Asset Allocation: The Great Balancing Act

Last week we explored the first part of asset allocation in Asset Allocation: Tools of the Trade. We reviewed the asset classes investment managers use to build portfolios for their clients. This week we will explore how client portfolios are constructed and change over time as assets are deployed. Before looking at the mechanics, we should review the primary foundational principle of asset allocation: client objectives.

Client Objectives

Every investor is different. While many may have similar goals, all have unique circumstances. Some might be looking forward to a retirement full of international travel and posh leisure activities. Other investors’ objectives may be more modest in nature, but no less important. Whatever the goal, good investment managers start by understanding their client’s objectives. Then, they put together an investment plan that will seek to meet these objectives while minimizing the risks associated.

Portfolio Construction

A big part of the investment plan is asset allocation, which is using different asset classes to construct a portfolio designed to meet client objectives. These asset classes are varied. They include cash, stocks, bonds, commodities, real estate, insurance, and more. Experienced investment managers use many or all of these asset classes in varying degrees to build portfolios for their clients.

Hypothetical Asset Allocation

To illustrate how asset allocation can work, we have a very simple, hypothetical case: Sam and Sally. Sam, 40 years old, is married to Sally, also 40, and they have no children.

They enjoy what they do, but both want to retire when they are 65. They plan to travel extensively and prefer to relocate to the beach upon retirement. That gives them roughly 25 years to make their world traveling, beach living retirement a reality. Both are comfortable with taking on higher-risk for the potential of more growth in their investments, so they are okay with greater volatility.

Understanding Sam and Sally’s objectives and risk tolerance is crucial for determining how to deploy assets in their portfolio, and typically there’s a lot to work that goes into determining the proper asset allocation. Let’s go forward with the understanding that this extensive planning process had been completed because the point is to illustrate the difference in asset allocation models at different stages in life. A reasonable asset allocation mix over time for Sam and Sally may be:

Phase 1: Age 40-55

• Allocate 60% in stocks, 15% in commodities/real estate, 20% in bonds, 5% in cash.
• Continue to work, receive average raises in relation to inflation, and save 15% of their income per year before taxes.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 2: Age 55-60

• Start re-allocating to a 50% stocks, 30% bonds, 10% commodity/real estate investments, and 10% cash portfolio.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 3: Age 65+

• Start re-allocating 30% in stocks, 50% in bonds, 10% in cash, and 10% in commodities/real estate investments.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

As this couple gets closer to generating income from their portfolio, their investment approach transforms from a growth portfolio to an income portfolio and you can see how their portfolio is restructured over time to reflect this. Still, at no time is their plan one of extremes. There is always a growth component and conservative component, just of differing degrees to reflect their needs in life.

Real retirement plans should never be all in one asset class, whether in growth mode or income mode. You need the proper balance to protect your plan from the multitude of risks out there. Additionally, you’ll notice this asset allocation schedule roughly follows the Three Phases of Retirement Investing. Asset allocation is fundamental to investment planning, and although there are different ways to be successful in managing your investments, it remains a staple of how to reduce risk.

Income Planning: How To Spend Your Retirement

Much has been written about the importance of saving for retirement. However, people pay less attention to an equally important subject – how to take income once you do retire. As we noted in a previous article on the phases of retirement investing, the third phase is less about saving and more about spending.  In other words, how to efficiently spend the money you’ve saved during your working years.  The term professionals use for this process is “capital distribution.”

The goal of capital distribution is NOT to outlive your retirement nest egg, but to maintain the desired lifestyle for you and your loved ones through your non-working years. Capital distribution (not to be confused with capital gains distribution) is about spending your retirement savings the best way for your unique situation.  Here are three common strategies:

1) Annuities

One way to generate income during your retirement is with an immediate annuity, sometimes called an income annuity.  This is not the same as a fixed or variable annuity. An immediate annuity is similar to a self-funded pension. You deposit a chunk of cash with an insurance company and they pay you a certain dollar amount over a period of time. There are different distribution options related to spousal benefits, number of payments to be made, immediate or deferred payments, etc.  No matter the options chosen, the mechanism is the same: give an insurance company some money, and they pay you back every month until you and/or your spouse die.

The risks of this approach can relate to your life span, market risks, performance risk, and whether the insurance company stays solvent. Also, if you die after receiving the first payment, your family may lose the majority of your initial deposit if you did not cover that contingency in the annuity contract.

