What All Tax Professionals Should Know About Client Retirement Portfolios

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IMGCAP(1)][IMGCAP(2)]The triumvirate of financial professionals (tax professional, estate counsel and investment advisor), collectively provide the expertise necessary to deliver a complete solution for high-net-worth clients. It has been our experience, however, that the tax professional who is an expert in tax management, compliance and tax-aware consulting, often has a closer relationship with clients. And with this deeper relationship comes an outsize role and greater responsibility to act as the “financial quarterback.”

High-net-worth clients rely upon their tax professional for thoughtful consideration and dialogue in a number of crucial areas. This support, in arriving at the best possible tax-aware financial outcome, is indispensable-especially as retirement approaches. Therefore, it is essential that tax professionals develop an understanding of the key vulnerabilities faced by retirees.

Seven years of extraordinary stock market returns (S&P averaging 14.9 percent annualized for period 2009-2015) have left valuations stretched. The S&P cyclically adjusted P/E ratio is now over 26, or fully priced. Many experts predicted annualized stock returns of around 7 percent over the entire secular cycle, which would mean substantially lower future returns closer to 3 to 4 percent for the remainder of this 20- to 30-year period.

A combination of runaway federal deficits among developed countries, an emerging market infrastructure fueled debt spree and an unsustainable corporate borrowing binge have contributed to massive debt accumulation (now 300 percent of worldwide GDP). Too much debt damages growth by crowding out the productive use of capital and increasing an economies’ exposure to latent market shocks. GDP growth in developed countries has been halved in the new century which is sure to have lasting consequences on incomes and lifestyles. Resurgent nationalism and rising class struggles may be at least partially explained by slower growth.

Central bank monetary policy has pushed interest rates to the lowest on record with a significant percentage of short maturity sovereign debt now offering negative yields. These low rates have severely impacted retirees dependent upon fixed incomes while creating unnatural and potentially dangerous market imbalances. We believe the next decade’s stock and bond returns will prove both more unpredictable and meager with several drawdowns of substance along the way much like the 2000-2009 timeframe.

Growing market uncertainty, commodity deflation and a newly emergent Alfred E. Newman (the Mad magazine character whose catchphrase was "What, Me Worry?") asset rally may indicate the markets have entered a new and more threatening timeframe. As the Fed’s interest rate policy unwind occurs and the credit cycle concludes, defining and managing risks may become more challenging. Maintaining a suitable asset allocation dedicated to each client’s specific objectives and retaining that mix over time may well determine the success or failure of the entire investment process. Tax professionals should play a role in support of education and behavioral coaching.

So Why Worry?
Well established return assumptions that rewarded oversized equity allocations and allowed 4 percent plus retiree withdrawal rates over the past several years may now prove overly optimistic. Inferior Portfolio Returns (lower baseline stock and bond returns) coupled with Adverse Return Sequencing (or large cumulative negative stock returns occurring over just a few years) could test the sustainability of established investment advisory convention and end up permanently damaging already vulnerable retirees’ lifestyles.

Risk assets (including stocks, commodities, alternative investments and high-yield bonds) can experience sizeable drawdowns with little warning. These assets are particularly dangerous as overzealous allocations to them can cause significant losses capable of crippling client portfolios. And this is especially the case in the five years prior to and just after retirement as we will discuss. This 10-year window is significant because of the client’s susceptibility to negative return sequencing as large negative returns could rapidly destroy portfolio value. We call this period the “dangerous decade.”

Inferior portfolio returns or several years of below average returns can, over time, slowly debilitate client portfolios as well–but it takes far longer, is readily recognized, and thus controllable. Adverse return sequencing can be difficult to anticipate and more difficult to counteract.

At the point of retirement (let’s use 65 years of age), because remaining life expectancy is greatest at around 15 years, there is enormous dependence upon the healthy continuation of the portfolio without adverse sequencing. Further, the portfolio has likely reached its maximum size and thus is most at risk of a large percentage loss. Put another way, large negative front-loaded returns (like those that occurred in the 2000-2002 and 2007-2009 timeframes) could cause extensive losses to retiree stock portfolios which might then be further degraded by ongoing retiree lifestyle withdrawals.


Both factors are clearly important but adverse return sequencing is more difficult to manage in the short run as it can cause impairment or permanently damage a retiree’s ability to maintain originally planned withdrawals. We consider portfolio impairment to have occurred when the portfolio has declined by 20 percent over the planned valuation for that year. Impairment, if large enough, can cause permanent damage to lifestyle, especially when it occurs in the dangerous decade.

Substantial losses can be difficult to recover from. The 2000-2002 bear market caused the S&P 500 to slump by almost 38 percent. Similarly, the 2008 single year fiscal decline was a monstrous 37 percent! These drawdowns required a nearly 60 percent rally to offset the loss. At the extreme, the 89 percent shellacking investors suffered between September 1929 and July of 1932 required nearly a 900 percent price gain for full valuation recovery. We have no reason to anticipate another drawdown of such magnitude.

Best Practices Make a Difference
Fortunately, there are several proven practices that can improve returns regardless of market conditions. During bull markets investing can be stress-free and high returns often increase investor appetite for risk climaxing near the market high. However, when markets grind sideways or lower, returns suffer and volatility frequently rises reinforcing an emotional response that can lead investors to quit or exit the market. During these “risk-off” timeframes discipline and adherence to proven practices can add significant value and perhaps most importantly, save clients from themselves.

