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A reader recently asked me to share my investment choices and portfolio breakdown. I’ll do this by sharing our investment policy statement (IPS). This includes our asset allocation, strategies to control investment fees and taxes, and plans for managing the portfolio.

A well written IPS ties an investment plan together, marrying investments with a system for managing them on an ongoing basis. Having a written plan helps prevent making bad decisions driven by fear or greed. It’s also helpful to have a written plan because, inevitably, we all forget things. Morningstar provides a worksheet that serves as an excellent starting point for developing an IPS.

We wrote our IPS five years ago. Writing this blog post provides me a great opportunity to review what we originally wrote, how well we’ve been following our plan, and what, if any, changes we need to make as we transition to a new stage of life.

Our Investment Policy Statement

I’ll share our investment policy statement as originally written. This will be in italic font for consistency.

I’ll then provide commentary to share key things we got right, where we’ve veered from our written plan, and how our plan has evolved. My commentary will be in normal font.

Investment Plan

This plan will be followed to build our assets to reach financial independence and provide for financial security in early retirement.

Assets Included In Allocation

Investment Accounts

Investment accounts include taxable, rollover IRA, and Roth IRA accounts. We will also include our current work retirement accounts. All of these accounts will be considered together for the purpose of planning and asset allocation.

Since we originally wrote our plan, my wife switched jobs, and I’ve terminated my employment. We rolled over my wife’s old 403(b) and my 401(k) to IRAs with Vanguard. This means that the vast majority of our funds are held with one brokerage.

Having this concentration of funds in one place is mildly troubling from a security perspective. However, we feel the simplicity of having our accounts in one place as well as the benefits that come with having a larger account balance outweigh the security risks. We currently have no plans to move any funds to another brokerage.

Cash

Part of our financial plan will include having cash to serve as an emergency/opportunity fund and to hold money we will plan to spend in the near term when in retirement. Cash held in a high-yield savings account and money market account will be included as part of our allocation.  

We will always keep at least 6 months of living expenses in cash. We will never carry more than 2 years of living expenses in cash at any time to avoid excessive drag on investment returns.

Cash held in checking accounts that will be used to deposit paychecks and cover normal spending will be omitted from the plan/allocation.

Cash was our biggest point of contention when developing our asset allocation and IPS. I’ve never liked holding cash because of the drag on investment returns. It seemed wasteful to have money sitting around when we had abundant cash flow and a high savings rate when both of us were working. My wife has always loved the feeling of security a large cash cushion provides.

We generally kept our cash reserves at about 6 months living expenses when both of us were working. After much debate, we decided to build savings up to 12+ months expenses in anticipation of losing my income when retiring and having the unknown expenses associated with moving across the country.

This worked out very well, as having cash on hand allowed us to move quickly on buying our new home, which we then used as a rental for a year. However, this left us cash poor for most of the last year. We agreed this added unnecessary stress to our lives.

Assets Not Included in Our Allocation

Our Home

Part of our plan will be to own our home. We currently own our home outright, valued at approximately $250k. This also will not be included in our investment plan, asset allocation, or our assets factored into reaching financial independence (FI).

When developing our IPS, our thinking was heavily influenced by Rick Ferri, CFA. In his book, “All About Asset Allocation”, he wrote that your primary residence should not be included as part of your portfolio because it is illiquid, produces no income, and typically appreciates only at about the general inflation rate.

Still, our home is a large piece of our net worth. So I’ve started to look at it as a potential investment. We bought our current home, in part, because it could be used as an AirBNB rental to produce income if needed or desired.

Harry Sit recently wrote an interesting article titled “You Can’t Eat Your House. Or Can You?” He points out there are various ways you can use the equity in your home to produce income. They include utilizing a reverse mortgage, selling and downsizing, or moving to a less expensive area in retirement to free up cash. There is also the option of using a home equity line of credit (HELOC) or a cash out refinance.

We still don’t include our home in our allocation, and are not currently using it to generate any income. Home equity has never been directly factored in when calculating the assets we would need to retire. However, home ownership does lower living expenses and provides an inflation hedge, because we won’t have to pay rent.

We view our home as a back up to our investment portfolio. Still, the change in perspective has given us more confidence given all the options that owning this asset provides.

