Working through a portfolio makeover with a new client.

Bertram Johnson III, despite his elegant moniker, is related to neither the yacht nor the marine engine dynasties with whom he shares, alas, only a name. No scion of privilege, Bert managed a one-location Chevy dealer in a small New Jersey township for nearly 40 years. Over those years, while supporting a family of three children, he was able to faithfully squirrel away money in tax-deferred accounts that, as he proudly (though inaccurately) related to me on the eve of his retirement, now amount to a half million dollars.

About five years ago, Bert's wife, Hilda, inherited some stocks from her mother's estate which, when added to their collection of mutual funds purveyed by an assortment of friends and relatives over four decades, now constitute a taxable portfolio worth about $300,000.

That is where we begin the saga of reshaping Bert and Hilda's eclectic nest egg into a professionally diversified portfolio that they can confidently expect will support their modest lifestyle for perhaps 30 or 40 years and provide a cushion for emergencies.

Routine Assignment, Right?

I am a retirement investment specialist, so this should be duck soup, right? Having determined with the Johnsons the amount of money they will need to withdraw each month, and having worked out their long-term cash flow model replete with assumptions for inflation, investment returns and contingencies, I will mentally begin with $800,000 of cash, start crafting the appropriate mix of asset classes and work my way down to the individual securities selections. No problem, right? Well, maybe in a theoretical universe, but not in the world of real people.

Any advisor who has done even a few portfolio makeovers has almost certainly learned from experience that it's not as simple as liquidating all of your client's holdings and starting over with a list of investments to your professional liking. But isn't that what they are hiring me to do, you might object? Well, yes and no.

Except in relatively rare cases (lawsuit settlements, insurance proceeds and cash inheritances) the advisor is usually presented a collection of existing investments, each of which arrives with some baggage: financial and emotional characteristics that will need to be considered before changes are suggested. Here are a few examples.

When we recommend mutual funds in my firm, we always use no-load funds. But often we are called upon to redesign a portfolio that already includes investments that are exposed to surrender charges, such as "B" shares or annuities. We not only must make a professional decision about whether or not it makes sense to incur the charge in favor of what we consider a more appropriate investment, but also be prepared to articulate our judgment for a client who may be convinced that it is always best to wait out the surrender charge period.

In a taxable account, for another example, an investment's cost basis or holding period may be a meaningful issue. This is sometimes complicated by the client's lack of information. Were these shares inherited or were they an intervivos gift? When did you buy this mutual fund? Were the dividends always reinvested? Often the honest answer to such questions is a shrug of the client's shoulders.

A client may have a personal attachment to a stock for one reason or another. Probably the case we all see most often is a position in the employer's stock. Is our client afraid that selling would look bad to his boss or peer group? Is she just convinced that the company she works for is the next Microsoft? Or maybe the client is legally restricted as to sale of the employer's shares.

Not infrequently, inherited stocks are regarded as a personal connection to the decedent, usually the client's parent; obviously we need to be sensitive in our handling of this situation. If an advisor proposes liquidating shares that a client has personally selected, there could be a small confrontation of egos. Another common situation is a client's attachment to a stock because it has been good to him, and its rising price has created an expectation of endless ascent ("I finally got a good one and you want to sell it?!)

Occasionally I have had to cope with a client's unexplainable affection for a stock. In my very first portfolio makeover assignment, I unwittingly recommended selling 200 shares of Hershey. The lady, whose modest girth offered no hint that she was among the most ardent consumers of that company's fine products, sat down to our presentation exclaiming emotionally, "You can't sell my Hershey." It turned out to be the only objection she had to my recommendations, but she made it clear that it was a non-negotiable objection.) To this day, one of the questions on my interview checklist is, "Do you have a personal attachment to any of these investments?"

These and other real-life complications, both quantitative and emotional, need to be addressed and evaluated by any advisor who wants not only to create a retirement portfolio that reflects all his or her best investment judgments, but also a portfolio that the client can embrace.

Entering Bert's World

Bert Johnson's portfolio offers a useful model for suggesting ways that the advisor charged with redesigning a new client's portfolio could address some of these personal investment realities.

The Johnson's portfolio, if I may charitably refer to it that way, was classically messy. Among my associates we call a thoughtlessly accumulated list of securities a "Shoe Box" portfolio, and a really out-of-control collection we refer to as a "Weed Garden." This one was deep into Weed Garden territory! The Johnsons had one or both of their names on five tax-deferred retirement accounts, two variable annuities, two taxable brokerage accounts, a Treasury Direct account, four separate mutual fund accounts and 12 stock certificates held in a safe deposit box, four of which had developed corresponding dividend reinvestment plans.