There are several fundamental best practices tax professionals can support to maximize client after-tax returns. These practices include location management, gain budgeting and tax loss harvesting. Tax professionals should also encourage a core satellite approach using separately managed accounts and a long-term balanced core portfolio of both stocks and bonds. Finally, behavioral coaching, designed to help keep clients from quitting during trying times, may be the most important assistance the tax and investment professional can provide.

Tax-Aware Best Practices for Client Retirees
Diminish equity allocations near retirement timeframe: The newly retired, especially those who are risk averse, should hold fewer stocks early on in an effort to avoid the potential of significant drawdowns. At the point of retirement both drawdown risk and remaining lifetime are greatest. If markets were to unfold in a manner similar to 2000-2009, a lower allocation to stocks, holdings of 35 to 40 percent versus 50 to 60 percent, for the first few years or until better valuations become available should serve to lessen the potential of significant loss due to Adverse Return Sequencing. In our example, for simplicity’s sake, we use an equity-only analysis. However, if the allocation were diminished from 60 percent to 40 percent, the equity portion and therefore loss potential would have declined by a third.

Manage return expectations for pre- and post-retirees: Managing client retiree return expectations through ongoing dialogue is an absolute necessity. We believe that equity returns of 2 to 4 percent (with greater volatility) are likely over the next decade. Unless more conservative assumptions are embraced now, clients run the very real risk of suffering a portfolio drawdown due to Adverse Return Sequencing, which could lead to portfolio impairment. Behavioral coaching, in this case managing return expectations, is an essential element of tax-aware advisory.

Recommend a retirement withdrawal percentage below advisory convention: By withdrawing less in retirement than is customary (advisory convention is typically 4.0 to 4.5 percent) and instead working with 3.0 to 3.5 percent retirees can substantially reduce the risk of impairment. In our 2000-2009 all stock portfolio example, decreasing the household’s withdrawal rate to 3 percent (from 4 percent) would have diminished the drawdown by an impressive 11 percent to 59.32 as opposed to the 48.31 in the example. Unfortunately, lower withdrawals would mean a more frugal lifestyle for the retiree as spending power would have diminished by 25 percent.

Base each year’s withdrawal percentage on the prior year-end portfolio total: Basing each year’s withdrawals on the prior year-end valuation of portfolio principal can also provide protection from losses. With this method, principal declines are automatically factored into the withdrawal process regardless of the percentage withdrawn. If variable withdrawals had been used in the 2000-2009 all stock portfolio example, assuming the original 4% withdrawal rate, losses would have been moderated by 10% to a decline of 59.53. Once again, lower withdrawals would require a more frugal existence.
Advise pre-retirees to increase portfolio contributions where possible. Larger pre-retiree contributions substantially increase the probability that portfolio objectives will be reached. In our example, the 10 consistent contributions of $4 (or 4 percent of the initial portfolio of $100) would have increased the terminal value by $42.17. It is essential that pre-retirees remain disciplined irrespective of market dynamics.

Practices Tax Professionals Should Help Retiree Client’s Avoid
Maintaining too high an allocation to risk assets: By avoiding too high an allocation to risk assets (including equity, equity-like securities, alternative and high yield domestic and EM sovereign debt) portfolio drawdowns can be far better controlled. And this is especially important during the period we refer to as the dangerous decade.

Refraining from irrational or emotionally motivated portfolio alterations: Improved lines of communication can lead to greater depth of client understanding of markets and help limit irrational or emotional behavior. Helping clients to remain calm while preserving their resolve is one of the most important value-adds tax and advisory council can provide. In a 2014 white paper Vanguard argues that effective behavioral coaching can add up to 1.5 percent to annual retiree client returns.

Retiree withdrawals should remain under 4.5 percent of portfolio regardless of market returns: Clearly, in a lower return more volatile market environment, retiree withdrawals of greater than 4.5 percent of portfolio may be hazardous to the portfolios long term health. A more conservative 3 to 4 percent withdrawal will serve retirees better, especially the newly retired who are most vulnerable. This lower withdrawal rate will mean less spending and a more frugal lifestyle but significantly increases the margin of safety.

Continued aggressive withdrawals once portfolio “impairment” has occurred: Once portfolio impairment has occurred, informed communication from tax and investment professionals along with capable management becomes a must. Portfolio impairment can often be managed if caught early and this is especially so if the markets recover quickly. However, once impairment occurs, the decline in portfolio should be respected and steps must be taken to lessen the risk of future losses as described above. 

Challenging markets and rising volatility will significantly increase the probability that emotional decision making will lead to behavioral mistakes. And as we witnessed in the 2000-2009 timeframe, portfolio impairment can occur with little warning, placing retirees in a critical financial position. Further, lackluster market returns over the next several years could slowly reduce retiree portfolios requiring larger contributions, smaller withdrawals or postponed retirement in order to build and maintain principal.

Helping clients adapt to changing markets by providing the tools and knowledge to maintain control of their financial lives should be the goal of the financial quarterback. As an enlightened tax professional, you should play a central role in this ongoing process.

Stephen Riley, CFA, CFP, and Rick Furmanski, CFA, CFP, CPWA, are the co-founders of Clearview Wealth Solutions, a firm designed to manage custom tailored portfolios in a tax-aware manner.

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