Wed, 18 Jul 2012
Director of personal finance Christine Benz will help you check your true exposures and stress-test your holdings in session 2 of Morningstar's 2012 Midyear Financial Checkup.
Jason Stipp: Next we're going to move to our portfolio piece of the presentation. We've got Christine Benz here. She's our director of personal finance. She has also served as Morningstar's director of fund analysis in the many years that she's spent here with the company. She is also the author of a couple of books including 30-Minute Money Solutions. This is where she walks investors through quick and easy ways to get their financial house in order.
Christine is going to be walking you through how to do a checkup on your portfolio, and interestingly she has got three key risk factors that she is going to have you keep an eye out for. We will have a Q&A session with Christine following her presentation. So please do keep those questions coming specifically on the portfolio section. We'll be taking your questions on that after her presentation.
Also, Christine's slideshow is available for you to download. If you click the link of her slideshow presentation beneath your webcast player, you'll be able to access those slides. So I'd like to welcome now Christine Benz, our director of personal finance. Christine?
Christine Benz: Thank you, Jason, and thanks to all of you for watching today. Before I get into the presentation, I would like to quickly share my overarching philosophy on checking up on a portfolio, and I really have two key parts to the philosophy. The first is less is more. So, I recommend a quarterly checkup at most. I think for many people a semi-annual or even an annual checkup, where you do a thorough review of your overall portfolio and your holdings is just fine. I think the more you check in on how you're doing, the more you're inclined to get in there and monkey around and maybe make some trades that aren’t necessarily in your long-term best interests, and you might also rack up some tax and trading costs along the way. So that is the first ground rule.
The second is to the extent that you possibly can, and I know it can be difficult to tune out performance, but I think it's useful to focus on what fundamentally is going on with your portfolio. So you'll see that in the review that I will talk about as we go forward, I've really focused on fundamental factors that underpin a portfolio.
So let's just give a little roadmap of where we'll go in this presentation. First of all, I'll talk about how to check the viability of your current plan. So if you don't have a lot of time to devote to checking up on your portfolio, think at the very least it makes sense to check up on this and see if you're on track or if you need to make some midcourse adjustments.
The next part of a portfolio review involves taking a look at your aggregate holdings and your aggregate weightings. How do they look like in terms of asset allocation, sector weighting, style exposure, and so forth? The next step of any portfolio review is to dig into individual holdings, and as Premium users of Morningstar.com, you have a lot of tools at your disposal to do that. I'll talk about how to avail yourself of those tools.
As Jason mentioned, I will also talk about troubleshooting some risk factors that I think exist for a lot of investor portfolios these days. So the first three steps are more or less evergreen. These are steps you'd want to take regardless of the market environment. The last step will look specifically at risk factors that lurk for investors right now.
So the first step is to check the viability of your plan. Ask the question "How am I doing?" and set about answering it. I would really break this task up into two key groups. First of all, if you're an accumulator, what you've got to check up on is whether your current savings rate combined with your portfolio value to date puts you on track to reach your financial goals.
Morningstar's tool for this task is called Asset Allocator. It's located on our Tools tab of the site. You just click on that tab, and if you have a portfolio saved on Morningstar.com, Asset Allocator can actually harness your holdings and use your own asset allocation, your own style exposure, to help determine whether your current portfolio and your current savings rate and additional contributions put you on track to reach the amount that you hope to have at retirement or any monthly income that you expect to have during retirement. So Asset Allocator, I think is a great one-stop tool that does, in fact, harness your individual portfolio holdings, but investors can also look at some other tools.
In fact, I think it's a good idea to sample a range of opinions on this important question of whether your portfolio is on track. So a couple I like are two from Fidelity. The Retirement Quick Check is kind of a quick and ready tool, but nonetheless another source of guidance on whether your current savings plan and portfolio are on track. The Retirement Income Planner I know is one that a lot of our Morningstar.com users have told me that they have gotten a lot out of. It's definitely a good tool for people who are closing in on retirement and have some visibility toward what their in-retirement expenses will look like. T. Rowe Price Retirement Income Calculator is another terrific tool.
