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By Christine Benz | 10-11-2011 03:27 PM

Armstrong: Invest for Total Return

Retired investors need the ballast of bonds, but in today's environment, they can't depend solely on a portfolio's income stream, says Investor Solutions' Frank Armstrong.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Big market swings are unnerving to everyone, but especially to retirees who are looking to their portfolios for current living expenses. Here to discuss some coping strategies for retirees is Frank Armstrong. He is president and founder of Investor Solutions LLC, which is a registered investment advisor based in Florida.

Frank, thank so much for joining me.

Frank Armstrong: It's always my pleasure.

Benz: So, Frank, you have been one of the pioneers of the bucketing approach to retirement income. Let's talk about what that is exactly, and why you think having separate buckets in retirement can help retirees manage volatility a little bit better?

Armstrong: Well, first, if you have an income bucket of fixed-income today, at least, it's going to produce next to nothing, but its purpose is to serve as a store of value and to moderate the risk in the portfolio as a whole. You're not going to be able to accomplish your objectives using that unless you're so incredibly wealthy that you don't need to bother about planning.

However, the other half of the portfolio needs to grow to counter inflation and meet your growth objectives. So, your total return is enough to support a reasonably liberal withdrawal program.

So, on one hand you've got a bucket of safe, safe assets that you can use to withdraw your fixed income for some period of time in the future. We recommend eight to 10 years. That allows you to sleep well at night, have the intestinal fortitude to ride out the ups and downs, and also have the financial ability to ride the ups and downs with the market, because you know that all your bills are going to be paid for some very long time out into the future, and the overwhelming probability is that the market is going to self-correct whatever disaster we have today, and go on to all-time highs during that 10-year period.

So, we use two buckets, one for safe, safe assets to meet your needs off into the future and moderate the risk of the total portfolio, and the other bucket to grow to meet your long-term needs to hedge inflation and have real growth of the portfolio.

Benz: So, eight to 10 years, Frank, you're not saying sink eight to 10 years' worth of living expenses in cash though, right?

Armstrong: ... In a short-term, high-quality portfolio that doesn't vary a lot, and it's a near-cash, one- to two-year durations. It doesn't vary a lot in capital values as interest rates go up and down.

Should you go longer or lower quality, at some point, interest rates have to go up, which means capital value is going to fall like the rock, and you don't want to be there.

So, short-term portfolio protects your downside in a rising interest rate environment. Very few of us would like to bet the farm today that interest rates can't go up.

Benz: Right. I want to talk to you specifically about how you're thinking about client portfolios. It seems like a very vexing environment for fixed-income investors, people are concerned about, as you said, rising interest rates, but also, if the economy weakens, about going to junky. So, how should people manage in such an environment? Do you have any tips for what a diversified fixed-income portfolio should look like right now?

Armstrong: Well, there is no income left in fixed income. ... Yesterday we just saw 30-year mortgage rates fall below 4% for the first time in history. The 10-year Treasury is hovering around 2% or less. There is no income in fixed income. And the downside risk of either going long or lower quality is just not worth whatever little tiny incremental yield you could get.

So, you have to invest for a total return of the portfolio, and give up on the idea that you might have inherited from your grandfather of: live on the dividends, live off the interest, and preserve principal--whatever that means to you--for the rest of your life.

So, the total return portfolio is demonstrably safer than an income portfolio would be, and right now in this current environment, it's going to have a lot of upside--with, obviously, also downside--but as opposed to an income portfolio, I only see downside in it.

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