Episode 114 – Asset Allocation Strategies That Will Maximize Your Retirement with guest P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx

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Asset Allocation Strategies That Will Maximize Your Retirement
James Lange, CPA/Attorney
Guest: P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
Episode 114

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TOPICS COVERED:

  1. Guest Introduction – P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
  2. What is Asset Allocation?
  3. What is Diversification and Why is it Beneficial? 
  4. Having An Adequate Cash Reserve
  5. Different Portfolio Management
  6. How Time Affects Asset Allocation
  7. Gifting
  8. Different Asset Allocation Scenarios
  9. Rebalancing
  10. What Changes your Asset Allocation?

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1. Introduction to Guest – P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx

David Bear:  Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks. I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney and author of two best-selling books, Retire Secure! and The Roth Revolution: Pay Taxes Once and Never Again. Most people recognize that proper asset allocation is essential to long-term financial success, but too many people and investors fail to consider factors appropriate to their particular situation, changing circumstances or life stage. For example, a retired person with a million dollars in investments and an annual income of $75,000 from pensions and Social Security should allocate assets differently than a retiree with the same million-dollar portfolio, but only $20,000 in annual income. For perspectives on developing and maintaining an asset allocation strategy appropriate to your situation, we welcome back P.J. DiNuzzo to this edition of The Lange Money Hour. A nationally recognized expert in investment management, P.J. has been featured in numerous business publications and TV shows. Approved as one of the first one hundred Dimensional Fund Advisors, he’s rated a five-star advisor by Paladin Registry Investor Watchdog, scoring in the top one percent of America’s more than 800,000 investment advisors. Based in the Pittsburgh area, his firm, DiNuzzo Index Advisors, also consistently ranks among the country’s top 500 investment companies. For the next hour, P.J. and Jim will discuss asset allocation strategies to maximize retirement income. And listeners, since the show is live, you can call and join the conversation with your questions and comments. Call the KQV studios at (412) 333-9385, and with that, I’ll say hello, Jim and welcome, P.J.

Jim Lange:  Welcome, P.J.

P.J. DiNuzzo:  Hello. Good evening.

Jim Lange:  So, before I start with the content of the show, I feel obligated to provide full disclosure. Usually, when I have a national expert on the show, I usually plug their book, assuming that they have a good book, but ultimately, I don’t have any financial interest in whether you buy the book, whether you don’t buy the book, whether you use their service or whether you don’t use that service. That is not true tonight. P.J. and I have a strategic relationship whereby if somebody comes to my office and they are looking for both the strategic advice that we tend to provide, like Roth IRA conversions and Social Security maximization and estate planning and how much money people should spend and how to provide for education for children and that kind of thing, we provide that information, and then P.J. and his office actually does the true investing using Dimensional Fund Advisors, which, we believe, is the best set of low-cost index funds on the planet. The way it works, in terms of the client, is the client pays one percent or less, depending on how much is invested, and then P.J. and I split that fee. So, it’s a win for me because I get to do what I like, which is the strategic part, and it’s a win for P.J. because that’s a client that P.J. otherwise would not have received, and it’s a double win for a client because they’re getting an excellent set of very low-cost, and what I believe, are the best set of index funds on the planet, as well as our strategies all for one percent or less. So, anyway, the point of all that is that I am not independent with P.J., and I felt morally obligated to mention that.

Today’s show is going to be about asset allocation, and we really hope to get into some real meat here because this is one of the areas where I think P.J. provides enormous value, and has a lot of expertise in this area, and I also think that it is perhaps the most important area of investing. A lot of times, people think it’s individual security selection, and that just isn’t true. And it’s also the area that I see, it is routinely botched and is done just terribly and has caused people endless anguish and reduced portfolios and unnecessary risk. So, I thought doing a dedicated show on asset allocation would be important. So, P.J., could I just start with kind of a basic question? What is asset allocation?


2. What is Asset Allocation?

P.J. DiNuzzo:  Yeah, Jim. Asset allocation, looking at its most basic definition, would be the percentage of stocks versus bonds and cash. The bonds and cash should be looked at together. So, asset allocation is the percentage of stocks and/or stock mutual funds versus bonds and cash in a portfolio. So, if an individual had 50% in stocks and stock mutual funds…let’s say they had a million dollar portfolio to make the math easy, $500,000, if they totaled it up in stock and stock mutual funds and the other 50% in bonds and cash, they would have a 50/50 allocation: 50% stocks, 50% bonds.

Jim Lange:  Well, if that’s what asset allocation is, then what is diversification?


3. What is Diversification and Why is it Beneficial?

P.J. DiNuzzo:  Diversification would be the consideration, if we took a really egregious example, or scenario, if we said of that million dollars, I had $500,000 in General Electric stock, just in one security, and $500,000 just in one individual bond (maybe you had a Ford Motor bond, whatever it may be), that’s not diversified. The audience would understand that. So, really, once you go from that single asset class, to go to a mutual fund example, since we talk about indexes, if you had the S&P 500 as one-half of your portfolio, and let’s say you had one single bond from maybe even the total bond market index, you still would have a 50/50 allocation, but there are still a lot of benefits to be achieved by walking down that road of diversification that you mentioned.