College Savings

We will keep an account for our daughter that will be used to fund college. These funds will be invested in taxable accounts. We’ll continue to consider tax advantaged accounts if the tax savings outweigh the restrictions on the accounts. These funds will be held in a separate account and will not be considered as part of our investment asset allocation or assets factored into reaching FI. This will eventually be her money, but we will have control over how it is used.

Since developing our initial IPS, we’ve saved aggressively for our daughter’s college education. We’ve reached our funding goal, and have stopped saving for her since I’ve stopped working. This money remains invested in a taxable investment account, so theoretically this is another backup that we could tap into without penalty if needed. However, that would be a last resort.

I won’t comment further on college savings at this time. I have a full blog post planned outlining how we saved for college and why we elected to bypass tax advantaged college savings options.

Social Security

We will periodically monitor our Social Security benefits. Given the long time frame until we are eligible to claim benefits and the political uncertainty around Social Security, we won’t factor these benefits into our plan. Instead, we’ll consider benefits we eventually receive as a bonus and backup to our plan.

Not much to add here. We’re still 20-30 years from claiming Social Security benefits.

I’ve become more interested in Social Security over the last few years while helping my parents with their finances and serving the needs of the audience of this blog. I still don’t give Social Security much thought with regards to our plans.

Asset Allocation

We will begin with an asset allocation of 80% stocks, 15% bonds and 5% cash distributed across these different accounts.

Stocks

Domestic

  • 35% Vanguard US Total Stock Market Index Fund (VTSAX)
  • 10% Vanguard Small Cap Value Index Fund (VSIAX)
  • 10% Vanguard REIT Index Fund (VGSLX)

International

  • 10% Vanguard European Stock Index Fund (VEUSX)
  • 10% Vanguard Pacific Rim Stock Index Fund (VPADX)
  • 5% Vanguard Emerging Markets Index Fund (VEMAX)

We continue to hold 80% of our portfolio in stocks. The only change we’ve made to our stock allocation is shifting 5% of our portfolio from VTSAX to VEMAX. Thus 50% of our portfolio is held in domestic stocks with 30% international. 30% of our portfolio is in VTSAX, with 10% in each of the other funds.

All our funds are in Vanguard Admiral shares, the lowest cost share class available to retail investors with Vanguard.

When starting to manage our portfolio, we considered all our old actively managed funds as part of our VTSAX allocation until we were able to gradually sell them off in a tax-efficient manner.

While invested in my 401(k), I didn’t have the option to invest in the exact funds specified in our IPS. I used the Vanguard S&P 500 (VFIAX) index fund as a proxy for VTSAX and the Vanguard Small Cap Index Fund (VSMAX) as a proxy for VSIAX.

The only portion of our stock portfolio not currently held in these funds is a few shares of SPDR Portfolio Total Stock Market ETF (SPTM) held as a proxy for VTSAX in our HSA account. If we continue to be eligible for an HSA in the future, I would anticipate future contributions going to this fund.

Bonds

Domestic

-10% Vanguard Total Bond Market Index Fund (VBTLX)

-5%  Vanguard Intermediate TIPS Fund (VAIPX)

I’m not excited about holding bonds. Given our time horizon and low interest rates, I’m far more concerned with the inflation risk of bonds than the volatility of stocks. My wife liked the idea of having some bonds in our portfolio, so we settled on this allocation.

We’ll likely increase some of our allocation from stocks to bonds as we get older, need the income, and/or the risk/reward ratio of bonds becomes more favorable.

On paper, we settled on a ratio of 2:1 Total Bond Index to TIPS when designing our portfolio. But we never purchased the TIPS until earlier this year when rolling over my 401(k). Prior to that we didn’t have a space in our portfolio to hold TIPS in a tax and cost efficient manner.

My wife’s 401(k) is currently 100% bonds, invested in the John Hancock Total Bond Market Fund (JTBMX). Our HSA is also predominantly bonds, held in SPDR Portfolio Aggregate Bond ETF (SPAB). Prior to leaving my job, I held a portion of my portfolio in the Federated Total Return Bond Fund (FTRBX) until rolling my 401(k) over to an IRA. Each of these funds are held as a proxy to VBTLX.

