Rebuilding Investment Portfolios Post-Divorce

We are often introduced to recently divorced individuals who find themselves in uncharted territory. In many marriages, one spouse filled the role of "Chief Financial Officer" of the household, handling most or all areas of the family's financial management. Once the divorce process and division of assets are finalized, those who were not the household CFO can suddenly find themselves in that role, whether they feel prepared or not.

There are many financial planning topics to address when planning for your financial future post-divorce. Cash flow management, tax planning, estate planning, life insurance and investments may all need to be reassessed as a new phase of life begins. In reality, each of these areas is interconnected. The common denominator that touches nearly every facet of these planning topics is the investment portfolio.

As a result of a divorce settlement, many people find themselves owning an investment portfolio with an asset allocation that may no longer suit their individual circumstances. For someone who did not take a highly involved role in overseeing or managing these accounts during the marriage, this can be an understandably daunting responsibility.

So, what should you do with your investments after a divorce? Start by understanding the assets you now own, your new income and cash flow needs, and how your existing portfolio is invested. Then determine whether the portfolio's risk, asset allocation and withdrawal strategy still align with your individual circumstances and long-term financial goals.

Before knowing where to go from an investment standpoint, it’s critical to know where you are, what you have, and what you can expect in accordance with the divorce settlement.

• Identifying Assets and Liabilities

Constructing a Net Worth Statement, also called a Personal Balance Sheet, is the first step to understand what you own and what you owe. This starts by taking a detailed inventory of all bank accounts, investment accounts, retirement plans, real estate holdings, and other financial assets awarded in the settlement to ensure all necessary transfers of assets have taken place or are in process. Then, make a list of outstanding liabilities, such as mortgages, personal loans, credit card balances or tax obligations, still maintained personally.

• Assessing Income Sources and Cash Flow Needs

The next step is understanding and quantifying income sources post-divorce. This would include spousal support payments, investment income, Social Security, earned income from work, or pension payments. A more tedious, though necessary, assignment is budgeting for expected expenses as a new, separate household. The goal is to establish an average monthly expense number and determine how much, if any, would need to be pulled from the investment portfolio to supplement shortfalls.

With a clear understanding of cash flow needs, the investment strategy should be structured in a way that supports sustainable withdrawal strategies. The different types of accounts that make up the portfolio, such as brokerage accounts, pre-tax accounts (traditional IRAs or 401(k)s), and Roth IRAs will all have different tax treatments for income and distributions. This will influence not just the withdrawal strategy but the investment allocation of each.

• Analyzing Current Holdings

Once cash flow needs, account types, and balances are identified, the next step is to obtain account statements to understand what is currently held. The actual investment vehicles vary but could include some combination of individual securities (such as stocks or bonds) or pooled investments (mutual funds or exchange traded funds (ETFs)). These are all publicly traded investments with publicly available information.

There may be purchased financial products, such as annuities or structured notes, or more complex, private investments transferred as part of the settlement. It’s worth obtaining a prospectus for any such investment, as they may have little public information available.

What’s most important, however, is the investment exposure of any investment holding and the associated risk and return prospects. There are thousands of mutual funds and exchange traded funds in the investable universe, but they span a variety of different asset classes and react differently in varying market conditions.

At the highest possible level, we classify holdings into two primary groups: those intended for growth with more return potential, and those intended for portfolio stability with more limited return potential. Stocks or stock funds comprise the growth portion of the portfolio. Bonds or bond funds, along with cash and money market funds, primarily make up the less volatile sleeve of the portfolio. The holdings should be broadly classified into these groups to determine the percentage exposure to each. Although the portfolio was initially constructed with an ideal allocation to support the married household, this will likely change post-divorce. The ideal percentage of stocks, bonds, cash, and possibly alternative assets will need to be tailored to the new situation.

Once there is a clear grasp of assets and cash flow, the next step is to evaluate whether the investment strategy aligns with a new situation.

• Aligning Portfolio Allocation with Cash Flow Needs

Now that income sources and expenses have been identified, the portfolio should be structured to support them. If cash flow needs come from investment withdrawals in the coming years, we advise maintaining sufficient liquidity within those stable assets (bonds and cash) equal to multiple years’ worth of expense needs as a minimum allocation. This isolates these dollars from the near-term volatility of the stock market. As withdrawal needs decrease, the propensity to take more risk in pursuit of higher growth potential increases.

• Factoring in Risk Tolerance, Market Volatility, and Diversification

Though the thought of more growth and higher return is appealing, the tradeoff for that anticipated future reward is greater volatility in the interim. It’s not uncommon to see the stock market decline by 10-20% without warning. In fact, it’s expected. Given the potential for volatility, it’s not unusual for divorcees to be unnerved by these market moves as they take on management or oversight of significant investment assets for the first time. As a result, a common mistake we see is new divorcees being overly conservative out of fear of market losses. This mistake, over the long run, can leave a significant amount of wealth on the table that may be needed to support purchasing power later in life or passed on to beneficiaries.

It’s also important to differentiate between investment risk from normal market volatility and risk that comes from investing in highly speculative individual investments or asset classes. The latter of those should be avoided by developing a plan to take a disciplined investment approach to appropriately diversify holdings and invest in companies with strong financial standing and proven track records. Stock allocations should be invested across different sectors of the market (technology, consumer staples, healthcare, and others). Utilizing mutual funds and ETFs, rather than individual securities, is an effective way to implement this diversification strategy. If there are concentrated positions that remain in the account after the divorce, or individual stock holdings representing more than 10% of the portfolio’s value, we believe it prudent to strongly consider reducing these positions to lessen the stock’s future impact and potential risk to the broader financial picture.

• Rebalancing and Ongoing Adjustments

Investment portfolios require ongoing oversight and rebalancing on a scheduled basis to ensure asset allocation remains aligned with financial goals and the ever-changing personal financial landscape. Reviewing withdrawal strategy, investment performance, and cash flow needs may prompt adjustments, especially when market movements cause weightings of different asset classes to drift from their targets.

You don't need to have every financial decision figured out before talking with an advisor. If you've recently gone through a divorce, a financial advisor can help you understand the investments you now own, how they fit together and whether they remain appropriate for your cash flow needs, tolerance for risk and long-term goals.

At Johnson Investment Counsel, we help individuals look at their investments in the context of their broader financial lives, including cash flow, retirement, taxes, estate planning and other considerations that may change following a divorce.

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