Jim Lange:  And can I assume that the purpose of having a well-diversified portfolio is twofold? Number one, being a better rate of return, and equally, or perhaps more importantly, having a safer portfolio. Safer meaning it is less likely to lose financial purchasing power over time.

P.J. DiNuzzo:  Yeah, that is correct, Jim. It seems like common sense to a lot of folks now that we would like to diversify, but there are two main goals that we’re going after. Anything, any member of the audience, one of the things that you mentioned, Jim, that you see and I see a lot that are improper in an individual’s portfolios are there really wasn’t a purpose when they added anything to that portfolio. So, if we started off with that S&P 500 as a stock position, total bond market, or whatever they bond may be, the bond fund or individual, when the audience would add anything to their portfolio, they want it to do at least one of the two things you had mentioned. They want it to be able to at least increase the rate of return, or decrease the risk in a portfolio by adding it, or, ideally, as we’re able to do with our portfolios based on an extraordinarily long track record, is increase the expected rate of return while decreasing the risk, up to a certain point, of course.

Jim Lange:  All right. So, that’s obviously the home run: increasing the rate of return, decreasing the risk. And it would seem to me that one of the ways you would decrease your risk (and I’m going to oversimplify) is not having all your eggs in one basket. By the way, if you did have a Dimensional Fund asset portfolio, roughly how many stocks would be represented in that fund, or in your portfolio, that would presumably consist of a variety of index funds?

P.J. DiNuzzo:  Yeah, if we did an x-ray and took a look at our typical portfolio, well in excess of over 10,000 stocks in over 40 countries, just in the stock portion of the portfolio.

Jim Lange:  All right. So, that’s a heck of a lot more diversified than, say, the S&P 500?

P.J. DiNuzzo:  Yes.

Jim Lange:  All right. So, I do want to get into, you know, 60/40, 70/30, and that type of analysis and how you arrive at that, but I also know that you have a different approach to asset allocation that I find extraordinary, and I just like the idea of it from a gut instinct. Could you tell the audience…and by the way, you don’t necessarily have to, you know, use P.J. DiNuzzo and Lange Financial Group to get this. You can do this to some extent on your own, but could you tell us about your stack analysis, because I think it just makes so much intuitive sense?


4. Having An Adequate Cash Reserve

P.J. DiNuzzo:  Yeah, it does, Jim, and it’s something we’ve refined since I started the practice in 1989, of course.  We’ve just refined this process over and over during the past 25 years. But where a lot of people go wrong, Jim, before we even get into the asset allocation, is they don’t have enough of a cash reserve. They don’t have enough of a cash cushion. I recently talked to a household, a husband and wife, who had, materially, over a million dollars, about $1.1 million in total investments, and of that $1.1 million, they had $3,000 in the bank. So, it was almost $1.1 million in IRAs, 401(k)s and 403(b)s (they were getting ready to retire), and $3,000 in the bank. So, the audience can appreciate you don’t want to go into retirement with just $3,000 sitting in your money market fund. If you need anything, heaven forbid, I mean, the mixer breaks or washer and dryer, if you take anything out of your IRA account when you retire, that’s a taxable occurrence every time. So, you want to have after-tax money as a cushion.

Once you take care of that cash reserve bucket, one of the things that people like that we work with, and again, we’ve just refined this over the years, is really identifying, giving a purpose for every dollar that you have, especially while you’re in retirement. Now, we start modeling this, and if you want to think of it as a funnel, we start channeling this and channeling it more and more towards the ideal range whenever you retire. We would call that the glide path. The folks like that, we set up a special portfolio for their food, clothing, shelter, health care and transportation, in Pittsburgh, people are going to just think of these as your needs. So, what are my needs in retirement? And what you find is if individuals have to set up a portfolio for those needs, and generally, if you just have Social Security, that’s not enough to pay for your needs. If you’re lucky enough to have a pension, a defined benefit pension, in most cases, that is enough to satisfy your needs. But let’s take the majority of cases, for three out of four, or four out of five retirees in Pittsburgh and southwestern Pennsylvania, the tri-state area, Social Security’s not enough. And what out mantra is, at my practice, at our practice, is that you really don’t want to place in a portfolio that could go down more than 10% in one year. When you take a look back, and of course, ex-post or, you know, looking back on the market, when individuals have bailed from their portfolio, it’s really based on the topic of the show that you came up with this evening, is they haven’t first and foremost, even forgetting about active funds or indexes, passive, etc., they’re in an improper asset allocation. So, if the audience can think of…really, it equals a portfolio between 20% and 30%. We have an awful lot of 30% stock portfolios for those need expenses, but if you can just think what happens if you had 70% in stocks, 80%, or heaven forbid, 100%, we’ve got a couple clients on board this year that had 100% in stocks all the way across the board, for their need expenses, their want expenses, for their wishes and dreams and extra travel and buying a new car. And just the investor DNA, you are not going to be able to live through a poor market period. So, when you go back and analyze 2000, ’01 and ’02, ’08 and ’09, more people got scared.  Out of who did sell out of the market, all, most or some got scared out more because they had an improper asset allocation. Now, there were a lot of bad investments in there a lot of times, but really it was that asset allocation was really improper. They were too aggressive in one of those…especially the need and the want bucket, they were too aggressive. That’s why they got scared out of the market.

