Portfolio Strategy From A Retiree's Perspective

Summary

• Diversifying to produce stability and Alpha will follow.
• Each piece of the portfolio should serve a purpose.
• Managing large issues can be simplified by breaking them down.
• Provide for one's basic needs first, but anticipate surprises.

Introduction

This is a first in a series of postings that will focus on looking at a total portfolio in terms of its components. Specifically, it breaks down the total portfolio to focus on groups of holdings with slightly different objectives. There are a number of authors on Seeking Alpha who manage portfolios as one single portfolio despite holding shares of a broader number of individual companies. My experience has been that that approach requires a level of trading and analysis beyond the scope of the effort I'm willing to put into achieving retirement.

Focusing on groups of stocks within the portfolio facilitates a greater level of stability in the holdings. It can result in slower growth and income over the short run, but if the components of the portfolio are carefully selected and bought at advantageous prices, it can result in Alpha over the long run. Long run doesn't refer to months or even quarters, rather the focus is on multiple years until retirement and then in retirement.

Previous postings providing updates on the portfolio (e.g., “Dividend Growth Portfolio Update,”, Oct. 16, 2017, Dividend Growth Portfolio Update, or “Year-End Portfolio Summary: Keepers Carry The Portfolio,” Dec. 31, 2017, Year-End Portfolio Summary: Keepers Carry The Portfolio) presented the entire stock portfolio of 40 some holdings. However, as stated in the December 31 year-end summary:

“No stock in this portfolio is held for its own sake. It is a part of the portfolio with a portfolio objective that is more or less permanent. Any objective for an individual stock is very temporary. For example, it is nice to get a bump up in price immediately after the purchase, but that bump up in price does not justify a semi-permanent holding as a part of the portfolio.”

In many respects, looking at the total portfolio shortchanges anyone reading the postings from the perspective of planning for retirement. It's a necessary monitoring process, but it overlooks substantial potential value in the discussions of the portfolio. As explained in commenting on another posting on Seeking Alpha, I don't track performance quarter to quarter. Instead, I review the portfolio each quarter in order to see if it still makes sense. An examination of the rationale for the holdings has far more potential for enhancing long-run performance than a quarter to quarter focus on performance.

It's a portfolio of business interests

Last year the series of postings on buying stocks for a dividend growth portfolio made it clear that the objective of the portfolio was to generate a dividend income that would facilitate retirement. The posting entitled “Buying Stocks For A Dividend Growth Portfolio: Part 2a Core Examples,” Aug. 27, 2017 (Buying Stocks For A Dividend Growth Portfolio: Part 2a Core Examples) illustrated the approach. It discussed 10 stocks that were originally designed to be the core of the portfolio.

Over a 30+ year holding period, the portfolio required that only one stock be abandoned. A second was replaced not because of expected poor performance, but rather because the portfolio fit deteriorated. The more important development over that period of time was that the original 10 stocks provided a firm foundation on which the portfolio could be expanded to include a more diversified set of businesses.

In constructing the portfolio, the 10 firms were not selected because their stocks were all “buys.” They were not selected because of expected stock performance over the next month, quarter, year, or even business cycle. Instead, they were selected to include businesses that would perform differently in response to economic and market conditions. The objective was to construct a portfolio that could be held regardless of short-run considerations.

Thus, although, as stated, “it is nice to get a bump up in price immediately after the purchase,” that was a secondary consideration. In fact, in some instances, an initial small position was acquired even though the stock was not expected to appreciate much over the near term. Dividends from that initial investment were reinvested and the position was expanded over time. Consequently, looking at the total portfolio and total portfolio performance ignores the most important aspect of the portfolio, which is the internal dynamics of the performance of the individual businesses.

As will be discussed, right now that approach of acquiring stocks that are not expected to recover quickly is being employed to accumulate some positions in higher-yielding stocks. Initial purchases are reflected in the current holdings, but often they are the only positions where I'm continuing to reinvest dividends. Further, the positions can be built out using dividends from other stocks. These are often noncyclical businesses being bought during the cyclical expansion.

Thus, over the short run, one would not expect them to experience price appreciation, and since they are high yield, the price may actually decline as interest rates rise. That environment should be an opportune time to build a significant position.

