Jason Stipp: I'm Jason Stipp for Morningstar.
So, today, we're playing catch-up and answering some retirement-related questions with one of our panelists, Christine Benz, our director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: No shortage of retirement-related questions. We were able to answer a lot of those at our recent events. But we have a few that we didn't get too, specifically, that we're going to cover it today.
The first one is about withdrawal strategies--obviously very important to folks who are in retirement mode and taking money out of their portfolios, and it has to do with a very well-known rule of thumb, the 4% rule. The question is can you explain the 4% withdrawal recommendation for a retirement account?
Benz: When you hear that 4% rule, I think a lot of people get confused about what it means. But what the classic 4% rule means is that you take 4% of your portfolio balance on day one of your retirement, and that's the amount that you can withdraw in year one of your retirement. Then you can inflation-adjust that amount--so nudge it a little higher to keep up with cost of living increases--on an annual basis.
And under the research that has been done--and there has been a lot of research done on this particular topic--the ideas that that portfolio could last roughly 30 years through a variety of market conditions, and it would be a roughly 60% equity, 40% fixed-income portfolio. [Research suggests] that person employing that strategy would have a very good chance of not outliving his or her money during his or her lifetime.
Stipp: So, under that methodology, then, you get one amount on year one, and that amount then is adjusted by inflation each year.
So, 4% doesn't mean each year I take 4% of my portfolio value, and that's what I have that year?
Benz: It doesn't, although that is another strategy.
In fact, in conversing with some of our Morningstar.com readers, that's the strategy that they use, and that's the strategy they like, because it does plug their portfolio into market sensitivity--what's going on in the market. And that has been one frequent criticism of the 4% rule. So, even though it gives you that fixed, inflation-adjusted dollar amount, you're really not responding to big periods of market down-draughts, when you may want to actually be taking less, nor are you responding if your portfolio does particularly well. So, you're not giving yourself a raise if you've had really great results. So, by taking a fixed percentage per year, you're more plugged into the market environment.
On the downside, it means that your actual paydays will change a lot, and that's not something that some people want during retirement. They want more or less a static stream of income.
So, it does come down to individual preference and the extent to which individuals are willing to adjust their lifestyles to accommodate what's going on with their portfolios.
Stipp: Some interesting facts about 4% rule--thanks for helping to clear some of those up, Christine.
A second question also has to do with building income from a portfolio and getting income out of a portfolio. A reader asked, "How can a retiree reconcile a portfolio designed for total return with the need for downside volatility protection?"
So, before we answer that specific question, let's talk about total return, investing for total return, versus income investing. A lot of folks are very focused on [income investing] right now--getting an a income stream from investments without touching principal. What are the pros and cons of those two methods of investing in retirement?Read Full Transcript
Benz: I'm really happy to hear this particular reader is plugged into using a total return approach. People naturally are attracted to just living on whatever income their portfolio kicks off. The risk --and it's one that we've seen in vivid color over the past few years--is that when yields are way, way down on safer securities, the risk is that to earn a livable income stream, you have to venture into increasingly risky securities. And I think that's something that investors have very much been doing over the past few years. You've seen big-time flows into high-yield bonds, some of these risky categories. Frankly, I think investors are supplanting dividend-paying stocks in some cases for bonds. So, the downside is that you could end up with a much higher volatility profile, even though you are able to live on the income that your portfolio kicks off. So, that's the income approach.
Stipp: So, a total return approach, then, is looking at the earning power or the capital gain power of your entire portfolio, and then drawing off of that portfolio, and it may mean basically drawing down some of that principal.
So, I think what this reader is saying, if I run my portfolio that way, I could see some volatility there--maybe I'm not [invested] in those more stable income-producing investments--and I don't want a lot of volatility when I'm retired. So, how can you reconcile those two issues if you're going to go with a total return approach?
Benz: I think there are some misconceptions about total return--that it means all stocks or that it means you forsake income-producing securities altogether. It doesn't.
