Adjusting AA between accumulation and preservation phase in years preceding RE

[markus]

Howdy forum,

My current plan is to retire early in about five years. Thus far I've made no overall changes to my asset allocation which is 75% stocks/20% bonds/5% cash across the total portfolio. I'm still reading up on the best asset allocation plans for wealth preservation with a withdrawal rate of 3.5% (including the excellent 'Living Off of Your Money' by McClung, and of course plenty of reading on this forum), but let's go ahead and assume for simplicity's sake that I'll go with the results of the McClung book and aim for about 55% stocks/40% bonds/5% cash in the end. That target allocation isn't really part of my question here, but rather:

What's the best way for me to adjust my current allocation of '75/20/5' to '55/40/5' in about five years? I'll be about 45 years of age then, and I believe I'll be happy with a 3.5% withdrawal.

My current portfolio (and I'm greatly simplifying for this question, but the proportions are accurate) looks like this:

- total portfolio value: $1,000,000, consisting of:

[taxable ... 70% of total portfolio]
- VTSAX: $700,000

[tax-deferred ... 25% of total portfolio]
- 401k total bond index: $200,000
- tIRA stocks: $25,000
- Roth IRA stocks: $25,000

[cash ... 5% of total portfolio]
- held in checking and savings, plus a 2-year CD ladder

My portfolio's bond allocation is currently held completely in my 401k. The total portfolio is heavily lopsided toward taxable accounts because of income gains over the years while not changing much about my lifestyle, plus a couple of windfalls from project successes at work through the years, the vast majority of which I socked away into the market. My bond allocation was more evenly spread across the whole portfolio until I shuffled things around after reading up on tax efficiency here.

What would you do to adjust the AA above to 55/45/5 by that time? My first thought was to start adjusting future contributions from my paycheck and any future windfalls should I be so lucky much more aggressively into bonds, but within my taxable account. What would you do?

Thanks very much for everyone's time,

Markus

[markus]

Hello again,

I wanted to bump this topic because I've been searching about a bit more, figuring that there are surely others out there who might be considering a glidepath-style approach for their starting retirement asset allocation, but who then naturally hit the question of how, when and over how long to reach that AA. Kind of a pre-retirement glidepath, if you like.

At the top of this page in a post from Bogleheads.org, 'trophy_husband' raises my point exactly. He's looked at the McClung research, is looking at the 'Prime Harvesting' approach, and is now thinking about how to adjust from an aggressive accumulation stage AA to that of a more bond-heavy glidepath starting point for retirement:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=192105&start=400

And the replies to that post on that same page gave me a few leads to consider. Some of those include:
- go ahead and just sell and then withdraw from stocks in taxable, but then offset that sale within tax-deferred accounts by selling bonds and buying stocks there
- in the last years leading up to your RE date, stop reinvesting dividends and interest in stocks in your taxable account. Divert that money into bond purchases to start building up that portion of your AA.

In my own case, I've looked at my AA across my entire portfolio (let's say 70/30), drawn up a new target AA for the start of RE (55/45), then compared the difference in target bond amounts vs. my current bond amounts. I need to "make up" that difference between now and my RE date, so I'm now looking at how long it would take if I start 1) divert dividends from reinvestment to instead purchase more bonds, 2) re-direct my regular paycheck contributions more toward bonds than stocks, and 3) plan on investing the net of any future bonuses, which I can conservatively estimate but not completely count on, toward bond purchases.

All of that taken together appears do-able over the next several years, and all hopefully without outright selling stocks in taxable in order to increase my bond AA in time for the start of RE. The key thing now is that I need to be pretty sure about this RE date as this is would be the beginning of my glidepath of sorts toward RE at which point I'll begin the real glidepath (be it Prime Harvesting or some variation on that) in order to try and shield myself from sequence of returns risk in the first decade or so of retirement.

So there are some more details to chew on in case anyone would like to poke holes in all of this, raise other issues or considerations that I'm missing or anything else you like. I'd love to hear others' thoughts who might be considering similar plans having to do in any way with adjusting one's AA from a more aggressive accumulation angle to that of a more preservation angle. I'm also thinking about asking 'Big ERN' from the EarlyRetirementNow blog if he might do a follow up piece on this topic as he's covered a lot of material concerning glidepaths.

Thanks, everyone.

[Financial.Velociraptor]

I'm 60/40 about 5.5 years into FIRE.  The fixed income is largely in the taxable account.  I don't let the tax tail wag the investing dog.  My 40% in fixed income plus some buy to hold high yield equity covers 120% or so of my budget.  That is currently supporting a 4.73% withdrawal rate.   My 'secret sauce' is most of my fixed income is in closed end funds bought at a discount to NAV.  These have a higher yield due to the discount of purchase and some modest leverage employed by the funds.  I have some duration risk but since my budget is covered I never have to sell.  Therefore my duration risk expires with time.

