The Retiring Founder's Contradictory IPS
Dana, 61, is selling her logistics software firm for $14 million net after tax in 90 days. She has $2.1 million in a 401(k), a $900,000 brokerage account with a $600,000 unrealized gain concentrated in two tech stocks, and a $1.3 million mortgage at 6.1%. She states her goal is to "never worry about money again" and to leave $5 million to her two children. She describes herself as "moderately aggressive" and wants 8% annual returns. She also says she cannot tolerate losing more than 15% of her total portfolio in any year, will need $220,000 per year pre-tax to live on starting next year, and plans to keep working part-time for $60,000 annually for five years. She has no long-term care insurance and a family history of Alzheimer's.
1. Identify the internal inconsistencies in Dana's stated objectives and explain how you would resolve them in a written IPS.
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Three tensions must be surfaced explicitly rather than averaged away.
1. Return target versus loss tolerance. An 8% nominal return expectation with a 15% maximum tolerable drawdown is achievable only with a portfolio whose expected worst-case annual loss is roughly 15%. Using a rough 2-sigma annual volatility framing, a portfolio with ~15% expected return and ~20% volatility has a meaningful probability of a 25%+ loss year. The advisor should show her the historical distribution of returns for candidate allocations and ask her to choose which constraint binds: the return target or the drawdown limit. Document the chosen trade-off in the IPS.
2. Liquidity versus concentration. Her $220,000 annual spending need against a $17 million post-sale balance sheet is a ~1.3% withdrawal rate, so the portfolio is not actually required to produce 8%. This reframes the return target as aspirational, not required. The advisor should separate "required return" (spending plus inflation plus fees, roughly 4%) from "aspirational return" (funding the $5 million bequest with high confidence).
3. Risk capacity versus risk attitude. Her risk capacity is high (low withdrawal rate, part-time income, no debt service after payoff), but her stated risk attitude is constrained by a hard drawdown limit. The IPS should record risk capacity and risk tolerance separately and let the lower of the two govern the strategic allocation.
Also flag the uninsured long-term care exposure as a distinct goal with its own funding line, and the concentrated $600,000 gain position as a tax-management problem, not an allocation problem.
2. Draft the risk, liquidity, and tax sections of the IPS, including specific policy language the advisor can enforce.
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Risk. State a maximum tolerable annual portfolio decline of 15% measured on a total-return basis including income, reviewed at each calendar year-end. State that the strategic allocation must have a modeled 5th-percentile one-year return no worse than -15%. Prohibit leverage and prohibit single-position concentration above 10% of total investable assets after a 24-month transition window. Record that the client's risk capacity exceeds her risk tolerance and that tolerance governs.
3. Liquidity. Reserve a two-year spending bucket of $440,000 in cash and short Treasuries, funded first from sale proceeds. The remaining spending is met from portfolio income and rebalancing. Note that the mortgage payoff decision is a separate liquidity event: at 6.1%, prepayment is a risk-free 6.1% return, so recommend paying it off from proceeds unless liquidity reserves would fall below the two-year bucket.
4. Tax. The $600,000 unrealized gain should be managed with a staged disposition: harvest losses elsewhere, use charitable giving of low-basis shares for any philanthropic intent, and consider a donor-advised fund in the sale year when income is elevated. Do not let tax tail wag the allocation dog, but set a policy that no single position exceeds 10% after 24 months and that disposition is scheduled to minimize bracket creep. Coordinate the sale-year income spike with the advisor's tax counsel.
3. Dana asks whether she should pay off the mortgage or invest the proceeds. What is the correct analytical framing, and what non-financial factors should enter the IPS?
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The core comparison is the risk-free after-tax return of prepayment versus the expected after-tax return of the invested alternative at equivalent risk. At 6.1%, prepayment earns a guaranteed 6.1% (assuming no mortgage interest deduction benefit, which is likely given her income and the standard deduction). A diversified portfolio's expected return of, say, 6-7% carries substantial volatility; the risk-adjusted comparison favors prepayment unless the portfolio has a clearly higher expected return at comparable risk.
Non-financial factors that belong in the IPS rationale: liquidity (paying off reduces cash reserves, which matters given her two-year spending bucket), behavioral comfort (a paid-off home reduces sequence-of-returns anxiety), and estate considerations (the home passes to heirs with a step-up in basis; mortgage debt reduces the estate but also reduces liquidity).
Recommendation: pay off the mortgage from sale proceeds only after funding the two-year cash bucket and the long-term care reserve, and document the decision and its rationale in the IPS so it is not revisited emotionally during a market decline.