Financial Retirement Planning: Principles to Guide Decision-Making A savvy look at organizing your portfolio for maximum returns, including how to reduce sneaky expenses.

Reading Time: 5 minutes

You can plan to spend 37% of your life retired from the day you turn 21 until the day you die, which is approximately 41 years of work to fund 24 years of unemployment. It’s a challenge richly endowed with uncertainty. What follows addresses principles that lead to things you can do to quell the uncertainty and improve your financial retirement planning success:

  • Asset allocation, diversification, and minimum variance are three related topics central to successful retirement and investment planning. You’ll read here what you’ve probably never heard about allocation and diversification. 
  • Investment expense (including taxes) might be the single greatest threat to retirement plans. The solutions described here are easy to implement.

1. Allocation, Diversification, and Minimum Variance

Academia and the investment industry confuse investors about the meanings of asset allocation and diversification. These words – asset allocation and diversification – aren’t just academic; the difference between them matters for investors who are serious about managing investment risk. 

The confusion might originate with the Investment Company Act of 1940 which, in part, defines diversified management companies (i.e., diversified mutual funds) as those whose total investment value is represented by not more than five percent of one issuer’s securities. For example, a corporate bond mutual fund with a total value of $1 million would be considered “diversified” if no single corporation’s bonds represented more than $50 thousand of the fund’s total value. This definition of “diversified” is based on allocation breadth. 

This “allocation breadth” idea is what most people think about when they think about diversification. However, instead of basing allocation on issuer representation, investors usually think about the representation of asset classes like stocks and bonds. It’s a quantifiable idea and it’s simple even though it confuses allocation and diversification. 

Let’s put asset allocation in its proper place: Asset allocation addresses the “don’t put all your eggs in one basket” adage. It’s the best-known protection against a bankruptcy in a portfolio, it’s been practiced since ancient times, and it’s even alluded to in the Bible and the Babylonian Talmud. But broad allocation doesn’t make a portfolio diversified. It’s just broadly allocated. Diversification in your portfolio, despite what the 1940 law says about mutual funds, is about reducing variation in returns, not about reducing the impact of a bankruptcy. Diversification is about combining low-correlated assets in a portfolio. For example, combining real estate and common stock holdings can create diversification because their returns tend to have low correlations.

A fairly new method can simultaneously address the eggs-in-the-basket thing, help maximize diversification, and keep volatility low. The method is called “minimum variance,” where “variance” is the statistical metric for variations in returns. The terms “variance” and “volatility” are often used interchangeably. Minimum variance portfolios are available through mutual funds and exchange-traded funds. Some of the leading sponsors of minimum variance mutual funds include Fidelity, SBI, and Vanguard. The argument favoring the use of mutual funds, especially managed mutual funds, is a tough one to win because unmanaged exchange-traded funds (ETFs) often outperform mutual funds because of their lower costs and superior tax efficiency. Some of the leading minimum variance ETF providers include Fidelity, Invesco,  iShares, and State Street Global Advisors. ETFs offer an excellent way to manage investment expenses so it’s useful to devote a few paragraphs to the factor that might be the greatest threat to your retirement plan. 

2. The Expense Threat

Investment expense is different from other kinds of expense. When you buy a vehicle and decide to pay extra for accouterments, you figure they confer benefits worth the additional expense. However, investment expense works against your investment objective because higher investment expense fails to confer additional benefits and the effect is insidious because of expense compounding. Here’s why: Money you would otherwise invest pays for investment expenses.

What’s the big deal here? Everybody knows if you invest, you expect a positive return. However, if you fund investment expenses with money you would otherwise invest, you lose not only the money to fund the expense but the growth it would have earned if it had been invested. Therefore, the value of investment expense is more than its nominal amount. For example, a $1,000 expense-free investment that grows 7% per year equals $7,612 after 30 years. If a financial adviser and other investment expenses total 1% of investment value per year, then the net investment growth rate is only 6%. After 30 years, the value after expense equals only $5,743, a difference of $1,869. The expense represents a whopping 32% of the final net investment value. This is not an extreme example. It’s typical, and for many retail investors, it’s conservative. 

3. Other facts exacerbate the expense problem:

4. Fund expenses, investment management fees, and taxes represent the three biggest expense sources.

  • The best way to keep fund expenses down is to use ETFs instead of alternatives like mutual funds and insurance products. 
  • As for investment management fees, few investors realize the fees are almost always negotiable; don’t let a financial adviser charge an asset-based fee as high as 1% per year.  
  • Tax-sheltered plans help with tax expenses. Traditional IRAs defer taxes, and Roth IRAs exchange future taxes for the payment of tax when the income is earned. Employer-sponsored plans offer the same tax benefits, but employees usually have less discretion over investment funds.

Because many people use employer-sponsored plans, it’s useful to address a couple of their unique issues.  

5. Navigating Employer-Sponsored Plans

On one hand, some employer-sponsored plans – 401k, 403b, 457b, SIMPLE, and a few others – can have too many fund choices. The funds’ objectives and performances overlap, and participants unfamiliar with selecting mutual funds can feel confused. In other plans, the sponsor provides only a few funds, so it’s impossible to participate in markets that can provide valuable sources of growth and investment income. A well-constructed plan should, at a minimum, include investments with exposure to: 

  • Large and small domestic stocks;
  • Real estate investment trusts (stocks of real estate trusts);
  • Domestic corporate bonds;
  • Stock issuers domiciled in developed non-U.S. markets; and
  • Stock issuers domiciled in developing economies.

This is not to say everybody should invest in all of these kinds of investments, nor is this list exhaustive. However, participants who want growth in their investments should have exposure to at least the four stock categories because correlations between their returns are often low; for these investors, bonds are optional. Bonds present an interesting problem. Almost all retail financial advisers suggest all investors, even growth investors, should own bonds to help diversify and stabilize the value of the portfolio during turbulent times. However, growth investors pay a high price for those benefits in lost growth opportunities because bond returns are much lower than stock returns for long-term investors.

One selection tactic uses two steps to select funds in the plan:

  1. Identify the funds with potential to match your objective: growth or preservation.
  2. Within the four or five categories listed above, select the least expensive fund.

6. Final Thoughts About Retirement Plan Allocation

The two steps above tackle expense management and part of the allocation objective but they don’t help with precise allocations among selected funds. One mindless solution equally allocates value to all of the choices after you’ve made your fund selections. Even though it’s mindless, this equal allocation approach has gotten a lot of traction in some of the academic literature because it produces surprisingly large risk-adjusted returns. Another solution uses an online or financial adviser-administered risk-tolerance test to help with allocation specifics. Ruth Lytton and John Grable published one of the more thoroughly evaluated tests.

Digital and online advisers can aid the allocation decision. A couple of the leading digital advisers include Betterment and Wealthfront. Some traditional investment companies like Fidelity and  Vanguard offer these services, too; however, many offer the service only to account owners. A few independent digital or online advisors include Morningstar, Personal Capital, and Sigfig.  Be sure to do your homework before selecting any of these firms so you understand costs and potential benefits.

  1. This estimate is based on average life expectancy of a 21-year-old male and retirement at age 62. According to the Social Security Administration’s life expectancy calculator, a 21-year-old who will retire at age 62 has a life expectancy of 24.1 years after retirement.


Via Unsplash by Aaron Burden.

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