I would say regardless of what tool you use, just make sure that it's as holistic as it can be possibly be. So ideally any tool you use would factor in the fact that some of your assets will take a haircut when you retire because you'll actually pay taxes on those assets. So if you have traditional 401(k) or IRA assets, for example.
Another factor that should go into the pot would be inflation. So you'd want to make sure that any tool is factoring in the role of inflation. You'd also like to see a tool that is factoring in other sources of income that you might have available to you in retirement. So for many of us, we'll also have Social Security, for example, to augment our retirement portfolios. The more holistic tool you use, the better.
Another thing that you want to check your progress on if you're in accumulation mode is whether you're on track, if you possibly can, to meet the maximum allowable contributions to both 401(k)s and IRAs for the calendar year. So in 2012, the 401(k) contribution limits are $17,000 if you're under age 50 and $22,500 if you're over 50, and the contribution limits for IRAs are the same as they have been in years passed, $5,000 for those under 50 and $6,000 for those over 50. I would also point out that those contribution limits for both IRAs and 401(k)s are the same regardless of whether you're making Roth or traditional contributions. So the effective contribution rate for Roth contributions is actually higher than is the case for traditional contributions. That's an important thing to keep in mind.
If you are retired, one of the key things you want to focus on if you are at the point where you're actually withdrawing assets from your portfolio is whether that withdrawal rate is on track to not prematurely liquidate your nest egg. I think we could devote a whole presentation to this idea. It's so important and such an important part of retirement planning, but one rule of thumb that is often thrown out there as a sustainable withdrawal rate for retirement is that 4% rate. That means if you had an $800,000 portfolio on day one of retirement, that means that your initial withdrawal in year one would be $32,000, and then you would subsequently inflation adjust that amount in every year thereafter.
So, the year-two withdrawal assuming a 3% withdrawal rate would be $32,960, but there are lots of different ways to think about these withdrawal rates. I think the key thing to keep in mind and the key thing that has come out through a lot of the important research that has been done in this area of withdrawal rates is that it's best to stay flexible to the extent that you possibly can. So I know a lot of retirees really prize the idea of a steady income stream; I know I do in my working years. But to the extent that you can be somewhat flexible, especially during periods of market duress, the better. So if you are able to reduce your withdrawal rate in periods of extreme market depression such as a 2008-type environment, that greatly improves your portfolio's long-term longevity.
The good news is as we've comes through the first half of 2012, the market has really behaved pretty well. So there probably aren't a lot of those midcourse corrections that are in order right now. If you were working with a withdrawal rate that was sustainable for you six months ago, chances are it still is.
So once you've gone through that process of checking up on how you're actually doing, the next step is to spend a little bit of time evaluating how your portfolio is positioned, and the favorite tool for doing this is using Morningstar's X-Ray tool, which is available if you've got a portfolio saved on the site in Portfolio Manager you can tap into X-Ray right there. If you do not currently have your portfolio saved, you can use our Instant X-Ray tool to get your holdings into the site and take an X-Ray view of them, and then you can subsequently save them as a portfolio. In fact, I think that's probably the easiest quick and dirty way to get your portfolio on the site, to enter through that Instant X-Ray tool, which is on the Tools tab of Morningstar.com's cover page. Once you've got your portfolio holdings in, you can take a look at a view that, depending on your portfolio, will look something like this. You can see that the pie-chart gives you a snapshot of your asset allocation, which you can then in turn compare with your targets. You can see your style, exposure in the Morningstar Style Box. You can see your sector weightings, and below this on that little bit of screen that got cut off, you can see your geographic exposures.
