Asset Allocation / Portfolio Recommendation for Soon to Be Early Retiree

[aim-high]

HELP - AA / Portfolio for Soon to Be Early Retiree

Over the next several months I will divest from a concentrated position into a diversified portfolio. The goal is to completely divest the position and join the class of 2014!!! I have to figure out my asset allocation and retirement portfolio.

I am 48, DW is 50. I am figuring on a 45 year retirement. As long as everything holds together, we will end up at 35x when done. That doesn't include social security. As long as Congress doesn't change our benefits, SS would cover 23% of our expenses if taken at 62 and 42% of our expenses if taken at 70. I ran several retirement calculators with 35x and early SS and we have the green light. I'll probably take late SS though.

My first inclination was to have an asset allocation of 75% equities / 25% bonds. After reading Dr. Pfau's work on sequence of return risk I thought I might adjust it to be something like 25% equities / 75% bonds - especially because I've got fear of heights having just been on a roller coaster and given the markets are at all-time highs.

As far as types of accounts here is our situation as it relates to annual expenses.

Taxable - 7.5x
IRA     - 2.0x
ROTH    - 25.5x

Vanguard suggested the following allocation.

28% Vanguard Total Stock Market ETF (VTI)
12% Vanguard Total International Stock ETF (VXUS)
48% Vanguard Total Bond Market ETF (BND)
12% Vanguard Total International Bond ETF (BNDX)

Thoughts? It seems as good as anything I'd be able to come up with. I think I'd sleep ok for the short term, but it really cuts against the articles that indicate I should be at 70 to 80% stock allocation based on my age. Too conservative?

I will be divesting equally from all 3 types of accounts and making purchases as I divest into whatever allocation I end up going with. This will sort of be like DCA into the markets over 4 months.

How should I be allocating the money across accounts though. Balanced proportionally? I don't think I'd want all VTI in my taxable account because then I'd be 100% in stocks for what I can access until DW turns 59.

If for some reason our Taxable account doesn't last, we do have 4x in the Roth that we can take out early without penalty since it was our initial investment and has been there 5 years.

I thought I had a good handle on all this earlier in the year. Now that I'm going to start executing on it this month, I'm getting anxious.

 

[pb4uski]

A number of thoughts.

I think 25%/75% is way too conservative especially given your WR is less than 3%. 1/35 = 2.86%. I think sequence of returns risk is better accomplished through flexibility in spending. So if you have vacations and other discretionary spending in the 2.86%, then I don't see a need to be so conservative in your AA.

I concede it is easy for me to say since I retired 2 1/2 years ago and my nest egg is 25% higher than when I retired even after 2 1/2 years of withdrawals at 3-3.5%.

Even the 40%/60% you are considering is too conservative for my taste. I target 60% equities/34% fixed income and 6% cash (6% ~ 2 years of living expenses).

Other than our 6% cash position all my taxable account investments are equities for tax efficiency since qualified dividends and LTCG are tax-free since I stay within the 15% tax bracket and I can use foreign tax credits from my international equities in my taxable accounts.

Since you have so much in tax-free (congratulations BTW) you'll probably be best having your IRA be all bonds, your taxable be all equities and balance things out in your tax-free. Don't worry about liquidity. When you need cash you can sell equities in your taxable account at preferable tax rates and rebalance through your tax-free accounts by selling fixed income and buying equities as needed to bring you back into balance. (I do the same thing, but in my tax-deferred accounts).

Do you expect to be in the 15% tax bracket in retirement? If so, you might be able to do Roth conversions at low tax rates. Last year I was able to convert the equivalent of a year's withdrawals at 7% federal tax - a low cost IMO since I was in the 25-28% marginal tax bracket when working.

 

[clifp]

I think 25% is too low for a 40-45 year long retirement, especially considering the record low interest rates.

At 35X according to FIRECALC 25% is the minimum equity percentage you need for 100% success. Moving your expenses up to 30x and 25% equity gives a <90%.

I'd advise reading this thread on Monte Carlo simulation, while my opinion is a bit on the extreme (I think they are worse than useless) the forum consensus is they aren't very useful.

While I respect Dr. Pfau knowledge, I believe he made an awful assumption in his paper which results in silly things like people switching from a 75% to 25% equity AA during a time of historically low interest rate, and admitted today high stock valuations. In addition the inherent flaws of Monte Carlo simulation compounded the problem by arbitrarily deciding the US equity returns were going to revert to the rest of the world.

Why? I don't know he doesn't say. I'd argue over the last 30 years the rest of the world capital market have evolved to become more like the US (greater transparency, less cooking the books etc.). So why not project that rest of the world equity start to look the US and other developed countries like Canada and Australia.

