20. My Financial Plan (Part 2)

This is the second part of my "going naked" post, where I share with you my financial plan. The first part was published last week.

As before, comments are in red.

4          Asset allocation after retirement

Living expenses will be paid from my cash reserves. 2% cash is about $56K. I will withdraw money twice a year by selling positions. Choosing the position should be based on my allocation goal (rebalancing).

Rebalancing will be done once a year, on the shortest day of the year (Dec 21^st):

ñ  I will actively rebalance once a year all assets that deviate 10% or more from their goal.

ñ  I will grow my bonds allocation by 2 points every year, targeting an allocation of my age*2-70: age 45 → 20% bonds allocation, 55 → 40%, 65 → 60%, 75 → 80%.

ñ  For example, in Dec 2011 I’ll be 44.5, setting the bonds goal to 19%.

Rebalancing is extremely important. Besides making sure you remain on track, it's a neat way of forcing yourself to sell high and buy low - you sell your "winners" (assets that have appreciated more than your average portfolio) and buy the "losers" (assets that have appreciated less than your average, or even lost value.) It's counter-intuitive for most investors. We all want to keep our winners and get rid of the losers. But when it comes to investments, this instinct is dead wrong. 

Tax swaps: if an investment accumulated losses, it may be a good idea to sell it and buy an equivalent – but not identical – investment. For example, SCHB is identical to any other index fund investing in the broad US market, but not to an S&P 500 index fund (or Russell 3000 ETF). To make it acceptable by the IRS, these funds should be managed by different companies and track different indexes. Harvesting these losses will enable me to offset gains, or offset up to $3,000 of income tax annually. This may be difficult/impossible without allocating specific tax lots.

I'm on the fence regarding this tax strategy. It will make my tax returns much more complicated. I'll need to evaluate the potential annual benefit against the cost of hiring a professional to do my taxes. 

5           To-do list after retirement

ñ  Roll-over 401K into IRA (enable more investment options)

ñ  I will track my portfolio against the expenses and the plan annually, and adjust the maximal allowed withdrawal.

ñ  I will track my expenses on a calendar year and make sure I live within my means.

ñ  I will update this plan as needed.

The last bullet is perhaps the most important. Things change - your financial situation, family status, income, etc. It's important to maintain a good balance between "staying the course" and being flexible. Too much change and you risk abandoning your strategy. Too little, and you ignore life-changing events. By setting an annual review of the plan, independent of recent market turmoils, you'll give yourself a chance to weigh your situation with a cool head.

6           Withdrawals

My first withdrawal is going to be the lower between $93,750, adjusted to inflation, and 3% of the portfolio (all the sums are pre-tax and taxes will be paid from the withdrawals, not from the investing accounts). I still need to work out the methodology for further withdrawals. 

The sources for withdrawals will be chosen according to the following goals:

ñ  Rebalance the portfolio

ñ  Minimize taxes

ñ  Avoid penalties in retirement accounts (avoid 401K and IRA until I'm 70 ½; this gives the money the maximal time to grow tax-free without penalties)

ñ  Keep it simple

7           Other issues to consider

At some point I need to consider the following issues:

ñ  Is it worth paying off the mortgage? With a lower tax bracket, mortgage interest deduction may not be as attractive. Wait and see until the first tax return after retirement to see if I still itemize deductions.

ñ  When to start taking Social Security benefits?

ñ  Update will: add a document listing my property, bank accounts, Fidelity, 401K, RE, insurance policies, etc.

ñ  Consider creating AD/LW (Advanced Directive/Living Will) or naming a DHCS (designated health-care surrogate).

This section is a good place to park any ideas/questions you have during the year. During the annual review, pay close attention to the items here and determine what you can incorporate into your plan.

Last note: I'm going on vacation for a few weeks (Tel Aviv and Paris). I'll start reposting when I'm back in June. 

19. My Financial Plan (Part 1)

One of the recommendations I read while doing my research was to put my plan in writing. It sounded easy enough, but once I started writing it down I realized how many details are involved. It's a good exercise in making sure you got all your bases covered, as well as committing yourself - at least mentally - to doing the right thing.

As a reference, below you can find my plan - with some $ amount removed. I hope it can help you build yours. I added in red comments that are not part of the plan.

Is it perfect? No, but it's a basis. The important thing is not to tweak it endlessly. Flexibility is good, but don't make it too easy for yourself to change the plan. Consistency and keeping your direction and plan through turbulent water will win at the end.

So here it goes - part 1 of my plan. My next post will contain the rest of it.

My Financial Plan

1           Retirement Goal

My goal is to secure after-tax annual income of $75,000 with no debt (including mortgage) and no dependency of inheritance, social security, home equity or additional income. This number was calculated at the end of 2010 and should be adjusted to inflation. 

