If you ask 10 different financial advisors how they would invest a client’s money, you’ll get 10 different answers. So, what’s the best strategy?
Shakespeare believes the best investment strategy is achieved when it is derived from your financial plan with the sole purpose of achieving your life goals. An advisor could have great investment ideas; but if they don’t meet your income needs, your risk tolerance and your overall financial objectives, then how great are they? To demonstrate how Shakespeare builds and manages an investment portfolio around your financial plan to best meet your goals, we’ve created this case study.
Meet Bob and Mary:
Bob and Mary were recently referred to Shakespeare by their CPA after mentioning their pending retirement. Bob is Vice President of a local company and Mary is a nurse working 30 hours a week at a local hospital. They both plan to retire in two years; although Bob plans on working 20 hours a week for a few years in retirement for one of his key customers.
A little about the couple:
Bob: 66 | Mary: 62
Bob Salary: $175,000 | Mary Salary: $45,000
Retirement Job = $40,000
Bob IRA: $50,000 | Mary IRA: $250,000 | JT Brokerage Assets: $750,000
Bob 401k: $1,100,000 | Mary 401k: $160,000 | JT Bank Assets: $100,000
Deferred Comp $150,000
Home Value: $450,000 | Property Taxes: $6,000 | Mortgage: $200,000
Cottage Up North: $250,000 | Property Taxes: $3,000 | HELOC: $18,000
Bob and Mary have 4 Primary Life goals:
1. Generate a reliable income stream in retirement to maintain their current lifestyle;
2. Moderate risk to protect against a significant market downturn;
3. Minimize taxes where possible; and
4. Keep pace with inflation.
Let’s take a look at their financial situation and potential investment strategies to prepare for life before and during retirement.
After completing a comprehensive review of Bob & Mary’s investments, we’ve identified that they have more than 80% of their assets in equities and less than 20% in bonds. Based on their goal of moderating risk to protect against a market downturn, we have identified the need to reduce the risk in their financial accounts. We will reduce their equity weighting to 60% and increase their conservative holdings to 40%. We’ll refer to this as a 60/40 portfolio.
A review of each of their individual brokerage and retirement statements revealed several planning opportunities. Their brokerage account contained an assortment of individual stocks and mutual funds, many of which they held for years with little direction from a previous advisor. As individual stocks are not diversified and contain a high degree of risk, and mutual funds are less tax efficient than Exchange Traded Funds (ETFs), these securities aren’t helping them facilitate their goals of risk reduction and tax efficiency. We sold all of the securities that were at a loss, generating $30,000 of realized losses. This allowed us to sell several appreciated securities in their portfolio for a combined gain of $30,000 (net gain of $0). What remained were three securities totaling $100,000 of value and $25,000 of unrealized gains. We left these securities intact and will invest ‘around them’ using more diversified Exchange Traded Funds and will potentially use these to facilitate charitable gifts until Bob turns 70 ½.
Bob’s 401k investment options were reviewed and reallocated to accomplish several goals. First, we reduced their risk by investing toward their target asset allocation of 60/40. Next, we selected more competitive funds relative to what he had previously chosen in an effort to earn higher returns. Finally, the funds we selected had lower cost relative to his previous holdings.
Mary’s 403b had a provision that allowed for an in-service distribution to her IRA (Bob’s 401k did not have this provision). This allowed us to manage these funds in a customized fashion and incorporate into our Householding strategy (below).
Tax Management & Householding
There are several layers of tax planning that we incorporated into Bob and Mary’s portfolio. From the standpoint of security selection, the mutual funds in their brokerage account were generating unwanted year-end capital gain distributions. Exchange Traded Funds do not generate these unwanted distributions, allowing for greater tax control. The increased tax control allows us to leverage other tax planning strategies in the current year and in the years ahead. As a result, the mutual funds were sold and ETFs were purchased.
Householding is a sophisticated strategy that helps lower lifetime taxes. It entails the placement of tax inefficient asset classes such as bonds and REITs into retirement accounts first, and then allocates tax efficient assets such as equities (via ETFs) into brokerage accounts. Bob and Mary achieved their goal of reducing the risk in their overall portfolio by shifting their target asset mixture to 60/40; but each account holds different securities based on their tax characteristics. This is a complex strategy, but when coupled with the other strategies, is another tool in controlling taxes, moderating risk, and providing income. Note, sophisticated software and a knowledgeable financial advisor are required to implement this strategy efficiently.
An additional tax strategy that will be utilized includes the gifting of appreciated securities from their brokerage account to facilitate charitable intentions until Bob turns 70 ½. At 70 ½, future gifts will be made via Bob’s IRA which will lower their Adjusted Gross Income. Several other strategies were utilized related to the timing of their Social Security and Pension benefits, but we won’t cover that in this case study.
At Bob and Mary’s retirement, they’ll need to begin accessing their investments to supplement their other income sources to help pay their monthly living expenses. The various holdings within their accounts produce approximately a 2% income in the form of dividends and bond interest. As they need 4% from their portfolio, Shakespeare will harvest the additional amount by selling portions of one or two securities each month in their portfolio. The securities that will be sold will the ones that are doing well at that moment in time. If the equity markets are doing well, we sell equities. If equities are doing poorly, we utilize the fixed income securities to provide the needed proceeds. Whether we sell securities in their brokerage account or their IRAs is a function of their tax situation in a given year.
Shakespeare established a monthly transfer from their investment accounts to their bank account. From Bob and Mary’s perspective, they receive the needed amount each month to facilitate their lifestyle, own sufficient fixed income assets to protect them during a prolonged market downturn, and own sufficient equities to keep their assets growing at a rate above inflation. Of course, Shakespeare coordinates and manages all of the above behind the scenes so Bob and Mary don’t have to worry about it.
Having investments that provide competitive returns, at low cost, and in a tax efficient manner is critical to a successful investment plan. Notice however that none of Bob and Mary’s primary objectives relate to beating the S&P 500 or outperforming the markets. Their main concerns relate to providing needed income, protecting principal, growing faster than inflation, and minimizing taxes where possible. Having a portfolio geared toward outperforming the S&P 500 violates several of these goals and isn’t suitable for most clients.
Bob & Mary have confidence in knowing their lifestyle won’t change in retirement. This provides peace of mind and allows them to focus on the most important things in life.
Note: Shakespeare doesn’t offer a ‘Complimentary Investment Review’ like most advisers. As mentioned in this case study, a comprehensive financial review must be done to derive at the optimum portfolio for your goals. If you’re serious about your retirement and would like to learn more about our financial planning process, give us a call at 262-814-1600.