“Money’s only something you need in case you don’t die tomorrow.

- Wall Street (1987)

Gary and Erin Dickinson have come to me for help in planning their finances. I hope to educate them,
protect and grow their life’s savings, and reduce the some of the worry and uncertainty associated with
personal financial decisions. If I can guide them to a financial position which will allow them to reach
their goals, then I will have done my job.

After being briefed on their current situation and future goals, the first thing I would like do with Gary
and Erin is put together a net worth statement.

Cash $12,000
Joint Brokerage Acct $131,000
Erin 401(k) $43,000
Erin IRA $212,000
Erin SEP $173,000
Gary 403(b) $239,000
Gary IRA $57,000
IBM Shares $1,341,000
Tobias 529 Plan $16,000
Michelle 529 Plan $9,500
NY Apartment $680,000
Mortgage ($375,000; 5.75%; 30 yr; 06/2004) ($340,000)
Adirondacks Home
Mortgage ($70,000; 6.25%; 30 yr; 02/2007) $180,000
($67,000)
Net Worth $2,686,500

The net worth statement gives us a snapshot of the value of G&E’s assets. It is the foundation from
which we can start thinking about what adjustments we might make so that these assets best serve
G&E’s interests.

I will first look deeper into G&E’s financial standing, discuss their goals, and make assumptions for the
future. My aim is to think about what G&E should do in order to have the best chance of meeting their
goals, and identify what we have to work with.

I will then figure out how much they need to be saving every year to meet their goals. From there, I will
work backward to figure out how much they can be spending on everything else.

Later I will discuss asset allocation and recommend a portfolio for G&E.
GOALS, ASSUMPTIONS, APPROACH
I will now look further into G&E’s current financial situation. I will identify their goals and what is needed
to reach those goals. I will make various assumptions for the future. These assumptions will give me a
foundation to work from when creating a plan.

A sound financial plan must be holistic. To create a plan for G&E, I will try to look objectively at all facets
of their finances. Each part will serve its own purpose, but will be evaluated in terms of its contribution
to the plan as a whole. The tendency of people to evaluate different aspects of their finances
independently of the others, to categorize financial decisions and ignore the relationships that exist
between those decisions, can lead to trouble. This will be avoided.

However, I will take liberties with respect to the treatment of three aspects of G&E’s finances: real
estate, Tobias and Michelle’s education, and charity. I will explain my reasons for each as we come to
them, but my intention is set those items aside, treat them as given, and thereby be able to focus their
portfolio on planning for retirement.

INFLATION be defined in terms of asset allocation. Each part

of the portfolio will be made up assets from a
The annualized rate of consumer price inflation given class. Whatever asset allocation we settle
was 3.3% for urban areas in the US from 1914 to on, I will keep a stable of replacements ready to
2010. G&E stated that inflation is high right now, take the place of any losers that we want to lock
around 6%. This is not the case. The current level in as tax losses. These bench players will share
is much lower, well under the Fed’s 2% target. the same risk factors as the original components
of that part of the portfolio, with similar expected
Assumption: 3.5% annual inflation will be
performance and similar expected contribution
assumed for all calculations, except for private
to the portfolio as a whole.
college tuition.
Through our active tax loss harvesting, I expect
the real tax bill on G&E’s portfolio to be less than
TAXES 20%. However, as a conservative estimate, I will
assume a flat 20% across the board. As a rule of
Given their level of income, G&E probably pay thumb, I will subtract 2 percentage points from
about 30% of income to the federal government, the expected returns on the portfolio.
and another 10% to the state and city. I will
assume 40% until retirement, at which point I will Additional, their retirement funds are tax-
assume they will not be taxed on their social deferred, but I will not treat them any differently
security benefits. than the brokerage account with regards to
taxes. All the money is for retirement. Taxes will
Capital gains tax in the US is 20%. I will assume be paid at the end of the day anyway. There
that all investments henceforth will be taxed as might be opportunities to use this tax-deferred
capital gains and not as ordinary income. status to our advantage, but I will not consider
them here.
There are ways to mitigate the amount paid in
capital gains tax, mainly through tax loss Assumption: G&E’s income tax rate is 40%, and
harvesting, and I will work with G&E to use losses capital gains tax is 20% or 2 pp off expected
to offset their capital gains throughout the returns.
duration of our relationship. G&E’s portfolio will
INSURANCE CHILDREN’S COLLEGE