In addition, a typical annuity payment is fixed even if the market goes up. You may find you have given up some potential opportunities for growth. Finally, you must consider the risk that the insurance company may go bankrupt and will no longer make good on their end of the contract. Annuities can be an effective capital distribution method, but they’re not appropriate in all situations.

2) Systematic Withdrawals

Another way to finance your retirement is through systematic withdrawals.  There are two main methods: constant dollar and constant percentage.  Just as you once saved money systematically and let dollar cost averaging work for you, so also you can systematically pull money from your retirement account on a monthly, quarterly, semi-annual, or annual basis.  The constant dollar withdrawal plan has the benefits of convenience and consistency.

However, there can be a major risk with constant dollar withdrawals.  When you withdraw money from your retirement account during a bear market, you’re locking in a permanent loss to your portfolio. Some advisors suggest that this method, known as “reverse dollar cost averaging,” can be a great detriment to your portfolio when you make withdrawals during a bear market – which you almost certainly will if you live long enough.  So beware of the additional risks associated with constant dollar withdrawals.

Another systematic withdrawal option is the constant percentage method.  Instead of consistently taking out the same dollar amount, regardless of economic climate, you take out a constant percentage, thereby limiting your realized losses in a falling market and not compounding the losses to your nest egg.  The risk is that very few people want their retirement budget to be a slave to the market.  Less consistency in income streams means less ability to plan future life events.

3) Strategic Withdrawals

The final type of capital distribution is a strategic withdrawal of retirement savings.  There are several ways to implement this method. For instance, you can categorize your savings in buckets: low-risk, medium-risk, and higher-risk investments. A strategic withdrawal would be pulling funds from a lower-risk investment regardless of where the market is.  This reduces the negative effects of market risk on your retirement savings.  The risk is that this strategy requires some sort of market-timing plan.  It takes more time and expertise and is far from full proof.

Building a retirement income plan is one of the most important investment decisions that you’ll consider.  While these are three conventional methods used, they certainly aren’t the only ones.  Like most things in life, generally one size does NOT fit all.  Mixing a few of these methods or others may be the optimal blend for your income plan.  Also, often the right method is dependent on the type of assets you’ve saved: individual securities, pooled investments, employee pensions, or a mixture.  All have benefits, but all have risks as well.

Before implementing any of these strategies, discuss your situation with a qualified investment advisor. A professional can guide you through different ways to distribute your assets during retirement so you don’t outlive your savings.

Five Tips For an Easier Retirement

Generally, retirement planning isn’t considered a relaxing leisure activity, but it’s a necessary step to enjoy your later years. We’ve warned you before about four risks that could ruin your retirement. In a more positive context, we want to help your retirement be secure to reduce stress and have a tidy nest egg waiting for you when your working days are over. Here are five tips to help accomplish that objective.

1) Never stop growing.

Inflation isn’t a four-letter word. But when it comes to the impact on your retirement, inflation is one of the nastiest words in the dictionary. Rising costs coupled with taxes can ravage your portfolio without proper planning. Remember that health care costs are rising faster than general inflation, and health care will be one of your biggest costs in retirement.

2) Hedge your bets.

One of the best ways to protect your portfolio against risk is to allocate your resources amongst different asset classes and to diversify your holdings inside those asset classes. Unfortunately, “Asset Allocation” is too narrowly defined at times, and diversification is often not enough to protect common day investors. Real Estate, commodities, and even currency hedges can be a valuable part of an overall investment plan. Also, ensure that you have a strategy for your portfolio. Invest-and-forget can lead to untimely volatility with often severe impacts on your retirement plans.

3) We’re here to pump you up: Always Max Out.

You’d be surprised how many investors don’t contribute all they can to their IRA accounts and 401(k) plans. If you’re under 50, you can contribute up to $5,000 a year to a Roth IRA or to a traditional IRA. Contributions to the latter may be tax deductible. If you’re under 50, you can contribute up to $16,500 a year to a 401(k) plan as well.

If you’re over 50 and need to bolster your nest egg, don’t worry. Take advantage of the “catch up” provisions allowable by the IRS; $6,000 a year to each IRA and up to $22,000 to your 401(k) if you’re over 50. If you have the investable cash available, contribute as much as you can.

4) Hold on loosely.

It always surprises me how many folks confuse loyalty to their companies with holding too much of its stock. Does anyone remember Enron? AOL? Adelphia? Many loyal employees, who decided not to sell their stock or stock options and then diversify, when they had the chance, ended up with next to nothing. This happens all too often, yet many are still compelled to keep a big part of their portfolio in their employer’s company stock. This is too much stress to put on a portfolio. Ten percent or less is a good rule of thumb for one security in a portfolio. Sometimes these holdings can be intricate to unwind, so consult an investment professional if you need help to diversify.