Jim Lange:  So, are you basically saying…let’s say it’s 2008, and instead of having all your money in stocks, or even a fairly high percentage of it in stocks, or even, let’s say, a 70/30 allocation, that if you had set aside a separate account that literally has a separate statement, or a separate sub-account, and it was mainly cash and CDs, or something that people could reach, that when the market went down, they said, “Oh, well, that’s okay because I have more than enough money to carry me through the next year or two and the markets have historically returned. So, I’m just going to spend the money that I have put aside and wait for the market to return, and not take a 40% hit because they sell.” Is that kind of the idea that you’re getting at?

P.J. DiNuzzo:  Yeah, that initial cash reserve, our recommendation, again, our mantra at our practice, at my practice, is one year in that cash reserve account. So, if the listener’s retirement expenses are going to be $5,000 a month, they’d like to at least have $60,000 in that cash reserve. Now, a practical nirvana would be up to three years of a cash reserve. That gives you a tremendous amount of sleep at night, and we’ll build that higher cash reserve. For clients who are more conservative, we’ll give them that extra belt and suspenders with the cash reserve. Then, as you said, Jim, what they like is you have a specific portfolio, you’re receiving a separate statement for that need bucket, a separate statement for the want bucket, and another separate statement for the wishes and dreams. We call it quality of life while you’re living and then legacy once you would pass.

Jim Lange:  All right. And the thing I like about that is, if people are seeing different buckets and different purposes of the money, I think that they are much more likely to hang in there in the event of the market going down, and likewise, not getting overly excited when the market’s going up because they…I would imagine you have trained your clients to say, “Hey, we don’t want to be greedy either. We don’t want to try to hope that the market’s going to go up, roll the dice, put everything in the market,” because what I have found, and particularly for people, investors in their sixties and older, they’re actually somewhat conservative. Yes, sure, there’re some risk takers, but there are also some people who are a little bit risk-averse. And it sounds like that this idea of separate buckets and separate needs would help calm the nerves of risk-averse, nervous investors.

P.J. DiNuzzo:  Yes, it does. Very much to the point.

David Bear:  In that cash reserve account, though, you’re not expecting to get any appreciation in today’s market, in particular, are you?

P.J. DiNuzzo:  Yeah, that’s correct, Dave. We actually have an image we show individuals, the percentage of stocks in each of those buckets, and there’s no range on that bucket. That is zero in stocks.

David Bear:  Right.

P.J. DiNuzzo:  I know it’s a tough environment now, but money markets, CDs…

David Bear:  Right.

P.J. DiNuzzo:  …fixed income, no stock at all.


5. Different Portfolio Management

Jim Lange:  All right. Just out of curiosity, isn’t that a lot more time for you? Because it seems to me that it would be a lot easier to manage one 70% stock and 30% bond portfolio than to have…you’re talking, like, three or four portfolios right off the top of your head.

P.J. DiNuzzo:  Yeah, that is correct, Jim. Our average client who’s retired has three different asset allocation strategies (which is the topic of tonight’s show that you had come up with with Dave). If there are four, there will be a separate one in that top bucket, that quality of life, because oftentimes, individuals will say, “Well, there’s a chance I might need some of this money at some point in time,” but oftentimes, at the very top of the top bucket, we can say, “Hey, there’s a 99.9% chance you’re not going to need $50,000, or $75,000, or $100,000 at the very top of this.” And if we’re able to show them, you know, with the stretch IRA work especially that you do in your office, you know, what if we can just grow that? If we had that 100% in stocks, what if we just grew that one or two percent more than even a 70/30? It’s amazing, over even a ten-, let alone a twenty-year period of time or longer, how much more money that’s going to put in their heir’s, in their children and their beneficiary’s pocket over time.

Jim Lange:  Well, if you’re doing that, and you’re allowing a certain amount of time, whether it’s one year, or for the very, very conservative, three years, don’t you need to do an accurate analysis of how much cash they actually need?

P.J. DiNuzzo:  Yeah, there’s a lot of upfront work. I’ve always looked at it, Jim, that, you know, we’re real big…I mean, a lot of firms will say, “Everybody would love high client retention,” but really, to me, it’s just a direct cause and effect. I mean, the more time you put into the beginning of the relationship, the beginning of our relationships is you’ve had one or two consultations with these individuals. In most cases, they’ve attended one or two of your workshops. You have one or two consultations in the office. But even at a minimum, they come to one workshop. They have one face-to-face consultation with you. Then, at our end, we’re having two to three with them. So, there’s a lot of education that’s going on. They’re getting a lot more comfortable. We’re taking the extra time to develop all these financial statements, their balance sheet down to the last penny, their current cash flow, their cash flow at 62, at full retirement age, at age 70, to be able to make all these different decisions and act in a strategic manner, and with them developing that level of comfort, by the detail that we put into the financial statements, really helps everybody involved.

Jim Lange:  Yeah. To be honest, that was a slightly self-serving question because I know your process is so detailed, and as a result of you spending that extra time, they’re actually getting a more accurate and more useful asset allocation because if they just gave you a number off the top of their head, and you went by that, you could end up with too much money in cash, or not enough. And going through the analysis, and I know that, you know, we send you a lot of quantitative folks, and every single one of them has come back and said, “Hey, he was really into the numbers.” And you’re maybe a little bit too nice or modest, but your projected cash flows, where you take everything coming in and everything going out, which is, in effect, is like a personal income statement, and your personal balance sheet, I find to be extraordinarily useful.