The combination of flaws in Monte Carlo simulation for predicting asset class returns and his stacking the deck against stocks results in things like super low equity allocations.

I think the 4 funds you have a fine; if you had more normal 50-75% allocation However, with 75% devoted to bonds the huge risk your retirement face is inflation risk, and the only inflation hedge you have is 25% equities. So if you are going to have such a bond heavy portfolio than I strongly feel you need a large amount of TIPs bonds, and/or REITs, or even gold or commodities.

 

[walkinwood]

IIRC, historical SWR studies show the best results with 40-70% equities. (See Bengen's paper).

 

[REWahoo]

IIRC, historical SWR studies show the best results with 40-70% equities. (See Bengen's paper).

+1

Or this FIRECalc chart showing equity allocation success rates:

 

[ejman]

+1

Or this FIRECalc chart showing equity allocation success rates:

This kind of chart makes me wonder if I shouldn't just convert to equal parts Wellesley/Wellington or Life strategy Conservative/moderate for an index approach and be done with it. Nice 50/50 overall until the cows come home with basically no active input.

 

[Animorph]

I agree, a higher equity percentage (>25%) would be better. The 40% of your example portfolio would be fine.

The problem with sequence of returns is that if you start with low equities and the market tanks you're in good shape. But if the market takes off your portfolio doesn't do as well as it would have with more equities and you are still in danger from future downturns. If you start with high equities and the market tanks you're in trouble. But if it goes up you are set.

What you really want is the best way to reach <3% WR as soon as possible (100% FIRECalc success rate, or pick your own target). The best way to get there depends on the market, and your chances are somewhat 50/50 since the best way to do it depends on which way the market goes. I'd go middle of the road equity percentage or a good sized cash buffer that gets spent down quickly. At 35x, you're pretty much there already. I don't think I'd worry too much about sequence of returns.

I'd go a little heavier in bonds in your taxable account to make sure you have enough funds to cover you until 59.5. That's kind of medium-term money. Roth convert the remaining IRA funds as the tax brackets allow. If you can stay in the 15% bracket with 0% cap gains you'll be in good shape.

Your fund selection is OK. I like more international and more equities, but there's nothing wrong with your allocation.

 

[REWahoo]

This kind of chart makes me wonder if I shouldn't just convert to equal parts Wellesley/Wellington ....... and be done with it. Nice 50/50 overall until the cows come home with basically no active input.

That's essentially what I've done. Roughly 40% Wellesley, 40% Wellington and 10% cash/CDs.

 

[clifp]

This kind of chart makes me wonder if I shouldn't just convert to equal parts Wellesley/Wellington or Life strategy Conservative/moderate for an index approach and be done with it. Nice 50/50 overall until the cows come home with basically no active input.

I'd say that 50/50 W&W will out perform a very high percentage of portfolio, and virtually all on risk adjusted basis. But I suppose it could be possible that the next 20 years that W&W managers lose their touch, but I wouldn't bet it.

 

[aim-high]

Thanks for all the feedback. I'll look at the Monte Carlo thread. I think maybe I'll start with a traditional 60/40 and see how it feels. Once I pay my taxes for this year's earning and capital gains, I should be able to manage my situation and live tax free under the current laws.

After making some adjustments with the Vanguard questionnaire, it returned the following.

42% Vanguard Total Stock Market Index Fund Investor Shares (VTSMX)
18% Vanguard Total International Stock Index Fund Investor Shares (VGTSX)
32% Vanguard Total Bond Market Index Fund Investor Shares (VBMFX)
8% Vanguard Total International Bond Index Fund Investor Shares (VTIBX)

That's 60 / 40.

I'm curious. The Vanguard system is recommending investor shares. Why wouldn't they recommend the Admiral shares or ETF's when my assets qualify for those?

VTSAX / VTI
VTIAX / VXUS
VBTLX / BND
VTABX / BNDX

Using the Admiral shares or the ETF's I'd cut the already low ER by almost 80%. All three options, investor class, admiral class, and ETF are available for all four at TD Ameritrade. I'll be able to DCA out of my concentrated position right into a diversified portfolio.

I've done a little reading on ETF vs Admiral shares and have not been able to find a compelling reason to choose one over the other. Most of the articles say it's 6 of 1, half dozen of another - go with your preference.

Anyone have opinions on that?

Thanks in advance.

 

[pb4uski]

This kind of chart makes me wonder if I shouldn't just convert to equal parts Wellesley/Wellington or Life strategy Conservative/moderate for an index approach and be done with it. Nice 50/50 overall until the cows come home with basically no active input.

I have often thought that this would be a good choice if tax efficiency was not an issue. Since the OP has so much in tax-free he might go total equities for taxable, total fixed income for tax free and then use a balanced fund in the Roth that brings the overall AA to what he wants it to be.