5) Don’t let the tax tail wag the dog.

Few people enjoy paying taxes. Taking advantage of available tax-advantaged accounts is important in retirement planning. Equally important is minimizing tax liability. However, tax avoidance shouldn’t preclude you from mitigating risk. I’d much rather folks pay a little more in taxes and keep more of their portfolio than risk their retirement by refusing to diversify. Yes, you might have to pay some taxes, but that might be better than waiting around only to see the bottom fall out. Remember, capital gains means you made money on an investment. Don’t cut off your nose to spite your face. If your portfolio requires you realize a little taxable gain in order to reduce risk, then you should do it or else risk that gain melting away for good.

The thought of retirement can be captivating, but the road to a successful retirement takes a well thought-out plan and the discipline to follow that plan. Keep your eye on the prize and your feet on the ground. If you don’t know where to begin, consult a professional. Retirement dreams can become reality with hard work and wise preparation.

Do 401Ks Need ETFs?

Retirement accounts like 401(k)s, 403(b)s and Roth IRAs can be invested many ways. For employee-sponsored plans like 401ks or 403bs, employers usually opt for diversified trading pools, specifically mutual funds. Traditional mutual funds give employees the benefit of diversification while providing 401k plan sponsors and record keepers an easy way to track transactions through traditional mutual fund pricing.  Investors get affordable access to different investment styles and markets. Historically, mutual funds have been a great fit for employer sponsored retirement accounts.

Now this may be changing. Exchange traded funds (ETFs) have grown in popularity since their invention in the early 1990s. ETFs are investment funds traded on the stock exchanges with regular tickers. Like mutual funds, ETFs are collections of stocks, bonds,  or other securities and trade at (or at least near) the net asset value.

As ETFs have become more popular, calls for them to be made available within 401k plans and the like have been loud.  Companies like Sharebuilder 401(k), WisdomTree and Vanguard are finally opening up options for ETFs in retirement accounts.  These firms are trying to capture or keep market share in the nearly 3 trillion dollars currently in 401k mutual funds.

At first glance, the demand for ETFs in 401ks isn’t palpably clear, as some of the advantages that ETFs hold over mutual funds aren’t applicable.  Tax efficiency doesn’t matter in a tax-deferred account.  Also, the benefit of real-time pricing, while attractive to short-term traders, would drive 401k record keepers batty.

Recently plan administrators have found ways to overcome these record keeping and trading issues.  Cost now seems to be driving 401k providers from mutual funds to ETFs. According to BlackRock, the largest seller of ETFs in the country, “the average expense ratio of an iShares ETF is 0.41% versus the average mutual fund’s 1.50%, a difference that can result in tens of thousands of dollars over 30 to 40 years.” Advisors and employees understand the math. If you can make an extra 1% by moving to ETFs, why wouldn’t you do it?

Critics will point out that in larger plans, the difference in cost between ETFs and comparable index mutual funds is negligible.  Also, any cost savings in management fees will be offset by additional record keeping and administration costs that will be passed on to employees.

Will ETF’s displace mutual funds as the preferred investment vehicle in 401ks?  Probably not anytime soon.  Still, ETFs are evolving; mutual fund titans such as Fidelity, Vanguard, and Charles Schwab now have their own ETF offerings.  And as many small and medium sized companies gravitate to ETFs for the cost savings, how long until the big 401k providers sit up and take notice?

To Invest in a Roth or Not?

While the title of this article could stir many a great rock ‘n roll debate about the front men of Van Halen, we’ll focus on investing for retirement.  Americans are not saving for retirement as much as they once did.  The frugality of “the Greatest Generation” has steadily given way to the excess of later generations.  One way to save more is with the Roth IRA, which remains a mystery to some investors despite being a great way to save for retirement.  Today we will try to de-mystify it.

Named after the late Senator William Roth of Delaware, the Roth IRA is a federally structured retirement plan.  It usually serves as a supplemental retirement plan to Americans with employer-sponsored retirement plans.  However, it can be used as a primary retirement savings vehicle in certain situations.  A Roth could be perfect for some people.

Several attributes of the Roth IRA distinguish it from other retirement plans.  For one, Roth contributions have already been taxed.  In other words, you cannot deduct contributions in your current tax year with the Roth.  The upside is that direct contributions to those accounts can be withdrawn tax-free at any time.  The real benefit happens after 59½ – when all monies in the Roth IRA are tax-free.

