Ready For Retirement

The Retirement Portfolio Shift- How to Make the Transition Smoothly

September 05, 2023 James Conole, CFP® Episode 179
Ready For Retirement
The Retirement Portfolio Shift- How to Make the Transition Smoothly
Show Notes Transcript Chapter Markers

It’s common knowledge to have a different portfolio allocation before retirement than you actually have in retirement. But how and when do we actually go about making that change?

This episode is based on a listener question: Alan, has a portfolio mix weighted too heavily in stocks. As he shifts into retirement, he is looking to have a new allocation strategy. 

James discusses how to shift into a different allocation, when the right time to do that is, and what makes the most sense for Alan’s situation.

Questions Answered:
How do we shift into a new allocation strategy?
When should you begin that process?

0:00 Intro
3:08 The framework
8:41 Where should you hold assets?
14:14 What’s the timing?
18:14 In summary
19:11 Outro

Create Your Custom Strategy ⬇️

Get Started Here.

Speaker 1:

We all know it makes sense to have a different portfolio allocation before retirement than you actually have in retirement, but how and when do we actually go about making that change? That's the topic for today on Ready for Retirement. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's topic is based on a listener question, and this question comes from Alan. Alan says this James, I really like your podcast. You always bring a lot of useful information that I can incorporate into my retirement plan. I will be retiring in a few months and unfortunately I am weighted way too heavily in stocks and need to add more fixed income to balance out my portfolio. It's my fault for not doing it earlier. We will be getting about two hundred thousand dollars on the sale of my mother's house very soon. We've already maxed out our IRAs this year, but even if we didn't, it would only add fifteen thousand dollars to our portfolio. We probably need to add another fifty thousand to seventy five thousand dollars to fix income. The only option I see is to put that money into a taxable bond fund. We're only in the twelve percent tax bracket, so it wouldn't be a huge tax hit. Any other thoughts you may have as to where to put the bond fund or at least how to balance out the portfolio? Thank you, alan. Well, thank you for that question, and essentially what he's asking is I have my portfolio mix, but this portfolio mix is maybe too heavily weighted towards stocks, because I've been growing my portfolio and so I've had a stock and a growth focus. But now I'm gonna retire and as I'm retiring, I now need to make an abrupt shift towards a new allocation, because I'm too heavily weighted in stocks and on top of that, I have this new inflow of cash coming in. How do I think about this? How do I go from where I am today to where I should be with my portfolio allocation? And that's exactly what we're gonna talk about today. Before we jump in, I will highlight the review of the week, and this comes from username AJ Dubia, and AJ says five stars. James discusses topics that are relevant to aspiring retirees, along with those of us who have already taken the plunge. His communication style and topics are both informative to those of us who are contemplating retirement, but also engaging for those of us who are already a little more informed and always looking to learn more about retirement planning. Keep up the great work. Five-star review. Well, aj, thank you very much for that. Thank you to everyone who's left reviews. If you have not already done so, and if you've gotten any value of this show, would really appreciate you taking a moment to do that. Also, make sure that you check us out on YouTube, if you haven't already. The YouTube channel name used to be root financial. It's now just under my name, james Kanol, so you can find it there. Where you can find this episode, which is just the podcast, and there's also videos we release every single Saturday to make sure that you are preparing the best you can for retirement, ultimately in that effort to get the most out of life with your money. So on to the podcast episode for today. So how do we start to make this shift from where we are to where we want to go? Seems like a fairly straightforward answer of you should do this five years out and you should do that three years out, and there's some formula that you should follow, but unfortunately, that's not necessarily the case. Here's actually the framework that I would apply, and I would start by taking a big step back. Here's the order of operations. I would do things in number one. I would first ask you what is your target investment allocation? Why does this matter? This matters because so often we jump right into the. I'm retired, therefore, I need to be more conservative mindset now. Sometimes that is the case. Oftentimes that's the case where, when you're retired, your portfolio allocation should be a little bit more or a lot bit more Conservative than your working year allocations, but that's not always the case. What you need to ask yourself instead is what role does my portfolio play in creating the income I need to create in retirement? So, in other words, how does this supplement or how does this play along with my other income sources, like social security or pension or rental income or part-time work or whatever the case might be? But what specific needs do I have from my portfolio? Let's look at a super basic example just to illustrate this. Let's assume