How our portfolio will change as we approach financial independence

Our portfolio requirements, as with most investors, will change throughout our lives. This is a result of our life circumstances and risk tolerance gradually evolving. As a result, our asset allocations will need to change to suit. For a look at our current asset allocation, please refer to this post.

General requirements for portfolios
I’m an advocate for looking at your entire financial position holistically. Having an investment portfolio is a result of spending less that you earn. Some of the general reasons why someone would want to build an investment portfolio include:

  • Saving for larger expenses such as a house
  • Saving for unexpected expenses
  • Having money to fund your cost of living if/when you do not have employment
  • Provide them with financial freedom to give them more control over their time

Of course, from the title of this blog, you already know what is our most important reason for building an investment portfolio. For the purposes of this post I will break down the investment journey into a couple of distinct phases which will be referred to as the accumulation phase and the draw down phase. 

Accumulation phase
This is the phase we are currently in; it’s a time when the primary goal is to increase the size of the portfolio equity in a risk appropriate manner. For the majority of household’s, us included, the capacity to take risk is highest during this phase because at least one of the household’s members are working. Because there is no reliance on the portfolio for income, portfolio volatility can be high. If a household’s risk tolerance allows then leverage can also be considered. Taxation can be a significant drag on portfolio growth rates so it’s important to try to invest in a tax efficient manner. Our current strategy is to choose assets that prioritize capital growth over distributions in order to minimize taxation.

Draw down phase
This is the phase where a household does not make enough money through employment to fund their cost of living. As a result, the primary requirement for a household’s portfolio is as a source of income. Income volatility should be low which generally implies that, as a secondary objective, overall portfolio volatility should also be low. However, it should be noted that in some cases income stability can be achieved with higher levels of portfolio volatility. A tertiary objective of portfolio construction is to reduce taxation on distributions.

What would our financially independent (draw down phase) lives look like?
When constructing portfolios, it’s very important to consider what you want your life to look like. Factors to consider are things like:

  • How comfortable are you with portfolio volatility? Will it affect your actions to deviate from your plan? Are you comfortable with it from an emotional stand point?
  • What sort of, and how much effort, are you willing to exert to manage your portfolio? This especially relates to things like direct investment in property vs REIT’s, if you like spending your time managing property or doing physical work on it then direct investment could be for you. Or, if you prefer a more ‘hands off’ approach then perhaps REIT’s are more suitable.
  • Will you be earning an income whilst financially independent? As we know, work has many positive benefits besides earning money and many of the ‘retired’ FIRE bloggers out there actually still have paid employment.

At the FFE house our draw down phase likely to look something like this:

  • We will probably still do work that is meaningful us, albeit sporadically, with far less hours overall. I’d estimate that we would earn around $20,000 per year each, pre-tax. We’d likely achieve this by doing a few consulting jobs each year.
  • Our portfolio will have approximately $1.3m worth of equity outside of superannuation. Superannuation has not been considered in this post as we will be too young to access the funds.
  • To meet our remaining cost of living (approximately $60,000) we’d need to withdraw another $20,000 per year from our portfolio, which equates to a 1.54% withdrawal rate – for the purposes of this post let’s assume some lifestyle inflation and boost it to a 3.0% withdrawal rate which equates to $39,000

Options

So, given our portfolio requirements during our draw down phase and what our lives are likely to look like what options are available to us?

Option 1: Maintain current asset allocation
If we did this, we would stop automatically re-investing our distributions and take them as cash payments. Because our funds typically only have distributions of about 2.6%, we’ll need to sell down 0.4% of our portfolio in order to make the 3.0% withdrawal rate.

Advantages

  • There is no rebalancing cost to be paid upfront, which means we are only taxed on the capital gains from the sale of 0.4% of our portfolio. 
  • Because this asset allocation is fairly risky there is a high potential for long term portfolio growth after inflation, if we assume a raw growth rate of 7% with inflation at 2% then the real growth would likely be around 2% (7% – 2% – 3% = 2%)

Disadvantages 

  • Because we need to sell units of our portfolio, we will be decreasing the size of our asset base owned over time, this presents emotional issues when selling during a market down turn.
  • In the event where consulting work is unavailable, we will need to withdraw 4-5% of our portfolio to meet our living costs (assuming the equity does not change). This means that we will need to liquidate between 1.4% and 2.4% of our portfolio each year.
  • In its current state the portfolio is reasonably volatile; in the event where a market down turn halves portfolio value, withdrawal rates could increase to as high as 10%. Depending on the sequence of such returns this could greatly reduce the probability that our portfolio lasts the remainder of our lives (40-50 years).


Option 2: Hold a 3 to 5-year cash and bonds buffer
This would be similar to the above strategy except instead of only holding 5 months with of living expenses as we currently do, we would hold a about 3 to 5 years with of cash and bonds in our portfolio. This equates to about $250,000 worth of cash and bonds. The rationale behind this is that over the last 11 market crashes it has taken on average 2.73 years for the market to regain its previous high. To achieve our required income, we would sell our down shares and take distributions during the years when the market grows and would live off our cash and bonds during market down turns. We would achieve this mix by spending the last 2 to 3 years of our accumulation phase exclusively investing in cash and bonds using our new funds.

