Ready for Retirement

How to Manage Asset Allocation and Asset Location Leading Up to Retirement

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Our topic on this episode of the Ready for Retirement podcast is about managing asset allocation and asset location leading up to retirement.

Questions answered: What are the benefits of asset location and why is it important for retirement planning? What is the right asset allocation for my various accounts? How can I position my portfolio for my retirement goals? What is the best approach for my individual situation? 

Are you ready to start focusing on the things that truly matter when it comes to your financial future?

Key Points

  • Standard Financial Planning
    • Most retirement advice will advise future retirees to invest in a 60% (stocks) / 40% (bonds) portfolio and take 4% or 5% from their portfolio each year.
    • There’s nothing terribly wrong about this approach, but it’s not taking into account your specific financial goals.
  • True Financial Planning
    • As is the case with the listener who asked today’s question, a 60% (stocks) / 40% (bonds) portfolio isn’t taking into consideration your specific goals.
      • When do you want to retire? Do you want to retire early?
      • What do expenses look like in retirement? 
      • What various income sources do you expect in retirement?
        • Will you have a steady income throughout retirement or periods of time with both low and high income years?
      • Is your pension covered or non-covered (WEP – Windfall Elimination Provision)
  • Expenses
  • Income Sources
    • The listener mentioned he will have a delayed pension and Social Security income at age 70.
      • Let’s assume expenses are $100,000.
        • How much gross income (pre-tax) will come in?
        • Let’s assume your pension and Social Security can fully fund all of your expenses.
          • Understand your full expenses so you know how much you need your portfolio to generate for you.
        • You will likely see an income gap at certain points throughout your retirement and this directly dictates how much of your portfolio you should have at different points in your retirement.
    • Ensure you have five years of living expenses in cash/bonds before you retire to ensure you don’t have to pull funds from your investment portfolio and realize unnecessary losses.
      • Multiply your annual expenses by five to determine how much you want in conservative investments.
  • Conservative Investing
    • If inflation increases at 3%/year and your bonds currently pay 2%/year, it doesn’t look great.
    • You’re guaranteed to lose purchasing power over time with current interest rates.
    • Owning bonds can act as a ballast in your portfolio to ensure your portfolio doesn’t decrease as drastically, and it’s about understanding your risk tolerance and being comfortable with giving up potential return for a smoother ride.
  • Common Retirement Portfolios
    • Common retirement portfolios recommend 60% (stocks) / 40% (bonds) or 65% (stocks) / 35% (bonds). 
      • There’s nothing terrible about this allocation, but it’s not specific to your goals and what you’re hoping to accomplish.
    • Example:
      • Assume you retire with $1,000,000 and you want to spend $50,000/year from your portfolio and your friend has $10,000,000 and also wants to spend $50,000/year from their portfolio.
        • Should you and your friend both have a 60% (stocks) / 40% (bonds) portfolio?
        • If you take the approach outlined above of ensuring you have 5 years of cash/bonds, this would mean you need $250,000 to ensure you can live for 5 years and not have to take funds from your portfolio.
        • Compare this to your friend with $1,000,000 who also wants to spend $50,000/year. If they allocated 40% of their portfolio to bonds, they would have $4,000,000 in bonds compared to the recommended $250,000.
          • Your friend has 80 years of living expenses set aside and there is a large opportunity cost for having a surplus of living expenses and significant purchasing power risk.
  • Goals
    • Ask yourself: Are your goals to grow your funds as much as possible? Is your goal to retire and not worry about the volatility of the stock market? 
    • Your asset allocation is a very personal decision and a decision that should be made in relation to your overall goals.
  • Asset Location
    • Once you’ve determined the mix of stocks/bonds and asset classes you want to invest in, the next question is “Where do you own these different investments?”
    • Asset Location is most important when you are in a higher tax bracket as you are taxed at higher ordinary income tax brackets.
    • Growth is going to come in one of three places: 
      • Interest, Dividends, and Capital Appreciation.
      • Each of these are taxed differently and we want to ensure we’re owning the tax-inefficient assets in tax-advantaged accounts and the tax-efficient assets in a taxable account.
    • Asset Allocation should always come prior to Asset Location. 
      • “Never let the tail wag the dog” can also be thought of as “Never let the tax tail waive the asset allocation dog”.
    • Tax-Efficient Accounts (IRA, Roth IRA, 401(k), etc.)
      • Bond interest isn’t tax-efficient and by owning bonds in your retirement accounts, you’re avoiding additional taxes that would be paid if held in your brokerage account (taxable).
        • Taxes on capital gains are less than taxes on interest & dividends.
        • I often strongly advise against owning any bonds in a Roth IRA or Roth 401(k) since this is your most powerful account. 
          • Everything in a Roth IRA / Roth 401(k) grows completely tax-free and maximizing the growth often makes the most sense to create more income in retirement.
    • Tax Planning
      • How can we use asset allocation in conjunction with a traditional IRA?
        • If we want to limit the growth to any account for tax purposes, an IRA is often the best option to put bonds to limit future RMDs (Required Minimum Distributions) and allow for Roth Conversion strategies.
    • Listener Question
      • The asset location textbook would say to put stocks in your brokerage account and bonds in your retirement account (i.e. IRA).
        • But, the textbook doesn’t take into account the listener’s goals.
      • The listener informed us that retirement is something he hopes to do sooner rather than later and it’s unlikely he wants any stocks in his brokerage account to derail his ability to create income for himself.
        • Many strategies make sense on their own, but it’s important to consider the impact on your overall financial strategy.
    • Roth Conversions

Timestamps


1:00 – We’re on YouTube!

2:10 – Listener Question

4:41 – Standard v. Custom Financial Planning

7:33 – How Much to Set Aside For Living Expenses

10:59 – Retirement Expenses Example

14:39 – Asset Location (and taxation!)

16:30 – Tax Planning

18:02 – Asset Allocation v. Asset Location

20:40 – RMDs (Required Minimum Distributions)

22:18 – Aligning Your Investments With Your Financial Goals

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