So this is a great way to get your arms around whether you have any big inadvertent bets in your portfolio. I'm not saying that every portfolio needs to look exactly like the S&P 500 or exactly like the Dow Jones total market index, but I think you want to be aware if you are making any big bets in any one part of the market, you want to know where those bets are. So that's what X-Ray helps you with.
Here, I've just provided some benchmarks. Once you've gone through this process of X-Raying your portfolio, here are some tools to help you make sense of what you're looking at. So the U.S. market style I have portrayed in the style-box exposure here, you can see that the bulk of the market is concentrated in the biggest-cap stocks, roughly 75% of the U.S. markets' market capitalization resides and what we consider large-cap stocks.
Then I've provided some benchmarks below for your foreign versus U.S. exposure as well as your emerging- versus developed-markets exposure. Here again, most portfolios don't have 53% of their equity exposure in foreign stocks, but it's important to realize if you have substantially less than that that you do have a significant home-country bias going on in your portfolio.
On the flip side, I know lot of investors have become very engaged in emerging markets in recent years, and there is certainly a lot to be excited about long term in emerging markets. But I think you need to be aware if your portfolio's exposure is venturing much beyond this 13% or 14% level that is represented by the global market capitalization, you just have to understand that you are taking some extra risk there because developing markets have historically had higher volatility than developed markets.
Once you've gone through that process of seeing how you are doing and reviewing your overall asset allocation and style and sector and geographic exposures, the next step is to really take advantage of those Morningstar.com resources and drill into individual holdings. So I find that our Analyst Reports are the easiest way to quickly get my arms around what's going on with the various funds and stocks in my portfolio. Our analysts should be capturing pretty much in real time any salient developments at funds, stocks or exchange-traded funds. So I think that's a great all-purpose resource. Certainly, there are lots of great ratings tools also available.
We have our Morningstar Ratings for stocks, which can help you see what our analysts think the forward-looking prospects are for individual stocks. And for mutual funds, we have our new Gold, Silver, Bronze, Neutral Analyst Rating system, and you can use that to get a forward-looking view of what our analysts think are the prospects for open-end mutual funds.
So those are some tools you can take advantage of. You can also do your own due diligence, and I know a lot of our users really like to do their own homework and home in on specific data points. I have laid out some red flags that I would focus on in conducting individual holdings checkups. So those are listed here on this slide.
I wanted to spend the rest of the portfolio talking about risk factors that lurk for a lot of portfolios right now, and the first two here really focus on this tendency of many investors really since the financial crisis too want to prioritize current income over long-term total returns. I think investors rightfully are very much in "show me the money" mode. There has been really too terrifically large bear markets in the space of a little more than a decade, and investors are concerned that their portfolios could hit turbulence again. So they perceive current income as safety. But I'll talk a little bit about how I think that investors could be overdosing on income-producing securities and maybe not paying full attention to some of the risks that are going on.
Then I wanted to talk a little bit about what's on deck for taxes for 2013. Certainly, Congress could make a lot of changes between now and year-end, but I think it's well worth having on your radar some of the tax law changes that are set to go into effect and also be prepared to make some changes to your holdings preemptively to avoid getting hit by higher tax rates in the future.
Let's just take a quick look at what I see is risk factor number one for a lot of portfolios. It's that we've seen very strong performance from a lot of dividend-paying stocks. So valuations aren't quite what they once were a couple of years ago. When I think back to sort of 2010, early 2009 we had a very easy story to tell in terms of quality looking cheap, dividend payers looking cheap, and now a few years later, that's not necessarily the case. In fact, when we are prepping for the roundtable which we'll have later this afternoon, that was one of the first things Heather Brilliant, our director of equity analysis, said. Heather said that she thinks a lot of dividend payers are overdone and overvalued currently. I think it's worth getting in there, looking at the price/fair value ratios for any individual dividend payers in your portfolio or if you have a dividend-focused fund, looking at its role within your portfolio and just making sure that you're not inadvertently courting some extra risk there.
