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By Christine Benz | 03-23-2013 03:30 PM

How to Build Your Income Stream

As yields remain low, today's retirees have to really think out of the box when it comes to building an income stream; noted advisor Harold Evensky and Vanguard's John Ameriks explore practical strategies to obtain income without overstretching for yield.

The following is a replay from the 2013 Morningstar Individual Investor Conference.

Christine Benz: Hi, I’m Christine Benz for Morningstar.com, and welcome to our session, How to Build Your Income Stream.

In this session, we will talk about the challenges confronting retirees today, and we’ll also talk about some practical strategies for navigating the retirement landscape. As in all of the previous sessions, we invite your questions, we welcome your questions. So, please use the Ask a Question button to the right of your viewer if you'd like to submit a question. We’ll actually be taking some of your questions throughout this session.

I’m happy to introduce today two of the preeminent retirement experts in the United States, who have joined us here today. John Ameriks is here from Vanguard. He is a principal at Vanguard. He is also head of the firm’s active equity strategies. He is an expert in a lot of different research topics, including portfolio construction, investments, and retirement planning. We’re very pleased to have him here today.

Harold Evensky is also here. Harold has been called the dean of financial planning by Morningstar's Don Phillips. Harold is the founder and president of Evensky & Katz Wealth Management. He's also an adjunct professor of personal financial planning at Texas Tech University. So, thank you both for being here.

This is such an important topic, I think we could talk all afternoon about retirement planning and probably end it tomorrow morning, but I would like to pick up on the income in the title of this panel and use that as kind of a jumping off point. One theme we've heard throughout today is that investors are very interested in income, and I'd like to get your take on the role of income-producing securities within retirement portfolios. What are the pitfalls of anchoring strictly on income-producing securities and using them to try to wring your living income from? Harold, you want to take that?

Harold Evensky: Sure, I’m happy to. My answer is that it results in somewhere between a bad and catastrophic result. People need consistent real cash flow, not dividends or interest. And if you design your portfolio based on that, that's going to control the stock/bond allocation which clearly will have no relationship to what's appropriate. So, our approach is you design a portfolio for total return, then figure out how to get the cash flow out of it.

Benz: John, you're nodding.

John Ameriks: I completely agree with that, and I would say focusing on income, just as focusing on any single characteristic, when you're talking about investing, if there's a mistake you can make, it is focusing on just one thing. Investing is all about making trade-offs and thinking about trade-offs, and the notion that somehow targeting income is going to be best for someone is really, as Harold says, can be catastrophe from a lot of different viewpoints.

Evensky: I mean, if you think about it if today if you did that, you'd end up largely with fixed income with bonds, and it means when interest rates go up you're going to feel rich when in fact the value of your portfolio is going down. When interest rates go down, you will feel poorer; when your portfolio value is going up, and then over a time if you have a nominal return, inflation is going to eat you alive. So other than that it's a great strategy.

Benz: So, Harold one strategy that you've pioneered is this bucket strategy, and it’s one that we’ve talked a lot about on Morningstar.com. People seem to really get it and like employing it and see how that total-return approach works. Let's talk about the bucket strategy that you use with your clients.

Evensky: The bucket strategy that I talk about and use would be called the two-bucket strategy, real simple concept. Originally, when I did it I had suggested two years. With some subsequent research, I had it down to a year. Basically carve out what you're going to need for living expenses and that goes in what we call a liquid, basically money market account. Set it up to pay yourself a check once a month like a payroll check. The investment portfolio is a long-term portfolio and then you manage that very cost- and tax-efficiently. As you're managing that at some point you need to rebalance, market collapses you're going to sell bonds. And then you look and say, "Geez, it's kind of down. Let me fill it up." The point is you can control when you're selling something as opposed to the market.

Benz: So you take sort of a total-return and opportunistic approach really to refilling that bucket number one.

Evensky: Exactly.

Benz: So whatever has done well that gets trimmed and the proceeds go in there.

Evensky: That's correct.

Benz: John you've taken a slightly different spin on a total-return approach in the managed payout funds that Vanguard has. Let's talk about how those work and how they employ multiple asset classes to give that total return?

Ameriks: Sure. I'm happy to talk about that, and I think the strategy itself is built into a fund, so that's I think what makes it different. But I think the spirit of what we're trying to do is very similar to what Harold talks about, and when talking to folks from Vanguard you’ll hear the same kind of things, focus on total return, make sure you have your liquidity needs taken care of, and then use the cash flow needs or the cash flows that you are receiving from elsewhere to tax efficiently manage a portfolio.

Now managed payout can make the task of rebalancing and maintaining a total-return target or spending target in one portfolio a little easier. It puts together a set of funds and a set of exposures at a different risk level to provide a sort of targeted level of withdrawals over time. And in looking at the managed payout funds, an investor has to consider "What's the trade-off I'm making?" Again, I mention trade-offs once before.

Here's the trade-off. The higher the amount of withdrawals I want to take now, the more I have to understand that that will lower the amount of growth I can expect going forward in my portfolio. And I really have to think about that.

So, yes there's one of the managed payout funds that has the highest payout that's called the Distribution Focus Fund. It’s focused on taking the distributions. At the opposite end of the spectrum, is a fund that’s bounced and diversified again, but with a growth target. It has a lower level of payout, and one can expect a higher rate of growth going forward. But it simplifies the process and tries to put it together in one place.

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