Asset allocation, flexibility and retirement

Too many investors focus on absolute returns and less on relative return or their net return after taxes

Do you know the difference between asset allocation and asset location? Asset allocation, based on years of economic research, is intended to help hedge the risk on your investments by efficiently dispersing them across diverse asset classes.

Asset location, or what we call tax efficiency in our practice, is the strategy used to structure your assets to efficiently optimize the return on your investments in the real world, where taxes are likely to be any investor’s greatest lifetime expense.

Yet, this simple distinction between these two vital concepts is one that too many investors and far too many advisers don’t understand. (In my opinion, to their detriment.) One striking aspect I have observed over the years is that too many investors and advisers neglect how asset location and asset allocation should work together to help maximize returns while minimizing taxation.

When properly executed, this collaboration can make a huge difference in the long run. The great economist John Maynard Keynes said “the importance of money flows from it being a link between the present and the future,” and how that future unfolds depends, in part, on the effectiveness of asset location.

Too many investors focus on absolute returns and less on relative return or their net return after taxes.

This topic is important because I believe asset location and the importance of tax planning will become crucial in the coming years. The current tax-cut rates enacted beginning in 2001 are set to expire, and political and economic realities will change the tax code.

If we are lucky, this will result in a less complex and more straightforward tax code that will help and allow people to plan accordingly. We probably won’t get a less complex tax code, but regardless of one’s political views, taxes are unlikely to move lower, in my view. With significant numbers of baby boomers stepping up to retirement each day, the goal is to get ahead of this wave and not get swallowed up in it as one attempts to efficiently draw on their nest egg.

Diversified efficiencies

As a virtual chief financial officer for many of the families we serve, we are trained to pay close attention to Modern Portfolio Theory (MPT) and attempt to optimize risk and return across a broad array of assets in strategies uniquely designed for our client’s investment policy, risk profile and plan.

We also acknowledge that MPT has its flaws, especially when the market becomes unhinged and slips into a crisis (1929, 2008, for example), and assets become highly correlated. Proper allocation does not insure against risk or loss but may provide a greater sense of "insulation" from market events.

On the other hand, we can guarantee that taxes will likely be a significant portion of most investors’ future expense.

Investors who do not create diversified tax efficiencies in their long-term plans may find themselves hit with much greater tax burdens than they expected or needed to pay in later years. I’ve cautioned previously that there is often confusion about the benefits and mathematics of “tax deferral,” because sometimes a tax-deferred account or investment only defers one from paying potentially more down the road — which, in fact, may not always be to an investor’s advantage.

For example, if a sleeve of income-earning bonds or high-yield bonds is part of an investor’s overall allocation, should these holdings be held in an individual’s taxable or tax-deferred account? Why does it matter? What is the cost differential if done improperly? These are questions investors should ask and advisers and tax counsel should answer.

Nothing makes me crazier than when we take on a new client with his prior adviser’s “hot strategy du jour” that crashed and the position is held in an IRA account. This results in not one but two lost opportunities. First, even if the strategy had worked, the client would have likely paid more taxes when he needed the eventual distribution from his IRA. Secondly, and even more painfully, the loss cannot be written off for tax purposes, since it is held in the IRA. Mitt Romney's $100 million IRA may be the envy of many, but take a moment to reflect on its future tax burden as ordinary income.

Though too many investment products from Wall Street reek of rocket-science complications, the steps for successful asset location are similar to asset allocation. Its key is about the honest assessment of risk and long-term lifestyle goals with a keen eye on expense control and tax efficiency in the process.

From our experience, those who are happiest in retirement are those who have the greatest flexibility in their future sources of cash flow with the lowest tax burden available. Once these options are explained, boomers and their advisers can and will understand the subtle changes that can have significant, long-lasting effects.

Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000.