When you go sector by sector and look at our analysts' price/fair value ratios for the stocks within those sectors, you see a clear expression of the trend that Heather said she was worried about. So real estate REITs mainly, which tend to be quite an income-rich sector, you can see that that's our most overvalued sector currently based on the price/ fair value ratios of the companies that we cover within that sector.
Utilities, another income-rich sector, historically, are also trading above our estimates of their fair value. The same goes for consumer defensive stocks. A lot of those big-cap consumer staples names now we think are at least trading in line with our estimates of fair value.
Again, nothing terribly is scary with the exception of perhaps REITs, but nonetheless, [it's] something to keep on your radar if you're looking for great upside from dividend payers going forward. We think the valuations are pretty fair at this juncture, but by contrast, I do think if you're willing to venture into some areas that have some headwinds, that perhaps are more cyclically or economically sensitive, I think you can pick up a decent dividend yield at potentially a more attractive valuation.
One area that our analysts have definitely been calling attention to over the past few months has been the energy sector, which has been arguably a little beaten up for good reason because I think there are concerns about slowing global growth, but our analysts still think that the big-cap energy companies represent a pretty good value and they tend to have above-market dividend yields currently.
So that's just one thing to keep on your radar as you're thinking about your equity portfolio and thinking about positioning it for maximum upside in the years ahead.
One other thing to keep on your radar is the extent to which you balance riskier bond holdings with the safer stuff. So we have seen this strong trend over the past few years, really, but really picking up steam in the past six months or so where investors have been embracing riskier bond types. You can see why this is happening. Yields have been low. Yields on this safe stuff really would be hard-pressed to keep up with inflation at this point, whereas high-yield bonds and some foreign and emerging-markets bonds have yields that are appreciably better. So we've seen the stampede into some risky bond types. [This slide shows] the top five bond categories to which investors have been adding new assets. You can see that they've been balancing new investments in safer bond types like intermediate-term bond and short-term bonds, but they've also been adding very aggressively to what I consider noncore bond types.
The point I would make here is that you really do need to step back and think about why you have bonds in your portfolio. For most people this is not the return engine of their portfolio. It's the part of their portfolio that's going to serve as ballast for the risky stuff. This risk of venturing into categories such as high yield, for example, with a large share of your portfolio is that you run the risk of having your bond portfolio acting overly equitylike and not serving as that ballast that you intended to.
I'm not suggesting that we are retracing our way to 2008 anytime soon, but I've just provided a little bit of context here to show you the risks that may be embedded in some of these categories. In the case of high-yield bonds, for example, we had a terrible liquidity crunch in 2008, and the typical fund in the category lost more than a fourth of its value. Emerging-markets bonds also were very hard-hit during that period. So, again, I'm not suggesting that we are going to find our way back to that environment anytime soon, but I do think it's safe to say that higher-quality bonds in a true flight-to-quality or a true market shock will tend to outperform lower-quality or high-yield bonds in such an environment.
If I am saying that credit-sensitive bonds aren't a good place to go overboard with, what about long-duration bonds. Well, I would say that if I had to have my druthers, if you had to say, "Well, would you take credit-quality risk at this juncture or interest-rate risk?" I'm with Bob Johnson. I'll be more willing to take the credit-quality risk. So I think you need to be especially aware of what could go on with longer-duration bonds if interest rates were to head up in the years ahead. And of course, they have a lot more room to move up than they might go down.
So as part of your portfolio review, I think it's worthwhile to do kind of a stress test of the holdings in your portfolio to see just how they might respond in a period of rising interest rates. I have provided the stress test that came courtesy of Ken Volpert from Vanguard. He heads up Vanguard's fixed-income assets. Ken's simple formula is simply to take the duration which you can find on Morningstar.com or on a fund company's website and subtract from it the fund's SEC yield, which is a data point that you can find on the fund company's website. The amount that’s left over is the amount by which you could expect a fund to lose if interest rates were to jump up by one percentage point in one-year period.