that Alan retired and he has pension and a social security benefit that combined for $6,000 per month. But let's also assume that Alan says do you know what? I only want to spend $5,000 per month. Well, in that example, alan's portfolio or anyone's portfolio for that matter, could be viewed as extra. We still want to manage it correctly, we still want to make sure that we're making wise decisions with it, but he's not dependent upon it to generate current income so that he can survive. Now I don't know Alan's living expenses, I don't know how there's other income sources. It wasn't part of the question, but just using that as an example, that's a very basic example of when you wouldn't necessarily need your portfolio to get more conservative in retirement. Here's another example. Let's assume that you have a million dollar portfolio and you need $20,000 per year from it because that 20,000 will supplement your social security, your pension or other income sources. Well, you look at that and what I would look at first is what cash income is that portfolio delivering? So say, hypothetically, it's entirely in stocks, it's diversified, it's well-spread out, but the whole million dollars is stocks. Well, my guess is that portfolio would be generating at least $20,000 per year just in cash dividends. So, even though in this example you actually do need some of your portfolio, there's still cash dividends being paid, to the point that you wouldn't have to sell any of your stock investments to create income, even if there was a downturn in retirement because, again, the whole reason we don't have the entirety of our portfolio in stocks and retirement is there will be downturns. They happen very regularly. Now they're temporary, but we need to be in a position where we're not having to sell our stock investments to free up cash for distribution for living expense needs when those downturns are happening. Now let's look at a final example. Let's assume that you have that same million dollar portfolio, but this time you need $50,000 per year from it. Let's assume the same portfolio is still delivering $50,000 per year in dividends. A quick side note, real quick, that's important to note with this conversation as we're incorporating dividends is dividends that companies pay typically remain very consistent, even if that company stock price has fallen 20, 30, 40%. Now there are exceptions to this and we need to prepare for the exceptions to this, but in many instances, yes, the stock price might be fluctuating dramatically, even towards the downturn, but dividends oftentimes remain very consistent. So that's one of the reasons I'm still incorporating it here. If dividends were cut in half anytime stock price is cut in half, we couldn't count on them the same way that I am, at least in these examples. So let's now go back to the third example here. In the third example, you still have that million dollar portfolio. It's still generating $20,000 per year in dividends, but now you need $50,000 per year in income from that portfolio. Well, now there's a potential liability there of $30,000 extra dollars above and beyond dividends that are needed from that portfolio. So if stocks drop 20, 30%, let's assume that we can still count on that $20,000 per year of dividends, but there's remaining $30,000 we'd still need, and we don't want to have to sell stocks to free that money up. Because, again, we don't want to have to sell stocks when they've dropped, especially not 20, 30% or more. So in that example, that's when you'd want to have enough money in cash or bonds to be able to live on. So, essentially, something that's more stable, that's not dropped 20, 30, 40% or more. That's why we incorporate cash, bonds, other stable assets, into our retirement planning. So start there. Number one is understand what is your target investment allocation, and that's going to be a function of your retirement living expenses as well as your other retirement income sources. So when Alan says, unfortunately, I'm weighted too heavily in stocks and need to add more fixed income to balance out the portfolio, he may be saying that because he actually went through this exercise and has a specific investment allocation that's suitable for his needs. Or he may be saying that because he's retiring and just by default thinks he needs a more conservative allocation. So, alan, I'm not sure which one it is for you. For other listeners, I'm not sure what it is in your case either, but start by understanding what is your actual target investment allocation by the time that you get to retirement. That's number one. Hey everyone, it's me again for the Disclaimer. Thanks for watching. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Number two is this when should you hold those assets? So once you've determined an allocation let's assume, for an example, it's 80% stocks, 20% bonds what accounts are you allocating those stocks in those bonds too? This is the concept of asset location. So, going back to that example, let's assume we want 80% stocks and 20% bonds, and let's assume that Alan has an IRA and a Roth IRA in a brokerage account. Should Alan have 80% stocks and 20% bonds in his IRA and 8020 in his Roth IRA and 8020 in his brokerage account? I would say no, almost certainly not. It should depend upon what accounts is Alan going to pull from first, based upon his specific drawdown strategy. So let's assume for a second that he's going to try to spend down his brokerage account to keep his taxable income low and simultaneously