This article is part of Portfolio Makeover Week.
Robert and Jenny, both 75, are in their 10th year of retirement.
Their lives are full: They're heavily involved in charitable endeavors in their community and in their church, and they also love travel, outdoor activities, and cultural events. Their daughter, son-in-law, and grandson, 12, live nearby and are a big part of their lives.
The couple is also comfortable on the financial front: Even though they retired during the financial crisis, the market has performed exceptionally well since then, and their portfolio currently weighs in at nearly $1 million. That's about where their balance was at the outset of their retirement, despite their portfolio withdrawals. Robert worked as an environmental engineer before retiring 10 years ago, while Jenny was a high school science teacher.
They rely on Social Security and Jenny’s pension for a good share of their spending needs and use required minimum distributions from their IRAs for their additional expenditures. Robert notes that the couple takes out an additional $10,000 per year, above and beyond their RMDs, to fund travel and hobbies; he says their withdrawal rate has averaged about 4% over the past decade. They own their home and intend to remain there throughout their retirement years; while it's a two-story house and they're in good physical condition, their master suite is on the first floor.
When it comes to investments, Robert is a self-taught investor and a big believer in the low-cost, index-centric approach espoused by the Bogleheads. That approach has served as the couple's true north through varying market environments. With recent market volatility, however, he and Jenny are wondering whether their portfolio allocations are appropriate for their ages. As they age, they'd also like to transition to a portfolio that's easy to manage and won't require a lot of oversight in case of cognitive decline. And while they've always been self-directed investors, they've begun mulling whether it's time to enlist the help of an advisor.
Asset Allocation -- Before
Robert and Jenny's traditional IRAs represent the bulk of their portfolio, accounting for nearly 85% of their assets. Their next largest silo is their taxable account. Finally, they each have Roth IRAs, though those accounts are a fairly small piece of their overall assets.
Their portfolio's total asset allocation is on the aggressive side given their ages; roughly 60% of assets are in stocks with the remainder in bonds and cash. Their portfolios are dominated by broad-market index funds but include a smattering of nonindex options, too. Their largest bond holding, for example, is Fidelity Total Bond (FTBFX); although the "Total" in its name implies an index fund, it's actively managed. Their portfolio also includes two small-cap index funds, as well as a foreign-stock index fund that focuses on the universe of companies with lower expected volatility. All of the holdings in their portfolio receive high marks from Morningstar's analyst team.
Extensive exposure to broad-market equity index funds gives them decent dispersion across the Morningstar style box but their portfolio has a bias toward large-growth and –blend stocks at the expense of large-value names. Their portfolio is underweight in the technology sector, while a position in Exxon Mobil (XOM) (in their taxable account) contributes to a slight overweighting in energy.
Asset Allocation -- After
Overall, Robert and Jenny's plan is in solid shape. Because they have assets beyond their traditional IRAs, it's not unreasonable that they'd be spending a bit more than their RMDs annually. They also have long-term care insurance, having purchased a policy 15 years ago. While it may not cover each and every long-term care expense that arises, it should help safeguard their nest egg from devastating long-term care costs. Should Jenny predecease Robert, he'd be eligible for 75% of her pension payments. Jenny also receives Social Security benefits based on her own work record. That means that unlike many people with public-sector pensions, she'd still receive Social Security if Robert passes away before she does.
Because most of Robert and Jenny's portfolio withdrawals are through their required minimum distributions, I like the idea of employing a Bucket system for their traditional IRAs. That can help them determine how much equity risk they need to take while setting aside an appropriate amount in bonds and cash for near-term expenses. Because Robert's RMDs are about $27,000 and Jenny's represent another $7,600, give or take, I included two years' worth of RMDs in cash in each of their IRAs. I then steered another eight years' worth of their RMDs into bonds. (I used their current RMDs to guide the allocations; while their RMDs will trend up over time, their portfolio's value may also fluctuate, so it's impossible to be completely scientific.)
I did add a short-term bond fund, however, to serve as next-line reserves in case their cash bucket needs topping up and their portfolio's income distributions and/or rebalancing proceeds are insufficient. For core bond exposure, Fidelity Total Bond gives them a lot of diversification in a single shot. It has the ability to own Treasury Inflation-Protected Securities, so I didn't add a dedicated position to them.
The remainder of their IRA portfolios can reasonably go into stocks, because they've built a bulwark amounting to 10 years' worth of withdrawals in safer securities. Here I kept things straightforward. Both iShares Core S&P Total U.S. Stock Market ETF (ITOT) and iShares Edge MSCI Min. Vol EAFE (EFAV) work well in this capacity. Because Robert indicated that market volatility was making them jittery, I jettisoned individual-stock positions, including Amazon.com (AMZN). After all, they have plenty of exposure to the company in their total market index fund. I also cut the more specialized growth and small-cap ETFs for the same reasons.
Because they're withdrawing an additional $10,000 per annum from their portfolios, it makes sense to organize their taxable portfolio in a similar fashion--two years' worth of withdrawals in cash, then stepping out on the risk spectrum from there. Withdrawing from that portion of their portfolios will tend to be more tax-efficient than drawing additional funds, above and beyond their RMDs, from their IRAs.
In addition, I made some adjustments to their taxable holdings to reduce the tax drag, as Robert and Jenny are likely to be in the 22% tax bracket under the new tax laws. Specifically, a total market ETF, such as iShares Total U.S. Stock Market ETF, will tend to have a lower tax cost ratio than Fidelity's otherwise excellent traditional index fund. I cut ExxonMobil in an effort to simplify and reduce company-specific risks and volatility. Additionally, one of Fidelity's excellent municipal-bond funds, such as Fidelity Intermediate Municipal Income (FLTMX), could make sense in the bond slot in lieu of the taxable fund. Robert and Jenny will want to make sure that they won't incur tax costs to make changes to their taxable portfolios, however. And if they're able to stay in the 12% tax bracket in 2018 and beyond, managing their taxable holdings for maximum tax efficiency will be less important.
Because Robert and Jenny's Roth IRAs would likely be last in their distribution queue, it's reasonable for them to be invested in stocks. I didn't make any changes, save for investing straggler cash positions.
Robert and Jenny are charitably inclined, noting that they donate approximately 6% of their adjusted gross income to charity each year. Because they may not be itemizing their deductions going forward, they should make sure to use the qualified charitable distribution for their donations, which will help reduce their AGI.
Finally, I like the idea of Robert and Jenny enlisting the help of a financial advisor to provide ongoing support for their financial plan and to provide a once-annual check-in. The "After" portfolio is designed to require just a single annual review, so they could work with a fee-only advisor to assist with that process and to provide backup in case they become unable to manage the portfolio on their own. Finding an advisor who works on an hourly or per-project basis will be more cost-effective than paying for the services as a percentage of their assets on an ongoing basis, especially because Robert is comfortable with many aspects of portfolio management. If Robert and Jenny decide they need more hand-holding, employing an advisor who charges an annual fee as a percentage of their assets will make more sense.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.