This stress test tends to work best for assets that are highly correlated to Treasury bonds. It tends to be less effective for assets, such as junk bonds, that have no correlation with Treasury bonds. So in the example I have provided here, Vanguard Total Bond Market with a current duration of 5.1, subtract its SEC yield of 1.8, and what you're leftover with would be a 3.8% loss give or take. This is a very rough formula if interest rates were to jump up by 1 percentage point in a one-year period.
Let's spend the rest of the presentation talking about what's on deck for taxes. There've certainly been a lot of political discussions about this, and my guess is that there will be plenty more to come. But as investors, I think it's best to just focus on what is actually happening. Certainly wait until their finality before making any changes based on what might happen to various tax rates in the years ahead, but here's what scheduled to happen unless Congress takes action.
We're set to see dividend tax rates jump up quite significantly from 15% currently for most investors to ordinary income tax rates. We're set to see capital gains taxes for most investors jump from their currently low level of 15% currently up to 20%. We're set to see broad income tax increases with the highest rate jumping from 35% back up to 39.6%. Estate taxes, even estates of folks who aren't high-rollers, will be taxable at a 55% rate and any estate over $1 million will be taxable at that rate, that $1 million sum also includes real estate assets. So you can see that you don't need to be a very wealthy individual to be subject to the estate tax based on what is set to happen in 2013.
We also have this new Medicare surtax that's going into effect next year. This one I think probably is pretty close to a sure thing due to the recent Supreme Court ruling about health-care reform, but we can see here that it's a 3.8% Medicare surtax that's set to go into effect.
So I just wanted to spend a little time on that one because that one is brand new for all of us. It's not something we've had before. What the tax will do is impose that 3% tax on the lesser of two items. It's the lesser of net investment income or any income over a certain threshold. For married couples filing jointly, that threshold is $250,000. For individual filers, that threshold is $200,000.
Net investment income for the purpose of this surtax includes what you might expect it to include. So it includes dividends, capital gains, royalties, rents and so forth, annuity income that is taxable. It does not include IRA distributions. It does not include 401(k) distributions. It doesn't include Social Security payments or pension payments. It's pretty artfully crafted to carve out retirees who are subsisting heavily on these sources of income. But it is nonetheless a tax that will fall on the lesser of those two income sources.
So let's take a look at how this surtax would work. I provided a couple of examples here. I don't think I have time to get through all of them. But let's assume we've got a married couple with $275,000 in adjusted gross income and another $15,000 in net investment income. For this couple, they are $25,000 over that threshold, so they've got that. But they've also got that $15,000 in net investment income, and because it is the lesser of those two numbers, that's the part that would be subject to the tax.
In the next case, we've got a married couple with $220,000 in AGI and $15,000 in net investment income. This couple wouldn't be subject to the surtax at all, because their AGI falls below the threshold. That is the lesser of those two numbers, so they wouldn't be subject to it.
This is something to keep on your radar as you position your portfolio for the years ahead, but it's generally worth noting that unless you have income that's high in absolute terms and a large share of that income is also coming from net investment income, you will not be subject to the tax. One of our readers recently pointed out, however, that those thresholds aren't currently indexed to inflation, so unless they are, there is the potential for the surtax to affect more individuals.
So, how do you diffuse some of these ticking tax time bombs between now and year-end? Well as I said you certainly don't want to put the tax cart before the horse, but you do want to think about positioning to make sure that you are at least mindful of what could happen with taxes in the years ahead. The tips that I've thrown out there tend to make good sense regardless of the tax environment, but a couple of them are sort of specific to this time period. One idea particularly for people who had long held winners that they were thinking about selling anyway would be to preemptively sell them prior to 2013 when capital gains rates are scheduled to go up.
