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An investor’s allocation to stocks and bonds is often the most consequential investment decision he or she will make. But the practice of translating investment risk into a stock to bond ratio is fraught with misunderstanding.
This is due in part to the impact of taxes on tax-deferred accounts, but even more so to assets and liabilities not shown on the typical investment statement. Put another way, if I say I have 40% in stocks, I’m describing the numerator of a fraction. But what I haven’t said, and often haven’t considered, is the denominator.
To explain, let’s consider a 60-year old single retired client who has a brokerage statement showing a $1 million portfolio, with $400,000 in a global stock index fund held in a taxable account and $600,000 in a short-term Treasury bond fund held in a tax-deferred IRA account. Her plan, which appears reasonable given her income and expenses, is to supplement her retirement income solely through withdrawals from her IRA, while leaving her stock fund held in the taxable account untouched so that it can be passed on to her heirs tax free at a stepped-up basis.
What is her stock/bond allocation? Let’s look at some versions of the answer.
1. As stated in black-and-white on her brokerage statement, she has a stock/bond allocation of 40/60. Following the dictum of “your age in bonds” mentioned by her advisor, this allocation seems exactly right.
2. However, if one discounts the $600,000 of tax-deferred bonds at their after-tax value (assuming a 33% combined federal and state tax rate) she really has only $400,000 in bonds that’s “hers.”So it might be more accurate to say that she has an after-tax allocation of 50/50. Presented this way, it seems a bit riskier to her, but in reality it is the very same portfolio described in #1 as 40/60.
3. This client then decides to use $400,000 of her bond assets to buy a single-premium immediate annuity (SPIA). Her next statement correctly reports a reduced total portfolio of $600,000, with the same $400,000 in stocks but now $200,000 in bonds. The statement now reports her asset mix to be a seemingly more aggressive 67/33, though in reality she has not increased her investment risk at all; she may have reduced her risk by transforming part of her bond holdings into a life-long stream of guaranteed income.
4. If the post-annuity calculation in #3 were adjusted to its after-tax value, her $400,000 of stocks in the taxable account would remain the same, while her $200,000 of tax-deferred bonds would be valued at only $134,000, for a total after tax portfolio of $534,000 and a stock/bond allocation that would appear to be a quite aggressive 75/25.
5. The client then decides to withdraw $150,000 of the remaining $200,000 of bonds held in her IRA account to pay-off her mortgage balance of $100,000, with the remaining $50,000 to pay the taxes due on the distribution. So on her next statement her total portfolio appears further reduced to $450,000, still with $400,000 in stocks but now with only $50,000 in bonds. Her brokerage statement mindlessly auto-calculates her new allocation to be an extremely aggressive 90/10, and it would be even higher if we tax-adjusted the remaining $50,000 in bonds in the tax-deferred account. (Don’t worry about this client’s loss of liquidity. She took out a reverse mortgage line of credit to provide for unforeseen needs.)
Through all these versions the client has maintained the same exposure to stocks – $400,000 – and therefore she’s maintained the same level of investment risk. If the stock market drops 50%, in all versions she will experience the same paper loss of $200,000. This is despite the fact that her apparent stock/bond allocation could be described in these various versions as 40/60, 50/50, 67/33, 75/25, and 90/10.
If the circumstances described in #1 and #5 were two different people discussing their risk tolerances over lunch, #1 might be horrified to hear that #5 was taking so much risk by holding 90% in stocks while she was more conservatively holding only 40%. But if they dug deeper, which often never happens, they would see that their exposure to investment risk was essentially the same.
Net household wealth is more important than how much of this wealth is sitting in an investment account. But while this is obvious, it gets easily and frequently overlooked when a client, or even an advisor, is staring only at the number of investable dollars and how they are allocated by percentage.
Barry Wasserman is retired mental health professional and now a volunteer retirement counselor.
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