P.J. DiNuzzo:  Yes, they’re just very beneficial. You know, the old saying, “The devil’s in the details,” and it’s really funny, Jim. You’ve got a ton of quantitative clients. I mean, you’ve got more engineers than you could shake a stick at…

David Bear:  And professors…

P.J. DiNuzzo:  …and professors, yeah. It’s just amazing. I mean, you know, engineers, professors, architects, you have a lot of highly quantitative individuals, and a lot of them are very good at what they do, but, you know, we always say personal finance, what you specialize in with your team and what I do with my team is a whole completely different discipline. And even these individuals, obviously, it’s not an IQ test because…I always joke around with them and say, “Hey, your IQ’s a lot higher than mine. I’ll just give you that to start off with.” But when you get into personal finance, a lot of times, what they think their monthly expenses are, they’re off considerably. By $500 as a low number, it could be $1,000 or $2,000, which represents a portfolio needed in the future of hundreds and hundreds of thousands of dollars.

Jim Lange:  All right, well, that obviously makes a huge difference. What I’d like to do…and David is motioning that it’s time for the break, so what I’d like to do when we return is to go into some of the specific asset allocation recommendations in different situations.

David Bear:  Well, again, let’s take that break, and listeners, if you have questions or comments for Jim or P.J., call the KQV studios now. That’s (412) 333-9385.

BREAK ONE

David Bear:  And welcome back to The Lange Money Hour, with Jim Lange and P.J. DiNuzzo.

Jim Lange:  And for those of you who are just joining us, and I mentioned this earlier, but I feel obligated to mention it again, usually when I have a guest on, I am independent of that guest. I try to get national experts. I often plug their book if I think there’s a good book. But I don’t have a financial interest whether you buy the book or whether you don’t, whether you use their services or whether you don’t. That is not true for tonight’s show. I do have a financial interest. P.J. and his firm.  His firm, DiNuzzo Index Advisors, and our firm, Lange Financial Group, actually have a working relationship, a joint venture, if you will, where if somebody comes to our office and we identify a need in the area of, say, tax planning and Roth IRA planning and Social Security planning and safe withdrawal planning and college education planning, etc., that we do that part. P.J. and his firm actually do the actual money management and the asset allocation that we’re talking about today, and P.J. and I have an arrangement where we, in effect, split the one percent or lower fee between the two of us. And it is a win for me because I get to do, and my office gets to do, what we are strong at and what we like to do, which is the strategic part, Roth, Social Security, how much to spend, etc. His firm gets to do what they are really strong at, which is the asset allocation and actually managing the money, doing a lot of the things that we’re actually going to be talking about today. And so, it’s a client that he otherwise would not have received, and I believe it’s a double win for the client who gets the combination of, I believe, the best index funds on the planet, Dimensional Fund Advisor funds, with P.J. a very excellent hardworking advisor, and the benefit of meeting with our firms where we run the numbers, etc. So, anyway, the point of all that is, we are not independent to P.J. So, going back to where we were talking about asset allocation, one of the mistakes that I think a lot of people make in this area is not paying attention to time horizon. So, let’s say, for discussion’s sake, that you had two people, and you were developing their portfolio, and one was sixty years old and one was eighty years old, and they had roughly the same risk tolerance, etc. Would those portfolios that you would recommend look differently?


6. How Time Affects Asset Allocation

P.J. DiNuzzo:  Yes, Jim. Generally, they would look differently. I guess one asterisk on that would be that oftentimes, if there are extra assets that the individual has over and above their needs, that oftentimes, we’re working with clients and starting to…there are going to be two time horizons that we’re analyzing: one for the current existing client who’s sitting across the table from us, and the other one for their heirs or beneficiaries. So, we get to that top bucket oftentimes, whether it’s children or grandchildren. We’re able to customize these portfolios for the full comfort of the client, along the time horizon for their children or grandchildren, equaling a higher exposure to stocks to equities. But basically, to answer your initial question, yeah, we’d have a shorter time horizon for an older client and retiree, which would equal overall a more conservative portfolio.

Jim Lange:  Okay. But I love the point that you just said because very, very few clients do this right coming in before they see you, even if they have seen other people. So, let’s take an example of…you know, most of our clients, despite my efforts, are not really spenders when it comes down to it. So, I have clients that might have $40,000, sometimes more, in Social Security, they might have $1,000,000 or $2,000,000 in their portfolio, and they’re still spending $5,000 a month. And let’s just say, for discussion’s sake, that they are even older. That would point towards a more conservative portfolio. Are you basically saying that you would, in effect, construct two different sets? One is money that they would likely need during their lifetime and invest that in a certain way, presumably using the bucket analysis, or the stack analysis that we talked about earlier, and a separate portfolio for money that they are likely to leave their children and grandchildren, but not give that money to them at this point.

