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Back to the Garden

It's time to find healthier approach to retirement income.

Don Phillips, 06/16/2008

In his bestseller, In Defense of Food: An Eater's Manifesto, journalist Michael Pollan asserts that the rise of nutritional science has caused modern eaters to switch from eating food to consuming food products. Where once we dined on bread made simply from stone-ground wheat, water, and yeast, we now eat bread formed from overly processed white flour and a host of additives designed to replicate the nutrients and freshness that the modern food industry has purged from our food. Turning bread into a collection of vitamins and micronutrients may allow food scientists to create breadlike products that are easier to mass produce and distribute, but it's not clear that there are any health benefits for consumers, and there may well be unforeseen consequences.

The same might be said of the modern financial- services industry. For our grandfathers, investing was simple. They bought either the equity or debt of established companies or the debt of government entities. For convenience, they might buy into an investment company or mutual fund that prudently invested, for a reasonable fee, in a balanced portfolio of these securities. Nearly all of the dividends and capital appreciation generated from the stock and bonds flowed back to shareholders in a pure, straightforward process.

Today's fund investors are far more removed from the basics of their underlying investments. Funds are still called bond or stock funds, but they may be composed entirely of synthetic ingredients, such as collateralized debt obligations or stock market futures. An investor's connection to the basic nutrients of stocks and bonds, namely dividends and capital appreciation, is tenuous at best. The hedge fund community has taken the process even further, decomposing investment returns into alphas and betas, much like nutritionists have broken down food into a simple combination of proteins, carbohydrates, and fats. Rather than deploying "whole" investments, today's investors are apt to use a set of genetically re-engineered investment products tailored to create desirable product characteristics.

It's clear that this process has benefitted the producers of financial services. It's easy to charge a premium price for fancy engineering--just look at the expense ratios of the new 130/30 and market-neutral mutual funds. But synthetic securities also introduce new risks and uncertainties to the market, as seen in the damage done by products used to repackage subprime debt. Moreover, even when these products do work, it's rare that their merit--after all fees and taxes are deducted--results in a better investor experience than the plain-vanilla products they were designed to improve upon. How many of the sexy asset-allocation or target-risk balanced funds have produced a better result than good old Vanguard Wellington Fund VWELX in recent years? Not many.PAGEBREAK

Investors would be wise to remain skeptical about the benefits of financial engineering when it comes to the topic of this issue's spotlight, retirement income. For our grandfathers, retirement income would likely have come from a pension that had been invested in blue-chip stocks and investment-grade bonds. In essence, the whole benefits of stock and bond ownership would be harnessed to meet the retiree's income needs. In today's non-defined-benefit world, the logical means of recreating this income stream would be to buy dividend-paying stocks and investment-grade bonds.

Unfortunately, investors are likely to start too late and save too little in planning for retirement, thus making such conservative investments insufficient to meet income needs. The problem is made doubly difficult because most of today's mutual funds have shifted their distribution fees into their expense ratios. The rise of 12b-1 fees and high distribution costs now embedded in expense ratios undermine the industry's ability to pass along income. Mutual funds must pay all of their expenses out of their investment income stream before they tap into capital gains; thus, increases in expense ratios generally mean a drop in income for retirees.

A portfolio of stocks and bonds that collectively yields 4% would return only 2.5% in a fund with an expense ratio of 1.5%. That's a crippling 37.5% loss of potential retirement income. This math puts pressure on both fund investors and companies to find ways to stretch for yield. When firms offer yield-stretching funds that can overcome investors' savings and expense gap, it's the investment equivalent of food marketers promising overweight people that they can lose weight without diet or exercise if they just purchase some new chemically altered potato chip. Both parties are pleased with the immediate perceived benefits, but the longer-term consequences aren't always clear.

A healthier approach to retirement income will be to focus on the basics: increase savings, make wise asset-allocation decisions, assemble a diversified portfolio of stocks or low-cost mutual funds with strong, growing dividends, and incorporate appropriate annuity products, if needed, into the mix. It won't dazzle the portable alpha crowd, but it'll do wonders toward ensuring a long, happy retirement. Sometimes, the simplest solutions are the surest.

Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.


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