Portfolios within the portfolio during retirement

It's surprising how often examining a portfolio from that perspective results in potential enhancements. That is true even though the overall portfolio objectives remain the same:

1. Generate a reliable dividend stream that will grow over time

2. Display less volatility than the market in general

3. Provide returns that do not lag the overall market over a full market cycle

4. Contain core stock holdings in a diversified portfolio of assets

5. Require very few changes over a long period of time

Although the portfolio objectives remain the same, that does not mean they are a straitjacket that precludes adjusting to changes in personal circumstances. That is why in the quotation above the objective is referred to as “more or less permanent.”

There is a tendency to over-focus on the major change in personal circumstances represented by retirement. However, even after retirement, just the process of aging represents a change in personal circumstance. For example, a posting entitled “Dividend Growth Portfolios And Retirement,” Oct. 1, 2017 (Dividend Growth Portfolios And Retirement) discussed one change that's totally unavoidable: the Required Minimum Distribution from IRA's and 401(k) type of accounts.

Unlike changes in health, fluctuations in income, or market fluctuations and the resulting sequence of returns, the RMD is totally predictable. It is date specific, and with a little bit of analysis, its tax and portfolio impact can be calculated well ahead of time.

However, as discussed in a Seeking Alpha article by Robert Allan Schwartz on April 19, 2018 entitled “The Stages Of Dividend Growth,” (The Stages Of Dividend Growth) there is an inevitable and gradual shift in focus that will be experienced by any successful dividend-growth investor planning for retirement. The relative importance of dividend growth and dividend levels gradually shifts over time. That gradual shift is relevant to both planning for retirement and planning in retirement.

In a previous article I introduced the idea that the total portfolio of 40 stocks should be viewed as consisting of holdings that would be appropriate under different tax circumstances. Those tax circumstances are related to their appropriateness at various stages of retirement planning. For example, the dividend growth stocks are more appropriate to a Roth IRA than a traditional IRA. They would also be more appropriate the further one is from retirement since they would have more time for that growth in dividends to compound.

By contrast, higher-yielding stocks may be more appropriate in a traditional IRA. They might also be more appropriate when one is in retirement and dependent upon the cash income, especially when a Required Minimum Distribution is involved. (IRA is used here to refer to a tax-advantaged account, which could be either an IRA or 401(k) like account). Robert's article presents a thorough discussion of which stocks are appropriate at various stages of retirement planning.

Since Robert’s article presents such a thorough analysis, including screens to identify list of stocks appropriate at various stages in one's retirement planning, the balance of this series of postings will focus instead upon how to organize those stocks into portfolios that play different roles in the overall retirement plan. Of particular importance are the tax status and the degree to which the retiree can control the cash flow that results from the dividends. The discussion will be in terms of work in progress since managing a portfolio in retirement is a work in progress that goes on as long as the retiree goes on.

Overview of the portfolio

As is documented in the spreadsheets attached to “We All Like Toys And Retiring Rich,” Dec. 22, 2017 (We All Like Toys And Retiring Rich), it is reasonable for anyone who takes tax-advantaged retirement saving programs seriously to end up with a significant portfolio in tax-advantaged accounts. That will be the focus of these postings. After all, they are the retirement accounts, and, for me, that meant that taxable investments differed significantly both in objectives and the types of assets held.

Further, the postings will focus only on retirement accounts where I retain trading authority. If an account is set up so that the owner actually makes the trades, it is disregarded in these discussions. Those accounts must, of necessity, address the objectives and risk tolerance of the owner rather than the specific objectives outlined for these accounts. In addition, even in instances where I retain trading authority on taxable account where the proceeds may, or may not, be used for retirement, the accounts have been excluded from the analysis that follows. The result is a discussion of accounts that are purely retirement oriented.

Looking just at the retirement assets, the portfolio breakdown is as shown in the table that follows. The first column of the table shows the account and the holdings. The second column shows the percent of dividends generated by that account.

It represents only dividends from the holding of individual stocks. As will be discussed, there are some equity mutual funds in the accounts. Dividends from the mutual funds are not included in the calculations. The third column shows what portion of the total retirement assets are represented by the account. These percentages of the dividends and the values are in terms of the total portfolio of all retirement assets.

The next two columns which focus on yield also shift the focus to the accounts rather than the total portfolio. The fourth column shows the yield on the stocks in the account. It differs from the fifth column, which represents the yield of the stock holdings in the account against the entire asset holdings of the account. Thus, for example, the yield is the same for Roth 1 whether calculated against the stocks or the total account because the account is fully invested in individual stocks.

By contrast, the yields are different for the traditional IRAs because they hold cash and mutual funds. Remember, as discussed in connection with column two, the focus is exclusively on dividends from individual stock holdings.