P.J. DiNuzzo:  Yeah, that is correct. That’s where that customization comes in in that top bucket, when we have, you know, some really nice heart to heart conversations regarding what their wishes are for their beneficiaries and heirs, and of course, there could be, again, a material difference between children, a lot of times just in age differences. You know, Jim, from all the clients you meet with, you can have a difference of fifteen years or even more between the oldest child to the youngest child. Then you apply that to the grandchildren. So, you can get a wide range. So, oftentimes, we’re customizing part of that legacy quality of life bucket on the children’s time horizon, and also usually a smaller portion of that based on the grandchildren’s time horizon. So, we’re able to lay it out from a planning perspective and have someone be able to go to sleep at night, who is fundamentally (as you said) a conservative investor. They’re invested moderately higher than what their normal comfort level would be, but they understand, getting back to your initial point, on the time horizon that’s not based on their time horizon, but rather their children or their grandchildren.

Jim Lange:  All right. And let’s also take it to the next step, because most of the time, particularly after somebody gets done working with our firm, they usually end up having (I’m going to oversimplify here) three different types of assets: one is what I’ll call after-tax assets, assets that are not IRAs, not retirement plans, not 403(b)s, 401(k)s. It’s savings. It’s inherited money, money that somebody has already paid income tax on. Then, there’ll be what is often the larger bucket, which is retirement assets, money that nobody has yet paid income tax on. That might be IRAs, 401(k)s, 403(b)s, SEPs, Keoghs, etc. And then, what we often encourage people to do is we don’t usually do a lot of whopper IRA conversions, but we do do an awful lot of small Roth IRA conversions based on tax brackets. So, by the time people are done with us, they often have these three different buckets, and you’re already, it seems to me, spending a lot of time trying to craft these different asset allocation strategies, but how do you work in the fact that people will often come to you, not with all IRA or all after-tax or even all Roth IRA, they will come to you, some will be after-tax, some will be IRA and some will be Roth IRA?

P.J. DiNuzzo:  Well, yeah, Jim, a couple different aspects of that: one would be, for individuals, what we would call their withdrawal hierarchy. So, the average individual, if they want to take withdrawals from their overall portfolios, as you said, there were wide ranges of those blends, the taxable portfolios, the traditional IRAs, roll over IRAs, then versus the Roth IRAs. But individual listeners would always want to take money out of their taxable portfolio first, then followed by their IRAs, and then finally, last, the last area they’d want to take them from would be their Roth IRAs. Another comment to make there, Jim, what our recommendation at our practice is, for that sleep at night capability, when you’re taking those from your taxable assets, not to draw those down too far, but to just take those down no lower than your cash reserve bucket. So, we had mentioned earlier the one-year minimum to the three-year maximum, a lot of individuals will make a mistake where they’ll draw their taxable assets down too far and get down to $5,000 or $10,000 and then limit their planning opportunities. So, again, the audience would just want to take withdrawals out of their taxable portfolios down to their cash reserve bucket level, and then start to tap those IRA assets.


7. Gifting

David Bear:  Since we’re in the season of giving here, where do you stand in regard to gifting to children and grandchildren at this point?

P.J. DiNuzzo:  Well, gifting…in fact, we just worked on a case earlier today, you know, we do plug that into our projections, as well.

David Bear:  Umm-hmm.

P.J. DiNuzzo:  You know, in this case, the parents were maximizing the $14,000 per year, so we were budgeting in $28,000 for this year. Actually, they hadn’t done it, so we’re going to be doing it before the end of the year, and they felt comfortable. They were going to do it for the next couple years. So, that comes into the cash flow analysis, as well.

David Bear:  And that’s $14,000 per gift?

P.J. DiNuzzo:  Yeah, per gift, per person. So, a husband and wife can both gift a total of $28,000 to one individual…

David Bear:  Umm-hmm

P.J. DiNuzzo:  …if they wanted to. Yeah, but it’s $14,000 per person.

David Bear:  And which bucket would that come out of?

P.J. DiNuzzo:  Well, that’s getting into more of a cash flow analysis. So, that would be…basically, that gets in a lot of times to the legacy quality of life to that top bucket…

David Bear:  Umm-hmm.

P.J. DiNuzzo:  …because that’s almost like a luxury to be able to do that. If we don’t have it in that bucket, then it would be in the want bucket, for something that I would prefer doing, because a lot of times, parents, a lot of folks that we have as clients will do that when they have a better year or things go a little bit better, where they’re more comfortable. You know, we joke around a lot of times. You know, I always tell clients that, you know, we love your kids and your grandkids to death, but the folks that are sitting across the table from us, which, in this case, is grandma and grandma, grandma and grandpa look them in the eyes and say…your job, number one, I don’t want you to ever take this the wrong way, but any money you ever gift to your children or grandchildren is sort of a one-way street. I’ve never seen it come back! And he’ll say he had a rough couple years in the market. Can you, like, kick that back to me? I’ve never seen it yet in twenty-five years. So, you need to be real careful. What goes out doesn’t come back. But, yeah, that would be in one of our upper buckets.

David Bear:  Right.

P.J. DiNuzzo:  It’s not in the needs. It’d be up above, yeah.


8. Different Asset Allocation Scenarios

Jim Lange:  Well, if we could take some of the different types of situations that you might run into, and some of the differences that you might recommend. So, let’s say, for example, somebody is still working. Maybe they’re sixty years old, and they still have a substantial portfolio, but they are still working. So, there is some cash coming from their work. Is that going to change your asset allocation, given that they had the same amount of money, or even a little bit more money, and they’re not working?