Another idea, and I think this is an evergreen idea that makes sense no matter the market environment or no matter the tax environment, is to relocate those dividend payers to tax-sheltered accounts. [Dividend payers] have been fairly benign in taxable accounts for the past several years since 2003, but they could become less so in 2013. Muni bonds make sense on a number of levels. For one thing, they are not subject to this new Medicare surtax, so they are not counted as AGI nor are they counted as net investment income, so I think that's a reason to consider munis and a reason to give them another look even if you're not in the highest tax bracket.
Maxing out tax-sheltered accounts is another other strategy that makes sense, regardless of tax climate but particularly so right now, when you can receive perhaps a reduction in your reported income in the year in which you make the contribution. You can also avoid paying taxes on income and capital gains in the years in which you receive them if they're held within the confines of the tax-sheltered account.
Finally, you can also reduce your exposure to the surtax by the extent that you get investments over into the tax-sheltered column. We talked about how those distributions are not subject to the surtax because they're not counted as net investment income. The extent that you can do that that's also a positive.
As we've been discussing often on for the past few years, Roth anything in a climate that could feature higher tax rates in the years ahead could make a lot of sense. So that means discussing conversions with your tax advisor. If you're young person and you're just sort of at the beginning arc of your career path, you may want to think about opting for Roth contributions to 401(k)s and IRAs because there is a good bet that your tax rates in the future will be higher than they are today.
So with that, I want to take a pause, and I know that Jason and I are going to take some questions from the audience, and I look forward to hearing from you. Thank you.
Stipp: Thank you, Christine. So I'd like to remind you, we've gotten some great questions so far. Please do go ahead and input your questions for Christine. Now's your chance. We would love to hear from you. We want to know what's on your mind, and we will be reviewing those questions in real time. So it's not too late. Please do let us know what you'd like to hear about. Christine can address your questions.
Christine, we had this question about asset allocation; this is one of probably the most important decisions you make on your portfolio. This person said, they've managed, and I think this is to their credit, to have a pretty well-sized portfolio for what their needs are, and they're wondering if they feel like they'll have an overage or they might have more money than they'll be able to use in my lifetime. Does that affect their portfolio allocation, and how they might allocate their assets? What are some of those swing factors there?
Benz: That's a really good question. It's a good problem to have. I wish more people had that problem, but I think the key thing to keep in mind if you find yourself in that situation, you want to think about what your other long-term goals might be for that money. For a lot of people, particularly with children or grandchildren or even favorite nieces or nephews, it's more about setting money aside for the next generation, which typically would call for having a higher equity exposure, especially if you are a fairly young retiree or something like that. You would have a lot of time for that money to compound and grow over the years for your heirs.
So if you are in that enviable position that probably calls for having more equity exposure than you otherwise would.
Stipp: A lot of our readers are very concerned about their bond allocations, the allocation to fixed income. We do know that there are indexes out there, total bond market indexes, but we had a question about what are some of the rules of thumb generally for fixed-income allocations, and should we think differently about our fixed-income allocations given the current environment? How might you think about where you would allocate those assets? Should you carve out a sleeve that would be fixed income and put it in something more risky, for example, because the bond outlook is cloudy?
Benz: That’s another great question and top-of-mind with so many of our users now. I do think it is a reasonable strategy to take maybe a component of what you might have otherwise earmarked for bonds and dedicate it to some other income-producing vehicle, whether it's most likely dividend-paying stocks, but I do think you have to mind the volatility profiles of bonds versus dividend-paying stocks and just how different they are. So I haven't run the numbers recently but last time I did, the standard deviation of the typical intermediate-term bond fund was just one fourth of what dividend-paying stock funds were. Usually, dividend-paying stock funds are pretty high-quality stock funds, so I think it's important just to be mindful of the fact that you're courting a lot of volatility with that part of your portfolio and really step back and think about, well, why do I have bonds in my portfolio. Not so much for return generation but stability and so if you have a high-quality fixed-income portfolio, and you're not really going way out on the duration spectrum, I think you can safely assume that even in an environment of rising interest rates, that part of your portfolio is going to swing around a lot less in value than any equity component would.