The most accurate way to calculate your required funds is to start with what you spend now. I downloaded my 2010 expenses from my bank account, and then removed all irrelevant entries: salary, transfers, mortgage, etc. To the total, I added new expenses I expect to have: more money for medical coverage, travel, hobbies, etc. Regarding the mortgage, since it's a variable expense with a limited lifetime, for this calculation only (!) I assumed I'll pay it off on my first day of retirement. This of couse is not what I'm going to do, but it makes the calculations much easier. 

Assuming 20% average tax on withdrawals, I'll need $93,750 before tax. With 3% annual withdrawal rate, this translates to $3.125M in 2010 dollars.

Yup, that's a huge amount but it's because I'm calculating the required funds to retire now, when I'm only 43. As I'm getting older, I'll need to save for less time (i.e., I don't expect to live to 200). This will reduce the goal.

This SWR (Safe Withdrawal Rate) is based on conservative assumptions: a portfolio with growth of 5% with inflation of 3%, lasting for 50 years.

You can read more about SWR in this previous post. 

Assuming 15% tax at retirement reduces all these amounts by about 6%.

I had long discussions with my CPA regarding this number. My calculations showed an average of 15%; his (more conservative) calculations showed 20%. It's pretty difficult to calculate your tax bracket at retirement, since your income will come from different sources, some taxed as income (interest, bonds), some as capital gain (stocks) and some not taxed at all (401K, principal of your savings.) Also, it depends on how much taxes you've already paid. For example, since I recently converted all my savings to index funds and paid taxes on all my accumulated gains, my base is close to my total savings - meaning lower taxes in future.

2           Asset allocation

My investment methodology promotes low-cost broad index funds. Whenever possible I will choose no-load, low-commission, negatively correlated, well-diversified index funds in the segments I invest in.

Why not managed accounts? Start with my first post and go from there... 

A current exception is my choice for Municipal bonds (MUNI), which is actively managed. 

Yup, my plan is not perfect. I couldn't find an index fund for MUNI that satisfied me. But, remember, the greatest enemy of a good plan is a dream of a perfect plan!

Asset Class	Low Risk	High Risk	Accounts	Funds	Comments
US economy		30%	Fidelity, 401K	SCHB, FSEMX	Broad market fund (Spartan index fund in my 401K)
		5%	Fidelity	SCHA	Small-cap
		5%	Fidelity	WMCR	Micro-cap
Real Estate (US)		5%	401K	VGSNX	10% of total US stock
International		15%	Fidelity	FSIVX	All world ex. US
		7%	Fidelity	VWO	Emerging Markets	Counted together as 15%
		8%	Yahav	TA-100 Meitav	Israel
Bonds	8%		Fidelity	BND	Tracking Barclays Aggregate (corp, government, municipal bonds)
	5%		Fidelity	MUNI	Municipal Bonds (PIMCO)
	5%		Fidelity	SCHP	TIPS bonds
		5%	401K	PHIYX	High-yield bonds (PIMCO)
Cash	2%		Fidelity, BOA	Money-market, BSV, BOA saving account	For immediate expenses, highly liquid. Grow to 4% at retirement.
	20%	80%

The table came out more complex than I anticipated.This is mainly because I split my savings between my 401K account and my Fidelity account. While the Fidelity account is very flexible, I'm limited in my 401K account to the funds chosen by my employer. This resulted in some asset classes (such as US economy) split between the two. Additionally, I have investment in Israel, which I count as "emerging markets". Probably, your table will be simpler.  

3           Managing my 401K

ñ  In a couple of cases I chose alternative funds due to the limits of my 401K plan (VGSNX, Pimco High-Yield). At retirement I’ll rollover my 401K to an IRA where I’ll have more flexibility.

ñ  The balance of the 401K is invested in Spartan Extended Index Fund (mid-cap and small-cap), creating further diversification. Currently this is 28% of my 401K, where the rest is REIT (36%) and High-yield bonds (36%). These correspond to 5% positions in my portfolio.

ñ  To minimize taxes, I should try to keep tax-inefficient funds in the 401K: bonds, REIT and mutual funds with high turnover.

ñ  However, since the 401K is going to be used last (at age 70.5), it should have more volatile stocks. These two considerations are incompatible.

It's never too early to capture future plans. As you can see, I'm not 100% sure how to manage my 401K in future, and I might change my plan by the time I get to retirement. Still,  it's easier to capture what I know now and revise it later than trying to figure it all out from scratch 5 or 10 years down the road. Write it down, and revise it as you learn more!

Part 2 -- next week!