P.J. DiNuzzo:  Yeah, Jim. What would strike me when individuals are still working, I guess the main point that I could leave with the audience would be that you need to think about being on a glide path to that point in time, that point of inflection, when you turn off that earned income spigot or faucet (as we refer to it), and now, you have to live the rest of your life off of your portfolio. So, that gets down to the point, you had mentioned earlier, a lot of other firms paint with a broad brush. They’ve got the client all 70% or 80% in stocks, and now, they come down to the point, they’re 62, they’re 66, the husband and wife are both going to retire, and how do you get from 100% in stocks, or 80% or 70%, down to, let’s even say, 50% in stocks? Very, very difficult, and I can tell you when mistakes are made in the market, it’s because of a lot of the research that’s gone on, but, you know, the fancy word is behavioral sciences, but people aren’t comfortable with it in the pit of their stomach. They’re feeling bad. They make emotional decisions. They do the wrong thing. So, if you can identify this, I mean, I was elated the other day. A prospective client we’re working with with your firm came in and they’re looking at this twelve to thirteen years in advance of their expected retirement date. So now, we can start to put the financial planning together, the retirement planning, and get a couple of their portfolios on the glide paths. We’re getting a real range now. I mean, we’re going to be pretty close on both of those buckets that, let’s say, we’re going to have 30% in one that’s going to pay for that food, clothing and shelter shortfall, and in the other one, we’re going to have 50% in stocks. So, we’re able to bring those down. So, they’re not going to be…when they’re talking to someone over the water cooler at work, or their neighbor over the hedges who’s some genius of some type, that they’re not going to lose their mind. They’re like, “No, I’ve got a plan. This bucket’s going to pay for my food, clothing and shelter. I know I have to be in this range. I know I don’t want too much volatility.” It really reduces a lot of anxiety in that retirement plan, and then also lets us know, “Hey, I’ve got, let’s say, a couple hundred thousand dollars or more that I can keep on that 30,000 foot cruising altitude with 100% in stocks, or 70%, whatever my comfort level is, but, again, it gives them a purpose and a reason, a philosophy, a strategy for every dollar that they have.

Jim Lange:  Yeah. By the way, I love the concept of the glide path because…and it’s different than some of the, you know, you might have heard well, you take a hundred and you subtract your age and that’s how much you should have in stocks, and the rest you should have in bonds. But the glide path seems to me to be a much better way of doing it, saying how much money do we need? How much money do we have to set aside? And then, taking a look and being realistic about how long you’re going to need the money, and realize that the asset allocation for a sixty-year old’s going to be a lot different than an eighty-year old, and that, in effect, it’s not going to just be okay, you’re sixty, now you’re sixty-one, now you’re sixty-two, everything stays the same, and then boom! You’re eighty and you sell half your stocks, you know, that day that you turn eighty, but it’s more of a gradual planned process that will ultimately provide for, I believe, a better return, and, perhaps more importantly, a safe never run out of money, never lose a lot of purchasing power strategy.

P.J. DiNuzzo:  Yeah, that’s correct, Jim. One thing we look at a lot, because we’ve got…one thing that’s great about the database, you know, we have an eighty-five year track record in our U.S. indexes, about forty years internationally and about twenty-five years in the emerging markets, and when you take a look at, you know, withdrawing, what if you had 100%, or close to it, in stocks, and you went through 2000, ’01 and ’02, or ’08 and ’09, even going back to 1973 and ’74, and just at the risk of oversimplifying this, you get some real heinous, some very bad outcomes if you have too much money in stocks in a retirement and you’re taking withdrawals. So, really, you know, there’s some overused phrases, but in retirement, it’s about just hitting the ball, hitting singles, hitting doubles. A lot of people are going in loaded for bear. They have 100% in stocks. They start taking withdrawals out, and a lot of very bad outcomes. We see it, unfortunately, all the time.

David Bear:  Well, speaking of time, let’s take one more break.

BREAK TWO

David Bear:  And welcome back to The Lange Money Hour, with P.J. DiNuzzo and Jim Lange.

Jim Lange:  So, P.J., one of the things…there are three specific situations that I want to cover in the asset allocation area: one is if people have Social Security income or will be receiving it shortly, the second is if there is pension income, and third, income from another source such as rental property. But I know that there are an awful lot of things that you do in the asset allocation area that I haven’t even asked about. So, if I can kind of throw out an open-ended question, and assuming we have time, we’ll get back to Social Security, pension and income from other assets, or other income sources. What are some of the things that I haven’t brought up that you think is important in the asset allocation area for our listeners?

P.J. DiNuzzo:  Yeah, Jim. We had touched on these collectively, but it’s just such a broad topic. I was just thinking, I want to make sure that I mention a couple of other staples in the asset allocation conversation. One would be, as you were developing your asset allocation, you would want to run off of a game plan or a blueprint. That would be your investment policy statement. So, we have investment policy statements for every client, and that’s identifying, again, the account types, what the allocation’s going to be, what the purposes are, etc. So, that’s really going to drive the whole process, the investment policy statement, so everyone’s on the same page. Then, as you mentioned, time horizon is directly tied in and sort of sewn at the hip with the asset allocation into the exposure to equities in our comfort level, our potential success rates, etc. When we take a look at the investments, we talked earlier about diversification, and our key aspects there, as you had mentioned, Jim, were the expected rate of return along with the commensurate risk in a portfolio, so increase in the return, while lowering the risk. And also, the correlation of these assets, and that gets me back, again, I know we talked about the indexes a lot. We haven’t touched as much today, but you know, where else can you find a better estimate moving forward than what these market premiums have been doing, capturing them with eighty-five year track records, and knowing what these correlations have been. The other benefit we have on our side, Jim, we take a look at…you know, we’re always building at least a thirty-year time horizon for clients once both spouses typically have retired. So, we always want to build at least a thirty-year plan for individuals once they have retired.