Stipp: What about Treasuries? I know there have been concerns about how much the Barclays Aggregate Bond Market Index has in Treasuries. We've been worried about Treasuries just because the yields have been so low, yet we see Treasuries continue to perform so well. How should you think about Treasuries given that their performance has been a bit confounding recently?
Benz: It definitely has. I hate to be sound milquetoast about it, but I do think it makes sense to balance Treasuries with other securities in a fixed-income portfolio. I know that there was this big vogue to sort of starve portfolios of Treasury exposure a couple of years ago and as you said it didn't work out that well. The other thing we've seen is that in true flights to quality, Treasuries tend to outperform other asset classes. So I think that while you may not want to go full on Barclays Aggregate for your whole bond exposure because as you said, Jason, it's very concentrated in Treasuries and other government bonds, I think you do want to make sure that you have at least some Treasury exposure in your portfolio. Or if you're opting for an active manager, make sure that you have a manager who has that in his or her toolkit.
Stipp: Having that diversification over the last couple of years has really paid off for folks who did have a slug of Treasuries they kept in their portfolio. We have several questions on inflation and how to battle inflation. I know you've done some work on inflation and the bite that that can take out of returns. So, the first thing I would say is, what magnitude should investors consider for inflation? We seen it be relatively mild, but over time it's taken a pretty big bite, right?
Benz: It has, and when you run the numbers and look at how much you need inflation-adjusted versus non-inflation-adjusted, it's pretty staggering that what looks like a decent pile of money, once you account for inflation over say a 20-year period, it's maybe not enough. So that was one reason, Jason, I was saying any tool you use should absolutely be factoring in the role of inflation. That's a fundamental underpinning.
In terms of specific investments that I think work well against inflation, Treasury Inflation-Protected Securities are the most direct vehicle for doing that. The problem is they are Treasuries, so their values have been bid up pretty well over the past few years.
Dividend-paying stocks or stocks in general I think give you the best long-run chance of outgunning inflation. And then another category that I think is probably worth a look is bank-loan investments. I noticed that investors have been yanking money recently because yields are no great shakes there in absolute terms. But they have a neat feature that makes them sort of impervious to rising interest rates so the yields that they pay or the interest rates on the loans actually reset upward as interest rates go up. So I think it provides kind of a neat hedge against higher inflation. Those would be some of the key things I would have in a toolkit.
Stipp: Do you have a take about commodities and the percentages that you might want to consider for commodities in a portfolio for inflation?
Benz: You know, I have been watching that category. I know Ibbotson, a Morningstar company that focuses on asset allocation, typically recommends an allocation in the 5% or 6% range. My view is that a lot of the commodities investments that have rolled out over the past, say, five years were not quite ready for primetime and that they're not perfect trackers of commodity prices. So I think a lot of investors if they have, say, energy exposure, any energy equity exposure in their portfolio, that might be adequate rather than going out and purchasing that dedicated commodities play.
Stipp: One thing that I will say about inflation overall is if you think that we're in for a lower-growth, lower-investment-return environment when you factor in inflation, when you factor in investment fees on top of that, it really can make your returns quite low. So it just pays to do what you can for inflation and also to really keep an eye on those fees because if you're talking about a 6% or 7% return environment for stocks and maybe a 3% or 4% return environment for bonds, it doesn't take a whole lot to bring those way down in real terms after fees.
Benz: That's so true. So I think you want to think about the total hurdle rate that your portfolio has to deliver a positive return. As you said Jason, once you factor in fees, I think people might think, "Oh, what difference does it make if I pay 1% or 2%?" Well, gosh, if you're lucky to earn 6% on a balanced portfolio, it makes a big deal. So, it's absolutely worth factoring in the whole gamut of the hidden hands that are going to reach into your portfolio and extract some return from it.
