Note: CFP CE Quizzes may generally only be taken twice, so please plan your answers accordingly. If a technical problem occurs during your quiz and you need the quiz to be reset to take it again, please contact firstname.lastname@example.org.
For instance, while the traditional asset location strategy “rule of thumb” is that tax-inefficient bonds go into an IRA, while equities eligible for preferential tax rates go into a brokerage account, the reality is that for investors with long time horizons the optimal solution may be the opposite. Once stock dividends and portfolio turnover are considered, the ongoing “tax drag” of the portfolio can be so damaging to long-term returns that placing equities into an IRA may be more efficient, even though they are ultimately taxed at higher rates!
In fact, it turns out that almost any level of portfolio turnover will eventually tilt equities towards being held in IRAs given a long enough time horizon (and especially while today’s low interest rates result in almost no benefit for bonds to gain tax-deferred growth inside of retirement accounts). Which means in the end, good asset location decisions depend not only on returns and tax efficiency, but an investor’s time horizon as well!
For the past several decades, asset allocation has been the cornerstone of portfolio design, with a focus on diversification and the addition of non-correlated investments to the portfolio to reduce overall volatility and improve risk-adjusted returns. This trend has been accelerated in recent years, as weak returns in both bonds and stocks have helped to fuel a drive towards “alternative” investments that further increase the intended diversification and the number of asset classes in the portfolio.
Yet running in parallel with this trend has been the rise of various types of tax-preferenced accounts, with first the IRA and 401(k) and more recently the Roth IRA and Roth 401(k), in addition to the ongoing presence of tax-deferred annuities and the standard taxable brokerage account. As a result, a new challenge is beginning to emerge: the question becomes not only which asset classes should be owned and in what amounts, but also where should those asset classes be held? In other words, it’s not just about allocation of the assets to build a diversified portfolio now, but also about the locations in which to place those diversified investments.
Given that recent research has shown effective asset location strategies can add 20-50+ basis points of “free” value to annual returns, providing guidance on asset location is becoming increasingly popular. Yet unfortunately, asset location strategies are often dominated by myths and misperceptions! Ultimately, the reality is that good asset location decisions actually should be influenced by both the tax efficiency of investments and also their expected returns, which makes the analysis somewhat more complex… but also reveals why in today’s environment most bonds actually should NOT go into tax-deferred accounts!
For the past 40 years, variable annuities have been on a rollercoaster, where the popularity of various features and benefits rise and fall as the contracts shift and adapt to the then-current environment. In the early years, variable annuities were popular for tax-deferred investing as top tax rates of the time were 70%, and remained popular in subsequent years as the burgeoning bull market made equity investing more appealing overall, even as tax rates declined. As the 2000s approached, variable annuity companies innovated, creating a wave of so-called “living benefit” riders that included GMIBs and GMWBs, to make variable annuities appealing to the coming onslaught of baby boomer retirees. Unfortunately, though, with the financial crisis, living benefit riders became far less appealing – old contracts forced annuity companies to raise reserves, and new contracts experienced a significant cost increase as annuity companies struggled to hedge and manage risk in a more volatile post-crisis environment.
As a result, annuity companies are now entering a new wave of innovation – where variable annuities are bolstered by more innovate active management and alternative investment strategies, and the annuity itself is used as a tax shelter for these rather tax-inefficient investments, at a drastically lower cost than the annuities of recent years. Whether this new line of investment-only variable annuity (IOVA) contracts will catch on remains to be seen, but the potential is for variable annuities to become a major part of portfolio design in the future – where the variable annuity becomes an asset location tool and clients can voluntarily choose how much of their most tax-inefficient investments will be sheltered by tax deferral.
For retirees who are more concerned about running out of money in retirement than leaving a large inheritance behind, the optimal retirement asset allocation strategies shift from focusing on wealth maximization and owning as much in equities as you can tolerate (to provide the greatest return on average), to approaches that do a better job of preserving wealth in adverse scenarios (even if it costs excess upside when times are good).
This retirement approach of focusing on minimization to spending risks over maximization of wealth accumulation has led to a wide range of retirement asset allocation and product strategies, including the use of annuities with guarantees, bucket strategies with cash reserves, and most recently the “rising equity glidepath” approach where portfolios start out more conservative early in retirement and become progressive more exposed to equities over time as bonds are spent down in the early years.
The caveat of risk minimization strategies, though, remains the simple fact that most of the time, they turn out to be unnecessary, as the risky event never actually manifests. As a result, tools like Shiller CAPE that allow advisors to understand whether clients are more or less exposed to a potential decade of mediocre returns (which brings about the “sequence-of-return risk” in retirement) can be remarkably effective at predicting when it’s necessary to focus on risk minimization in the first place, and when wealth maximization may be the more prudent course.
In fact, as it turns out, market valuation measures like Shiller CAPE can actually be so predictive of the optimal asset allocation glidepath in retirement, that the best approach may not be to implement a rising equity glidepath or a static rebalanced portfolio at all, but instead to adjust equity exposure dynamically based on market valuation from year to year throughout retirement. While this kind of tactical asset allocation approach is not necessarily a very effective short-term market timing indicator, the results suggest nonetheless that it can help to minimize risk when necessary, take advantage of favorable market returns when available, and have some of the best of both worlds – albeit with the caveat that markets can still deviate materially in the short run from what valuation alone may imply regarding long-term returns!
The foundation of investment education for CFP certificants is modern portfolio theory, which gives us tools to craft portfolios that effectively balance risk and return and reach the efficient frontier. Yet in his original paper, Markowitz himself acknowledged that the modern portfolio theory tool was simply designed to determine how to allocate a portfolio, given the expected returns, volatilities, and correlations of the available investments. Determining what those inputs should be, however, was left up to the person using the model. As a result, the risk of using modern portfolio theory – like any model – is that if poor inputs go into the model, poor results come out. Yet what happens when the inputs to modern portfolio theory are determined more proactively in response to an ever-changing investment environment? The asset allocation of the portfolio tactically shifts in response to varying inputs!Read More…
This browser is no longer supported by Microsoft and may have performance, security, or missing functionality issues. For the best experience using Kitces.com we recommend using one of the following browsers.