This article is part of Portfolio Makeover Week.
At 67 and 64, respectively, Bill and Kathleen are starting to see many of their peers retire. But they've decided retirement will have to wait. They have almost $13,000 in credit card debt, as well as a $14,000 student loan they took on to help pay for college for one of their daughters. In an effort to retire debt-free and to preserve their retirement assets for as long as possible, they plan to continue working for another five to seven years.
Bill spent his career in sales and marketing roles and continues to do a home-based sales and marketing job. Kathleen is the office manager for a pediatric medicine practice. The pair has two adult children who live nearby with their spouses and grandchildren; Bill notes with pride that family get-togethers are part of their weekly routine.
"We enjoy having meals together and playing games," he wrote, "and in the summer months we all love to hang out by the pool."
With retirement on the horizon, Bill and Kathleen have been in belt-tightening mode, focusing on debt paydown and reducing expenditures.
"We are now on a cash-only basis," Bill wrote, "which is working out fine." Their credit card debt totals about $12,500, while the student loan debt is another $14,000. The interest on those debts is onerous: 7.8% on the student loan and 8% on $3,500 of the credit card debt. The remaining $9,000 in credit card debt has an introductory rate of 3.5% until March 2019, but that spikes to a double-digit interest rate after that.
In addition to working, the pair has also begun to draw upon Social Security. Bill and Kathleen aren't spending from their portfolio at this point; Bill notes that they will only do so in emergencies.
With so many balls in the air, Bill, wrote seeking a check on their $400,000 portfolio's overall asset allocation and how all the pieces work together.
Asset Allocation -- Before
Bill and Kathleen's assets are distributed across a few main silos: traditional IRAs for each of them, a taxable brokerage account, and small Roth IRAs. The combined portfolio features a 56% stake in stocks (mainly U.S.), with the remainder in bonds. (Because the PIMCO bond funds in the portfolio employ a lot of derivatives, those stakes show up as a negative cash position.) More than half of their total portfolio lands on the growth side of the style box, whereas a total market index would have just a third of its assets there. They also have an above-market weighting in technology stocks.
Bill's traditional IRA is the largest pool, accounting for more than 60% of their total assets. It includes roughly half of its assets in stocks and the remainder in bonds with a smattering of cash. On the equity side, Bill's IRA has a sizable concentration in mid-growth stocks; 21% of his assets reside there, versus just 7% for a broad U.S. market fund. That’s an outgrowth of his sizable positions in T. Rowe Price QM US Small-Cap Gr Equity (PRDSX) and Primecap Odyssey Growth (POGRX), both Gold-rated. Bill's IRA holds a grab-bag of smaller positions, including Oakmark International (OAKIX) (Gold), Fidelity OTC (FOCPX) (Neutral), a low-volatility S&P 500 tracker, and a handful of individual stocks.
Bill's IRA is positioned pretty aggressively on the bond side: While interest-rate sensitivity is muted, it tends to skew toward mid-quality bonds and eschew the highest-quality ones. PIMCO High Income (PHK), a closed-end fund, is the largest position; Silver-rated PIMCO Income (PONAX), a multisector bond fund, is the second-largest. Thompson Bond (THOPX), rated Neutral, is another big position; while its results have been extremely competitive among short-term bond funds, it has historically taken on more credit risk than its peers. Bill also holds a cash stake.
Kathleen's IRA is a bit more conventional for a pre-retiree portfolio, but it's not without its quirks. She has a 60% equity weighting, with the remainder in bonds and cash. Her largest position is the superb T. Rowe Price Blue Chip Growth (TRBCX), followed by Vanguard Balanced Index (VBINX); both funds are Gold-rated. And in contrast with Bill's IRA, Kathleen's IRA includes healthy allocations to plain-vanilla bond funds. Vanguard Balanced Index supplies a healthy share of such exposure, as do Dodge & Cox Income (DODIX), Fidelity Limited Term Bond (FJRLX), and Vanguard Long-Term Investment-Grade (VWESX). Like Bill, Kathleen holds a cash stake in her IRA. On the equity side, Kathleen's portfolio skews dramatically toward the growth side of the style box, largely because of her big position in the T. Rowe fund.
In addition to their Traditional IRAs, Bill and Kathleen have small Roth IRAs. They also have a taxable account that’s heavy on growth stocks, including Amazon (AMZN), Apple (AAPL), and Microsoft (MSFT).
