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By Christine Benz and Jason Stipp | 03-22-2014 02:30 PM

Ready Your Portfolio for Retirement

Morningstar's Christine Benz demonstrates how to make a bucket portfolio best work for you, touching on allocation, RMDs, other income sources, and more.

Christine Benz: Hi, I'm Christine Benz. And welcome to the final session of our Morningstar Individual Investor Conference, Ready Your Portfolio for Retirement. I'm going to be talking about some of the key challenges facing retirees today as well as some of the central ingredients that belong in every retiree's portfolio.

I'm going to be discussing the bucket strategy for managing a retirement portfolio, and I'll also share some model portfolios that I have developed that use the bucket concept.

We will be taking questions. My colleague Jason Stipp will be coming out toward the end of this presentation to help me tackle some questions.

My slides are also available for you. [You can download the slides here].

So let's go ahead and get started. I wanted to talk about why the current environment is so challenging for retirees. And a lot of you will be familiar with the trend that is depicted on this slide, namely, that if you want to stick with very safe securities, the interest-rate environment has been very, very cruel.

I did a presentation similar to this one a couple of years ago, and, unfortunately, the interest-rate climate, at least for short-term products hasn’t improved a lot. It's very difficult to earn a livable yield from your certificate of deposit, your money market investments. This is in sharp contrast to those who are lucky enough to have retired in the 1980s. They did have runaway inflation to contend with, but they did have much, much higher yields.

The net effect of this is that investors who want a higher yield have to edge out on the risk spectrum somewhat. So we can see, if you are willing to take on a little bit more interest-rate sensitivity in your portfolio, you can pick up a higher yield certainly than you can earn in CDs or money market funds, but it's not a lot higher. The Barclays Aggregate Bond Index, for example, just has a yield just a little bit over 2% currently. If you wanted to stick exclusively in Treasury bonds, it's under 2%. For municipal bonds, you can earn a little bit more, but you have a little bit more risk arguably because you have some municipal finances under a cloud. You can see that you can pick up an appreciably higher yield by venturing into long-duration bonds. At this point, the yield is nicely over 4% currently, but you're also picking up a lot of interest-rate-related volatility with such a product.

I recently looked at the duration [a measure of interest-rate sensitivity] for a long-term bond index, and it's in the neighborhood of 14 years. One thing we often use to try to get our arms around how interest-rate-sensitive such a portfolio would be, is it you take that duration statistic, subtract the yield from it, and the amount that you're leftover with, in this case 10 percentage points the difference between that 14-year duration and the 4% yield, that 10 percentage points is roughly the amount you could expect to see that index lose in a one-year period in which interest rates trended up by just 1 percentage point.

You can see, you are able to earn a better yield on such products, but it comes at the expense of substantial interest-rate-related volatility. Needless to say, a lot of investors are not comfortable taking that risk right now, particularly given that interest rates have a lot more room to move up than they do now.

How about if you're willing to take more credit risk? This is certainly a trend that we've been seeing among investors. We've heard numerous panelists [at the Morningstar Individual Investor Conference] allude to this fact that investors are gravitating to some of these higher-credit-risk fixed-income types. You can see that the yields are better in many cases than what you can earn on high-quality bonds. High-yield bonds, for example, currently have yields well over 4% typically for the big core funds, high-yield funds that you might find out there.

Emerging-markets bond funds also have yields in that neighborhood. Multisector bond funds don’t have yields quite as high, but they are definitely attractive relative to high-quality bonds. And floating-rate or bank-loan funds, that’s another category that various individuals have discussed during this conference, that's a category that has seen a lot of interest in part because the yields are pretty attractive relative to high-quality bonds.

The trade-off, though, of some of these bond types is that you also get a lot more credit sensitivity. You get a lot more sensitivity to the direction of the economy, and you get a lot more sensitivity to what's happening with the equity part of your portfolio.