Stipp: Christine, we have a question from someone who says, "I am very close to retirement. Where should I invest money that I'll need in three to 10 years into my retirement?" I think this has to do with the bucket approach that you've espoused.
Benz: It does, and I love that our readers have really gotten into this idea of bucketing. The idea is sort of you're segmenting your portfolio based on when you expect to need your money. So one strategy that we've set out on Morningstar.com is sort of looking at bucket number one as cash or maybe a very safe short-term bond. Three through 10 is kind of your intermediate-term portion. So you think about assets where you'd want to have sort of that three- to 10-year time horizon. That's bonds, certainly high-quality bonds. It might also be say a high-quality balanced fund. So I know a lot of our users love Vanguard Wellesley Income and Vanguard Wellington Fund, which is sort of a value-oriented stock piece combined with a good quality fixed-income piece that's maybe a little heavy on corporates.
But I think that that's probably where you want to go with years three through 10, bond funds and balanced funds. And then 10 and beyond, that’s your growth engine, so you want to hold primarily stocks. That's where you are holding international stocks; that's also where you are holding very risky bond types, such as high-yield bonds.
Stipp: So we're running a little short on time, but I wanted to get a couple of more questions in, and you're actually going to be sticking around for our final panel, so we can pull some of these questions into that Q&A, as well.
A question on required minimum distributions. The major question that we got was I think some people want to avoid having to take them if they don't have to but they obviously do need to take RMDs for some kind of retirement accounts. What if I don't need that money though? What should I do with that money if I have got to take something out of my 401(k) or my IRA?
Benz: That’s a great question. First, Jason, I would say that one alternative if you are a very high income earner and you're concerned about RMDs and you don't think you need the money, is that you ought to look at conversions. So if that IRA money, for example, is mainly there for your heirs, it's worth talking to a tax advisor to run the numbers on whether converting those assets or some of those assets makes sense, but there are a lot of people who are in this boat where they say they don’t need the RMD money.
You can certainly reinvest it. You can't reinvest it in a traditional IRA once you're at that age where you are taking RMDs. But if you are say 70 1/2 taking RMDs and you have enough earned income to cover a Roth IRA contribution, you can actually reinvest in a Roth, or if your spouse has enough earned income to cover a spousal IRA for you. So I think that can be a really good strategy for people who find themselves in that mode where they don't need that RMD money, and they mainly want to pass on a good gift for their heirs. Roths are blessed on a few levels. But one of the big advantages is that you never have to take RMDs and that money will pass tax-free to your heirs. It won't necessarily be free of estate tax, though.
Stipp: Last question for you for this Q&A, Christine. The role of annuities, I think the income stream from, especially a simple annuity, is very attractive to folks, but there are a few things you need to think about with annuities, especially in today's environment, right?
Benz: Well, yes. So there are so many different types of annuities. If anyone is talking to you about any annuity type, just make sure you understand it backward and forward. I unfortunately talk to a lot of people who don't know what type of annuity they have. So, first just make sure you're doing your due diligence. There are no stupid questions when it comes to annuities because they're horribly complicated.
Then to home in on your specific question, Jason, if you're looking at the most simple type of annuity, an immediate annuity, or a single premium immediate annuity it's sometimes called, the bad thing about such a product right now is that because interest rates are very low, the insurance company knows that it's not going to be able to earn much on your money. So payouts are also depressed.
So I think that there is a big risk if you are just entering retirement, and you want to lock in that current stream of income. Unfortunately, if you're opting for one of these products, you're locking it in at historically low interest rates. So a better strategy, one that Harold Evensky, the guru of financial planning has talked about, is just laddering those annuities over a period of years, so planning to maybe buy one right now, waiting to buy another one in year two when maybe interest rates are more favorable, and on down the line. And the beneficial side effect of that is that you're also diversifying your risk across multiple insurers because I think the thing that we all worry about is that you might invest your assets with an insurer that in turn runs into some financial trouble.