Although much has been written about basic tax and financial planning strategies during retirement -- budgeting, cash flow projections, taking distributions from qualified plans, and rolling 401(k)s or 403(b)s into IRAs -- a number of more sophisticated financial issues have received less attention. These include diversification of retirement investment portfolios, developing tax-efficient drawdown strategies and effective use of nonqualified annuities in retirement.
The ability to help address these topics with your clients is a powerful value proposition that can separate you from your peers. By doing so, you can demonstrate a higher level of understanding about the advanced financial strategies that are necessary to help achieve all of your client's retirement goals. A great way to understand the importance of these complex issues is to look at a hypothetical example.
Our case study involves John and Mary Smith, both age 55, and married for 10 years after previous marriages. John is in his thirtieth year of working for ABC Corporation and Mary has been employed as a human resources specialist at a local company for nearly 20 years. They each have their own children and grandchildren.
John's corporate retirement plan allows him to retire with full benefits after 30 years, regardless of age. Mary would like to retire within the next 24 months. Both John and Mary would like to know that, when one spouse dies, the surviving spouse will have enough income to maintain his or her current lifestyle. At the second death, Mary and John want their four children to receive the residual financial assets.
Diversification Of Retirement Investment Portfolio
One of the first issues for John and Mary to address is how to diversify their investment portfolio. They have $5 million in investment assets, $4.6 million of which is in ABC or XZY stock and options on the XYZ stock. This represents 92.2% of their portfolio and the effective percentage is even higher, because the options provide tax advantages. Not only are John and Mary putting almost all of their eggs in stock and stock options, but the volatility associated with a concentrated portfolio drags down returns. They can help minimize this risk and increase expected returns by diversifying.
There are four general strategies for diversifying that we will focus on in this scenario:
1. immediate sale of all stock followed by reinvestment
2. staged selling
3. hedging strategies
4. charitable remainder trusts
The simplest way to diversify is to sell some of the concentrated investment assets and reinvest the proceeds in a diversified portfolio.
The best place to start may be with the ABC stock in John's 401(k) plan because it could be sold with no tax consequences and the full amount of the sale proceeds could be reinvested in other available 401(k) investment options. Selling the rest of the ABC and XYZ stock outside of the 401(k) would require a trade-off. The capital gains tax payable on the sale would reduce John and Mary's current wealth, but their new portfolio would be expected to produce a higher return because of reduced volatility. While they would have a smaller portfolio in the short run, it is expected that the portfolio may grow at a faster rate with the diversification.
If John and Mary are uncomfortable about paying a large tax bill all in one year, have a psychological attachment to the stock, or the stock is subject to sale restrictions, they may wish to sell it gradually over a period of time. Though selling stock more slowly can have a greater upside potential compared with immediate sale of all stock, there is also greater downside potential for a lower median after-tax return (Boyle, P., Loewy, D., Reiss, J., and Weiss, R., "The Enviable Dilemma: Hold, Sell or Hedge Stock," The Journal of Wealth Management, Fall 2004), because you cannot predict the existing stock's value over that period of time. Thus, immediate selling may generally be a better alternative.
Some investors believe that certain hedging strategies can give them the best of all possible worlds - delaying taxes, protecting their downside, allowing them to retain some or all of the upside potential on the concentrated stock position, and permitting diversification. These strategies -- including buying a put, or option to sell the stock, a cashless collar, or a variable forward sale -- might be appealing to John and Mary if they are bullish on the short-term prospects for the ABC or XYZ stock and want to protect themselves while continuing to hold the stock.
Transferring the stock to a charitable remainder trust may be particularly favorable for John and Mary. One of their long-term financial goals is to benefit their favorite charity, and a charitable remainder trust would make lifetime payments to John and Mary which could give them some of the additional cash flow they will need after retiring.
Developing a tax-efficient drawdown strategy.