start converting money from his traditional IRA into a Roth IRA Fairly common drawdown approach that we'll see. In that case, even if his high-level asset allocation goal is 80% stocks, 20% bonds, if he's going to be spending down his brokerage account first, we want that to be weighted far more heavily towards bonds than the rest of the portfolio. So he could still have the overall 8020 mix, but more of those bonds should be in his brokerage account and more of the stocks should be in his IRA and Roth IRA, because it's not necessarily are you retired or not retired. It's a matter of looking at every single account you have in understanding the role it plays in your portfolio and in your drawdown strategy. Accounts you're not going to spend down for quite some time. Those can still be more aggressive, even if you're in the decumulation phase of your spending, because it's not about what you're doing as a whole, it's about when will this specific account be needed and aligning your asset allocation in a manner that's appropriate with that. So let's look at Alan's situation. It sounds like Alan and his wife have IRAs I have no idea how much, but for a second I'm just going to assume it's $800,000, because this will make the math real easy for me. Well, let's also assume that his IRAs are 100% stock today. And let's also assume, for third assumption, that he and his spouse have determined that they want 20% of their investment portfolio in bonds. What would that mean right now, based on that $800,000? It means that they would need to sell $160,000 and reallocate it to a more stable allocation. So cash and bonds. That's difficult to do emotionally. To do that all at once isn't easy, especially after we suffered a down year in stocks, like we did in 2022. So it's not necessarily natural to feel like that's an easy thing for people to do to go from one allocation today to an entirely different allocation tomorrow. But here's the thing Alan just told us he received $200,000 as an inheritance. If I add that $200,000 to the made up number of $800,000 in his IRAs, then I'm assuming. Well, now, all of a sudden, alan has exactly $1 million. I told you I did that to make this easy math, because now a 20% allocation of a million dollars is $200,000 that needs to be allocated towards more stable assets. So that makes things for Alan a bit easier because he doesn't actually have to change anything in his IRA in this example Granted, this example is made up. I don't actually know how much he has in his IRAs, but in this example he really doesn't need to do much with his traditional IRAs, at least not yet. What he can do is use that new cash inflow to get his fixed income allocation accounted for without actually having to change any of his existing assets. So that's just a made up example. As I actually go back to Alan's question, he says and if I'm reading this correctly, they need to add another $50,000 to $75,000 to their fixed income assets. So what I would look at again go back to step one. Understand what is your target retirement allocation. It is $50,000 to $75,000, the actual right number to get you there. And then number two where do you need to hold that $50,000 to $75,000? Does that need to all be in your brokerage account? Well, probably, if that's what you're going to spend down first, versus are you planning to spend down IRAs or other accounts first? If so, you may need to have it there instead. So if it is truly $50,000 to $75,000, then, alan, to your point. Yeah, that's money that could be used in your brokerage account. And you talked about tax efficiency the way you worded your question. So you could either go buy corporate bonds, which are fully subject to federal and state taxes. You could look to buy municipal bonds, which have some tax benefits. You could look to buy treasury bills, which have some tax benefits. If you're in a state that charges income taxes, just in the sense that treasury bills, you're not paying that state income tax. So what you want to be looking for there is what's called the tax equivalent yield. Look at corporate bonds, look at municipal bonds, look at treasury bills, and they're all going to have different yields. But you don't make your decision based upon what that yield is. You based your decision on what's the after tax amount of that yield that you're actually going to keep. Now, this is a topic for different podcasts, different discussion. But to Alan's point if you are going to allocate some to bonds, then what kinds of bonds, what duration of bonds, what's the tax impact of those bonds. So there are still, of course, deeper things that you need to do once you've identified that, but that's the high level way that I think about that. Then, third, number three once you've identified what your target asset allocation is number one. Number two you've targeted the asset location, so what accounts are going to hold the various stocks and bonds that you're going to hold? Number three is what's the timing of that shift? So let's say you have a 90-10 allocation today between stocks and bonds and you want to move that to a 75-25 allocation by the time that you're tired. When do you do it? Well, this is one of those things where there's not a perfect science to it. I wish there was some simulation or formula where you can just plug in your numbers and you magically get the right answer. Unfortunately, that doesn't exist. What I like to do is I typically like to start the shift somewhere between about the five-year mark to the 10-year mark. On the long end. You