So, with that being said, we start to bring on the benefits of what I refer to as time diversification. Yeah, a 50/50 portfolio…let’s even say somebody grows more a 70/30 portfolio, we all know there’s approximately, you know, we have one bear market on average every five years where the market’s down at least 20% to 25%, and we know we’re going to go through those, but then again, what are the probabilities, the benefit of diversifying with time, that that portfolio’s still not going to get closer to its long-term averages over three years or five years or ten. I mean, you start taking a look at these over the last eighty-five years, rolling five-year averages and ten-year averages, it’s very, very encouraging because we have time on our side. The other one I wanted to mention, the big picture was, you’ll hear a lot, the audience will hear people talk about strategic asset allocation versus tactical, tactical we could sort of cross our fingers. You know, it’s sort of like voodoo. We would say tactical is market timing, and there’s just a ton of that that goes on out there. We don’t do any of that, nor would we recommend that you would expose yourself to that. We would say do your homework in the front end, set these asset allocations, and then, as Jim and I have been talking about, the portfolios that you’ll be taking withdrawals from, set those on a glide path so that they’re age appropriate, risk appropriate, withdrawal appropriate. A final reminder, I think, Jim, always is when you’re building these portfolios, low fees, low expenses. You had the honor and pleasure of interviewing Jack Bogle a couple of months ago, face to face, at the headquarters out at Vanguard on campus, and if there’s one thing that Mr. Bogle’s talked about, it is low fees, low expenses. It seems real common sense, but one percent lower fees and expenses for you and your family for the listeners equals one percent more total return for you over time, and you’re just not going to find low fees and expenses across the board with active funds the way that you will with the indexes that are available.

Jim Lange:  All right. And I still want to get to Social Security, pension and income, but one thing that we haven’t mentioned today, which according to Bernstein, accounts for at least half a percent of performance, is we haven’t talked about rebalancing.


9. Rebalancing

P.J. DiNuzzo:  Yes.

Jim Lange:  Can you tell me a little bit about why rebalancing is important, and how you do it for your clients?

P.J. DiNuzzo:  Yes, actually, I spent a couple hours on rebalancing today. As a lot of listeners will know, you know, a lot of the capital gain dividends and distributions will hit the first or second week in December for most mutual funds, and we’ve had a phenomenal year with U.S. large value index, our U.S. small cap index with DFA, and our DFA U.S. small value. So, I’ve just been going through hundreds and hundreds or portfolios, giving those three asset classes that were up in the mid 30% range this year a haircut, and adding those to the underperformers, or ones that hadn’t grown as much, and that’s one of the most common questions that I get asked, Jim. I’m glad you brought that up with newer clients the first year or two. You know, the common sense question would be well, P.J., why are you selling something that’s made 35% this year? You know, for example, I’ve been buying a lot of emerging markets recently, and it’s down about 4%. So, it just doesn’t make sense intuitively. Why are you selling something that’s up 35% and buying something that’s down 4%? But because you’ve got all these extraordinarily long databases, we have statistical levels of confidence, in plain English, we expect, and they always have, these areas that snap back to their long-term averages, and as we could expect, I mean, over the rest of our lives and all the listeners’, emerging markets will make the most money, they have an extraordinarily high probability of doing that. So, we’re really excited about buying in while it’s low right now, and that’s where you get the one-half of a percent from, from having a disciplined strategy that forces you to sell high and forces you to buy low, the hardest thing to do in trading.

Jim Lange:  Right. That’s the key.

P.J. DiNuzzo:  Yes.

Jim Lange:  And it’s not market timing, it’s rebalancing.

P.J. DiNuzzo:  Rebalancing.

Jim Lange:  And it’s basically sell high and buy low.

P.J. DiNuzzo:  It forces you to.

David Bear:  And you’re buying low with money that you made from selling high?

P.J. DiNuzzo:  Exactly, yeah. And we’re maintaining a risk profile in a portfolio…

David Bear:  Right.

P.J. DiNuzzo:  …because if you let a portfolio go in stocks grow, if you were 50/50, a lot of times, just a couple years later, you could be 70/30…

David Bear:  Right.

P.J. DiNuzzo:  …because your stocks have grown and the bonds haven’t really done much.


10. What Changes your Asset Allocation?

Jim Lange:  And I know that you have formulas that you, in effect, either do that automatically or you are alerted to it, and then you take a look. And again, we could spend a lot more time on any one of these, but the two areas I really wanted to talk about before we close out is how you change the asset allocation when people have a certain existing income, such as a pension or Social Security. So, let’s say, for discussion’s sake, that somebody, a couple is getting $30,000 or $40,000 or even $50,000 in Social Security. Do you ever say, okay, well, in order for them to get $50,000 in Social Security, that would be like having an enormous bond. So, depending on what interest rates you think bonds are getting these days, you know, it might be, let’s say, even a 2 1/2%, or a $2.5 million bond earning 2% would give you $50,000. So, do you ever say, “Okay, well, since you’re getting Social Security at $50,000, that’s kind of covering a certain bond portion, or fixed income portion, of the portfolio.”