These bond types, while they can be valuable additions to investors' fixed-income portfolios, will not provide that same ballast that high-quality fixed-income types might do for you. So I’ve provided here just a little bit of context, where you can see the losses that these investment types incurred in 2008.

I'm not saying we’re going to find ourselves back in a 2008-style environment, but it’s just here to show you the type of equity sensitivity that you’re getting with these products. The losses weren't quite as high as what one would have gotten with a pure equity portfolio, but they were certainly in the same ballpark. So that's something to bear in mind if you’re thinking about adding these investment types to your portfolio.

You can see that if you have a plain-vanilla 60% equity, 40% bond portfolio, your yield isn’t all that exciting, in this case, just over 2%, currently. And here again, you do have significant equity sensitivity.

If you are going to venture into a higher-dividend-yielding product for the equity piece and a higher-yielding fixed-income product for the bond piece, you can see that the yield is a lot better here. It’s quite attractive relative to what that 60/40 balanced plain-vanilla portfolio had. But what you have here is also a lot more loss potential. So this is marrying together a high-dividend-yielding equity index ETF with a high-yielding bond index ETF, and you can see that its performance was substantially worse in 2008 versus that plain-vanilla portfolio.

What is an investor to do given that the raw materials for an income strategy just aren’t adding up right now? You can certainly use income-producing investments for a portion of your portfolio, but I would argue that retiree portfolios really need to include a gamut of other ingredients, as well.

The first one and really a key one that we'll run throughout this presentation is that in my view retirees today need to focus on total return, not just exclusively on current income. That’s not to say they don’t want to own income-producing securities--they absolutely should--but they should embed them within a total-return framework.

And the key reason gets back to the slides I just showed you, that for many investors it’s difficult to deliver a livable yield using income-producing securities alone. A better strategy in my mind is to use income-producing securities but also leave open the idea that you might be opportunistic about where you go for cash on a year-to-year basis.

At the end of 2013, for example, I argued that one of the best things retirees could do for themselves was to actually rebalance their equity portfolios, sell some equities, because the equity markets had such a tremendous run, and use some of that money for living expenses versus gunning for current income.

So I think this is such an important concept, and I will be discussing it further in the context of the bucket portfolios that I’ll share with you later on.

A component of guaranteed income is another key ingredient. Thankfully most of us will come into retirement with at least one of these elements of guaranteed income, so this is Social Security, perhaps a pension for some individuals, or perhaps some sort of a single premium immediate annuity. The idea is that you want to supply your portfolio plan with some baseline of living expenses, and then your portfolio only has to supply the rest. But as I said, the good thing is that most people do have some element of guaranteed income as part of their portfolio plans.

A sustainable withdrawal rate, we could do this whole presentation on this topic because it is such an important one, but the key thing to bear in mind is that you want to make sure that whatever amount you are withdrawing from your portfolio in terms of income, capital gains distributions, or rebalancing, that it doesn't exceed the level that experts normally considered to be reasonable. So, we've all heard about the 4% rule, and what that means is that you withdraw 4% of your portfolio in year one of retirement and then you gradually inflation-adjust that figure as the years go by. That's one way to do it.

Another strategy, and this is one that I've heard that for many users about, they really like to use a fixed withdrawal rate, so they are using 4%, but they are using it on a year-to-year basis. The benefit they say, and I think it's a valuable thing to note, is that it makes their withdrawal rate more sensitive to whenever their portfolio is doing. So, when their portfolio is way down, they're willing to tighten their belts and stick with that fixed withdrawal percentage.

But the important point is to make sure that whatever withdrawal rate you're using in managing your retirement portfolio that it is within the realm of sustainability. So anytime run the numbers and looked at withdrawal rates that are running over 5%-6%, you are getting into a danger zone that might not be sustainable over your entire retirement. It's important, though, to underscore some of the assumptions that underpinned that 4% rule. Specifically, it looked at a roughly 60% equity, 40% bond portfolio, and it assumed a roughly 30-year time horizon.