Advantages

  • As with the previous option there is no rebalancing cost to be paid upfront. The only taxes will be on the ~2.6% portfolio redemptions – less if living off cash savings.
  • Overall portfolio volatility is lower than in the first scenario
  • Less requirement to sell units during the first market downturn

Disadvantages

  • Creating the selling rule adds complexity as there is a need to monitor the market and portfolio performance.
  • After a market downturn is survived and cash savings are depleted, assets will need to be sold to rebuild the cash buffer which will trigger taxation.
  • Interest on the cash will attract taxation during the accumulation phase which blunts overall portfolio growth
  • Because of the larger cash portion of this portfolio, the portfolio will be more heavily affected by inflation


Option 3: Add assets with higher distributions
A 3rd option is to tilt the asset mix towards assets with higher distributions such as dividend paying shares; listed investment companies (LIC’s); or REIT’s. In the case of companies that pay a franked dividend, franking credits can help to increase the gross yield. Assuming a 5% payout rate, to achieve $39,000 p.a. in total distributions we would take some distributions from our current portfolio (which has a distribution rate of about 2.6%) and the remainder from our high distribution assets. This would require about $220,000 worth of high distribution assets and $1.08m of our standard funds. To do this we would need to figure out a tax efficient rebalancing strategy as selling $220,000 during our accumulation phase would likely trigger a sizeable capital gains tax bill.

To be more specific, assuming a cost of capital of $150,000 and a holding time of greater than 1 year the capital gains would be:

Because the portfolio is owned at a 50/50 split between myself and my wife, we would each be adding $35,000/2 = $17,500 to our taxable incomes. Assuming that we are in the 39% tax bracket (37% tax bracket + 2% medicare levy) this represents a $6,825 tax bill each ($13,650 total).

Ideally this rebalancing would take place after we stop earning a full-time income which would place us in the 21% or 34.5% tax bracket however, the time period over which this actually happens needs to be flexible given that future market conditions would likely influence rebalancing and retirement dates.

Advantages

  • Much less need to sell portfolio units during the draw down phase
  • Likely to be more resilient to high levels of inflation due to having less cash

Disadvantages

  • The portfolio would be more heavily biased towards Australia which represents a higher country specific risk
  • We are relying on government policy to maintain franking credits.
  • Company dividend yields are likely to be maintained however the overall value of the distributions moves according to the share price
  • If not handled properly, this strategy will result a large amount of taxation

Combining all 3 strategies

After thinking about each of the strategies above I can say that a mix of option 2 and 3 will meet our objectives and risk tolerance best. The cash and bond components are expected to reduce portfolio volatility. The property securities, LIC holdings and bond trust will be used boost the value of distributions. The resulting portfolio asset allocation will probably look something like this.

Notes:
Argo Investments’ grossed up yield is calculated by using annual yield of 3.8% with 100% franking (ASX 2020)
Dividend yields are calculated using the average c/unit fund distributions divided by the redemption rate for 2018 through to 2020 (Dimensional 2020)

The key challenge will be achieving this mix with minimal taxation cost. This will likely mean that we would need to spend the last 3 years of our accumulation phase diverting all new investment funds into listed investment companies, cash and bonds. Then, at the start of the draw down phase we would sell the required units of our existing holdings in order to rebalance our portfolio.

Household take home income after tax
Assuming that the full amount of the distributions is taxable and distribution rates are the same as they are today then for each of us we will have the following situation:

As you can see, this solution, which includes part time work for both us, provides plenty of after-tax income along with a considerable buffer for downward changes in distributions.

Portfolio ownership ratio
In terms of reducing taxation on distributions it’s best to have the majority of the portfolio ownership under the income earner that occupies to the lowest tax bracket. This will likely depend on which of us intends on continuing full-time work as we approach our financial independence portfolio value. As a result, this is something that will need to be assessed closer to date.

Concluding thoughts
In conclusion the major objectives of our portfolio during the draw down phase in order of importance are:

  • Provide us with a reasonably stable source of income to fund our living costs
  • Have a stable equity value to support income stability
  • Minimize taxation

Our current plan is to achieve these objectives through the addition of international bond fund units, listed investment companies and increasing our cash allocation; which we will acquire during the last few years of our accumulation phase. We will rebalance during the first couple of years of our draw down phase in order to achieve the required asset allocation.

Engineer your freedom

References

Zack, 2018, Here’s How Long the Stock Market has Historically Taken to Recover from Drops, Four Pillar Freedom, viewed 27/10/2020, <https://fourpillarfreedom.com/heres-how-long-the-stock-market-has-historically-taken-to-recover-from-drops/>

ASX, 2020, Argo Investments Limited ARG, ASX, viewed 28/10/2020, <https://www2.asx.com.au/markets/company/ARG>

Vanguard Investments, 2019, Vanguard International Property Securities Index Fund, viewed 28/10/2020, <https://www.vanguardinvestments.com.au/retail/ret/investments/product.html#/fundDetail/wholesale/portId=8115/?prices>

Dimensional, 2020, Australian Core Equity Trust, Dimensional Fund Advisors, viewed 28/10/2020, <https://au.dimensional.com/funds/australian-core-equity-trust>

Dimensional , 2020, Global Core Equity Trust Hedged Class, viewed 28/10/2020, Dimensional Fund Advisors <https://au.dimensional.com/funds/global-core-equity-trust-aud-hedged-class>

Dimensional , 2020, Global Core Equity Trust Unhedged Class, viewed 28/10/2020, Dimensional Fund Advisors <https://au.dimensional.com/funds/global-core-equity-trust-unhedged-class>

Dimensional , 2020, Global Bond Trust AUD Class, viewed 28/10/2020, Dimensional Fund Advisors <https://au.dimensional.com/funds/global-bond-trust-aud-class>

ATO, 2020, Individual income tax rates, ATO, viewed 29/10/2020, <https://www.ato.gov.au/rates/individual-income-tax-rates/>