P.J. DiNuzzo:  No, Jim. In our practice, we don’t substitute any type of fixed income streams such as that for a bond position. Now, one thing that would allow us to do the higher the Social Security is, and/or the addition of the pension income, defined benefit pension income, would allow us to satisfy that need bucket and would put us into…so, instead of 30% in stocks, now we’re starting off with a bucket with 50% in stocks. So, it would allow us to have overall more growth in the total portfolio when we looked at it, but we don’t trade that off one for one as a bond position.

Jim Lange:  Okay. You’re not trading it off one for one, but the fact that somebody has $50,000 of income coming in, and they only need $10,000 in their portfolio to make their $5,000 a month, and you’re sitting on a million dollars, then that money would be invested significantly differently if that person had, say, no, or even a $10,000 or $20,000 Social Security. Is that correct?

P.J. DiNuzzo:  Yes. Everything else being equal, that would allow us to have materially more growth in their portfolio, yes.

Jim Lange:  All right. And is the same thing true for a pension? That is…and I realize that not every pension is 100% secure, but would it also be looked at as okay, that pension is going to provide a certain amount of cash flow. Often, it might be combined with Social Security. That’s going to take care of some of the short-term needs. Therefore, we can have more money in some of the longer-term funds, etc.

P.J. DiNuzzo:  Yeah, Jim. In my practice, I mean, our team of wealth managers at our practice, we look at defined benefit pension income being synonymous with Social Security. We’ve lumped that under, what we refer to as the guaranteed income category. So, yeah, we look at that as being synonymous with Social Security.

Jim Lange:  All right. And would it be the same thing if somebody has, let’s say maybe somebody has a rental property? And yes, expenses certainly go up and down with rental property, but there is some type of relatively predictable cash flow stream. Would you think of that in terms of cash that is available that doesn’t have to come out of the portfolio, and therefore, it would change the asset allocation?

P.J. DiNuzzo:  Yeah, that is correct, Jim. We have a lot of clients who have, you know, maybe one or two smaller apartment units, for example. We run into that a lot around southwestern PA, extraordinarily long rental track records, or they’re keeping the properties up. So, if they’ve got a strong track record, if it’s a quality property, if the occupancy rate has been, you know, been really strong over the years, we’ll look at that as, again, being synonymous with the Social Security and pension income, as well.

Jim Lange:  All right. And maybe this isn’t fair, but I’ll ask it anyway: so, let’s say that somebody does have some properties in western Pennsylvania (let’s assume that they’re local). Would that have a tendency for you to say, “Well, since you have properties, or even since you have a significant investment in your house, I’m going to shave, or reduce, the asset allocation component of the real estate.”

P.J. DiNuzzo:  We still like to have the real estate in a portfolio, but we do, that is one area where we do allow a degree of subjectivity to the individual to their comfort level. We’ve had clients, and we have clients currently, who have multiple millions of dollars, they may have one or two million dollars in real estate, and they’ll say, “You know, I really don’t want to add onto that with a $75,000 or $100,000 additional into the real estate stock index. So, I’ll keep my physical real estate, and then we’ll adjust the portfolio accordingly.”

Jim Lange:  All right. And the one last thing that I will say is, P.J., it is really a pleasure doing business with you. You know, one of these days, I’m going to get somebody on a lie detector test, and in front of the world, say that I think the combination of you doing all the work that you do combined with the asset allocation, and particularly, for low-cost index investors, and the combination of our firm is I believe the best one that I know of all of the thousands of arrangements that I know of.

David Bear:  Well, with that, let’s call this end to The Lange Money Hour. Thanks to P.J. DiNuzzo. You can reach him directly at his website, www.dinuzzo.com. Thanks also to Dan Weinberg, our in-studio producer, and Lange Financial Group program coordinator, Amanda Cassady-Schweinsberg. As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can also access the audio archive of past programs (including written transcripts), on the Lange Financial Group website, www.paytaxeslater.com under ‘Radio Show.’ While there, check out the series of short videos from Jim’s interview with John Bogle, founder of the Vanguard Group. You can also call Lange offices directly at (412) 521-2732.

END

 

 

jim_photo_smJames Lange, CPA

Jim is a nationally-recognized tax, retirement and estate planning CPA with a thriving registered investment advisory practice in Pittsburgh, Pennsylvania.  He is the President and Founder of The Roth IRA Institute™ and the bestselling author of Retire Secure! Pay Taxes Later (first and second editions) and The Roth Revolution: Pay Taxes Once and Never Again.  He offers well-researched, time-tested recommendations focusing on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, and intricate beneficiary designations for IRAs and other retirement plans.  Jim’s advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, his recommendations frequently appear in The Wall Street Journal, and his articles have been published in Financial Planning, Kiplinger’s Retirement Reports and The Tax Adviser (AICPA).  Both of Jim’s books have been acclaimed by over 60 industry experts including Charles Schwab, Roger Ibbotson, Natalie Choate, Ed Slott, and Bob Keebler.

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