Asset Allocation -- After
My overall impression is that Bill and Kathleen's portfolio is a bit more complicated than it needs to be, especially considering that their financial situation is a bit complicated in and of itself. I had a few goals for the makeover: to streamline and simplify their investment mix while also ensuring that they weren't taking any excessive risks given their proximity to spending from their portfolio. While they need to take equity risk to help ensure that their portfolio will continue to grow, I aimed to set aside enough in safer assets to cover them in case a big equity market shock materializes early in their retirements. I also sought to neutralize big risky bets on any one investment style. (Their portfolio's strong growth bias worries me given that growth stocks have enjoyed strong outperformance over the past five years, recent weakness notwithstanding.) I also think there's a strong case to be made for using their taxable assets not to invest in stocks but to pay down debt and set aside an emergency fund.
I started the process by thinking through Bill and Kathleen's proximity to drawdown; how much and when they'll begin spending from their portfolio can inform how they position their investments. With retirement as close as five years away and required minimum distributions set to commence from Bill’s IRA just three short years from now, I'd like to see a bigger weighting in safer, higher-quality securities in their portfolios. Bill and Kathleen also need to construct their portfolio with a nod toward the possibility that they might need to retire earlier than they hope to.
Because Bill's traditional IRA portfolio would come first in the couple’s distribution queue via his required minimum distributions, I started the repositioning with that account. His cash position is a good start, but I'd like to see more high-quality fixed-income exposure in the portfolio as well. PIMCO Total Return is a fine option he already owns (albeit just a small stake), but the A shares, at 0.89% per year, are too pricey for my taste. Harbor Bond HABDX is a near-clone that's substantially less expensive and provides exposure to a broad range of bond-market sectors, including foreign bonds and inflation-protected bonds when management finds them attractive. I excised the position in Thompson Bond and PIMCO Income (again, the A shares are too expensive). Bill notes that PIMCO High Income, the closed-end fund, has been a good performer for him and he likes its yield, but I scaled the position way back to help reduce volatility and lower expenses. I enlarged the position in Vanguard Wellesley Income (VWINX), to round out Bucket 2. Those changes give Bill enough money to meet roughly 10 years of RMDs if equities slumped early in their retirement.
On the equity side, I love the idea of employing a low-volatility fund for core U.S. equity exposure. Invesco S&P 500 Low Volatility (SPLV), already in the portfolio, is a solid choice, but our analysts prefer iShares Edge MSCI Min Vol (USMV), and it's cheaper, too. I retained the positions in Oakmark International and Primecap Odyssey Growth, though I trimmed the latter. It has been an exceptional performer, but I wouldn't be surprised to see some reversion to the mean in the years ahead. I also added a small position in Vanguard Extended Market (VXF), because otherwise their portfolio lacks any exposure to small- and mid-cap stocks.
With her cash and positions in Dodge & Cox Income and Fidelity Limited Term Bond, Kathleen's IRA features solid conservative building blocks. Because withdrawals are still several years off for her, her conservative stake needn't be as large as Bill’s. I earmarked a conservative position amounting to five years' worth of Kathleen's starting RMDS (based on her balance today). It pained me to excise the excellent Vanguard Balanced Index, but I think of it as a better vehicle for accumulation than for drawdown, for reasons discussed here. As with Bill's portfolio, I anchored Kathleen's portfolio with a core low-volatility equity fund. I shrunk her position in T. Rowe Price Blue Chip Growth and added the Vanguard Extended Market ETF.
My bias would be to use the assets in Bill and Kathleen's taxable accounts to pay down debt and set aside a small emergency fund that they can add to over time. After all, it's impossible for them to out-earn a guaranteed interest rate of 8% or 9% on their investments, so the return on investment from debt paydown is unparalleled. While the funds from the taxable account are insufficient to wipe out the debt entirely, they can make a good dent. It makes more sense for them to use the taxable account than the IRAs for the debt paydown, given that their working income is currently pushing them into a higher tax bracket than will be the case in retirement. I left Bill and Kathleen's Roth IRA assets intact.
Finally, because Bill and Kathleen are juggling so many different considerations, I like the idea of them using a certified financial planner for regular check-ins on their portfolio and their plan. The website for the National Association of Personal Financial Advisors allows them to search for a fee-only CFP in their geographic location. Alternatively, Bill and Kathleen could avail themselves of advice services that are now on offer through many investment providers; that's often the most cost-effective way to go, but the trade-off is that portfolios will tend to be populated with the "house" brand of mutual funds or ETFs.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.