Fixing a real-estate heavy portfolio

As Marc and Lillian Harris look past Army life, it's time to build a portfolio that can handle whatever the markets bring.

By Janet Paskin, Money Magazine staff reporterOctober 31 2006: 1:29 PM EST

(Money Magazine) -- Marc and Lillian Harris met in Iraq, where he was a communications officer and she worked in intelligence. After they returned to the States, Lillian left the Army, but Marc was back in the Middle East within months.

Reunited and, since June, married, the couple are facing big changes in their lives, and they're worried that their portfolio, heavily tilted toward real estate, isn't up to the task.

The Harrises: Marc, 42, and Lilian, 27.

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When do you need the money? 3 - 5 years 5 - 10 years 10+ years How much risk can you handle? Not much at all A reasonable amount As much as possible How much wiggle room do you have? If I miss my goal by a year or two, I'll still be okay. I can't afford to miss my target. As the bear market intensified, did you See an opportunity to buy more stocks Sell stocks thinking things will only get worse Do nothing

The Harrises' Assets Real Estate Equity: $844,500 Investments: $90,000 Insurance (cash value): $27,000

They want to start a family. Marc just began a one-year fellowship at Harvard's Kennedy School of Government, and Lillian quit her job to accompany him, knocking a third off the family income. They haven't decided whether she'll go back to the workplace or be a stay-at-home mom.

Meanwhile, Marc, who just passed the 20-year mark in the Army, could retire soon as a lieutenant colonel, but he may want to stay in the service longer.

Given all of that uncertainty, Marc figures he and Lillian need to get their investments straight. "You hear that people don't plan to fail, they fail to plan," Marc says. "I'm trying to make sure I have a plan in place."

Where They Are Now

Marc earns close to $125,000, and when he leaves the Army, he'll qualify for an annual pension of at least $40,000. Tenants cover the mortgages on three rentals in Virginia and Texas that Marc has bought over the past decade or so.

Thanks to the housing boom, the properties are worth more than $1 million (at least they were at the top of the market). The Harrises put an extra $680 per month toward their mortgage debt; in 10 years they hope to have paid off the loans and be pocketing $72,000 in rental income a year.

The couple may have aced the real estate piece of their portfolio, but the rest of it needs help. They have no emergency fund and comparatively few assets other than real estate.

What they do have isn't very good.

Lillian ended up paying double-digit sales commissions for mutual funds sold by First Command Financial Planning, which marketed high-cost investments to service members and used retired officers as pitchmen. The SEC has disciplined First Command, but Lillian's up-front charges were lost.

Marc also has a few doozies: $42,000 in a high-cost variable annuity held inside a Roth IRA, where the annuity's tax advantages do him no good, and a high-cost investment life insurance plan with poor returns.

Meanwhile, Marc took a pass on the Thrift Savings Plan, the military's version of a 401(k), and the couple have stopped contributing to their Roth IRAs.

What They Should Do

Marc's pension and the income from the rental properties should leave the Harrises in good shape, says Jim Ludwick, a retired Air Force officer and financial planner in Maryland who works with military families. But they are too vulnerable to the real estate market.

"The real issue for them is diversification," Ludwick says. "Historically, stocks have done better than real estate." He recommends that they begin building their stock portfolio and ditch their high-cost, low-performance investments.

Cut Investing Costs All of the Harrises' mutual funds levied sales loads, and the couple have since suffered from high expenses and spotty performance. They're better off moving their accounts to a low-cost fund company like Vanguard.

Ludwick recommends tilting their portfolio toward value stocks, which tend to outperform growth shares over the long term.

Ludwick would add Vanguard Value Index (VIVAX (Charts) and International Value (VTRIX (Charts) to traditional offerings such as Vanguard 500 Index (VFINX (Charts), Total International Stock Index (VGTSX (Charts) and Total Bond Market Index (VBMFX (Charts).

Build the Right Tax Shelter Even though the Thrift Savings Plan does not give servicemen the match that civil servants get, fees are incredibly low. Ludwick thinks that the Harrises can invest $10,000 per year in a so-called target-date retirement fund, in which the fund's asset allocation grows more conservative as they age.

He wants the couple to start with an aggressive 85-15 stock-bond mix. If Marc joins the private sector, they should contribute enough to get a 401(k) match and then max out their Roth IRAs.

One tax shelter they can lose? The variable annuity inside the Roth IRA.

Shape up the Insurance With three mortgages and plans for a family, Marc needs about $1 million in life insurance, which is far more than what the military provides.

He owns a variable universal life policy, but he should cash it in and use the $27,000 that he will net to create an emergency fund.

Ludwick suggests that Marc then buy a 30-year term plan, which will run about a third less than the $450 a month he's paying for the VUL policy.

Though Marc will pay surrender fees for making the switch, he should recoup the cost in less than three years if he reinvests the $150 monthly savings. It all makes sense to Marc. "I want to protect Lillian and our kids," he says. "That's what's important."

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From the November 1, 2006 issue