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By Jason Stipp | 04-12-2011 05:07 PM

ETFs and a Total Return Approach to Retirement Income

Morningstar's Christine Benz outlines the mechanics and reasoning behind the total return approach she advocates for her model ETF portfolios.

Jason Stipp: I'm Jason Stipp for Morningstar.

It's ETF Investing Week on As part of this week, Morningstar's Christine Benz revisited some ETF model portfolios for retirees.

Those portfolios follow a total return approach to generate that paycheck in retirement that retirees are searching for. She is here to explain a little about how that approach works.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, normally you think, when you are in retirement, you need that portfolio to throw off some income for you. You need to basically be able to draw the money for living expenses out of it. You've chosen with these ETF portfolios to take a total return approach versus an entirely income-generating approach. Why is that?

Benz: Well the key reason, Jason, is that, right now given the current low-yield environment, it's awfully hard for people to leave on yield alone. So, you either have to have an awful lot of wealth, in which case you may be able to get buy on 2% or 3% yields, or you have to be venturing into some risky income-producing investments. Right now, I fear that some investors are doing just that; we're seeing very strong flows into some of these higher-yielding categories like bank loan funds, high-yield funds. My concern is that investors are possibly taking on more credit risk than they should be, and they may be in for an unwelcome surprise if we do see some correction in those markets.

Stipp: So, given today's environment, it's important to think outside the box. I think traditionally, retirees would like to think of their portfolio as this principal that they protect and then this income is thrown off that they use, and they don't have to touch that principal, but that just might not be viable in today's environment.

So, if you are going to look at a total return approach, so basically you're going to also depend on some capital appreciation to help that portfolio sustain itself, how does that work? How do you put that into action and translate that to ultimately some kind of an income stream?

Benz: Well, the starting point would be to gauge your income needs. So, look at how much you need your portfolio to generate, so income that isn't going to be provided by Social Security or a pension. What you need your portfolio to kick off?

And then spend some time running through some models to see whether that amount is sustainable. So, use a tool like Morningstar's  Asset Allocator. There are lots of different retirement income tools on the web, kind of stress-test that plan withdrawal rate to see whether that's going to be doable and plan for a nice long life expectancy as well while you do that stress test.

Stipp: So, this is ETF Week, and if we're going to focus on how you'll put together a portfolio of ETFs that you could use after you figure out those income needs, how would you start to put it together? What different sorts of buckets might you use in order to put this approach into action, using ETFs?

Benz: It does get back to that bucket approach, Jason, which I think can be really powerful. So, the simple idea is that you've got bucket number one which is holding maybe zero to three years worth of income needs.

So, maybe you've got a true cash piece to that bucket number one and then maybe you've also got a very high-quality short-term bond fund, such as Vanguard Short-Term Bond ETF. That's bucket number one; that's what you're going to be drawing on for years zero through three of your retirement living expenses.

Stipp: So these are really short-term buckets, as we said before, they're not really going to be giving you much income. Really you're depending on those for the stability of the portfolio and those short-term needs, correct?

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