Cash

5% Held in online savings and money market accounts.

This is the portion of our IPS we’ve followed least strictly. Our cash holdings have typically been less than our target allocation. We built up a sizable cash position last year, then put it to work to purchase our new house, leaving us with less cash than we’ve ever had.

We currently hold about 7% of our portfolio in cash. This is because we just closed on the sale of our house and need to allocate the proceeds. The first $11,000 is set aside to fund Roth or Traditional IRAs for my wife and I for 2018.

We’re still discussing how much cash to hold on an ongoing basis. We’ll likely keep about a year to 18 months expenses in cash, putting the rest into taxable investments.

I still struggle with having cash sitting on the sidelines. However, we’ve had to scramble to produce cash to cover expenses on several occasions over the past few months until the sale of our house closed.

This brought me around and made me appreciate the importance of simplicity and the feeling of security that cash provides. Score one for my wife.

Changes to Allocation

  • We will adjust our allocation only when we mutually agree and only when something fundamentally changes to the point that it would be beneficial to do so. Examples would be shifting to a more conservative allocation as we meet investment goals, exiting an asset class if it no longer meets our investing objectives, or adding asset classes if they become available in a cost efficient way as we combine accounts over time.
  • If we choose to shift our allocation from stocks to bonds (or bonds to stocks), the relative percentages within each category will be kept the same.
  • If we exceed 2 years of expenses in cash, we will shift excess money into bonds.

Since we transitioned from two incomes to one and were rolling over my 401(k) account at the end of last year, we thought it made sense to revisit our plan. The only changes we made were to add TIPS, increase our allocation to emerging markets, and get our cash holdings in better alignment with our stated allocation as mentioned above.

I suggested shifting an additional 10% of our allocation away from the Total Stock Market Index Fund to the Vanguard Value Index Fund (VVIAX). I wanted to hold more value stocks when building our portfolio, but we didn’t have a good place to hold them for cost and tax efficiency at that time.

By dumb luck, this has worked out in our favor thus far. The total market has outperformed the value index in recent years. Still, I thought with current high stock valuations, this would be a great time to shift some money from the growth heavy total market fund to the value fund.

My wife did not like the idea of adding another fund to our portfolio. Per our written policy, if we couldn’t both agree to a change, we wouldn’t make it. So we didn’t.

Cost/Tax Control Strategy

  • For cost and simplicity, we will use Vanguard funds whenever possible to meet our goals. When this is not possible, we will use the closest alternative that meets our investment objectives.
  • We will attempt to choose index funds and avoid any actively managed funds unless none are available to meet our needs (in work sponsored retirement accounts).
  • We will consider funds only if the expense ratio is less than .3% annually unless there is no other option available (in work sponsored retirement accounts).
  • We will make every attempt to locate assets in the most tax efficient places. (Bonds, index funds with higher turnover, and REITS in tax sheltered accounts, broad stock index funds and cash in taxable accounts.)
  • We will limit transaction fees by rebalancing only once annually. Rebalancing will be done on May 1 each year after filing our previous year tax returns, at which point we will make our ROTH IRA contribution for the year.
  • We will limit capital gains taxes by rebalancing within our tax advantaged accounts. We will sell funds in our taxable accounts only for tax-gain or tax-loss harvesting when to our benefit.

We’ve been happy watching our taxes and expenses progressively decrease since managing our portfolio. We sold off our old actively managed funds at opportune times. Since selling off our last actively managed fund, we’ve paid no short or long-term capital gains taxes on our portfolio.

We’ve eliminated these taxes by holding tax-efficient index funds in our taxable accounts and rebalancing only in our tax advantaged accounts. Index funds still produce taxable dividends. Our lower household income means future dividends will likely be taxed at 0%, further lowering taxes.

We further lowered expenses when rolling over my 401(k) plan earlier in the year.

I’ve made two tax loss harvesting transactions since beginning to manage our portfolio. The first was in mid-December 2015, selling off funds we held in taxable accounts that had dropped in value. I moved that money back to the original funds in late January 2016 after the markets fell more. I harvested enough losses in those transactions that we still have a small loss to carry forward on our taxes this year.

