in a couple of spots. Within the couple's taxable account,
Vanguard Health Care (VGHCX) and Yacktman (YACKX) are fine options in their own right, but both are coming off a tremendous performance run and are ripe for pruning. The funds also duplicate some of the exposures found in other holdings. And given that Steven would prefer to invest in mutual funds to limit his oversight obligations, small positions in Berkshire and Leucadia can all go on the chopping block, too. (The couple should take care to assess the capital gains implications of selling all of these holdings, however.)
A new position in Vanguard Tax-Managed Capital Appreciation (VTCIX) can serve as a receptacle for some of these funds, and it has the added benefit of being explicitly managed to limit capital gains distributions. The couple own Vanguard FTSE All World ex-US Small Cap to provide exposure to foreign small caps, but its performance has been undistinguished. Given the dearth of decent foreign small-cap options available to no-load investors, putting those assets behind Dodge & Cox International Stock (DODFX) looks like a better bet. ( Vanguard Total International Stock Index Admiral (VTIAX), in Steven's Roth, provides at least some exposure to foreign small and mid-caps.)
Steven's 401(k) can also be pruned in a few spots. This portion of the portfolio features two small-cap offerings, T. Rowe Price Small Cap Stock (OTCFX) and
Vanguard Small Cap Index (NAESX), as well as a REIT fund. All three are solid options, but collapsing them into Vanguard Small Cap Index reduces costs while also slicing the total portfolio's heavy real estate exposure. (Morningstar's equity analysts view the REIT sector as one of the highest-priced pockets of the stock market currently.)
Steven might also consider building the bond stake in his 401(k) while leaving his Roth more equity-heavy, given that he's likely to tap the 401(k) before the Roth in retirement. To that end, he could invest in his 401(k) plan's core-bond option,
Vanguard Total Bond Market Index (VBMFX), while focusing his Roth assets on his equity holdings.
Given that it's a fairly small portion of the couple's assets, it's sensible to maintain Abby's Roth in a single well-diversified and low-cost package, Vanguard Target Retirement 2045 (VTIVX). Her 403(b) plan is in a managed account with asset-weighted costs that are substantially above those of the target-date fund, so she should consider rolling those assets into the Vanguard target-date fund within an IRA. (She and Steven should consult with a tax advisor to gauge whether it makes sense to roll her 403(b) into a Roth or traditional IRA. They'll owe taxes at the time of rollover, but the fact that Abby's not currently earning a salary could make it an opportune time to do so because they're in a lower tax bracket.)
Finally, the Coverdell ESA versus 529 decision: I'll admit that I'm not a great fan of 529 plans, mainly because of their extra layers of costs and the fact that you must choose from a preset menu. However, the 529 plan in Steven and Abby's state earns a Bronze Morningstar Analyst Rating and features low-cost Vanguard funds; that, plus the fact that they'll be eligible for a state-tax break on their contributions, argues in favor of the 529. It's also worth noting that many mutual fund companies, including Steven's preferred provider, Vanguard, are no longer offering Coverdell accounts. (Adam Zoll takes a closer look at Coverdells in this article.)
Holding Market Value ($) Weight (%) Star Rating Taxable: Vanguard Prime Money Market 19,904 4.72 N/A Taxable: Vanguard Ltd Trm TE (VMLTX) 20,898 4.96100
Data as of May 16.
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