My father and I spent a lot of time fielding questions at cocktail parties and on the soccer field sidelines about investing. My dad was the same Paul A. Samuelson who transformed the MIT Economics Department, was the first American to win the Nobel Prize in Economics and advised various presidents. He started studying the stock market as a high-school freshman. He regularly discussed investments with Jack Bogle; in fact Bogle cites my father's books as his inspiration behind the first index fund in 1976. He also spoke with Warren Buffett often and became an early investor and unpaid advocate for Vanguard’s index funds and Berkshire Hathaway stock. In short, my dad knew a thing or two about long-term investing.
Our Investment Strategy: Buy And Hold Low Cost Index Funds And Stocks With Limited Distributions
Over time, we both followed a simple investment strategy: buy and hold low cost index funds and stocks with limited distributions. That was it. We did everything possible to avoid realizing gains, including making gifts of appreciated stock. He determined long ago—and I followed his lead—the #1 enemy of long-term investing success is taxes. We shared that with anyone who would ask for investing “tips.”
The Debate Continues: How To Address The Complexity Of Maximizing Retirement Income
We understood how to grow assets, but like so many in our industry, we grappled with determining the best way to make withdrawals from multiple account registrations. I am reminded by the recent Michael Kitces and Bill Bengen articles that the debate continues as to how to address the complexity and challenges of maximizing retirement income. Bill Sharpe called retirement income the trickiest problem in all of finance.
The Conventional Wisdom, Like ‘The 4% Rule’ Is Not The Best Way To Maximize Retirement Income
My father and I had many discussions on this and agreed it is too complicated for anyone to do well on their own and fraught with opportunities for mistakes. Alas, no one lives forever, so I started a software company with my father’s blessing to help advisors and their clients get investing and retirement income right. My colleagues and I agree with Mr. Kitces and Mr. Bengen that conventional-wisdom approaches, like “the 4% rule” are not the best ways to shield clients from tax exposure. And we agree with Mr. Kitces that it takes fine-tuning of dials to do it right. The challenge remains: how to reduce risk and taxes in a household portfolio to increase what an investor can spend and leave as a bequest.
The Advice To ‘Lighten Up On Berkshire Hathaway’ Created A Half-Million-Dollar Tax Bill
A very painful example of the importance of considering taxes in managing a household portfolio happened in our own family. When my father died, his widow, my stepmother was advised she was “too concentrated” and should “lighten up on Berkshire Hathaway” stock my father had bought and held for decades. As you can imagine, it was a very costly mistake—a half million-dollar tax bill to cover the realized gains.
A Coordinated, Big-Picture Approach To Generating Tax-Smart Retirement Income
Based on years of our research and experience with investors and advisors, what is often misunderstood is the importance of considering a variety of factors to achieve the highest retirement income possible. You will notice a recurring theme of the importance of reducing taxes. As we all know, it’s not what you make, it’s what you keep, or can spend. Here are the key contributors to maximizing income in retirement:
1. Tax-smart asset location — Most portfolios include different account registrations and holdings, all with different tax treatments. Tax-smart asset location is achieved by managing accounts and holdings optimally, so the asset allocation is maintained while assets are located in the most beneficial accounts. This translates into significantly improved after-tax accumulation and a bigger nest egg.
2. Tax-loss Harvesting — Improves short-term tax efficiency by reducing a client’s cost basis in positions held in taxable accounts. But this strategy only kicks the can down the road where the client’s tax rates could be lower in the future. For those already in retirement and living off savings, this strategy can be used dynamically to reduce taxes paid when raising cash to support client spending.
3. Tax-Aware Household-Level Portfolio Rebalancing — Allows an advisor to set a target asset allocation and spread it across the multiple accounts in the household portfolio. When done with optimal asset location in mind, this strategy maintains the desired asset allocation and asset location targets as markets and circumstances change, keeping a client on track while improving after-tax returns.
4. Social Security Maximization — One of the first questions many investors ask as they near retirement is, “when should I take Social Security and how should I file?” It is important to note, the government provides a risk-free 8% guaranteed increase in Social Security benefits between the ages of 62 and 70. We see an average of $150,000 per household in improved outcomes by recommendations to defer taking benefits.
5. Optimal Sequence of Withdrawal — A coordinated sequence of withdrawals with tax efficiency on top of Social Security across all accounts and income sources, including pension, annuities and investments, is fundamentally important. Strategic withdrawals from investment accounts help meet necessary spending, fund discretionary spending, and pay taxes on non-investment income.
Ernst & Young conducted an independent analysis of this methodology and determined our approach could improve after-tax returns and income by up to 33% over an investment lifetime.
Maximizing Retirement Income Is Complex. Delivery And Execution Require Simplicity
Like we’ve said, it’s complicated. And yet, to explain it to clients requires simplicity. The only way we knew how to address this was by creating graphically intuitive software to help the advisor and the client understand how to improve financial outcomes and to quantify the financial benefits in dollars and cents. By doing this, the advisor’s value is demonstrated as they show clients how to maximize income across the investor’s household investment and product portfolio.
Paul R. Samuelson is LifeYield’s chief investment officer and co-founder.