Gary is well covered with life and disability G&E want to send Tobias and Michelle to private
insurance. Erin has a $500,000 term life policy universities. Tobias and Michelle will be 18 in
that covers through 2020. She has no disability 2020 and 2022, respectively. Private schools in
insurance. Given her health risks and the fact that the US currently cost about $45,000/year, which
she brings in over 2/3 of their joint income, I will grows at a rate approximately twice that of wider
recommend that she get another $500,000 in inflation.
term life coverage through 2020, and purchase
high quality disability insurance that will cover I will encourage G&E to take advantage of the tax
her through 2030. Later I will figure out if they benefits of 529 plans and get these accounts fully
can afford this at their current level of spending, funded soon, choosing a safe, age-based asset
or if they will need to spend less on other things allocation. A rate of return of 8% should be
to compensate for the premiums. sufficiently safe. Although we expect to make
more than 8% on assets outside of the 529 plans,
the opportunity costs here are minimal, because
a 8% return tax free would be like a 10% return
PROPERTIES AND MORTGAGES which is taxed.
The two mortgages combined have an annual 529 plan contributions are treated as gifts by the
payment of about $32,000 (see appendix, IRS. G&E can contribute $130,000 tax-free to
Mortgages tab for payment breakdown). Being each over the next 5 years. The additional
that the rates on the mortgages are reasonable, I $50,000 (2010$) needed for each child will be
see no reason to pay them off now. As long as taxed as a gift.
they are happy with their properties, I would
encourage Gary and Erin to keep the mortgages. I will encourage G&E to earmark $360,000 today,
to be added to the 529 plans over the next 5
They have indicated that they would like to sell years. This plus the current amount in the 529
the properties before retirement and move to plans, minus any taxes associated with the
the Southwest. If they sell in 2030, they will still contributions, should be enough for the kids’
owe about $120,000 on the two mortgages college education.
combined. The proceeds from the sales minus the
$120,000 can be used to buy a new home. They Note: I will not consider their expected
will likely be downsizing and moving to a part of performance in the context of G&E’s wider
the country with cheaper property values than portfolio. The 529s will be treated as if the money
NY and the Adirondacks, so I see no need to was already given to Tobias and Michelle, and it
allocate any further money toward the purchase cannot be taken back.
of the retirement home.
Assumption: G&E will need $180,000 (2010$) by
Note: G&E are not land speculators. They are 2020 for Tobias’s education and $180,000
home owners. I will not consider property as part (2010$) by 2022 for Michelle’s education.
of their portfolio. The only price I will look at is Inflation is 7%. Expected rate of return on 529
the amount of money left to pay on the plans is 8%.They need to set aside $360,000
mortgages between now and 2030. today, taken from their current stock holdings.
Appendix tab 529 gives rough breakdown.
Assumption: G&E will pay $32,000/year for the
mortgages for the next 20 years. Their retirement
home will be purchased entirely with money from
the sale of their two current homes.
INCOME rule of thumb, they will need around $2,800,000
(2010$). This will give them enough money to live
Gary works for a non-profit and his income is very comfortably in retirement and leave an
steady every year. Erin runs her own practice and inheritance for their children.
her income has fluctuated between $130,000 and
$200,000 over the past 5 years. Assumption: G&E will need $3,000,000 (2010$)
by 2030 to fund their retirement.
Assumption: Gary will earn $75,000/year (2010$)
until 2028. Erin will earn $165,000/year (2010$)
until 2030. Both figures are pre-tax, and both will
be adjusted for inflation. CHARITY

G&E want to give to Unicef and Habitat for

Humanity while alive. Since Gary is concerned
SOCIAL SECURITY about the capital gains tax associated with his
IBM shares, I will encourage G&E to set aside 20%
The current maximum monthly social security of the shares (2,000 shares; $270,000 at current
benefit for someone who retires at 66 is about price), and give the proceeds from the sale of
$2,300. I expect them to receive something near these shares to charity whenever they please.
the maximum benefit. Erin plans to retire at 63, 3
years before she will be eligible for her full Assumption: 2,000 shares of IBM will be taken off
benefits. the table and set aside for charity.

Assumption: G&E will receive $40,000 (2010$)

combined in social security benefits every year
starting in 2030. CASH

In addition to the $12,000 G&E have in their

checking account, I will encourage them to put
RETIREMENT another $100,000 or so in a money market fund.
This will be part of their portfolio, but could also
Gary wishes to retire at 66 (2028) and Erin at 63 be used as an emergency source of cash.
(2031). In addition to the $40,000 (2010$) they Emptying their checking account every month
will receive in social security benefits, they want might not be the best idea, but if it has been
to have enough money saved to be able to draw working for them then I wouldn’t pressure them
on $110,000/year (2010$). Using the 4% rule as a to change.

