Planning for Retirement—Preparing Your Portfolio

If you are like most people you think about retirement. The closer that day comes the more you may focus on a target date. The determination of that date typically involves both your age and the size of your portfolio. Understanding the many factors that influence reaching this target and planning ahead can increase your chances of success. One such factor is related to financial market performance. Another involves asset location.

The financial market performance factor is called “sequence-of-return” risk. While market returns will vary over time it is the sequence of returns that is particularly important to your retirement plans. A rising market in the years leading up to retirement can provide a greater cushion for later in life. A declining market during the same time frame, however, can negatively impact your portfolio and retirement plans.

The chart below shows two different portfolios, each having an average annualized return of 5.0% and withdrawals of $150,000 per year (inflation adjusted) over a thirty-year time horizon. During the time period each portfolio has three years of large losses—the red portfolio has losses at the beginning of the period and the green

The above chart shows the results of early losses (red) of 12% in year 1, 10% in year 2 and 5% in year 3, versus later losses (green)of 12% in year 28, 10% in year 29 and 5% in year 30. This example assumes a $4,000,0000 initial balance and an annual withdrawal rate of $150,000. Withdrawals are adjusted annually by an inflation rate of 2.5%. This hypothetical investment assumed an annual 5% rate of return. This example is for illustrative purposes only and does not represent the performance of an actual investment. There is no assurance that similar returns will be achieved.

While you cannot control market returns you can control, to some extent, your exposure to market risk and the returns that follow. Although a high-risk portfolio may generate higher returns over time it can expose you to more volatility and risk of loss of capital during certain periods. A low risk portfolio on the other hand, may expose you to less volatility and risk of loss of capital.

A high-risk portfolio in the years leading up to retirement creates potential risk that a planned retirement date may turn out to be much later than expected should markets, and the portfolio, generate negative returns. The best way to reduce retirement date risk in the years leading up to retirement is to reduce portfolio risk—or save a lot more!

A decreasing equity glide path (chart below) demonstrates this risk reduction. The planned glide path will depend on the number of years to retirement, years in retirement, and the targeted rates of return. This may indicate lower returns with a more conservative portfolio and if the portfolio is not large enough may push back the retirement date a few years—an acceptable trade-off given the higher level of confidence in reaching your goal.

One other factor is asset location—which assets are in taxable vs. tax-deferred accounts (IRA, 401K and others). Optimizing asset location can increase the tax efficiency of your portfolio and hence after-tax wealth. Under current Federal law, long term capital gains and qualified dividends are taxed at favorable capital gains rates—either 15% or 20% for most of our clients depending on their taxable income.

Interest income and distributions from tax-deferred retirement plans are taxable at ordinary income tax rates which are higher than capital gains rates at higher taxable income levels. Tax efficient investments are taxed at lower rates—capital gains/qualified dividends. Less tax efficient investments are taxed at higher rates—ordinary income. A basic rule of thumb is to hold the most tax-efficient assets in taxable accounts and the least-efficient ones in tax-sheltered accounts. The chart below shows the range of tax-efficient assets graphically.

Tax-efficiency can be achieved using several strategies under current law. First are the favorable capital gains rates noted above. Second, you can benefit from tax loss harvesting, which is the ability to sell taxable investments that have unrealized losses and use these losses to offset realized capital gains in the same calendar year. Third, charitable donations of appreciated securities eliminate recognition of unrealized capital gains.

Like most general advice, there are plenty of caveats to the guidance provided above and depend on the individual tax position and circumstances of each person. Your Round Table Wealth Management advisor can help identify the ideal asset allocation as well as asset location for you to help you meet your goals.

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By |2019-07-15T20:23:28+00:00December 19th, 2017|Blog|Comments Off on Planning for Retirement—Preparing Your Portfolio

About the Author:

Richard Freeman is a Senior Director, Wealth Advisor at Round Table Wealth Management. Read Richard's Biography >