How to Build an Optimized Retirement Portfolio

Building and maintaining an optimized portfolio can save or make a retiree tens or hundreds of thousands of dollars over a long retirement. Here is a framework for helping you construct an optimized retirement portfolio. The academic research from the last several decades would suggest seven major building blocks aimed at balancing liquidity, income, growth, and safety over a 20 to 30-year period. 

• Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.

• Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).

• Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.

• Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.

 

Here is an executive summary of how to build up a portfolio for retirement in seven steps.

1. Values clarification and goal-setting. Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.

2. Asset allocation glide path. Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.

3. Valuation-dependent efficient frontier. Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.

4. Multi-asset class approach. Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.

5. Tax-aware asset location and distribution. Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.

6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc.). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.

7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach. Readjust the investment mix based on your changing personal situation and changing market values.

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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.

 1.   Values clarification and goal-setting

Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.  

Ask yourself questions like, "What would I want to do if I didn't need to work for money?" or "What are the most important dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful ten years, what will I have achieved?”

This conversation allows you to create specific goals around your most cherished values. And your goals will be unique to you. You then design an investment plan to help you live your ideal life.

This kind of goal-focused, plan-driven approach minimizes the chances of making bad investment choices based on current events and emotions. Instead, you can choose and maintain the specific mix of investments that can best deliver the results you need--using a disciplined, research-driven approach.

 

2.   Asset allocation glide path

The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.

And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone.

3.   Valuation-dependent efficient frontier

The next step would be to assess how much of your stock allocation should go into which sub-asset-classes. For example, within stocks, how much should be allocated U.S. stocks versus foreign stocks. And within these categories, how much should be placed in small companies versus large, and how much in value (low Price/Earnings) versus growth (high Price/Earnings).

Within bonds, how much should be allocated to U.S. versus corporate, versus foreign, and what maturity and credit risk makes sense.

A more strategic approach may look at historical allocations and set your percentages accordingly. You probably want to also take into consideration the current valuation of the asset classes and weight your allocations tactically, assuming the principle of reversion-to-the-mean will punish recent overperformers and reward recent underperformers. Or at least, you may want to tilt the portfolio heavier toward those underperforming areas.

By using the Cyclically Adjusted Price to Earnings Ratio (CAPE) for the various asset classes, you can project the relative returns of the various asset classes based on their historical averages. The higher the valuation (CAPE) relative that asset class’ historical average, the lower the projected return and vice versa.

There are several combinations of asset classes that fall along the line which is called the “efficient frontier”. This means the portfolio maximizes the return for a given volatility level. Many more possible combinations fall below the efficient frontier, meaning an investor is not getting the most return for the risk taken.

As of the time of this writing, here are Research Affiliates’ projected returns and the valuation-dependent, tactical, efficient frontier (dotted line). Assuming you can rebalance the portfolio periodically as this tactical data changes, you can continually rebalance the portfolio to maximize the return/volatility characteristics of your investments.

If you do not do this, you are buying more pricey assets that will likely lower your future returns and/or raising your volatility with no extra reward for it.

A portfolio using these projections, as you can see, more heavily weights foreign stocks as opposed to US stocks. Depending on where on the efficient frontier line you choose, the weightings would change. For example, the 4.1% return/4.0% volatility (standard deviation) point has 21.7% in stocks, real estate, and commodities combined, with most of the balance (78.3%) in fixed income and cash positions. Whereas, using many of the same asset classes, the weighting for the 6.1% return/12.2% volatility point has 62.9% in growth assets and most of the balance (37.1%) in fixed income.

For someone nearing or in retirement, managing risk must be a key priority. And here is where the big decisions are made.

 

4.   Multi-asset-class approach

The object of diversification is to achieve the best risk-adjusted return for the portfolio, based on the volatility you are willing to endure. Another way of viewing it is that by diversifying, you can minimize your risk to achieve your target rate of return. Stocks, bonds, and cash are the three most basic asset classes. But outside and within these categories you can further diversify. For more on this topic, see Investment Basics to the Rescue.

