The Compounding Perils of Risk, Fees, Taxes & Withdrawals
It is all too common for investors to chase portfolio returns with very little consideration for the risk taken to achieve that higher performance. Even if they are working with a financial advisor that considers risk-adjusted returns in the plan, many of those advisors don’t integrate fee minimization and tax efficiency into portfolio design. The negative effects of risk, fees and taxes can be extremely harmful to investment or retirement accounts. But if a person is also withdrawing assets from these portfolios, the combined negative toll is compounded four-fold.
If an investor is withdrawing 5% from their assets and there is a 50% market downturn in their portfolio, they will now need 10% of those assets to get the same dollar amount withdrawn previously. If they also need to account for taxes and fees that might be another 5% combined (or more). That means that the portfolio could decline by 65% in one year. And that would require over 186% return to get back to even. This is the great retirement conundrum many people don’t consider in their journey, and many advisers don’t account for in their planning. (For more, see: The Importance of Diversification.)
Here are a few strategies that can help alleviate some of the pressure created by risk, fees, taxes and withdrawals:
There is no sure fire way to remove risk from a portfolio. However, true diversification is the best method to reduce risk. Rather than using a traditional strategy that involves the combination of equities and fixed-income securities, consider using alternatives like bank and insurance products along with real property and commodities to achieve more balance in your portfolio. Using only two assets classes (stocks and bonds) increases the correlation risk that both types of investment will drawdown at the same time.
This is a relevant issue to consider because of the high stock market environment and the low interest rate environment we are currently in. The use of bonds as a risk management strategy may not be appropriate currently. (For more from this author, see: How to Manage Risk With Bonds in Your Portfolio.)
It is inevitable that there will be some expenses or costs related to investing. But there are a few ways to minimize these charges. First, working with a fiduciary instead of a broker means that the adviser is compensated by an annual management fee rather than commissions based on transactions. This helps eliminate conflicts of interest and incentivizes the advisor to work in your best interest.
Second, avoiding mutual funds and using exchange-traded funds (ETFs) or direct holdings helps minimize or eliminate internal expenses (which can be rather costly over time). Lastly, overall transparency of the total fees (advisory, custodial, internal, 12b-1, transaction, administrative, etc.) provides you more knowledge and, thus, confidence in making investment decisions.
This is one of the most underrepresented areas of financial planning that may have the most dramatic effect on portfolio management. Many investors believe in a probable future with a much higher tax environment, but very few portfolios have been managed for maximum tax efficiency or adjusted for tax diversification. By placing investments that produce income tax liability in tax-deferred or tax-free accounts and by utilizing investments that produce qualified dividends and long-term capital gainsinside taxable accounts, the current tax liabilities of the portfolio can be greatly reduced. Also, by converting more assets into tax-free accounts (Roth, municipal bonds, life insurance, etc.), the risk associated to higher taxes in the future can be minimized (See my book: OVERTAXED: 6 Powerful Tax-Free Investment Strategies).
There is a lot of research in the financial industry about the right distribution percentage investors should use to ensure that their assets will sustain their retirement through life expectancy. However, there is very little discussion about taking those distributions from the right place at the right time. A well-balanced portfolio will support a dynamic distribution strategy. This type of advanced portfolio design includes investment diversification that provides negative correlation as well as tax diversification including taxable, tax-deferred and tax-free accounts. This would allow withdrawals to be distributed dynamically based on market conditions and tax environments. By taking money out of the right place at the right time, the investor has more control over the net effect of withdrawals on the portfolio (instead of putting the IRS or the market in control).
These are just a few of the available strategies that can help minimize the negative compounding of risk, fees, taxes and withdrawals. And, unfortunately, these strategies are rather complex and complicated. However, by utilizing the services of a talented financial advisory firm, investors can implement and monitor these strategies with very little personal involvement. As one can imagine, the combined effect of implementing these strategies can drastically increase overall net portfolio performance. And, at the end of the day, isn’t the net more important than the gross?