Now that our income is lower, tax loss harvesting doesn’t make much sense for us. As we continue to have less earned income, we may start looking for tax gain harvesting opportunities.

Future Contributions

  • We will contribute the maximum amount to our work sponsored tax-deferred accounts each paycheck.
  • We will make the maximum allowable annual contribution to our Roth IRA accounts.
  • After maxing out our tax deferred accounts and Roth IRA, we will invest any other available money into our taxable accounts monthly via automatic transaction.

These were no brainer decisions when we were both working. Maxing out our 401(k) accounts offered substantial tax savings. Our combined incomes were always too high to also contribute to a deductible IRA, but well below the limit where Roth contributions were restricted. This made the Roth vs. Traditional IRA decision easy.

As we transition to early retirement, we’re reconsidering this portion of our plan. Now that we have a lower income and lower tax rates, the deduction for investing in a 401(k) isn’t as valuable.

My wife’s 401(k) plan also has high management fees. Her 401(k) makes up only 4.3% of our portfolio, but accounts for 38% of our investment fees! However, not utilizing her plan means losing both the ability to defer taxes in the current year and the free money of her employer match.

Our goal in this phase of part-time work/semi-retirement is to keep annual recognized income low enough that qualified dividends will be taxed at 0%. We’ll continue analyzing our numbers and determine the best way to use our tax advantaged accounts.

We elected to make the maximal allowed contribution to her 401(k) account this year, and we’ll likely utilize each of our Roth IRAs. We won’t make our 2018 IRA contributions until sometime in 2019 when we can know with certainty whether traditional or Roth makes more sense.

Going forward, we’ll continue to monitor whether it makes sense to continue contributing to her 401(k), as the fees may outweigh the tax benefit. Most likely we’ll decrease the contribution to the level of the employer match.

Portfolio Monitoring

One area we neglected in our original IPS was monitoring our portfolio. I’ve since added two categories to monitor.

The first is fees. There are many things out of our control when investing. Fees are one of the few things we can control, so we focus on getting fees as low as possible without adding complexity.

The aggregate expense ratio for all our investments is currently .12% to hold a widely diversified portfolio. As soon as we are able to get my wife’s 401(k) rolled over, that number will drop to about .1%.

The other metric we’ve begun monitoring is the tax status of our investments. Two articles got me thinking about this. The first was Darrow’s post on this site, A Surprising Contender for Tax Efficient Retirement Saving. The other was Physician on FIRE’s My Money Is Worth More Than Your Money.

Not every dollar you have on paper gives you the same spending power in retirement. A dollar in a Roth account is worth a dollar, because it has already been taxed.

Tax-deferred accounts will be taxed at ordinary income tax rates in the year money is withdrawn. A dollar in a tax-deferred account can be worth anywhere from $1 to less than $.60 at the extremes depending on your personal federal and state tax situation.

Taxable accounts tend to be treated more favorably than tax-deferred accounts for most early-retirees because they’re taxed at capital gains rates. But again, the value of your dollars is dependent on your personal tax situation.

We still focus on limiting our current year tax burden, with an eye on getting more money to Roth and taxable accounts. Those dollars will be more valuable when we start drawing down our portfolio.

We missed out on years of tax-deferred savings and Roth contributions by following conflicted financial advice. Still, we’re happy with our tax diversification. Our current breakdown is 46.7% tax-deferred, 43.5% taxable, 9.5% Roth, and .3% in our HSA.

Investment Returns

So what have our returns been since we began managing our investments? I have no idea. We don’t monitor investment returns.

We’ve decided on a buy and hold approach to investing. This means accepting the returns the markets give us.

It’s tempting to calculate returns, but I think calculating investment returns would have more potential for doing harm than good. So I don’t do it.

Knowing I beat an arbitrary benchmark may make me feel smarter than I am and lead me to start tinkering with the portfolio. Knowing I applied extra effort and paid more fees to under perform a benchmark may tempt me to bail on our strategy at the wrong time. Either scenario is possible any given year.

I’m happy to be willfully ignorant of our returns. We focus on the things we can control, such as limiting portfolio fees, taxes, and complexity while building a portfolio that should do well in a variety of scenarios.

Otherwise, we let the chips fall where they may, confident that our plan will work out over the long term.

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