Account/	Percent	Percent	Yield	Dividends
Holding	of the	of the	from just	as percent
	Retirement	Retirement	the Stocks	of total
	Dividends	Assets		account
Roth’s				assets
Roth 1	48.56%	50.15%	2.63%	2.63%
Roth 2	8.37%	6.68%	3.41%	3.40%
Roth 3	8.63%	4.51%	5.26%	5.19%
Subtotal	65.56%	61.34%
Spousal	3.38%	2.84%	3.26%	3.23%
Roth Total	68.94%	64.18%
Traditional IRAs
T-IRA	20.05%	25.92%	2.86%	2.10%
Spousal	11.01%	9.90%	3.94%	3.02%
IRA-T Total	31.06%	35.82%

Click to enlarge

The explanation

All the accounts are now IRAs. Changes in employment and retirement provided an opportunity to roll 401(k)s into IRAs. The assets in the 401(k)s were usually mutual funds and over time were shifted to reflect the current mix of individual stocks and mutual funds. In some instances, the conversion from a 401(k) to an IRA was done with the same organization. Consequently, there are accounts with multiple organizations. Conversions from traditional to Roth IRAs were done over time as discussed elsewhere in this and other postings.

The explanation for where the mutual funds reside is a product of whether the account was originally established as a 401(k) or as an IRA. As assets were converted from traditional to Roth IRAs, the focus was on stock acquisition. However, it's also a product of the modified bucket approach used to manage the traditional IRAs. The traditional IRAs include enough cash to cover a couple of years of Required Minimum Distributions. The mutual funds could be liquidated to produce additional cash if there was an interruption in the dividend flow used to replenish the cash bucket.

This split of assets between traditional IRAs and Roth IRAs is probably not representative of many current retirees. The Roth IRA only became available after 1997. However, the relative proportions in traditional and Roth IRAs may be more representative of what those planning for retirement in the future can accomplish. Those who are planning for retirement in the distant future have the time to take advantage of the Roth to build up a distribution similar to that shown.

The combination of Roth contributions and carefully planned conversions make it feasible. It is also achievable for those in retirement who plan IRA conversions as a part of tax planning for their retirement and have other sources of income to use to cover the resulting tax impacts.

As discussed in “Dividend Growth Portfolios And Retirement,” one can calculate the tax impact of the income that will become taxable due to the RMD. It is then possible to convert or re-characterize part of one's traditional IRA to a Roth IRA in amounts that will result in paying the exact same tax rate that would result if the Required Minimum Distribution was applied to the entire retirement portfolio.

Alternatively, one can do conversions of amounts that keep the tax rate in retirement at exactly the tax rate that one was experiencing before retirement. Basically, by paying the tax on the conversions to Roth the lower tax rates one could have in retirement if retirement involves a drop in income, which is the usual assumption.

Forward-looking rationale

The tax impact is only one of the considerations when planning such conversions. It's also advantageous to look at the resulting cash flows in terms of one's anticipated future needs. An important question is how much of one's annual living requirements could be met from the funds that have to be taken out of the IRA in order to meet the Required Minimum Distribution.

It makes sense to allow enough funds to reside in traditional IRAs to cover living expenses from the Required Minimum Distributions. The only exception would be if one could lower one's total tax payments and increase one's after-tax income by converting more assets to the Roth.

If the Required Minimum Distribution from traditional IRAs covers one's anticipated living expenses, funds drawn from the Roth IRAs are totally discretionary. They’re discretionary in two senses of the word. First, they’re discretionary in that they are not required for basic living expenses - the economist definition of discretionary income. Second, they are discretionary in that when, and if, they are drawn is totally under the investor’s control - at the investor’s discretion.

Portfolio management implications

One of the implications of forward planning of the split between traditional and Roth IRAs is that the traditional IRAs have to meet a number of externally-imposed objectives. It is convenient if the traditional IRAs generate a large enough Required Minimum Distribution to cover basic living expenses. Further, to the extent possible, they should be set up so that they can sustain that cash flow over a long period of time during which the investor is planning to be retired.

Also, one should anticipate that the Required Minimum Distribution will eventually require liquidation of the assets in the traditional IRA. Consequently, while the Roth IRA can retain stocks that could be held forever if the businesses continue to perform, the traditional IRA requires only stocks that will generate the requisite return over the expected duration of ownership, which is related to the investor’s optimism about his or her life expectancy.

Cash equivalent to the eventual Required Minimum Distribution can be withdrawn starting at any post 59 1/2 initial retirement date if the retirement accounts are the only assets available and there is no other source of income. Alternatively, if one has assets in taxable accounts or other sources of income, it can be postponed until it actually does become required.