When I begin to analyze a portfolio with the intention of overhauling it, the first issue that I like to address is the account structure and titling. I have learned over the years that clients are very appreciative of our ideas for simplifying their investment world by consolidating accounts and reducing the number of institutions with which they have to maintain a relationship. Before I prepare their Investment Plan, I ask whether any of their current accounts represent personal relationships that they would rather not disrupt. In Bert's case, his two variable annuities had been purchased from a brother-in-law who was no longer in the insurance business, so we did not have to work around any relationship issues.

The annuities were traditional high-expense versions still dragging a 6% surrender charge that would reduce by 1% a year. I explained that we could preserve the tax-deferred character of this investment by arranging a 1035 exchange into a low-cost VA with no surrender charges. Although the switch would involve a $2,400 hit to a $40,000 market value, I continued, the 2% per year expense savings would recoup it in 3 years. I usually explain this situation by saying that from the insurance carrier's point of view it is a matter of "pay me now or pay me later." When you bought the contract you incurred the cost, whether you eventually pay it in a surrender charge or in high annual expenses. When, as is often the case, a 1035 exchange also can improve the available range of investment choices, clients usually agree with our judgment.

As a personal financial advisor I am not especially enthusiastic about Treasury Direct accounts, even though I understand and appreciate that they can reduce an investor's transaction costs, which usually involves a relatively small amount of money. For one thing, it is one more institutional relationship to deal with; both my clients and I value structural simplicity above a small cost saving. For another, owning Treasury bonds outside of a brokerage account complicates the process of reallocating resources within a portfolio. Hilda Johnson had, indeed, opened the Treasury Direct account to save money on bond purchases, but she had not bothered to learn the routine for bidding on new bonds, and it was easy for her to agree to close this account.

DRIP accounts present a similar circumstance-small cost savings on transactions but a constraint on portfolio changes and an unnecessary extra set of reports to deal with. Regarding the Johnsons' individual stock certificates, which Hilda had inherited from her mother, I encouraged her to deposit them into a traditional brokerage account for better record keeping and to make eventual selling and asset rebalancing easier. We also discovered that half of the stocks were actually a gift from her mother during her lifetime and half were received much later as an inheritance. So that we could understand the cost basis and make informed judgments about the tax consequences of any sales we might recommend, we questioned Hilda about the dates of the gift and her mother's date of death. We could then research the price history of each stock.

As I mentioned above, Bert had told me that his retirement portfolio was worth $500,000. In fact, the current market value the day I first met with him was closer to $450,000. Because the stock market has been in general decline for three years, I find it rather common that prospective clients believe their portfolios are worth more than they actually are. I don't know if they are in denial or just don't add them up very often. But I have had situations where a few months into our relationship a client begins to think that a portfolio shrinkage took place on my watch when in fact the damage had occurred before we met. It turns out they imagined a certain out-of-date value when they first came to see me. So, one of the first things we do when a new client engages us is request current statements for every account and enter the current values of every security into our Investment Plan spreadsheet, noting the valuation dates on our worksheet. This doesn't solve the problem of a market decline in already-owned investments before we have an opportunity to change them, but it does help clarify where our responsibility began.

Pilot Or Co-pilot?

Sometimes new clients will make it clear that they are hiring you to exercise your best judgment and have no need for involvement in the decision process. More often it is not so clear exactly to what extent your new client wants to delegate authority for the re-orientation of their investments. It is very important to discern at the beginning of the project whether your new client expects to hire a pilot or a co-pilot. (We are not talking about whether or not you have discretionary authority in managing a portfolio, for that should be made contractually clear. We are discussing the relationship expectations during the process of drafting a detailed Investment Plan.)

Take, for instance, my Hershey lady. I naively drafted a portfolio makeover without determining whether she had any personal input that she wanted to make into the process. Fortunately, with that one manageable exception, she had intended to hire a pilot. When a client wants to hold sacred certain securities, I ask myself two basic questions. First, to what extent might keeping this security compromise my best professional judgment. Second, is the amount of money involved material to the client's pursuit of her goals.

The Hershey stock was less than 1% of the client's portfolio value, and it is a classy company. I wish I were wise enough to know with conviction that a small position in Hershey was going to add or subtract value from a portfolio over time. The client's apparently unreasoned attachment to a stock, especially a blue-chip stock, has just as good a chance of adding value as my professional judgment about it. I could not say that holding 200 shares of Hershey would compromise this woman's portfolio. So Hershey was a keeper!

Now if the amount were more significant, and/or the quality of the stock more suspect, I would probably choose to contest the client's input even at the risk of jostling an otherwise smooth relationship. I would be gracious but insistent if, for example, an executive of an unprofitable Nasdaq business wanted to keep 50% of his modest portfolio in his employer's stock.

Naturally, clients have a right to exert any influence they want to on their portfolios; after all, it is their money. But ultimately, whatever the degree of involvement clients reserve to themselves, the advisor's professional reputation is going to be influenced by the eventual performance of the recreated portfolio. Since it is going to be regarded as your work, you will want to insist that it is essentially representative of your best judgments.J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.