 

[pb4uski]

...I'm curious. The Vanguard system is recommending investor shares. Why wouldn't they recommend the Admiral shares or ETF's when my assets qualify for those?....

I've done a little reading on ETF vs Admiral shares and have not been able to find a compelling reason to choose one over the other. Most of the articles say it's 6 of 1, half dozen of another - go with your preference.

Anyone have opinions on that?

Thanks in advance.

The only real advantage of the ETFs that I know of is that the ETFs are not subject to frequent trading restrictions like some of the fund shares are. for example, a couple years ago I wanted to do a gains trade for tax purposes (sell and buy the same shares on a day to recognize the gain for tax purposes) and the frequent trading restrictions made it difficult. I think I probably could have done it easily with the ETF.

 

[photoguy]

Aim-High -- in case you're not convinced by the posts on this thread so far, take a close look at the tables in Pfau's & Kitces paper on this. Depending on the scenario, even in their own results, the rising glide path can do *worse* than a standard AA.

Even when the rising glide path wins, the differences may not be much. For example, in their lower returns scenario, a fixed 60-40 portfolio allows a 2.9% WR at 10% failures whereas a rising glide path allows a 3.0% at the same failure rate. I think 0.1% difference is basically noise. However the rising glide path comes at a cost of worse median/average returns.

Regarding your 4 vanguard funds, definitely get the admiral or ETF (no big difference between the two). Personally, I would not buy international bonds (stick to US). Also if you increase the equities portion and reduce bonds (as most are recommending) I'd would keep international at 30% of equities or more (my personal portfolio is sitting at 43% international).

 

[aim-high]

I have often thought that this would be a good choice if tax efficiency was not an issue. Since the OP has so much in tax-free he might go total equities for taxable, total fixed income for tax free and then use a balanced fund in the Roth that brings the overall AA to what he wants it to be.

Everyone, thanks for all the help.

pb4uski, do you mean total fixed income in tax deferred and then use the tax free Roth to balance it out?

 

[Travelwanted]

I'm joining this late, but agree with the AA being too low. We are likely facing a "new norm" for low interest rates long term. I'd agree with at least a 50/50 split.

One of the most important issues with investing in equities is volatility, right? So, the key is to look back at history (which is not necessarily a predictor of the future... but its all we have!). During the pull backs, equities have been down for about 4 years at most. Thus, they key to sleeping well, for me, is to keep enough cash/cash equivalents for several years to ride out the next storm. Up to now, it always bounces back and then some. By keeping the cash there will be no need to panic sell. Ride it out.

Fixed income is paying out historically low returns. I'm guessing the rates will bump up soon, but not by much. I think at a young age, too much FI can be as dangerous as too much equities.

 

[pb4uski]

Everyone, thanks for all the help.

pb4uski, do you mean total fixed income in tax deferred and then use the tax free Roth to balance it out?

What I was thinking is if you decide to be 42%/18%/32%/8% overall then your taxable would be all Total Stock (to take advantage of tax preference of qualified dividends and LTCG) and your tax-deferred would be all Total Bond since bond income is taxable as ordinary income (as are IRA distributions).

If you did that then your Roth would need to hold 34.5% of Total Stock (which when combined with the 7.5% in your taxable account would get you to 42% Total Stock) and 30% of Total Bond (which when combined with the 2% in your tax-deferred account would get you to 32% Total Bond). The all the international investments would be in your Roth.

Alternatively, you could fill your taxable and tax-deferred accounts as described above and then select one of the Vanguard balanced funds that fills in the difference closely enough (for example 50% Wellesley and 50% Wellington). The rub with using balanced funds is as you use your taxable and do Roth conversions you might need to adjust the proportions to get to your overall AA and you can be more precise with index funds but I don't think precision is all that important.

As another alternative, you may wish to hold some international equities in the taxable account to take advantage of the foreign tax credit.

 

[tuixiu]

+1

Or this FIRECalc chart showing equity allocation success rates:

I love that chart.

Experimenting with firecalc using my numbers I find I can get down to slightly under 60% equities and still have exact same success rate as at the default 75%. It does significantly lower the average and max portfolio balance, but we give zero f**ks about how much is left after we're dead.

 

[target2019]

I love that chart.

Experimenting with firecalc using my numbers I find I can get down to slightly under 60% equities and still have exact same success rate as at the default 75%. It does significantly lower the average and max portfolio balance, but we give zero f**ks about how much is left after we're dead.

Same here. I've learned quite a bit from that and similar charts. We moved some investments for parents to a moderate allocation, from 20% stock funds to 35%, as they could take the additional risk, with all things paid by SS and pension.

It is also important to remember that you are taking on additional risk as you move to the right on that chart.