If your portfolio plan looks substantially different from those parameters, you may be able to use a different withdrawal rate. So, for example, if you're 85 and you are using the 4% withdrawal rate, that might in fact be too low, given your life expectancy, especially if you didn’t have a strong goal to leave additional monies for your children and grandchildren.

In addition to the previous factors, you also want to make sure that your portfolio plan includes a stable pool of assets to draw your living expenses from. This is really the linchpin of the bucket strategy. The idea is that, you've set aside money, usually one to two years' worth of living expenses, in truly safe instruments. And, granted, when you factor in inflation, this may well be dead money for you because we saw the very low rates that are available on truly safe securities right now. But the idea is that you are parking the money that you expect to need in the near term, and it’s not going to be harmed at all by market fluctuations. And so your longer-term portfolio can do what it's going to do; you know that you have the money set aside to fund your near-term living expenses.

You don't want to get fancy with this portion of the portfolio. You don't want to start venturing into riskier asset classes. You want to keep it safe. You want to keep it in guaranteed or near-guaranteed investments like CDs and money market funds. I sometimes talk to investors who tell me that they like to have even more than one to two years' worth of living expenses set aside in these truly safe investments. In that case, you might consider building a two-part bucket [for bucket 1].

And this might hold true CDs, money market funds, and so forth, as well as perhaps a high-quality short-term bond fund, such as T. Rowe Price Short-Term Bond. But the idea is that you don't want this position to be too large because there is opportunity cost associated with having so much money hunkered down in true cash.

A measure of inflation protection, why you need it is simply that, as you are no longer earning a paycheck, you're no longer eligible for those cost-of-living adjustments that you were able to earn, hopefully, while you were working. You may have some form of inflation protection. If you're taking Social Security, your payments are inflation-adjusted, but that's only a portion of your living expenses.

You need to make sure that that portion you're withdrawing from your investment portfolio also has some inflation protection embedded into it. The best way, long term, to make sure your portfolio is inflation-protected is simply to have some stock investments in your portfolio because that is the best way to outgun inflation over very long periods of time.

You can think about some additional categories though Treasury Inflation-Protected Securities or I-Bonds are ways to explicitly inflation protect your portfolio. So you receive a little inflation adjustment in either of those types of investments.

You might also look to other categories like commodities. The theory there is that as you're having to pay higher prices for the stuff that you need to buy to live your life, that you are participating in the price gains of those commodities as they increase. If you have some sort of a commodities-tracking investment, that means that even as you're having to pull more out of one pocket, you can perhaps put a little more in the other one.

Then there are other categories like floating-rate funds, which some of my colleagues have done some research on and have shown to be quite advantageous from the standpoint of protecting against inflation. But you need to make sure that that whole portfolio does have some insulation against inflation to make sure that inflation doesn’t gobble up the purchasing power of the money that you have in that portfolio.

A growth component for longevity--I just touched on the importance of having stocks in your portfolio to help provide some insulation against inflation, but stocks are also important because many retirees will be retired for 25 or 30 years or even more. So that means that you can’t just hunker down in truly safe securities, in cash and bonds. You absolutely need that growth engine for a portfolio. Even if you’re someone who is further on in retirement, I would argue that you still need at least some equities in the portfolio.

The ability to put a plan on cruise control. This is another topic that is so, so important. I often talk to investors in my travels where they are the person in their household who manages the investments, and they love it. The problem is, oftentimes they have a spouse who doesn’t love it, who is not that interested, is not that engaged, is not even that aware of what’s going on. So as you go into your retirement and certainly as you get further in your retirement, it becomes more important to build a plan that has that element of cruise control, that needs to be able to run itself for a time being if need be.

You can do that by having that cash set aside, that bucket 1, as I just discussed. That way if something should happen to you or if you should just not have interest in managing your portfolio for a while, at least you'd know that your near-term cash needs were covered. So that’s one idea.

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