Stocks can be further divided into the following Morningstar style-box categories.

Here is an example of how one might allocate U.S. and foreign stocks.

Note: International developed markets stocks are on the top two rows of the International Box. Diversified emerging markets is represented by the bottom middle box of International. These numbers are just examples to show how each segment gets an allocation. It is up to the investor to decide what percentages to put into these squares.

You might be thinking at this point that this extra diversification is not beneficial. Wouldn't U.S large stocks and bonds be optimal diversification? The answer is no. Wells Fargo Advisors recently wrote an article on the benefit of broad diversification, using this chart below to illustrate it.  

Note in this chart how the efficient frontier for more broadly diversified portfolios provide a higher rate of return for a given level of market risk. Or looking at it another way, more broadly diversified portfolios entail less risk for a given rate of return.  Source: https://engineeredportfolio.files.wordpress.com/2016/08/72_15_eps.png?w=913. 

Also see How to Reduce Investment Risk in Retirement.

So, let’s say a retiree has a flat glide path of 40% allocation to stocks. They have decided to place half of their stock allocation in U.S. stocks and half in foreign stocks. These boxes would then guide how the 20% portions would be divided.

Let’s take Susie, who has $500,000 earmarked for retirement. She wants to invest 40% in stocks and 60% in fixed-income. With a 50/50 U.S./foreign allocation, she would invest $100,000 in US stocks and $100,000 in foreign stocks ($100,000 + $100,000 = $200,000 which is 40% of $500,000.

Based on Susie’s further research, she wants to divide her stocks according to the style box allocations above. She would therefore invest $20,000 (20%) in foreign developed large cap value, $20,000 (20%) in U.S. large cap blend, $4000 (4%) in small cap US value, $10,000 (10%) in diversified emerging markets, etc. until all $200,000 is invested per the prescribed allocations. (Note: These are just examples and don’t represent my current allocations for clients.)

Morningstar also uses a similar style box for bonds, but instead of valuation versus size it is maturity versus credit quality.  A similar exercise would be done for bonds. Another consideration is whether to hedge foreign currencies in your foreign investments. For some you may; for some you may not. Typically, hedged positions will be less volatile, but if the dollar weakens you will lose some return you would have received from the foreign currency tailwind. I usually hedge foreign bonds to remove the currency impact on returns.

 

5.   Tax-aware asset location and distribution

To help grow and protect your retirement income, you will also need to focus on minimizing taxes by carefully balancing taxable and tax-deferred investments—placing the most tax-efficient investments in taxable accounts and less efficient investments in tax-sheltered accounts.

For example, Susie’s $500,000 is divided into three account types. She has $300,000 in a traditional IRA, $50,000 in a Roth IRA, and $150,000 in an individual brokerage account. Normally, it would make sense to hold most of her stocks in her taxable account and most of her bonds in her IRA. That is because bond interest is taxed at ordinary income tax rates and qualified dividends and capital gains from stocks are taxed at lower rates.

If she invests stocks through tax-efficient vehicles like Exchange Traded Funds (ETFs) as discussed below, she can defer or even avoid most capital gains taxes by holding the asset (perhaps for all her life if she passes the investments to her dependents at death—assuming the stepped-up cost basis rule is still in effect). She may also take advantage of periodic downturns by selling positions when down and buying a similar investment. This is called tax loss harvesting. Tax gain harvesting may also be in order if higher taxes are projected and filling up lower brackets now makes sense.

Meanwhile her bond interest is tax-deferred. She can either reinvest the interest and let it continue to grow tax-deferred or she can withdraw the interest and pay ordinary income taxes on the IRA distributions. She would also want to discover the optimum order for withdrawals if she is drawing an income from her retirement assets. For more on this, see Three Steps to Safely Maximize Your Portfolio Income and How to Dodge the Social Security Tax Torpedo.

Note: Most software packages assume it is best to tap taxable assets first, then tax-deferred assets, then tax-free assets; but this is not always the case. An individual analysis must be done to discover the most tax-efficient withdrawal strategy.  