The choice between liquidating funds in a taxable account and beginning withdrawals from traditional IRAs is very dependent upon personal circumstances. For example, if one plans to leave an estate, one has to choose between leaving an IRA that has no step up versus leaving taxable assets whose basis is stepped up upon inheritance. Focusing just on retirement assets avoids the issues related to their interaction with taxable assets.

The bottom line

The portion of the assets that needs to be in traditional IRAs versus Roth IRAs relates to lifestyle choices. Seeking Alpha has had a number of very interesting articles on how to retire on various levels of saving. They invariably result in very interesting discussions of lifestyle choices. If one assumes a certain size retirement nest egg and one keeps in mind that there is a cost associated with achieving the tax-free status of a Roth, the desirability of different breakdowns between traditional IRAs and Roth IRAs depends upon those lifestyle choices.

Clearly, one's ability to spend is higher if the income is received tax-free. However, that tax-free status is achieved by paying taxes at an earlier date. If one believes that their basic living expenses require all of the income from the retirement savings, the only consideration relevant to the split between traditional IRA and Roth assets is how to maximize after-tax income. The value of paying taxes in order to achieve tax-free status of a Roth is a mechanical financial calculation.

However, if one does not anticipate a need to spend all of one's retirement income, there is an additional consideration relevant to the split between Roth and traditional IRA assets. As mentioned, Roth provides the individual with considerable discretion regarding when, and if, the income from the Roth is to be used. If one has traditionally lived on less than his or her income, the Roth gives individuals the option to continue that practice.

The difference is that, in this case, the income is totally derived from the balance sheet whereas previous to retirement income may have come from employment. Further, the amount of discretion is increased by the fact that income from the entire portfolio is not needed for basic living requirements. Thus, the individual has the discretion to draw on the balance sheet without affecting the needed income.

Making the decision between pretax and post-tax savings or about re-characterizing assets in a retirement account can be approached as a financial optimization problem. It is inherently based upon assumptions about the future. In short, it's planning for an uncertain situation. A whole raft of changes can occur while planning and providing for retirement and while in retirement. They’re what is known as Life.

Consequently, there is a certain amount of subjectivity involved in how one evaluates the flexibility achieved by the financial transactions involved. Consequently, the desirable mix of traditional and Roth assets is dependent upon life choices beyond just one's definition of required minimum living expenses. It also depends upon one's choice regarding the desirability of the discretion that results from the transaction.

Responses to uncertainty

One can take a number of approaches to uncertainty. One approach is to take the best available current information and put in place a plan with the intention of sticking to the plan until the forecast proves to be wrong. Then one would adjust the plan to reflect the additional information. The next posting will address traditional IRAs. It will discuss the handling of two mutual funds, cash balances, and a portfolio of approximately 15 stocks.

The approach taken with the traditional IRAs could fairly be described as the first approach discussed above. The first approach seems appropriate given the constraints placed upon traditional IRAs and the portfolio management implications resulting from those constraints.

A second approach is to retain as much flexibility as possible for as long as possible. It would be fair to characterize the Roth IRAs as embodying that approach. After discussing the traditional IRAs, Roth’s will be a subject of the third posting in this series. The Roth IRAs involve a larger number of stocks. Because of the discretion implied by holding the stocks in a Roth, the objectives of the Roth can reflect the overall portfolio objectives discussed above.

Both of those postings will discuss not just what is in the portfolio and why, but also what future adjustments are planned. Further, as indicated in table above, both the traditional IRAs and the Roth IRAs are made up of multiple accounts that each represent a separate portfolio. They will be discussed in those terms. The planning discussed in those postings involves both the acquisition of additional holdings and the elimination of some positions over time.

They will also discuss the overlap between holdings in the traditional IRAs and the Roth IRAs. The overlap is often the product of where cash was available at a particular time when the stock was attractive. Similarly, some holdings would better serve the objectives of the portfolios in other accounts. Again, where they currently reside is often the product of where cash was available when the stock looked attractive.

What is particularly interesting about this series of postings is its implications. If one takes tax-advantaged retirement savings seriously, the result is that one will retire with a portfolio that requires management. That management is more than just buying and selling holdings. It requires planning the interaction between one's lifestyle choices and the structure of the portfolio. It also requires ongoing management of the portfolios’ response to the regulations associated with retirement savings, especially the tax implications, but also the impact upon Social Security taxability and Medicare costs.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.