don't want to start shifting 20 years out. 20 years out. You're just starting to get too conservative too quickly, in my opinion, and now there's just the drag of being too conservative too soon and missing out on some of the returns that you could have received. You also don't want to start the shift 20 days out. That's far too late. In 20 days there's just a major market downturn that could happen. That could potentially get in the way of you retired when you want to. So what's the sweet spot? Well, there's not a perfect science to it, but think maybe somewhere in five to 10 years out from retirement to actually starting to subtly make some shifts. Ideally you're not going from a 90-10 allocation today to a 75-25 allocation tomorrow. It's not the end of the world, it just subjects you to some risk. If you're hanging on to a more aggressive allocation for a longer period of time than an unexpected downturn in the market and, by the way, I'd argue they're all unexpected, but that unexpected downturn now hits you in a much harder way than otherwise would have. So if you're trying to go from 90-10 to 75-25 and say you've got five years to do so, do you make slow, gradual shifts of about 3% change to your stock, to bond allocation each year? Now here's another thing that I like to do Instead of just selling some investments to buy others to gradually shift my allocation or client's allocation, I like to use cash flows to build out the target allocation. What this does is it means I don't necessarily have to sell something or at least not sell as much as something to still gradually build up the fixed income allocation. So what are cash flows? Well, they could be dividends. So if your portfolio, for example, is paying 2% 3% in dividends and your goal is to shift 2% to 3% of your allocation towards fixed income each year, a simple way of thinking of that is do we take the dividends that are paid each year and reinvest those into the bond allocation of our portfolio? Same thing goes with the fixed income allocation. The interest from that? Do we just continue to use that to buy more and more bonds, more and more fixed income or even new 401k or IRA or investment contributions? So if you're continuing to put money into your portfolio, if you have an 80-20 portfolio or 60-20 portfolio or 100-0 portfolio, whatever it is you don't have to make new contributions to the same exact allocation as your existing mix of investments. So can you start to take new contributions and use those to slowly but surely build out the target allocation you're looking for, so that by the time you actually retire, it's more like you've landed a plane going from 30,000 feet to 25,000 to 20,000 to 15,000 to 10,000. You gradually landed that thing, as opposed to falling out of the sky and hoping for the best when you actually hit retirement. Obviously, a plane falling out of the sky is much more dramatic than changing an investment allocation, and there's many instances where you can and you should change an investment allocation all that once, right before you retire. The risk of doing that, the risk of holding on too long, is just that if there's a major downturn in the stock market and more of your portfolio is in the stock market than should be now, you face a setback that will take longer to recover from than had you slowly but surely started shifting your allocation. And then, finally, cash flows. In Allen's example, he just received an inheritance that's $200,000. That's a type of cash flow that we can't necessarily all count on. But if there is an expected inheritance, or you have stock that's vesting, or a final payout of PTO or vacation time or sick leave or whatever the case might be, factor all those things in to what you can use to build out the allocation that you're looking for. So, in summary, number one start with your actual target allocation and do it the right way, don't just do it because you're retired. Therefore, you need a 60-40 portfolio. Do it because you're trying to come up with the right portfolio mix for you that meets your financial needs and also satisfies your own unique risk tolerance. Number two find the right asset location. Where should you hold different stocks and different bonds? And then, number three, come up with a plan for how you will start to build out that allocation. How do you get from point A to point B? Ideally, it's not a dramatic shift all at once, but you have a plan that you can then act upon over the next few years to get from where you are today and gradually shift that to where you want to be in the future. So, alan, thank you for that question. I know it's a fairly simple question of when should I start making these changes, but there is a process you should follow. So I think it's good to actually go through those steps, starting by taking a step back and then working through things systematically. So that's it for today. Again, a reminder if you have not already left a review for this show, it would really mean a lot to me if you took a few minutes and did so, and then also check us out on YouTube, the channel name is now James Kanol. It used to be under Root Financial, but you can find that on YouTube James Kanol. With that said, thank you for listening. I'll see you all next time. Thank you for listening to another episode of the Ready for Attignment podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click Start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

Portfolio Allocation Changes in Retirement
Allocation Timing in Retirement Planning