 
  

6.   Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed)

Finally, we come to investment selection. Notice that this step, while first in many investors’ minds, is closer to the final decision to make.

Now that you know what type of investments you want in what type of accounts, based on your retirement income plan and tax situation, you can choose the best type of investment vehicle.

It could be a big mistake to use managed mutual funds for all your asset class choices. Some asset class categories show very little chance of management outperformance when compared to a low-cost index fund. Plus, mutual funds can have phantom capital gains that you could get saddled with that you didn’t even enjoy--if you bought them in a taxable account after a strong growth period for the fund. This would be the situation now. Now would be a terrible time to buy lots of mutual funds in taxable accounts as many of them are projecting large capital gains distributions this year.

However, to hold all low-cost, passive, cap-weighted ETFs for all your asset classes could be a big mistake too. Cap-weighted funds often get risky as the index tracking ETF keeps weighting more and more of the assets to the companies that have done the best recently. This is probably why the research indicates that there is a high propensity for, and magnitude of, outperformance in the growth asset classes. For example, John Hancock Investments show, over 5-year rolling periods, an 81% chance of active management outperformance over the index performance in the foreign small/mid cap growth space with an average outperformance magnitude of 6.55%. But even in the U.S. small cap area, over rolling 10-year periods, 68% of all small-cap value actively-managed funds outperformed the index by an average magnitude of 3.23%.

So, based on the type of accounts and asset classes, you should choose the best investment vehicle. For example, use more passive, low-cost ETFs for large value positions, and use more actively-managed mutual funds or multi-factor ETFs for areas like small cap and growth asset classes. Also, in this regard, you may want to use more mutual funds in IRAs, and more tax-efficient ETFs for taxable accounts, generally.

Notice with this approach, the fees are a secondary consideration after assessing which areas it makes sense to pay extra for active management or for a smart beta strategy. With passive investments, choose a fund with low expenses (considering expense ratios, bid/ask spreads, and commissions for trading). With active positions, focus on management performance (expenses are important but are a secondary concern since paying the higher expenses could be a good investment if it nets you a better performance).    

Also, as I discuss in Three Steps to Safely Maximize your Portfolio Income, when taking regular retirement withdrawals from the portfolio, using more income-producing investments (for example, dividend-weighted ETFs or income-oriented Mutual Funds) can protect you from having to sell growth assets at perhaps inopportune times (when you would take a loss).  

7.   Rules-based rebalancing based on retirement glide path and multi-asset- class approach

Finally, no plan is static. Things change. Even if your personal situation doesn’t change, a pure buy-and-hold portfolio will not likely be best. Portfolio drift over time can significantly change your risk/return profile and jeopardize your financial goals.

Neither buy-and-hold nor market timing are the most effective methods. Instead, rebalancing periodically will keep your portfolio in good shape. And dynamic rebalancing can take advantage of those valuation changes. For more on the basics of rebalancing, see Investment Basics to the Rescue.

As for how often to rebalance, many studies have been done. Michael Kitces’ Finding the Optimal Rebalancing Frequency – Time Horizons Vs Tolerance Bands suggests that tolerance bands are better than time frequency. In other words, why rebalance once per year, or six months, or quarter? Why not rebalance based on tolerance bands instead? The research shows that it is better to rebalance when positions are +/- 20% from the target (on a relative basis). And if this is done automatically, the more often the better. This also tends to keep the absolute basic stock allocation to within +/-5% of the target.

In other words, Susie would rebalance her 20% U.S. large value position any time it hits a tolerance band of +/-20% on a relative basis ($16,000 and $24,000, assuming the same total balance for simplicity’s sake). If she does this with all her positions, her absolute stock allocation is also staying within 35-45% range (since her target is 40%). To rebalance more frequently would increase trading costs and likely miss growth from momentum. To rebalance less frequently would likely decrease overall returns and/or increase overall volatility.

Travis Echols, CRPC®, CSA