Get With The Plan: July 31, 2011

73111Tommy and Janice, in their early 70s, have been enjoying retirement for about 10 years. They’re both healthy and active, but they’re thinking of more than themselves these days.

“Our goals are to be able to continue living in the same lifestyle understanding that we will have to purchase more services as we become less able to do things ourselves,” says Tommy, 72. “We would like to increase travel and vacation and be able to help with the grandchildren’s college educations.”

The couple, whose names have been changed, have saved $330,000 in IRAs, $290,000 in a brokerage account, $169,000 in mutual funds and $2,000 in a checking account. They both receive pensions and Social Security, and they also must take Required Minimum Distributions from their IRAs.

The Star-Ledger asked Reed Fraasa, a certified financial planner with Highland Financial Advisors in Riverdale, to help Tommy and Janice look at their retirement, and at their prospects for helping their heirs. “They have done an excellent job accumulating wealth via retirement accounts and taxable accounts,” Fraasa said. “They have also paid off their mortgage and do not have any short- or long-term liabilities.”

Fraasa says the couple wants to make sure they don’t run out of money while continuing their current lifestyle, increasing their vacation and travel expenditures and helping to pay for their grandchildren’s higher-education expenses.

Despite their ages, the couple’s investment portfolio is currently high-risk, says Fraasa. After looking closely at their holdings, Fraasa determined that their current allocation has about 75 to 80 percent of the portfolio in equities, which he says is overly aggressive considering their risk tolerance and financial capacity to tolerate risk.

“We recommend a balanced allocation of 60 percent equities and 40 percent fixed income,” he says. “This allocation should be monitored regularly to maintain the allocation over the long term.”

Fraasa says their current allocation is highly overweighted in U.S. large-cap domestic equities, specifically growth equities. Approximately 35 percent of their total portfolio is allocated to large-cap domestic growth equities, and approximately 26 percent is allocated to large-cap domestic value equities.

This makes up 61 percent of the entire portfolio.

“We recommend a more diversified portfolio across all asset classes to achieve their target return with less risk than they are currently exposed to,” he says.

Between these two adjustments to the portfolio, they should be able to maintain a similar return with about one-third less risk.

The couple has the majority of their invested assets split among three different portfolio managers or investment companies. They said this was in an attempt to diversify their portfolio.

Fraasa says there’s a better way.

“To properly monitor your investments in a diversified, asset allocation model, we recommend you consolidate the accounts to a single vendor,” he says. “Proper diversification revolves around the actual asset classes that your portfolio is invested in, not having separate accounts managed by different brokers.”

For example, Fraasa says if the brokers do not communicate with one another, there is no way for each of them to know what the other is holding. Therefore, a lot of an investor’s positions or asset classes may be duplicated at any point in time.

This is exactly what happened to Tommy and Janice, Fraasa says, with their portfolio being overly weighted in a small segment of the total capital markets and too weighted in equities.

“This is a common mistake people make, thinking that they are benefiting from spreading their accounts around with multiple brokers,” he says. “In the long run, it can add costs, taxes, added risk and missed performance.”

Also, their taxable accounts are managed through a couple of different firms, and that doesn’t help with efficient tax planning, Fraasa says.

“Efficient tax planning is crucial to accumulating wealth and managing your overall portfolio,” he says. “Having accounts managed by different vendors can make it difficult to achieve proper tax planning.”

For example, Fraasa says the couple could be missing the opportunity for tax loss harvesting and taking unnecessary gains that generate a tax liability that can diminish the after-tax returns of their portfolio.

On Tommy’s and Janice’s goal of assisting grandchildren with higher-education expenses, Fraasa says each of the grandkids has a 529 saving plan. He says they have two options.

First, for the two grandchildren who are 10 years old, they can make annual contributions to their 529 accounts for about $2,500 per grandchild. For the two grandchildren who are age 7, they can make annual contributions of about $1,950 per grandchild. He recommends they make these contributions until their first year of college.

“This recommendation allows the money to utilize the tax benefits of the 529 plan and factors inflation in the future equivalent of $5,000 today,” he says.

The second choice would be to make $5,000 contributions to the grandchildren’s 529 accounts each year that they are in school, assuming four years each.

Based on the couple’s current plan, their overall finances have an 84 percent probability of success, Fraasa says. If they act upon the recommended changes, which will reduce the overall risk in assets, their financial plan has a 99 percent probability of success, Fraasa says.

“The increase in probability has a lot to do with proper diversification which lowers the amount of volatility within the portfolio,” Fraasa says. “The decreased volatility will help achieve a steadier stream of returns over the long term.”