It really means that you stay diversified, and the beauty of the total return approach, in my view, is that it lets you be opportunistic about where you go for your money for your living expenses. So, in some years, like maybe the current very low-yield environment that we're in, you're getting a little bit of income from your portfolio, but maybe you are tapping it for capital gains. The equity markets have been very good, chances are you've grown your kitty a little bit if you've had stocks, so you've been maybe able to take distributions from both parts of your account, both those income distributions as well as periodic capital gain invasions.
So, I think it allows you to run a more balanced portfolio than you might if you focused exclusively on income producers.
Stipp: I think that the bucket approach that you've espoused can also be used here, because you can have a portfolio that's longer term--that is more total return focused and might be a bit more aggressive--and then you can have another slice to your portfolio that maybe is more income producers for nearer-term needs.
Benz: That's really the whole idea. So, you've got that stability piece, your bucket number one, which is in cash and other liquidity instruments. You've got the secondary reserves, which is intermediate-term bonds, high-quality bonds, maybe some high-quality dividend-paying stocks or balanced funds. Then you've got that growth piece. So, coming into the end of a year like 2012, for example, maybe you are getting some of your income from bucket number two, and you're using that to refill bucket number one, but maybe you're also doing a little bit of rebalancing as we come into the closing days of 2012. So, you're taking some of your capital gains, using that money to refill bucket number one.
Stipp: Christine, we had one more question. It's an interesting one. It keys in on some of our fund research, I think, to answer this.
The question is from a reader, "I'm 68 years old and retired. Is there one mutual fund, or two or three," the reader says, "out there that I could place in my IRA, look at it annually, and still sleep at night until," the reader notes, "I am in the grave."
So this reader is looking for a very long-term "sleep at night" kind of fund. What are your recommendations?
Benz: Well, to me it does depend on the investor's need for the money, or lack of need for the money. So, in this particular investor's case, it sounds like maybe there is no imminent need for the money. Maybe this is money that he or she is passing to the heirs--the kids or the grandkids will get this money. In that case, I would say, you'd probably want to consider it sort of the longest-term piece of the portfolio. You definitely would want some stocks, I would think. So, even though you'd have a little bit of principal volatility, you would want that growth potential that comes along with stocks. But maybe you would want to use some kind of a balanced fund that offsets the risk in the equities by holding bonds as well.
So, a couple of investments come to mind. Dodge & Cox Income is a longtime Morningstar fund favorite; I think it's a very good idea for a situation like this. Maybe a more equity-heavy idea would be Vanguard Wellington, another one of our Morningstar.com reader favorites. That is heavier on stocks but also uses sort of a value-oriented approach, a focus on dividend-paying stocks there. So, that would be an idea for an all-in-one investment.
Stipp: So, some good long-term funds that should give you a pretty good smooth ride over that time period and help you sleep at night.
What about, Christine, if this person was going to be drawing down, potentially, on some of those funds along the way, but maybe still has a long-term timeframe? Would you go with a couple of funds in that case or what would you recommend for good long-term hold-and-keep funds?
Benz: Well, I love to keep things simple. I love the idea of going with all-in-one funds, but here I would say, if you are in a position where taking income or liquidating part of your portfolio is part of the plan, as you are, for example, withdrawing from an IRA, it seems like you'd probably want more than one fund. And the reason is that if you have some sort of a balanced fund, typically what happens is, when you need to sell, they will sell sort of pro rata shares of both the stocks and the bonds.
So, you won't be able to pick and choose where you are selling, and it seems to me that most investors when they are in distribution mode, probably do want that level of control where they can say, [for example,] "It's early 2009, I don't want to sell stocks; I'd rather sell bonds, which have done really well." That's what you have when you do have a portfolio that's composed of multiple assets. It doesn't have to be a lot. It can be as few as two, but I think you would want to just be able to keep that level of control for yourself.
Stipp: All right, Christine. There's no shortage of retirement-related questions. I'm sure we'll have many more, but thanks for helping us answer these particular questions today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.