This is the primary difference between Roth IRAs and Traditional IRAs.  Contributions to traditional IRA’s are tax deductible at the time of contribution.  However, you must pay tax on your distributions during retirement.  You decide whether you want to pay taxes now (with the Roth IRA) or later (with Traditional IRAs).

However, not everyone can contribute to a Roth IRA.  Eligibility phases out at certain income limits.  For single filers, you cannot make more than $105,000 to qualify for a full contribution or $105,000-$120,000 to be eligible for a partial contribution.  For joint filers, you cannot make more than $166,000 to qualify for a full contribution.

There are also contribution limits for those who qualify.  According to the IRS,

“If you are under 50 years of age at the end of 2009: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $5,000 or the amount of your taxable compensation for 2009. This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $5,000. The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

“If you are 50 years of age or older before 2010: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $6,000 or the amount of your taxable compensation for 2009.  This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $6,000.  The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

Finally, you can contribute up until the tax-filing deadline in the following year.  In other words, for the 2009 tax year, you have until April 15, 2010 to make your contribution.  For those who qualify, the Roth is often the best way to supplement an employer- sponsored retirement program.  401k, 403b and similar programs are still the best place to save your money over the long-term, but a Roth IRA can be a good idea if you’ve maximized those contributions.  Don’t let the Roth IRA be a mystery any longer, and for the record, I’d go with David Lee Roth, too.

Retirement: An Outdated Concept?

Retirement planning presents many risks to consider.  What if something tragic happens to you and your family is left with large financial obligations?  That’s what life insurance is for.  What investment vehicles are best for you?  That’s why you need to pick a good investment planner.  But the biggest issue facing future retirees isn’t a potential early demise or the wrong portfolio mix.  The biggest problem is simply saving for retirement.

The idea of retirement is actually a recent phenomenon.  Before the Great Depression, only the affluent could afford to stop working.  Most folks worked until the day they died or lived with their grown children if unable to continue later in life.

The advent of Social Security, unions and industrial pension programs made retirement possible for the masses.  The World War II “Greatest Generation” were wonderful savers, having been toughened by lessons learned living through the Depression and World War.  Despite living when pensions were being offered, many shunned reliance on those programs.  However, as times changed and Americans started to live longer, the responsibilities of saving for retirement transferred from employers (pensions) to employees (401k/403bs) and the importance of sound saving habits became paramount.

As we trudge along into a new century, we need to remember the lessons of our forbearers.  Savings can help you achieve the economic freedom generally associated with retirement.  If you save enough and invest wisely, you should be able to live comfortably on your savings when your planned retirement date approaches or you are unable to work.  We certainly can’t expect to rely on Social Security any longer.  Despite the early promises of Social Security, it has not yielded the security that many seniors expected from a social retirement system.

If saving is the most important part of a good retirement, do we risk reverting back to a pre-Depression era mindset?  Many future retirees don’t really know how to save—nor are they even trying.  Last week, the Employee Benefit Research Institute released its 20th annual Retirement Confidence Survey.  The survey measured the thoughts of working and retired Americans.  The study found:

“A growing percentage of workers report they have little saved and invested.  Among respondents, 27% say they have less than $1,000 in savings and 54% report that the total value of their household’s savings and investments, excluding the value of their primary home and any defined benefit plans, is less than $25,000.”

Obviously many Americans are not saving enough.  Most people (54%) cannot envision a time when they won’t be able to work.  The optimism of Americans has nearly blinded them to some harsh realities.  As a result, they are not adequately preparing for retirement.

“Many workers continue to be unaware of how much they need to save for retirement.  Less than half of workers (46%) have tried to calculate how much money they need to save to retire comfortably.  Of those who did, 44% relied on guesswork, rather than a detailed review or professional advice.”

The study also found that a majority of Americans, if saving, haven’t done any planning to figure out what they’ll need to retire in the lifestyle they’ve become accustomed.  That’s the equivalent of driving through the Mojave Desert not knowing how much gas you’ll need to get across.  Will you have enough?  If not, is there a gas station available along the way?

What is the solution to these problems?  The first step is to acknowledge them.  Social Security will not be enough to live on when the time comes.  The second step is to develop a plan to save enough money and invest it wisely.  The third step is to execute the plan.  If you don’t know where to start, consult a professional or hit the internet.  There is a ton of information out there to help.

Save today and you won’t have to worry about your earthly tomorrow.  As Ben Franklin said, “For age and want, save while you may; No morning sun lasts a whole day.”