I like your second option better.  Just direct future contributions and distribution reinvestment to fixed income and see how close you get.  I single lump sum rebalance at the end if you are still a little "short." 

Best of luck!

[chasesfish]

There's really two sides of this argument, neither of which is necessarily *wrong*....

One side says stay 100% stocks and you'll win over the opportunity cost of holding Bonds/Cash.

The other side will say going into retirement you want to have 2 years of cash or a 20% bond allocation to soften your portfolio against the shock of a downturn.

All the risk is in the first five years.  If you're estimating a 4% withdraw rate and get a 10% annual return for each of the first five years, you're in really good shape.  If you get a 1920's or 1966-80 drop right after early retirement, you'll see some pain. 

[ChpBstrd]

You would just hit sell and buy, but this would trigger some nasty capital gains taxes. So the underlying problem is that your tax-advantaged Roth and tIRA only comprise 2.5% of your portfolio each. The only way this could have occurred is if you'd severely under-funded your tIRA and Roth in the past (unless by "proportional" you mean you are a multi-millionaire, in which case your spending habits are the only barrier to FIRE :) ).

So step 1 is to start maxing out your tIRA or Roth (in addition to your 401k) starting with tax year 2017 if you (hopefully) haven't filed taxes yet. Because your income is high, the tIRA probably makes the most sense. However, this will only move the needle by $5500/year. That doesn't add up to a 20% or 200k reallocation toward bonds 5.5 years from now. So to rebalance, you would be taking the capital gains hit. If you go this route, spread it over the next several years to the extent you stay in a particular tax bracket.

There are alternatives to make your portfolio more stable without actually rebalancing and realizing capital gains. For example, a protected put options strategy could essentially convert some % of your stock allocation into something with bond-like stability and lower yields. If the market crashed the day after retirement, you would live off the proceeds from the put options for a little while just like if they were bonds. Even better, during years when you spend money to hedge and the stock market goes up, making your hedge worthless, you could count the cost of the options as a short term capital loss. So to recap, this plan would (1) protect your portfolio from sequence of returns risks, (2) provide a nice windfall to live off of in the event of a market crash, (3) provide tax advantages during years the market continues to rise, and (4) allow you to maintain an aggressive stock allocation which is likely to offset the cost of the hedges over long periods of time. Added bonus: not being as exposed to rising interest rates, which might hurt the value of bonds.

If you did the above, I'd recommend the 2020 LEAP options on SPY, rolled each September to the following year. These will roughly translate to VTSAX (close enough anyway). At this duration, time decay is minimal. The downside is spending thousands of dollars on options and watching them expire worthless each year - the psychology of that would be brutal unless you are very disciplined and focused on the stock gains those expenditures are enabling.

[markus]

Thank you all very much for your replies. It's given me a few things to think about and I feel good about the plan.

I like your second option better.  Just direct future contributions and distribution reinvestment to fixed income and see how close you get.  I single lump sum rebalance at the end if you are still a little "short." 

I like it, and I think that will be my approach. I looked at the "difference" that I'd need to make up in my bond allocation between now and my target RE date, and then looked at how re-directing my normal weekly contributions toward my bond funds over the course of the next few years could put a dent in that difference. Then I added in expected dividend returns, and then any estimated bonuses (granted that's just an estimate and never a sure thing), etc, and I think I'll be able to pull it off. Could be that stocks continue to grow significantly for a while longer which would make that difference more challenging to make up as far as asset allocation percentages go, but there are worse problems.

All the risk is in the first five years.  If you're estimating a 4% withdraw rate and get a 10% annual return for each of the first five years, you're in really good shape.  If you get a 1920's or 1966-80 drop right after early retirement, you'll see some pain.

Understood and agreed, and that's actually the point of my plan, or rather the general gist of 'Prime Harvesting' or similar glidepath plans: you start off your early retirement at a perhaps more conservative AA (say, 50/50) but only withdraw from your bond allocation. When stocks rise past a certain threshold, you sell off a chunk and move that into bonds. If stocks sink, you don't sell and just continue to withdraw from bonds. In essence you're shielding your stocks from sequence of returns risk through your early years of RE. Naturally there's plenty to debate on Prime Harvesting or other glidepath schemes, but I don't want to derail this particular thread. Mostly I was just curious to get everyone's thoughts on this period of adjusting between accumulation and preservation, or a kind of pre-glidepath. Maybe call it the approach if we're to keep with the aviation terminology? Anyway, plenty of food for thought.

[Eucalyptus]

Just quickly, check out some of Kitces' writing on glide path ratios. This might be the kind of information you are looking for


Cheers!

[soccerluvof4]

I will be fire'd 3 years April 3rd and have maintained an allocation similar of 60/20/20. Bit more cash heavy due to profit taking in run up but for me ideally like to be at 60/30/10. I do like to have more cash than most MMM's but thats just simply by choice and I sleep better at night.