TARGETED PERFORMANCE

Now I want to see what kind of future performance is needed to meet the goals we have identified. First
I need to know what we have to work with after my assumptions have been taken into account.

Cash $12,000
Investment Accts $2,196,000
Charity (2,000 IBM shares) ($270,000)
College ($360,000)
New Net Worth $1,578,000
Earlier I set G&E target portfolio value for spend up to $18,500 on life and disability
retirement at $3,000,000 (2010$) by 2030. At insurance for Erin.
3.5% inflation, the figure is $6,000,000 (2030$).
This amount is reachable. 7% return means about 10% before taxes and
fees. This is certain attainable without accepting
We have about $1,566,000 to invest with. If it too much risk. 10% annualized return with 12%
grew at an annualized rate of 7% it would be annual volatility over the next 20 years is what I
worth $6,060,000 by 2030. And that’s without will shoot for. The name of the game is asset
making any more contributions. If they were to allocation. There has been extensive research
add $10,000/year until 2027 (the year before revealing the benefits of a well-diversified,
Gary wants to retire), the portfolio would be periodically-rebalanced portfolio. I will make
worth about $6,400,000 by 2030. I think recommendations based largely on the findings
$10,000/year is a good minimum level of saving of others. But first I want to look at how G&E are
for G&E. invested now.

Last year they contributed $28,500 to their Performance and Saving Targets for Next 20
portfolio. I assume that they can afford to do this Years: 10% pre-tax, pre-fee returns. 12%
every year up until Gary retires. I will encourage volatility. Contribute $10,000 of income to
G&E to maintain their current level of spending, portfolio every year.
add at least $10,000/year to the portfolio, and

CURRENT PORTFOLIO

G&E currently have a joint brokerage account and 5 retirement fund between the two of them. Gary
also owns 10,000 shares of IBM (8,000 after our charity assumption). As explained above, I will not
distinguish between the different accounts.

Investment Style G&E’s portfolio is highly concentrated in shares of large US companies. They are
very poorly diversified, in that the prices of most of their assets are driven by the same risk factors.
While the returns on their accounts have mostly outperformed their respective benchmarks in recent
years, they have been highly volatile and highly correlated amongst themselves. This leaves G&E very
heavily exposed to certain risks. The kind of event that would send one of their holdings tumbling would
likely send all of them tumbling. Such an aggressive investment style is not suitable for their life savings.

G&E have stated that they want to invest for maximum return and maximum income. If I could only do
one thing for G&E it would be to convince them that with high returns and a concentrated portfolio come
high risks—risks like not being able to afford to put Tobias and Michelle through college, not being able
retire when you want to, not being able to give to charity, maintain your standard of living, receive a
life-saving surgery, pay for your daughter’s wedding, etc. I don’t want to scare them, but they need to
understand that their current portfolio—and their view on investing in general—is not compatible with
their goals.
ASSET ALLOCATION

What I will recommend for G&E:

Cash Equivalents 6.0% $93,960

5 year T-notes 18.0% $281,880
Emerging Market Gov't Bonds 8.0% $125,280
Commodities 30.0% $469,800
US Equities (further breakdown below) 20.0% $313,200
International Equities (further breakdown below) 18.0% $281,880

Cash Equivalents: Money market funds.

US Government Bonds: 5 year Treasury notes.

Emerging Market Bonds: Short-term (1-5 years) government bonds from developing foreign countries.
Choose 3-10 countries who actively devalue their currencies in the foreign exchange markets, with view
that such devaluation cannot last forever.

Commodities: Entire amount can be invested in one diversified commodities index like those offered by
UBS and Goldman Sachs.

US Equities: Evenly split between value and growth, big and small. A few dozen individually selected
stocks are better than indices at capturing the desired risk factors. Use G&E existing holdings as much as
possible.

International Equities: Evenly split between emerging and developed, value and growth, big and small.
A few dozen individually selected stocks are better than indices at capturing the desired risk factors. Use
G&E existing holdings as much as possible.

EXECUTION

This is the asset allocation I would like to start with, as I think it is well suited for our targeted risk and
return. I will first sell any of G&E’s losing investment to take advantage of tax losses. Then I will work
with what G&E already own to make up the new portfolio as much as possible.

The portfolio will be periodically rebalanced to maintain its initial features. We will try to do as much of
the rebalancing as possible when adding new money to the portfolio, so as to limit the capital gains tax
incurred when selling winning investments. Additional rebalancing will be carried out when any one
asset class move 5 percentage points or so from its initial proportion.